What is Inventory Holding Cost? Why is it important for your business's profitability

Why does Zepto sell only limited products? It must be great if they can sell every product in their store like Amazon does.

Let's take Zepto's business model. They make money by applying margins on a standard product. They can apply higher margins because of their value proposition - the delivery time.

This also means, any product that is not sold and lying in their stores will result in a loss. So, Zepto teams keeps only those fast moving products ordered frequently by customers. If they store more products,

1. Longer time to pick up products (more products to go through)

2. Larger stores needed

3. Working capital lock in (because unsold products are lying in the store)

So, it is in Zepto's interest to balance between

a) The smallest number of products which will keep the customer interested

b) The smallest quantity of these products they want to have to avoid stockouts.

A good measure of this is "Inventory Holding Cost". Inventory Holding Cost is the total cost you incur for storing a particular product. You would want to keep that as small as possible.

Calculating Inventory Holding Cost

Here is the formula for calculating inventory holding cost:

Inventory Holding Cost = Average Inventory Value x Carrying Cost Percentage

Where:

Average Inventory Value = The average value of inventory over a certain time period. This is calculated by adding the value of inventory at the beginning and end of the time period and dividing by 2.

Carrying Cost Percentage = The annual percentage cost of holding inventory. This includes costs such as storage space, inventory tracking, insurance, spoilage/obsolescence, and capital opportunity cost. A typical carrying cost percentage is 20-30%.

So putting it together in an example:

- Beginning inventory value: $100,000

- Ending inventory value: $80,000

- Time period: 1 year

- Carrying cost percentage: 25%

Average inventory value = ($100,000 + $80,000) / 2 = $90,000

Inventory holding cost = $90,000 x 0.25 = $22,500

So in this example, the inventory holding cost for the year is $22,500 or 25% of the average inventory value.

Where does this work?

This is not a new phenomenon. If you observe closely, a lot of great companies follow this methodology.

Homelane promises delivery in 45 days or they pay your rent. This is a great value proposition to customers but they can do this because they limit their inventory.

Similarly, the famous example is Costco, which stores only 4000 SKUs while the standard is to store 40,000 SKUs.

Where does this not work?

Take Amazon for example. Amazon's value proposition is that they sell everything. They can't use this model to win. So, they focus on a different kind of strategy which we will discuss in another post.

Hope this was helpful to you in understanding how Inventory costs work. If you're looking to optimize the way you manage inventory, you should look at ZORP Inventory. This is the world's only Inventory platform built from the ground up to optimize inventory.