What Is Inventory Carrying Cost And How to Reduce It?

Inventory carrying costs can quietly drain your profits. Knowing what these costs are—and how to reduce them—can make a big difference for your business. In this guide, we’ll explain inventory carrying cost, how to calculate it, and share simple strategies to help you save money and boost your bottom line.

What is inventory carrying cost?

Inventory carrying cost, or holding cost, refers to the total expense a business incurs to store and maintain raw materials and unsold goods over time. These costs can add up quickly and impact your company’s cash flow and profitability. Understanding carrying costs can help businesses make informed decisions that allow them to reduce expenses and optimize inventory levels.

Components of carrying cost

According to La Londe and Lambert’s “Inventory Carrying Costs: Significance, Components, Means, Functions”, there are four main components of inventory carrying costs:

Storage costs

Storage costs are expenses for warehousing and maintaining storage space for inventory. These costs include rent, utilities, and the upkeep of warehouse space and other storage facilities.

Inventory risk costs

Inventory risk costs are expenses related to the risks a company assumes when holding inventory. These costs arise from potential losses that can occur while goods are stored. Risk costs include shrinkage (loss from theft or damage), obsolescence (items becoming outdated), and depreciation (value of inventory decreasing). Higher inventory levels increase these risks. 

Inventory service costs

Inventory service costs are expenses related to the services that support your inventory, such as insurance, taxes, and labor costs for inventory handling and managing. 

Capital costs

While carrying cost does not directly include the money spent on purchasing inventory, it does include other capital costs, such as opportunity costs. Opportunity cost is the difference between the return on the purchased inventory and the return on the best investment option foregone in favor of purchasing the inventory.

For example, let’s say you purchase a certain amount of inventory that would yield you $10,000 in revenue. However, you may determine that spending that money on advertising could have brought in $15,000 worth of business. The opportunity cost in this case would be $5,000.

In addition, capital costs could also include the interest paid on inventory. 

Why reducing inventory carrying costs matters

High inventory carrying costs can drain your cash flow, cut into profitability, and create challenges like excess inventory. When too much inventory sits in storage, it ties up valuable resources that could be invested elsewhere in your business. Beyond locking up capital, overstocking also increases storage costs and exposes inventory to risks like shrinkage, obsolescence, and depreciation.

Effective inventory management transforms these challenges into opportunities. By lowering carrying costs, you free up cash flow that can be redirected toward innovation or growth. Optimizing inventory levels means less warehouse space is needed so you can reduce your storage and utility expenses. Streamlining inventory cuts costs and makes your entire operation leaner.

Specifically, breaking down the primary carrying costs will help you spot areas for improvement in the following categories:

1. Storage costs. Are you paying more than necessary for storage? Reviewing storage expenses can reveal inefficiencies in your use of warehouse space. High inventory storage costs might indicate that you’re holding too much inventory or that your space could be better organized.
2. Inventory risk costs. Is your inventory vulnerable to loss or depreciation? Analyzing risk costs helps you identify areas of vulnerability, like shrinkage, obsolescence, or depreciation.
3. Inventory service costs. Are you spending too much on insurance and services for your inventory? Service costs like insurance and taxes can add up quickly, especially if you’re holding more stock than needed. 
4. Capital costs. Would you be better off buying more inventory and investing the money somewhere else? Reviewing your capital costs can help you determine if your inventory levels are aligned with your business goals and whether you should reduce stock to free up funds for higher-return opportunities.

How to calculate inventory carrying cost

Calculating your inventory carrying costs isn’t just about understanding the numbers—it’s about uncovering hidden expenses that may be quietly eating into your profits. Knowing these costs helps you understand how much of your cash flow is tied up in maintaining inventory over time. This can reveal valuable insights into the efficiency of your inventory management. High carrying costs can often indicate overstocking, inefficient storage, or slow inventory turnover.

You can determine your carrying cost by pooling together the aforementioned components of carrying cost. Then, you can calculate your carrying cost rate.

The inventory carrying cost rate formula is very straightforward:

Inventory Carrying Cost (%) = (Total Carrying Cost ÷ Total Inventory Value) × 100

This formula shows your carrying cost as a percentage of your total inventory value. This percentage clearly indicates what portion of your inventory’s worth is dedicated to inventory holding expenses.

Example calculation:

Imagine your total inventory value is $500,000, with the following carrying costs:

Storage costs: $10,000

Inventory risk costs: $5,000

Inventory service costs: $3,000

Capital costs: $60,000

Adding these gives a total carrying cost of $78,000. Using the formula:

Inventory Carrying Cost (%) = (78,000 ÷ 500,000​) × 100 = 15.6%

This 15.6% carrying cost percentage shows how much you’re spending just to keep inventory on hand. Tracking this number regularly can help you identify inefficiencies, reduce unnecessary expenses, and make better financial decisions that improve cash flow and profitability.

What is the perfect carrying cost rate?

Inventory carrying cost rates can vary significantly per industry, company size, and specific inventory practices. These rates typically range from 12% to 35% of the inventory’s value. For instance, a study published in the International Journal of Physical Distribution & Logistics Management notes that managers often use industry benchmarks within this range or textbook figures around 25% when estimating carrying costs. 

It is important to recognize that these figures are general estimates. The actual carrying cost rate for a specific business should be determined by analyzing its unique cost components, including capital costs, storage expenses, service costs, and risk factors. Accurate assessment of these elements is essential for effective inventory management and cost control.

For a more detailed analysis, Cory Lynn Harms’s thesis, “A Comparison of Inventory Carrying Cost in Literature and in Practice,” provides an extensive review of inventory carrying cost percentages reported in literature and their application in real-world scenarios. 

Using the inventory carrying cost rate as a KPI

A key performance indicator (KPI) is a measurable value that shows how effective you are at achieving a specific business objective. In inventory management, using inventory carrying cost as a key metric helps track how efficiently your business is handling stock and associated costs. For example, a high carrying cost percentage might indicate issues like excess inventory, underused warehouse space, or stock nearing obsolescence—all of which can drain cash flow. A low carrying cost percentage, on the other hand, suggests effective inventory control and optimized warehousing.

Here’s how to use inventory carrying cost as a KPI effectively:

1. Start by calculating your inventory carrying cost percentage at regular intervals (such as monthly or quarterly) to establish a baseline. Use the above formula for calculating inventory carrying cost. This percentage reveals how much of your inventory’s value is dedicated to holding costs and gives you a clear benchmark for comparison over time.
2. Set a target range for your KPI based on industry standards or internal business goals. Defining a target range helps you determine what “healthy” carrying costs look like and gives you a goal to work toward. According to the Association for Supply Chain Management (ASCM), inventory carrying costs typically fall within the range of 15-25%, though this can vary based on the industry and specific business needs. 
3. Break down the components of your carrying cost—capital, storage, risk, and service costs—to see which areas are contributing most to the overall percentage. For example, high storage costs may indicate inefficient use of warehouse space, while rising risk costs may signal issues like shrinkage or obsolescence. Identifying these factors will help you address specific cost drivers.
4. Track the KPI regularly to monitor trends and identify patterns. If your carrying cost percentage begins to rise, it could indicate overstocking, inefficient storage, or slow-moving inventory. Monitoring trends can alert you early to issues before they escalate and drain your cash flow.
5. Use the insights from your KPI analysis to make adjustments. If storage costs are high, reduce excess inventory to free up space and lower expenses. You can also optimize warehouse layout or inventory turnover. By fine-tuning these areas, you can gradually reduce carrying costs.
6. Track your inventory carrying cost KPI over time to see if your changes are working. If the percentage steadily goes down, it shows you’re improving inventory management. However, if it stays within your target range, your current practices are effective.

Regularly monitoring this KPI will make it easier for you to spot trends and adjust inventory levels to better align with demand.

Key strategies to reduce inventory carrying costs

Reducing inventory carrying costs requires efficient inventory management practices. Here are some key strategies to help lower these costs while maintaining the right amount of stock:

Implement demand forecasting and planning

Accurate demand forecasting is crucial for optimizing stock levels and avoiding overstocking. By predicting customer demand, you can order just enough to meet needs without holding excess inventory. This minimizes costs associated with unsold goods and frees up capital for other operations.

Use an inventory management system

A real-time inventory management system helps monitor stock levels, track trends, and identify slow-moving items. Using inventory management software to automate these processes improves accuracy, reduces errors, and enables quick adjustments to stock based on demand. Advanced systems also provide valuable data to refine reorder points and improve inventory turnover.

Optimize safety stock and reorder points

Balancing safety stock is critical to avoid stockouts without holding unnecessary inventory. Setting reorder points based on supplier lead times and customer demand ensures that inventory is replenished efficiently. This strategy reduces the risk of overstocking and lowers carrying costs.

Minimize storage space costs

Efficiently organizing warehouse space can reduce storage costs. Techniques such as improving shelving systems, adjusting warehouse layouts, or even relocating high-demand items to accessible locations within the warehouse can reduce the space needed to store inventory. If you lease warehouse space, reducing inventory levels can allow you to downsize to a smaller, more cost-effective facility.

Improve warehouse layout and processes

A poorly designed warehouse layout can increase operational costs and reduce productivity. Optimizing layouts by segmenting areas, improving the reception zone, or incorporating vertical storage solutions can lower carrying costs while simultaneously boosting efficiency. 

Build long-term supplier relationships

Negotiating long-term agreements with suppliers can reduce carrying costs in several ways. By negotiating terms such as more frequent and flexible deliveries, you can minimize the need to store large amounts of inventory at once. Smaller, regular shipments reduce storage requirements and the risks of shrinkage and depreciation. Additionally, a solid relationship with suppliers may provide opportunities for bulk pricing discounts, even if shipments are delivered in smaller quantities. 

Control inventory turnover

Improving inventory turnover by focusing on high-demand items and eliminating excess inventory can reduce costs related to shrinkage, obsolescence, and depreciation while also reducing your need for ample storage space. Regularly reviewing stock performance enables you to prioritize what sells so you can prioritize profitability.

Key takeaways

• Inventory carrying cost includes all expenses incurred to store and maintain inventory, encompassing storage, risk, service, and capital costs. Understanding these costs is essential for managing cash flow and profitability.
• Capital costs in carrying costs refer not to the purchase price of inventory but the opportunity cost of tying up funds that could yield higher returns elsewhere or incur interest when not bought out immediately.
• The carrying cost percentage provides insights into the efficiency of inventory management. A typical range is 12-35%, varying by industry.
• The formula for determining carrying cost is straightforward, dividing total carrying costs by total inventory value and multiplying by 100 to express it as a percentage.
• High carrying costs can lead to overstocking, cash flow issues, and inefficiency. Strategies like demand forecasting, inventory management systems, and optimizing storage space help reduce these costs.
• Tracking carrying costs over time as a KPI helps businesses identify inefficiencies, optimize inventory levels, and make informed financial decisions.
• Practical approaches include improving warehouse layout, negotiating better supplier terms, and focusing on inventory turnover to minimize risks and storage needs.

Frequently asked questions (FAQ)

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