Academic journal article Academy of Accounting and Financial Studies Journal

A Survey of Inventory Holding Cost Assessment and Safety Stock Allocation

Academic journal article Academy of Accounting and Financial Studies Journal

A Survey of Inventory Holding Cost Assessment and Safety Stock Allocation

Article excerpt


Inventory holding cost (IHC) and safety stock inventory (SSI) are critical to the effective management of inventory, and their quantification has impact at the highest levels of many manufacturing and service industries. This study demonstrates the necessity of accurately measuring and monitoring IHC. It is further demonstrated that knowledge of the underlying statistical pattern of supply and demand variations can significantly improve forecasting and impact the appropriate the levels of safety stock inventory in a variety of industries.


Controlling inventory is a fundamental purpose of supply-chain design for manufacturers. The key driver to the success of just-in-time (JIT) manufacturing is the minimization of work-in-process (WIP) inventory. This WIP inventory is minimized through an efficient matching of the manufacturing process and the rate of supply of component parts. Lean manufacturing systems are designed to minimize supply variability, both internally and externally, thereby minimizing concerns associated with inventory holding cost (IHC), and safety stock inventory (SSI) for raw materials and WIP. However, most businesses that carry inventory are unable to take advantage of the lean manufacturing concept. This concept is most applicable for firms who either mass produce make-to-stock finished goods or supply such firms. A prime example of this would be an automobile manufacturer and its first level suppliers. Most other firms are faced with the task of quantifying the costs associated with holding inventory, and deriving meaningful safety stock estimates for each particular product. For that reason, it is important for the remainder of firm types (even non-manufacturing firms) to give a diligent analysis to IHC and SSI, two very important elements of inventory management.


Inventory holding cost (IHC) is the variable cost of keeping inventory on hand, and is a combination of the costs associated with opportunity costs, storage, taxes, insurance, shrinkage, and other variables. Typically, the IHC is expressed as a percentage of the value of an item, which betrays that there may be a "fudge factor" associated with the IHC. In truth, few ultimately know its true value. Assigning a set percentage to IHC assumes that the IHC is linearly proportional to the amount of inventory held, when the rate itself very well may decay (or increase) with increasing quantities. In fact, IHC may change from one accounting period to the next. Failure to accurately determine IHC and use this cost to make decisions fails to recognize that inventory can represent one-third to one-half of a company's assets. A company with a 36% IHC will pay for the inventory twice in slightly more than two years: once to purchase it, and a second time to carry it for about 25 months. Hence, it seems problematic that nearly one half of companies do not use IHC to make their inventory management decisions. The IHC affects profitability, and may affect a company's business plan in terms of make-buy, or make-to-order/make-to-stock, as well as other top-level decisions (IOMA, Dec. 2002).


A part of the holding cost should include the actual cost of the item, and in many ways, it does. Cost of capital (opportunity cost) is the main component of holding cost that considers the item cost. In fact, the calculation of holding cost should ideally be divided between the price-dependent and quantity-dependent components, namely:

Inventory Holding Cost (Price, Quantity) = Cost(Price) + Cost(Quantity)

This quantity cost would include the allocations from overhead that affect all physical inventory to one extent or another. However, in practice, most stocking strategies do not incorporate the cost of the item; and as a result, expensive items are stocked the same way as cheap ones.

Calculating holding costs differs from industry to industry, but a general method can be illustrated from the used vehicle sales sector. …

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