How to calculate the true cost of holding inventory
Most Indian manufacturers and distributors think of inventory cost as the purchase price of the goods. The true cost of holding inventory is substantially higher — typically 20–30% of inventory value per year — and understanding this changes how you make stocking decisions.
Inventory carrying cost has five components: capital cost (the interest you pay on the money tied up in inventory, or the return you're forgoing — typically 10–14% in India), storage cost (warehouse space, utilities, material handling equipment), insurance (goods in stock should be insured), obsolescence risk (the probability that the inventory loses value before it's used), and shrinkage (loss due to damage, theft, or expiry). Add these up for your specific situation.
Example: if your average inventory is ₹2Cr and your carrying cost rate is 25%, you're spending ₹50L per year just to hold that inventory. Every rupee of inventory reduction saves you ₹0.25 per year in carrying costs. A 20% inventory reduction saves ₹10L annually — often more than the revenue from a significant new customer.
This changes the economics of bulk buying. A 5% discount for buying 3 months' supply instead of 1 month's supply sounds attractive. But if your carrying cost rate is 25%, storing that extra 2 months of inventory costs you 25% × (2/12) × purchase value = 4.2% of the purchase value. Your net saving from the bulk discount is only 0.8%, and you've tied up working capital for 3 months.
It also changes the economics of dead stock decisions. If you have ₹20L of slow-moving stock that you could liquidate for ₹12L, the ₹8L loss feels painful. But if that stock will sit for another 2 years at 25% carrying cost, holding it costs ₹10L over those 2 years. Liquidating at a loss is the better financial decision.
Build carrying cost into your procurement analysis. Every buying decision that involves inventory should include the carrying cost of the inventory over its expected holding period, not just the purchase price.
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