Inventory holding cost, also called carrying cost, is the annual cost of keeping inventory rather than converting that cash into another productive use. It can include the cost of capital, storage, insurance, handling, damage, shrinkage and obsolescence.
Economic Order Quantity (EOQ) is a simple inventory model that balances ordering cost against holding cost to estimate the order quantity that minimises their combined annual cost under a specific set of assumptions.
What Is Included in Inventory Holding Cost?
| Cost Component | Examples |
|---|---|
| Cost of capital | Financing cost or opportunity cost of money tied up in stock |
| Storage | Warehouse space, utilities and inventory-related facility cost |
| Service cost | Insurance, taxes and inventory administration where applicable |
| Risk cost | Obsolescence, expiry, damage, deterioration and shrinkage |
Companies should define their carrying-cost methodology consistently. Avoid double-counting an expense—for example, if shrinkage is already included in the annual carrying-cost percentage, do not add the same shrinkage again as a separate EOQ holding-cost component.
Holding Cost Rate
If average inventory value is BHD 100,000 and the company estimates annual inventory carrying costs of BHD 18,000:
Holding cost rate = 18,000 ÷ 100,000 = 18% per year
This percentage can then be used to estimate annual holding cost for stock values or converted into a per-unit annual holding cost for EOQ.
Cost of Capital vs Hurdle Rate
A hurdle rate is a financial return threshold used in investment decisions. It is not automatically the same as the inventory carrying-cost rate. However, the organisation’s cost of capital or opportunity-cost assumption can be one component of carrying cost because money invested in inventory cannot simultaneously be used elsewhere.
Economic Order Quantity Formula
The standard EOQ formula is:
EOQ = √((2 × D × S) ÷ H)
Where:
- D = annual demand in units
- S = ordering or setup cost per order
- H = annual holding cost per unit
Corrected EOQ Worked Example
Assume:
- Annual demand = 10,000 units
- Ordering cost = BHD 20 per order
- Annual holding cost = BHD 5 per unit
EOQ = √((2 × 10,000 × 20) ÷ 5)
EOQ = √80,000 ≈ 283 units
The earlier version of this article incorrectly showed approximately 632 units for these inputs. The correct result is about 283 units.
What Happens at the EOQ?
With an EOQ of about 283 units:
- Approximate orders per year = 10,000 ÷ 283 ≈ 35.3 orders
- Average cycle stock = 283 ÷ 2 ≈ 141.5 units
- Annual ordering cost ≈ 35.3 × 20 = BHD 706
- Annual cycle-stock holding cost ≈ 141.5 × 5 = BHD 708
The two costs are approximately equal at the EOQ, which is the balancing logic behind the formula.
EOQ Does Not Include Safety Stock by Itself
EOQ determines a replenishment quantity. It does not determine when to order and does not automatically calculate safety stock.
A common continuous-review system combines:
- EOQ for order quantity, and
- Reorder point for order timing.
If safety stock is held, average total inventory is often approximated as:
Average inventory ≈ EOQ ÷ 2 + Safety stock
EOQ Assumptions
The basic EOQ model assumes conditions such as:
- Relatively stable demand.
- Known ordering cost.
- Known annual holding cost.
- No major quantity-discount effect.
- Replenishment arrives as planned.
- No deliberate shortages in the basic model.
Real supply chains may violate several of these assumptions, so EOQ should be treated as a useful starting point rather than an automatic purchasing rule.
Shrinkage
Shrinkage is inventory that is recorded but cannot be physically accounted for because of theft, damage, transaction errors or other losses.
If recorded inventory is worth BHD 500,000 and annual verified shrinkage is BHD 25,000:
Shrinkage rate = 25,000 ÷ 500,000 = 5%
That 5% loss can materially increase the economic cost of holding stock and should trigger root-cause action rather than simply being accepted as a carrying cost.
How to Reduce Holding Cost Without Creating Stockouts
- Improve forecast and demand-parameter quality.
- Reduce supplier and internal lead times.
- Use appropriate order quantities rather than blanket MOQs.
- Improve inventory accuracy.
- Review slow/non-moving and obsolete stock.
- Segment service levels by item criticality and value.
- Improve supplier reliability so unnecessary buffers can be reduced.
- Use VMI or consignment where commercially suitable.
Useful KPIs
- Inventory turns
- Days of supply
- Inventory carrying-cost percentage
- Excess and obsolete inventory
- Shrinkage rate
- Stockout / service level
- Order frequency
- Average order quantity
Common Interview Question
Question: What does EOQ optimise?
Strong answer: Basic EOQ estimates the order quantity that minimises the combined annual ordering and cycle-stock holding cost under its assumptions. It does not by itself calculate safety stock or reorder timing, so I would normally use it together with lead-time and service-level policies.
Related SCMANA Guides
Download the Practical Workbook
Use the SCMANA EOQ & Holding Cost Calculator to calculate EOQ, annual ordering cost, annual holding cost and related inventory economics.
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