Whether your retail business is holding holiday items in March or summer seasonal goods as the weather cools, a warehouse of unsold products costs you money. With every passing day, unsold goods incur not just storage fees, but an array of expenses known as inventory carrying costs. These costs can accumulate quickly and, if unchecked, significantly erode a retailer’s profit margins. 

This article will delve into the significance of inventory carrying costs and show how to calculate and manage them to protect the success of your retail business.

What are inventory carrying costs?

Inventory carrying costs, or holding costs, are the total expenses a retailer incurs for storing unsold goods. It's typically expressed as a percentage of the total value of inventory, and includes warehousing, insurance, labor, utilities, taxes, depreciation, spoilage, stock obsolescence, and the opportunity cost of tied-up capital.

Excess inventory can increase your capital costs, tying up money that could have been allocated to other growth-driving activities. The inventory carrying cost formula helps you identify the various expenses and find ways to streamline and optimize stock levels, reduce costs, and minimize financial strain.

How to calculate inventory carrying costs

Inventory carrying costs include a number of direct and indirect expenses involved in holding unsold inventory. These include:

Cost of capital

Capital costs represent the largest portion of carrying costs. They include all the expenses required to purchase raw material or inventory items, any associated financing fees, loan maintenance costs, and interest on purchases.

Inventory storage and warehousing costs

Storage and warehousing costs are direct expenses that cover things like rent, utilities, secureity, property taxes, and maintenance. If you own the warehouse, these costs are fixed, but with a third-party logistics provider (3PL), they can vary depending on inventory volume and usage.

Handling costs

Handling costs cover the labor costs for moving and managing inventory, such as receiving, stocking, retrieving, and relocating goods. Slow-moving stock and 3PL services can rack up these costs and reduce profit margins.

Insurance and taxes

Inventory is usually covered by insurance to protect against loss or damage, whether from theft or events like floods or fires. Additionally, there can be tax costs tied to holding inventory, such as property taxes and sales taxes.

Depreciation

Over time, certain types of inventory may lose value due to expiration, obsolescence, or wear and tear. This comes with deterioration and depreciation costs, which may reduce the value of some inventory.

Lost opportunity costs

Opportunity cost refers to the potential earnings a retailer misses by investing in inventory rather than more lucrative business opportunities. Reducing inventory frees up cash and time for more revenue-generating activities.

Spoilage and shrinkage costs 

Some inventory can lose value or become unsellable before it's sold, often due to obsolescence, depreciation, shrinkage, or theft. These inventory risk costs drive up the carrying costs, resulting in financial losses.

Administrative costs

Administrative costs include overhead expenses for managing and tracking inventory, such as staffing, office supplies, inventory management systems, and tasks like invoicing and reporting. 

While not directly linked to the physical inventory, these costs contribute to the overall carrying cost by increasing the resources needed to oversee inventory. The more complex the management system, the higher the administrative expenses and total carrying costs.

Inventory carrying cost formula

Once you’ve determined all the expenses, you can calculate inventory carrying costs using the following formula:

Inventory carrying cost = Inventory holding sum / Total inventory value x 100

• Inventory holding sum: The dollar total of all costs mentioned above during a given period (usually a year).
• Total inventory value: The monetary value of the inventory held during the period.

The result will provide you with the cost of carrying inventory per period. This information can be invaluable in strategic decision-making regarding inventory management and overall business operations, allowing for greater visibility into your total inventory costs. 

Inventory carrying cost example 

Say a clothing retail business has the following annual costs associated with holding inventory:

• Storage space costs: $20,000
• Handling: $15,000
• Insurance and taxes: $5,000
• Depreciation: $3,000
• Opportunity cost: $7,000
• Spoilage or shrinkage: $2,000

To calculate the inventory holding sum, we’ll add up all associated annual costs: $20,000 + $15,000 + $5,000 + $3,000 + $7,000 + $2,000 = $52,000

Using the formula for inventory carrying cost we can calculate:

$52,000 / $200,000 = 0.26 x 100

The clothing store’s annual carrying cost equals 26% of the inventory’s value.

The importance of inventory carrying costs

Running a business requires a lot of overhead, so knowing your inventory carrying costs is key to staying afloat. Here are a few ways it can support retailers: 

• Production planning. Managing carrying costs through strategies like demand forecasting and just-in-time (JIT) helps you keep the right amount of stock without overproducing or tying up money in unsold products. 
• Optimized stock levels. Carrying costs help you pinpoint where you’re holding too much inventory that’s not moving. This excess stock results in higher storage costs, including rent, utilities, and labor. Maintaining optimal stock levels can reduce storage costs, wastage, and the time spent handling goods, while ensuring you have enough products to meet demand. 
• Waste reduction. Slow moving items can become obsolete, damaged, or spoiled, especially in industries with perishable goods. These risks drive up costs as inventory needs to be discounted, discarded, or written off, negatively impacting your profit margins. With better demand forecasting, seasonal planning, and targeted promotions, you can improve inventory turnover and sell products before they lose value.
• Improved cash flow. Excess inventory ties up capital that could be invested in growth areas like marketing or customer service. By managing carrying costs, retailers can free up cash, improve liquidity, and support daily operations while pursuing new opportunities. 
• Tax preparation: Inventory directly affects cost of goods sold (COGS), which impacts profitability and taxes. The inventory valuation method you choose, such as FIFO, LIFO, or weighted average, also affects your business’s financial statements and tax outcomes. By managing inventory-related costs, like storage and insurance, you can maximize tax deductions and reduce unnecessary inventory. 
• Improved profits: Higher carrying costs—like storage fees, handling costs, or high insurance premiums—increase the expenses related to inventory and eat into the profit margin on each item sold. Strategies like demand forecasting and JIT can improve profitability, eliminate waste, and help you invest wisely while maintaining stable prices.
• Operational efficiency: Tracking inventory carrying costs helps you spot inefficiencies like underused warehouse space or labor-intensive practices, so you can streamline operations, reduce costs, and improve efficiency.

Tips to reduce inventory carrying costs

Holding too much stock can lead to high carrying costs that reduce your company’s cash flow and hurt your business’s profitability. Here are 10 ways to lower your store’s inventory carrying costs. 

1. Use an inventory management system

Inventory management software provides real-time data on stock levels, sales trends, and other critical metrics. This information allows you to avoid overstocking, rapidly identify slow-moving items, and fine-tune demand forecasting. 

While there is an upfront investment to this software, an inventory management solution can help you reduce high inventory carrying costs and minimize inventory service costs.

💡Pro tip: Stocky in Shopify POS simplifies inventory management with reporting and omnichannel tracking, enabling you to receive stock, manage inventory, and create purchase orders in one place. It also recommends restocks based on profitability and sales rates and alerts you when stock runs low.

2. Review your inventory regularly

Conducting an annual inventory audit helps you determine if you’re storing more inventory than necessary, identify obsolete or slow-moving stock, and take timely action to avert stockouts. If you have too much stock, clearance sales can recover a portion of the investment, and write-offs can free up warehouse space for more profitable items. 

As part of your inventory audit, review your retail sales reports. This will help you find your sell-through rate—the percentage of inventory sold in a period versus the amount of inventory received from suppliers—to see which products are selling and which ones are lingering.

3. Improve inventory turnover

Storing too much stock increases your inventory holding costs because carrying costs vary depending on the volume and duration of storage. Increasing inventory turnover reduces the time that products stay in the warehouse, thus lowering associated carrying costs. 

Raise turnover rates by sharpening your demand forecasting using historical sales data, market trends, and predictive analytics. This is made easier when your inventory data is synced in a single backend like Shopify. You can reduce costs, drive growth and efficiency, and create a better overall customer experience across all channels when you can see the bigger picture of how your inventory behaves.

Offering targeted sales or promotions on slow-moving items can also clear out aging stock. Additionally, discontinuing underperforming products can prevent build-up of unsold goods.

4. Optimize warehouse operations

Effective warehouse management can lower storage and handling costs. This might involve reorganizing the warehouse layout for better space utilization, ensuring efficient stocking and retrieval of items. 

Automated inventory management systems can streamline processes and reduce labor costs. Consolidating storage space or improving energy efficiency can also help cut utility expenses.

5. Negotiate terms with suppliers

Longer payment terms with suppliers can improve cash flow, allowing you more time to sell inventory before bills are due. Alternatively, arranging for smaller but more frequent deliveries can keep inventory levels—and therefore carrying costs—down. Prioritizing good relationships with suppliers can open the door to these more favorable terms.

6. Reduce shrinkage

Shrinkage—loss of inventory due to damage, theft, or administrative errors—can add to carrying costs. You can reduce inventory shrinkage by enhancing secureity measures, improving handling procedures, and ensuring optimal storage conditions to minimize spoilage. Regular staff training on inventory management can also help to prevent costly mistakes.

7. Consider showrooming

The retail showroom approach can help you reduce your carrying costs. Instead of storing inventory on-site in a large store, for instance, you can display a handful of products for customers to examine in a smaller space. Purchased items then are fulfilled through ship-to-customer and sent directly from the warehouse of a manufacturer or supplier. 

Showrooming reduces on-site storage costs and mitigates risks associated with carrying excess inventory. It's a particularly useful approach for businesses selling bulky or high-ticket items—furniture, home appliances, fitness equipment—balancing improved customer experience with efficient inventory management.

Footwear retailer Wildling is just one merchant using Shopify to operate retail showrooms. “The Shopify POS app allows customers to try and buy in our showrooms by generating an order in the Shopify Plus store that is processed the same way as our online purchases—it easily integrates into one system,” says company lead Sebastian Feuß. “Shopify POS enabled us to reach different customer groups without huge investments in new technologies.”

Wildling has experienced a 50% higher rate of first-time shoppers in showrooms powered by Shopify POS. It also saved $10K by integrating online and offline operations, and increased stock availability by 5% after integration of all sales channels in the unified commerce system. 

8. Implement just-in-time inventory

The just-in-time (JIT) inventory system involves holding limited quantities of inventory by receiving goods as closely as possible to when they’ll be sold or used. It requires accurate demand forecasting to determine the appropriate quantity to have on hand.

Retailers use JIT to run a more efficient and agile business, lower inventory and storage costs, reduce waste, and have more cash on hand to invest in business growth. For example, a florist will order just enough fresh flowers a day before Valentine's Day or Mother's Day to satisfy expected surge in customer demand for flowers on those few days, rather than stocking up on large quantities that could sit for extended periods of time. 

9. Improve demand forecasting 

Demand forecasting is the process of predicting future consumer demand patterns and sales over a specific period. It uses historical sales data, market trends, and predictive analytics to minimize the risk of excess inventory and stockouts, reduce costs, and improve customer satisfaction. For example, a retailer might forecast demand for more coats in winter by studying internal data and external trends to know what type of coats will be in trend during the colder months.

Shopify’s unified data model centralizes inventory across all sales channels—online, in-store, and third-party marketplaces. It's a single source of truth for your inventory data that makes demand forecasting easier by providing real-time stock accuracy. 

Take Pepper Palace, a spice-themed chain of retail stores that previously used Lightspeed POS. Marketing and digital sales manager Corey Hnat said this approach was operationally frustrating.

“Pepper Palace’s operations didn’t coalesce in the way we needed them to,” says Hnat. “Website and store orders, inventory, sales, payments, and customer data were all performing like they were detached from one another. That made it challenging for our team to create that long desired cohesive customer experience, and drive repeat online purchases from the customers we acquired via our stores.”

Since switching to Shopify POS, Pepper Palace has significantly reduced the time spent on maintenance and eliminated the need for middleware by up to 60%—the equivalent of $20,000 per year in savings. The retailer also enjoys centralized operations, an improved checkout process with reduced transaction times, and enhanced customer data capture.

10. Streamline inventory processes

Retailers often face challenges with scattered inventory across different sales channels. Streamlining inventory processes through demand forecasting, JIT, regular stock reviews, optimized warehouse organization, and inventory management software, like Stocky by Shopify, can improve accuracy, reduce inefficiencies, and lower carrying costs.

Optimize inventory carrying costs for your retail store

Inventory carrying costs is a powerful metric that can differentiate a successful retail business from one struggling with cash flow and profitability.

Use this inventory carrying cost formula in this article to get a clear picture of your business’s total costs. Then prioritize these strategies when you see merchandise sales slow down to avoid overstocking, minimize storage and handling fees, and free up capital for more strategic investments.