Holding Cost Determination - an Activity Based Cost Approach

We consider the problem of choosing the holding cost in inventory models. Traditionally, the cost of holding inventory is assumed to increase linearly with a rate that is equal to a percentage of the product value. This since the capital cost is believed to make up the main part of the cost. However, recent research indicates that this is not necessarily the case. In the present work, we present a more general model of the cost of holding inventory based on a microeconomic framework. A method for determining a suitable holding cost per unit and time unit, h, which can be used in existing heuristics/formulas is derived. The method is based on the ideas behind activity-based costing (ABC). The suggested method works well in the considered numerical examples (maximum and average cost increase is 1.78% resp. 0.08%). There exist situations where the traditional approach, i.e., setting h as a percentage of the product value, gives rise to a significant cost increase (> 15%).