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I'm working on a model for inventory management. I'm trying to decide for each unit if it is worth holding, or if it should be liquidated at a cost $x$.

I'm wondering about the argument that marginal holding cost for any unit are 0, because the warehouse is there, the unit is there, etc., so there is no real cost of holding an additional unit in the warehouse other than cost of capital, with the exception that the last units that fit in start creating opportunity cost.

That seems intuitively right, but brings me to the problem that I have the incentive of keeping stock with extremely high reaches - which seems intuitively wrong.

Am I missing something? Is it "mathematically" correct to assume the first unit in the warehouse has all the marginal cost of the entire warehouse cost? How can I model this correctly? Is there literature on this?

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    $\begingroup$ I think it is related to the "Opportunity Cost". If you do not hold inventory, but use the money to investment. Assume that the investment return is 5%, then we can say the marginal cost of storage is 5%. Furthermore, higher inventory requires larger warehouses which can also incur the opportunity cost. $\endgroup$ May 19 at 13:18
  • $\begingroup$ I think there is opportunity cost if you run out of space to buy more , and there is cost of capital which might be viewed as opportunity cost as well. What I’m unsure about is how to get to marginal cost at a state where the warehouse isn’t full $\endgroup$
    – Jan
    May 19 at 15:23

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Cost of capital is one component of holding cost, but not always the only one. If the product is subject to degradation (for instance, produce that goes bad over time), that factors into holding cost. If there is loss due to pilferage or other reasons, that contributes. If the company insures the contents of the warehouse, it is possible (I think) that the cost of the insurance might factor into holding cost. I would be inclined to ask an accountant how holding cost is computed.

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  • $\begingroup$ Thank you very much! I’ll consider pilferage, I haven’t thought about this before, same goes for the insurance. Funny enough, I posted this question because two accountants in my company don’t agree on how to calculate this. One says cost of warehouse divided by all the products weighted by volume of the products, the other one thinks it’s zero. It seems there is room for belief in this. $\endgroup$
    – Jan
    May 20 at 9:53
  • $\begingroup$ One more wrinkle I didn't think of the first time. For some products, it is possible that they lose value while sitting around due to market volatility. For instance, a current model smart phone sitting in a warehouse abruptly loses value if a newer model is released. So expected reduction in sale price (or probability the value flat lines if you may be unable to sell the product due to a market shift) could contribute. Re accountants disagreeing: I am shocked, simply shocked. :-) $\endgroup$
    – prubin
    May 20 at 14:44

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