The following costs are used for inventory management decisions:
- Item Cost
- Carrying Costs
- Ordering Costs
- Stockout Costs
- Capacity-associated costs
Item cost is the price paid for a purchased item, which consists of the cost of the item and any other direct costs associated in getting the item into the plant. These could include such things as transportation, custom duties, and insurance. The inclusive cost is often called as landed price. For an item manufactured in-house, the cost included direct material, direct labor, and direct factory overhead. These costs can usually be obtained from either purchasing or accounting.
Carrying cost includes all expenses incurred by the firm because of the volume of inventory carried. As inventory increases, so do these costs. They can be broken down into three categories:
- Capital Costs. Money invested in inventory is not available for other uses and as such represents a lost opportunity cost. The minimum cost would be the interest lost by not investing the money at the prevailing interest rate, and it may be much higher depending on investment opportunities for the firm.
- Storage Costs. Storing inventory requires space, workers, and equipment. As inventory increases, so do these costs.
- Risk Costs. The risks in carrying inventory are:
- Obsolescence; loss of product value resulting from a model or style change or technology development.
- Damage; inventory damaged while being held or moved.
- Pilferage; goods lost, strayed, or stolen.
- Deterioration; inventory that rots or dissipates in storage or whose shelf life is limited.
What does it cost to carry inventory? Actual figures vary from industry to industry and company to company. Capital costs may vary depending upon interest rates, the credit rating of the firm, and the opportunities of the firm may have for the investment. Storage costs vary with location and type of storage needed. Risk cost can be very low or can be close to 100% of the value of the item for perishable goods. The carrying cost is usually defined as a percentage of the dollar value of inventory per unit of time (usually one year). Textbooks tend to use a figure of 20-30% in manufacturing industries. This is realistic in many cases but not with all products. For example, the possibility of obsolescence with fad of fashion items is high, and the cost of carrying such items is high.
Ordering costs are those costs associated with placing an order either with the factory or a supplier. The cost of placing the order does not depend upon the quantity ordered. Whether a lot of 10 or 100 ordered, the costs associated with placing the order are essentially the same. However, the annual cost of ordering depends upon the number of orders placed in a year.
Ordering costs in a factory include the following:
- Production Control Costs. The annual cost and effort expanded in production control depends on the number of orders placed, not on the quantity ordered. The fewer orders per year, the lesser the cost. The costs incurred are those of issuing and closing orders, scheduling, loading, dispatching, and expediting.
- Setup and Teardown Costs. Every time an order is issued, work centers have to set up to run the order and tear down the setup at the end of the run. These costs do not depend upon the quantity ordered but on the number of orders placed per year.
- Lost Capacity Cost. Every time an order is placed at a work center, the time taken to set up is lost as productive output time. This represents a loss of capacity and is directly related to the number of orders placed. It is particularly important and costly with bottleneck work centers.
- Purchase Order Cost. Every time a purchase order is placed, costs are incurred to place the order. These costs include order preparation, follow-up, expediting, receiving, authorizing payment, and the accounting cost of receiving and paying the invoice.
The annual cost of ordering depends upon the number of orders placed in a year. This can be reduced by ordering more at one time, resulting in the placing of fewer orders. However, this drives up the inventory level and the annual cost of carrying inventory.
If demand during the lead time exceeds forecast, we can expect a stockout. A stockout can potentially be expensive because of back-order costs, lost sales, and possibly lost customers. Stockouts can be reduced by carrying extra inventory to protect against those times when the demand during lead time is greater than forecast.
Capacity Associated Costs
When output levels must be changed, there may be costs for overtime, hiring, training, extra shifts, and layoffs. These capacity associated costs can be avoided be leveling production, that is, by producing items in slack periods for sale in peak periods. However, this builds inventory in the slack periods.