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Inventory Costs

Inventory Costs Assignment / Homework Help
The costs associated with holding inventories fall into two basic categories:
  • Ordering costs and
  • Carrying costs

1) Ordering costs

Ordering cost is the cost associated with placing an order to the supplier. Apart from placing orders, the other costs related to ordering also form part of ordering costs. Such other costs are:
  • Cost of preparation of purchase order
  • Receiving, inspecting and recording the goods received to check the quantity and quality
  • Clerical costs and costs of stationery(set up cost)

The set up costs are generally fixed per order placed, irrespective of the amount of order. To minimize the ordering costs, a firm should place minimum number of orders possible. In case of produced items, ordering cost also includes scheduling cost

Ordering cost = S/Q x P

Where: S = Total Usage
Q = Quantity Per Order
P = Cost of Placing an Order

Example: Say, a company needs a lot of 2400 units per year. The cost of placing one order is $50. At different lot sizes, the ordering costs would be:

Order Size No. of orders Cost per order Total ordering cost
1200 2 $50 $100
800 3 $50 $150
600 4 $50 $200
400 6 $50 $300

The acquisition costs are inversely related to the size of inventory; they decline with the level of inventory. But a large order may decrease ordering costs while increasing carrying costs. In the above example, the first case of 1200 units will attract more carrying cost, although the ordering cost is the least.

2) Carrying cost

The costs involved in stocking the inventory like maintenance ad holding inventory come under carrying costs. Carrying costs can be further sub-divided into:
  • Costs associated with storing of Inventory

    This type of costs consists of
    • Storage cost like tax, depreciation, and insurance, maintenance of the building, utilities and janitorial services.
    • Insurance of inventory against fire and theft.
    • Deterioration in inventory because of pilferage, fire or technical, fashion obsolescence and price decline.
    • Serving costs like labor for handling inventory, accounting and clerical costs.
  • Opportunity cost of funds

    Opportunity costs refer to the interest lost which otherwise could have been earned if funds blocked in inventory are invested in interest-bearing securities.

    The carrying cost and the inventory size are positively related and move in the same direction. If the level of inventory decreases, the carrying costs will also decrease and vice versa.
Carrying cost = Q/2 x C

Where: Q/2 = Average quantity
C = Carrying cost per unit

Example: If the order sizes are 1200, 800, 600 and 400 as given in the above example, if price per unit is $10 and if the carrying costs are 20% of average inventory value:

Inventory Value Average Inventory Carrying cost (25%)
1200 x $10 = $12,000 $12,000 / 2 = $6,000 $6,000 x 25% = $1,500
800 x $10 = $8,000 $8,000 / 2 = $4,000 $4,000 x 25% = $1,000
600 x $10 = $6,000 $6,000 / 2 = $3,000 $3,000 x 25% = $750
400 x $10 = $4,000 $4,000 / 2 = $2,000 $2,000 x 25% = $500

From the above example it is clear that ordering cost increases with a decrease in order size and carrying cost increases with an increase in order size.

Total cost is the sum of ordering and carrying costs.
Total cost = Ordering costs + Carrying costs
Total inventory cost = SP/Q + QC/2

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