Inventory Costs

Stephen Otieno

Inventory Costs

Inventories have tangible and intangible costs.
Item costs (direct material, direct labour, overhead, transportation, custom duty, and insurance), carrying costs, ordering costs, shortage costs, and capacity costs are all tangible inventory costs.

Inventory costs are important for three main reasons:
1. Inventory costs represent a significant component of total costs of goods sold in many organizations (the cost of inventory comprises up to 80% of the total costs of goods sold).
2. The inventory levels may affect the level of service the firm is capable of providing to its customers. Too much of the wrong inventory might limit a company’s ability to stock the right items.
3. The cost trade-off decisions frequently depend on and ultimately affect inventory costs as discussed below.
4. Inventory costs represent a significant component of total costs of goods sold in many organizations (the cost of inventory comprises up to 80% of the total costs of goods sold). Excessive and obsolete inventory build-up has a negative impact on cash flow and profitability of a company and ultimately viability and survival.
5. The inventory levels may affect the level of service the firm is capable of providing to its customers. Too much of the wrong inventory might limit a company’s ability to stock the right items.
6. The cost trade-off decisions frequently depend on and ultimately affect inventory costs as discussed below.

Types of Inventory Costs

Ordering Cost

- Ordering costs are the costs associated with placing an order with the factory or a supplier.
- The ordering cost does not depend on the quantity ordered.
- It is a composite of all costs related to placing purchase orders or preparing shop orders. Costs like:
  - Paperwork,
  - Work station setups,
  - Inspection, scrap, and rework associated with setups,
  - Record keeping for work-in-process.

Carrying Costs

Carrying cost is the total of costs related to maintaining the inventory, including
- Capital cost invested in inventory, or foregone earnings of alternate investment,
- Storage costs for space, equipment, and people,
- Inventory service costs such as taxes and insurance on inventory,
- Obsolescence costs typically based on inventory value loss or losing value altogether, and therefore having to be scrapped. This can be caused by market, design, or competitors’ product changes,
- Deterioration from long-term storage and handling,
- Record keeping for inventory.

Determining Holding Costs Example

*Category*	*Cost (and Range) as a Percent of Inventory Value*
Housing costs (including rent or depreciation, operating costs, taxes, insurance)	6% (3 – 10%)
Material handling costs (equipment lease or depreciation, power, operating cost)	3% (1 – 3.5%)
Labor cost	3% (3 – 5%)
Investment costs (borrowing costs, taxes, and insurance on inventory)	11% (6 – 24%)
Pilferage, space, and obsolescence	3% (2 – 5%)
*Overall carrying cost*	26%

Costs of not Holding Stock

A stockout occurs when an item that is typically stocked is not available to satisfy a demand the moment it occurs, resulting in any of the following:

Lost sales — A lost sale occurs when a stock out results in a customer buying the wanted item elsewhere.
Backorders — A backorder is a customer order that cannot be filled when promised or demanded but is filled later.
Substitutions — A substitution occurs when a stockout results in a substitute product being taken by the customer instead.