Inventory Cost Types and Affecting Factors

An inventory system may be defined as one in which the following costs are significant:

• Cost of carrying inventories (holding cost)
• Cost of incurring shortages (stock out cost)
• Cost of replenishing inventories (ordering cost)

Cost of carrying inventory: This is expressed in Rs. /item held in stock/unit time. This is the opportunity cost of blocking material in the non-productive form as inventories. Some of the cost elements that comprise carrying cost are-cost of blocking, capital (interest rate); cost of insurances; storage cost; cost due to obsolescence, pilferage, deterioration etc. It is generally expressed as a fraction of value of the goods stocked per year. For example, if the fraction of carrying charge is 20% per year and a material worth Rs. 1,000 is kept in inventory for one year, the unit carrying cost will be Rs. 200/item/year. It is obvious that for items that are perishable in nature, the attributed carrying cost will be higher.

Cost of incurring shortages: It is the opportunity cost of not having an item in stock when one is demanded. It may be due to lost sales or backlogging. In the backlogging (or back ordering) case the order is not lost but is backlogged, to be cleared as soon as the item is available on stock. In lost sales case the order is lost. In both cases there are tangible and intangible costs of not meeting the demand on time. It may include lost demand; penalty cost; emergency replenishment; loss of good-will etc. This is generally expressed as Rs. /item short/unit time.

Cost of replenishing inventory: This is the amount of money and efforts expended in procurement or acquisition of stock. It is generally called ordering cost. This cost is usually assumed to be independent of the quantity ordered, because the fixed cost component is generally more significant than the variable component. Thus it is expressed as Rs. /order.

These three types of costs are the most commonly incorporated in inventory analysis, though there may be other costs parameters relevant in such an analysis such as inflation, price discounts etc.

Costs and Inventory Decisions

In making any decision that affects inventory size, the following types of inventory costs should be considered:

Holding (or carrying) Costs – This broad category includes the costs for storage facilities, handling, insurance, pilferage, breakage, obsolescence, depreciation, taxes and the opportunity cost of capital. Obviously, high holding costs tend to favour low inventory levels and frequent replenishment.

Elements of inventory holding cost are

• Capital cost: the cost of the physical stock. This is the financing charge that is the current cost of capital to a company or the opportunity cost of tying up capital that might otherwise be producing a better return if invested elsewhere. This is almost always the largest of the different elements of inventory cost.
• Service cost: the cost of stock management and insurance.
• Storage cost: the cost of space, handling and associated warehousing costs involved with the actual storage of the product.
• Risk cost: this occurs as a consequence of pilferage, deterioration of stock, damage and stock obsolescence. With the reduction in product life cycles and the fast rate of development and introduction of new products, this has become a very important aspect of inventory cost. It is one that is frequently underestimated by companies. It is particularly relevant to high-tech industries, the fashion industry, and fresh food and drink.

Setup (or production change) Costs – To make each product different involves obtaining the necessary materials, arranging specific equipment setups, filling out the required papers, appropriately charging time and materials, and moving out the previous stock of material. If there were no costs or loss of time in changing from one product to another, many small lots would be produced. This would reduce inventory levels with resulting savings in cost. One challenge today is to try to reduce these setup costs to permit smaller low sizes. (This is the goal of a JIT system.)

Ordering Costs – These costs refer to the managerial and clerical costs to prepare the purchase or production order. Ordering costs include all the details, such as counting items and calculating order quantities. The costs associated with maintaining the system needed to track orders are also included in ordering costs.

Shortage Costs – When the stock of an item is depleted, an order for that item must either wait until the stock is replenished or be cancelled. There is a trade-off between carrying stock to satisfy demand and the costs resulting from stock out. This balance is sometimes difficult to obtain, because it may not be possible to estimate lost profits, the effects of lost customers, or lateness penalties. Frequently, the assumed shortage cost is little more than a guess, although it is usually possible to specify a range of such costs.

Establishing the correct quantity to order from vendors or the size of lots submitted to the organization’s productive facilities involves a search for the minimum total cost resulting from the combined effects of four individual costs, viz. holding costs, setup costs, ordering costs and shortage costs. Of course, the timing of these orders is a critical factor that may impact inventory cost.

Factors Affecting Inventory Levels

It is often perceived that avoiding design, process, management and operational problems also avoids inventory, but this does not hold true. Some fundamental reasons contribute towards the growth of inventory, though not desirable by an organization. At the same time, there are factors that can lead to the inventory growth and need to be managed to avoid any future losses. Some factors can create a long term impact on inventories, so it is necessary to first identify them and thereafter, manage them by preventing inventory from rising.

It is very important to keep your inventories at minimum levels, as they can seriously impact the progress of the organization and thus shouldn’t be ignored, as they also result into incurring extra expenditure, some of which cannot be avoided as they are hidden costs. If an organization is burdened with these costs, it will become less competitive and less profitable. Inventories make an organization bound by additional, undesirable liabilities. Manufacturers and distributors generally take ample time to understand the worse impact of extra inventory, and when they do, they are already late to take alternatives to fight it.

Inventory is the source of demand arisen from the customers. Billing involving paperwork can result into rise in the rate of inventory. Further, scraps and rejects often increase the inventory level in an organization, regarded as a buffer on account of many uncertainties.

Inventory is also known as the safety stock, which can though lead to hurdles in earning profits for the organization. Such buffer is usually created by the organization itself called anticipatory inventory required to face uncertainties and fluctuations. There are frequent expectations and fluctuations of rise in prices of commodities, making manufacturers penetrate into producing inventory.

In addition to the above, inventory increase can also be largely attributed to improper and faulty designing. If the organization is scattered with different department not properly interconnected or managed, it can also lead to increased inventory, since discrepancies can erupt in production control, proper service utilisation, space, etc.

Therefore, at the same, it is important to recruit competent people for effective management of the supply and demand factors, and maintaining data integrity. This can be ensured through proper induction and training of employees on management.