Types of Inventory Costs and Factors affecting Inventory

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.

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 

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.

Go back to Tutorial