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Inventory Costs

By Anonymous - Posted on 11 February 2012

The following costs are used for inventory management decisions :

- Item cost,
- Carrying costs,
- Ordering costs,
- Stockout costs,
- Capacity associated costs.

Item cost
Item cost is the price paid for purchase item, which consists of the cost of the item and any other costs associated in getting the item into the plant. The inclusive cost is often called the landed price. For an item manufactured in-house, the cost includes direct material, direct labor and factory overhead.

Carrying costs
Carrying costs include 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 3 categories:
- Capital costs. Money investment in inventory is not available for other uses and as such represents a lost opportunity cost;
- Storage costs. Storing inventory requires spaces, workers and equipment.
As inventory increases, so do these costs;
- Risk costs. The risk in carrying inventory are:
o Obsolescence, loss of product value resulting from change or technological development;
o Damage, inventory damaged while being held or moved;
o Pilferage, goods lost, strayed or stolen;
o Deterioration, inventory that rots or dissipates in storage or whose shelf life is limited.

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.

Ordering costs
Ordering costs are those associated with placing an order either with the factory or a supplier. The annual cost of ordering depends upon the number of orders placed in a year. Ordering costs in a factory includes the following:
- Production control costs. The annual cost and effort expended in production control depend on the number or orders placed, not on the
quantity ordered. 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;
- 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. It is particularly important and costly with bottleneck resources;
- Purchase order cost. Every time a purchase order is placed, costs are incurred to place the order. These costs include order preparation, followup, expediting, receiving, authorizing payment ant the accounting cost of receiving and paying the invoice. The annual cost of ordering depends upon the number of orders placed.

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. However, this drives up the inventory level and the annual cost of carrying inventory.

Stockout costs
If demand during the lead time exceeds forecast, we can expect a stockout. A stockout can potentially be expensive because of back-order cost, lost sales and possibly lost customers.

Capacity-associated costs
When output levels must be changes, there may be costs for overtime, hiring, training, extra shifts and layoffs. These capacity-associated costs can be avoided by leveling production. However, this builds inventory in the slack periods.

Cost Balancing
Whether inventory is an asset used to accomplish the objective of an organization or a liability depends on its management; both conditions may exist in the same firm at the same time. There are benefits as well as costs to having inventory. The problem is to balance the cost of carrying inventory with the following:

Customer service. Higher inventory levels result in higher customer service levels. Lower levels of inventory can cause potential stock-out, backorders, lost sales and lost customers.

Operating efficiency. Higher inventory levels allow leveling production, longer production runs and reduced set-up time. Inventory lets manufacturing purchase in larger quantities availing volume discounts.

Cost of placing orders. Ordering smaller quantities each time an order is placed can reduce inventory. However, this increases the annual ordering costs.

Transportation and handling cost. The more often goods have to be moved and smaller the quantities moved, the greater the transportation and materials handling cost. However, moving larger lots leads to higher inventory.


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