Many inventory decision rules involve economic criteria. Thus, it is very important to understand the cost of inventory, which may be broken down into the following details (4 parts):
1. Item Cost
This is the cost of buying/producing the individual inventory items. Item cost may be lowered by mass production due to the economies of large scale. Item cost of a bulk purchase is often lowered by a bulk (trade) discount.
Cash (settlement) discounts may not be taken into account because an early payment decision is usually not within the inventory management system.
Freight cost (also import duties and so on) may be part of the item cost if it varies with the number of items purchased.
The item cost can usually be estimated, with good accuracy, directly from historical records.
2. Ordering/Setup cost
The ordering cost is associated with ordering a batch or lot of items. Ordering cost does not depend on the number of items ordered; it is assigned to the entire batch. This cost includes: typing cost and postage of the purchase order, bank charges on letter of credit and bill process, expediting the order, receiving and inspection costs, and so on. Transportation cost and handling charges may be included if they are fixed per order of purchase.
Similarly, for a manufacturing concern, setup cost is those costs associated with placing an order of a batch of items to be produced irrespective of the number of items in the batch. It includes: paperwork of the production order, costs required to set up the production machine for a run, chasing the order, and so on.
The ordering/setup cost can also be determined from company records. However, difficulties are sometimes encountered in separating fixed and variable cost components. The ordering cost should include only the fixed costs for each order irrespective of its size for decision making purposes.
3. Holding (or Carrying) Cost
The holding cost is associated with keeping items in inventory for a period of time. It is typically charged as a percentage of the item cost per unit time. The holding cost usually consists of three components:
(a) Opportunity cost of capital – When items are carried in inventory, the capital invested is not available for other purposes.
(b) Cost of storage – This cost includes variable space cost, insurance, wages, protective clothing/containers, and so on.
In theory, only variable costs are included because fixed costs remain unchanged for different sizes of reorder quantity when we, say, consider the economic order quantity.
(c) Costs of obsolescence, deterioration and loss – Obsolescence costs, including possible rework or scrapping, should be assigned to items which have a high risk of becoming out of fashion. Perishable goods should be charged with deterioration costs which include costs of preventing deterioration. The costs of loss include pilferage and breakage costs associated with holding items in inventory.
The holding cost is more difficult to determine accurately. The opportunity cost of capital cannot be directly derived from historical records but may only be estimated on the basis of current financial considerations. Costs of storage, obsolescence and etc can be estimated from company records plus special cost studies; however, it is difficult to separate the fixed and variable components and only to include those variable ones into the holding cost. The effect of price level changes is the most difficult one for estimation.
4. Stockout Cost
It reflects the economic consequences of running out of stock. There are two cases here. First, items are backordered. Second, the sales are lost. In both cases, the cost of administration on backorders, the loss of profit from the sales forgone, and the savings on holding less inventory may be calculated. However the loss of goodwill or future business associated with both cases is very difficult to calculate and is often handled indirectly by specifying an acceptable stockout risk level.
Inventory costs are often difficult to assess, but with persistence they can be estimated accurately enough for most decision making purposes.