Inventory Costs

Inventory Costs


It is observed that there are many factors whose costs affect the size of inventory directly either advocating to decrease the size of the inventory or suggesting an increase in the inventory size e.g. the risk of the manufacturer for loosing sales decreases with size of the inventory but on the other hand expenditure on storage will increase. Thus for an effective inventory analysis and control of the system one should have a clear picture about the behavior of costs associated with different factors.

These costs are explained below:

A. Costs that encourage to have larger Inventories


1. Set up costs

These costs are incurred in setting up of a plant i.e. the costs of land, construction of buildings, purchase of machinery etc. These are not directly related with the numbers produced or ordered. But plants or factories are set up for a particular capacity to be manufactured. This cost can be reduced by planning with fewer setups of large size production run leading to an increase in the size of the inventory. Set up costs also include the costs to prepare a machine or process for manufacturing an order e.g. clean up costs, re-tooling costs and adjustments costs.

2. Ordering costs

Ordering costs are associated with costs of placing order and receiving goods. These are incurred each time an order is placed. Ordering costs start with the requisition sent to the purchasing office, include all cost issuing the purchase order and of following it up,  receiving the goods and placing them into inventory and end with the buyer’s firm paying the suppliers. In case, a concern, produces its own inventory instead of purchasing from an outside source, production set up costs are considered as ordering costs.

Ordering cost may be calculated as:

Ordering cost = (Cost per order ) X (Number of orders)

3. Procurement costs

An organization has to incur expenditure on the preparation of purchase order. These costs are related to :

i. typing and paper work to place and order,

ii. Inviting and screening the quotations,

iii. Making efforts for supply on due date by sending reminders,

iv. Contacting the supplier,

v. Inspection of the goods after receiving the supplies.

These costs can be fixed or variable. Fixed costs includes salaries of permanent staff of purchase and inspection department. This expenditures upto some stage is independent of the size of the lots ordered. Variable costs includes processing of an order and dispatching it to the vendor.

With decreasing number of orders, fixed cost remain constant but the variable cost will decrease. This will reduce average annual cost of procurement.


4. Depreciation costs

They are especially important for fashion items or items undergoing chemical changes during storage. Fragile items such as crockery are liable to damage, breakage etc. 0.2% to 1% of the stock value may be lost due to damage and deterioration.


5. Loss due to non-fulfilment of demand and delay in production

Sometimes the organization is not able to meet some demand due to smaller  inventory or delay in production then this will adversely affect the profits as well as goodwill of the company. The risk of loosing orders on this count can be minimized by increasing the size of inventory for finished goods. Similarly production delays due to non availability of raw materials or spare parts for machines can be avoided by keeping sufficient stocks of these items in inventory. This can reduce the losses due to unexpected delay in replenishment of the inventory.


6. Direct material and labour costs

It is observed that items are likely to be scrapped during each set up and trial of the equipment. This results in increased costs on material and labour. If the size of lots in each production run is increased then there will be fewer setups and loss on materials and labour costs due to scrapping will be reduced.


7. Costs incurred on overtime, hiring, training and lay off.

If inventory is not of sufficient size, then the organization may have to employ additional staff, pay overtime etc. to meet the requirement. Overtime also reduces the efficiency of workers. In such cases the organization may have to employ more staff in boom periods and retrench the staff in slack period. Both situations may result in employing untrained staff leading to additional expenditure and adversely affecting the efficiency of production.

B. Costs which encourage smaller inventory

1. Inventory carrying costs

They arise on account of maintaining the stocks and the interest paid on the capital tied up with the stocks. They vary directly with the size of the inventory as well as the time for which the item is held in the stock.


2. Storage costs

Maintenance of inventory means storage costs. These include expenditure made on inventory staff, expenditure on providing various facilities like heating, lighting, floor space, shelves and racks, bins and containers, material handling equipment and other provisions for safe and proper storage of items. These costs generally depend upon the volume to value ration of an item. Generally it varies between 1 to 3% .


3. Deterioration costs

Some items are likely to deteriorate in quality with time e.g. food stuff. If such items are in store for considerable time, then the organization may decide to dispose them at a loss. This results undue to the enterprise.


4. Obsolescence costs

It depends upon the nature of the item in stock. Electronic and computer components are likely to be fast outdated. Changes in design also lead to obsolescence. I may be possible to quantify the percentage loss due to obsolescence and it may be taken as 5 % of the stock value.


5. Pilferage costs

It depends upon the nature of the item, Valuables such as gun metal bushes and expensive tools may be more tempting, while there is hardly any possibility of heavy casting or forging being stolen. While the former must be kept under lock and key, the latter may be simply dumped in the stockyard. Pilferage cost may be taken as 1 % of the stock value.


C. Costs which may increase or decrease with the size of inventory


1. Handling costs

These include all costs associated with movements of stock, such as cost of labour, overhead cranes, gantries and other machinery used for this purpose.


2. Price fluctuations

The variations or ups and down in the price of a commodity is natural phenomenon. If there is increase in the price of the commodity then storing may be encouraged for finished goods. Besides this some other factors like fluctuations in demand, lead time and stock replenishment also play a significant role in inventory analysis.