Costs of Holding Inventories

Principle & Practice of Management

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Costs of Holding Inventories

Costs of Holding Inventories

Minimising cost is one of the operating objectives of inventory management. The costs (excluding merchandise cost), there are three costs involved in the management of inventories.
1. Ordering Costs: Ordering costs are those costs that are associated with the acquisition of raw materials. In other words, the costs that are spent from placing an order to raw materials to the receipt of raw materials. They include the following:
(a) The cost of requisitioning the items ( raw materials).
(b) The cost of preparation of purchase order (i.e., drafting typing, dispatch, postage etc.).
(c) The cost of sending reminders to get the dispatch of the items expedited.
(d) The cost of transportation of goods (items).
(e) The cost of receiving and verifying the goods.
(f) The cost of in unloading of the (items) of goods.
(g) Storage and stocking charges.
Cost of Holding InventoriesHowever, in the case of items manufactured in the house the ordering costs would comprise the following costs:
(a) Requisitioning cost,
(b) Set-up cost,
(c) Cost of receiving and verifying the items,
(d) The cost of placing and arranging/stacking of the items in the store etc.
Ordering costs are fixed as per order placed, irrespective of the amount of the order but ordering costs increases in proportion to the number of orders placed. If the firm maintains small inventory levels, then the number of orders will increase, thereby ordering cost will increase and vice versa. [ Cost of Holding Inventories ]
2. Inventory Carrying Costs: Inventory carrying costs are those costs, which are associated with carrying or maintaining inventory. The following are the carrying costs of inventory:
(a) Capital cost [interest on capital locked in the inventories]
(b) Storage cost [insurance, maintenance on building, utilities serving costs]
(c) Insurance [on inventory – against fire and theft insurance]
(d) Obsolescence cost and deterioration
(e) Taxes
Carrying costs usually constitute to around 25 per cent of the value of inventories held. [Cost of Holding Inventories ]
3. Shortages Costs [Costs of stock out]: Shortage costs are those costs that arise due to stock out, either shortage of raw materials or finished goods.
(a) Shortage of inventories of raw materials affect the firm in one or more of the following ways:
(i) The firm may have to pay some higher prices, connected with immediate (cash) procurements.
(ii) The firm may have to compulsorily resort to some different production schedules, which may not be as efficient and economical.
(b) The stock of finished goods – may result in the dissatisfaction of the customers and the resultant lead, to loss of rules.
Thus, with a view to keeping inventory costs of a minimum level, we may have to arrive at the optional level of inventory cost, its total order’s cost plus carrying costs are minimum.
In other words, we have to determine Economic Order Quantity (EOQ), at that level in which the total inventory [ordering plus carrying less] cost is minimum. [ Cost of Holding Inventories ]