Inventory Costs – Ordering Cost, Carrying Cost and Stock Out Cost

Inventory procurement, storage and management is associated with huge costs associated with each these functions.

Inventory costs are basically categorized into three headings:

1. Ordering Cost
2. Carrying Cost
3. Shortage or stock out Cost & Cost of Replenishment
   
   
   1. Cost of Loss, pilferage, shrinkage and obsolescence etc.
   2. Cost of Logistics
   3. Sales Discounts, Volume discounts and other related costs.

1. Ordering Cost

   Cost of procurement and inbound logistics costs form a part of Ordering Cost. Ordering Cost is dependant and varies based on two factors - The cost of ordering excess and the Cost of ordering too less.

   Both these factors move in opposite directions to each other. Ordering excess quantity will result in carrying cost of inventory. Where as ordering less will result in increase of replenishment cost and ordering costs.

   These two above costs together are called Total Stocking Cost. If you plot the order quantity vs the TSC, you will see the graph declining gradually until a certain point after which with every increase in quantity the TSC will proportionately show an increase.

   This functional analysis and cost implications form the basis of determining the Inventory Procurement decision by answering the two basic fundamental questions - How Much to Order and When to Order.

   How much to order is determined by arriving at the Economic Order Quantity or EOQ.

2. Carrying Cost

   Inventory storage and maintenance involves various types of costs namely:

   • Inventory Storage Cost
   • Cost of Capital
   
   

   Inventory carrying involves Inventory storage and management either using in house facilities or external warehouses owned and managed by third party vendors. In both cases, inventory management and process involves extensive use of Building, Material Handling Equipments, IT Software applications and Hardware Equipments coupled managed by Operations and Management Staff resources.

   1. Inventory Storage Cost

      Inventory storage costs typically include Cost of Building Rental and facility maintenance and related costs. Cost of Material Handling Equipments, IT Hardware and applications, including cost of purchase, depreciation or rental or lease as the case may be. Further costs include operational costs, consumables, communication costs and utilities, besides the cost of human resources employed in operations as well as management.

   2. Cost of Capital

      Includes the costs of investments, interest on working capital, taxes on inventory paid, insurance costs and other costs associate with legal liabilities.

      The inventory storage costs as well as cost of capital is dependant upon and varies with the decision of the management to manage inventory in house or through outsourced vendors and third party service providers.

Current times, the trend is increasingly in favor of outsourcing the inventory management to third party service provides. For one thing the organizations find that managing inventory operations requires certain core competencies, which may not be inline with their business competencies. They would rather outsource to a supplier who has the required competency than build them in house.

Secondly in case of large-scale warehouse operations, the scale of investments may be too huge in terms of cost of building and material handling equipments etc. Besides the project may span over a longer period of several years, thus blocking capital of the company, which can be utilized into more important areas such as R & D, Expansion etc. than by staying invested into the project.