In this lesson, you’re expected to understand the different types of costs associated with inventory management.
Inventory-related decisions take into account the cost structure of the given inventory system
Relevant Cost Factors
– The costs incurred in operating an inventory system significantly influence inventory decisions.
– Special attention must be paid to those costs that vary with the choices of inventory policy. Only those costs that vary with the inventory decision (e.g.: What to order? When to order? How much to order?) should be considered as relevant costs.
Now, we’re going to examine these cost types in more detail and, later, these costs are going to be used in the mathematical inventory models that we are going to study.
i) Amount paid to the supplier
This is simply the sum paid to the source from which the procurement is made and it simply represents the cost of the units procured.
These costs are incurred by the system itself in making a procurement and can arise due to several different reasons, such as:
– Costs of processing an order through the purchasing and accounting department, which may include paper, postage, labor, phone calls etc.
– Costs of transporting the units from the source to the stocking point (when not paid by the supplier). May depend on mode of transport, relative shipment size, and distance.
– Upon receiving the order, the items must be received, inspected, processed, and stored for the first time.
Let A denote the fixed costs, and let C(Q) denote the unit cost for Q units.
Then, the total cost of placing an order of Q units = A + C(Q).
Breakdown of Costs
i) Real, out-of-pocket costs:
– Inventory insurance
– Breakage or pilferage at storage site
– Warehouse rental
– Costs of operating the warehouse (e.g. light, heat, security etc.)
ii) Opportunity cost: capital tied-up in inventory rather than having it invested elsewhere.
• Carrying costs are often presented as a percentage of the unit costs, per year (i.e. how much is spent to hold the product in stock during one year).
• Typically represent between 20-30% of unit cost, per year.
• These costs are usually dependent on the demand rate; however, they do not generally depend on the inventory policy, thus they are not relevant to inventory decisions.
– Do not purchase the item (i.e. sale is lost)
– Buy it somewhere else (i.e. sale is lost)
– Delay purchase (i.e. backorder)
– Substitute by another product (if available)
• In the case of a backorder, calculating its costs may be tricky, as there are many factors that can be considered, depending on the case, such as:
– Loss of goodwill: in the future the customer may take his or her business elsewhere
– Cost of inoperative parts, for example if an airplane is not able to fly due to stock-out of spare parts (aircraft-on-ground) and airline is losing profits.
– You may rush to buy from your supplier at a premium, reducing your profits.
A study by Corsten & Gruen (2004) shows that, in the occurrence of stock-outs for a given product:
– 45% of demand is substituted by another product or brand.
– 40% of demand is lost: customers either buy it at another store (31%) or do not purchase de item at all (9%).
– 15% of demand is delayed: customers wait.
On average, 10% of items in a grocery or convenience store is stocked out. That implies that 4% of the total store’s demand is lost.
– Corsten and Gruen, Harvard Business Review (2004)
– Inventory control system cost and review cost
– Hardware: computers, scanners etc.
– Personnel: inventory managers, counters etc.
The relevance of such costs to the mathematical models generally used in inventory systems is usually treated apart from the model itself.