Inventory Costs

Inventory Costs

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.

Types of Costs

There are five types of costs that are important in making inventory-related decisions. These cost-types are depicted in the figure below.

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.

Enlarged version:
1) Procurement Costs

Procurement costs include the amount paid to the suppliers relating to the goods purchased, and the costs that the system incurs in placing an order.

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.

ii) Costs of placing an order
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.

iii) Fixed vs. Variable Costs

Some of these costs are VARIABLE, i.e. depending on the order quantity, such as the amount paid to suppliers and part of transportation and receiving costs; while others are FIXED, incurred each time an order is placed, independent of the amount ordered.

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).

2) Inventory Carrying (Holding) Costs

Breakdown of Costs
Inventory carrying costs include out-of-pocket costs as well as the opportunity costs for having capital tied-up in inventory.

i) Real, out-of-pocket costs:
– Inventory insurance
– Breakage or pilferage at storage site
– Obsolescence
– 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.

• These are the costs of holding inventory, which are usually proportional to the amount invested in inventory.

• 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.

[Optional] How to Calculate Inventory Carrying Costs
Watch this 1-minute video explanation of how to calculate inventory carrying costs:
3) Costs of filling customers’ orders

• In order to fill each customer’s order, a requisition must frequently be processed internally, such as accounting operations for preparing a shipping invoice and sending it to the warehouse, as well as preparing the package and sending it to the customer.

• 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.

4) Stock-out Costs

Stock-out costs are related to what happens to the demand when the system is out of stock: we distinguish it between lost sales and backorder cases.

We can think that, when a demand occurs and the system is out of stock, the customer may decide between the following:
– 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 lost sale, the cost is simply the profit that not gained due the not being able to fulfill the demand

• 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.

Stock-out Cost Example

For a typical retailer, 4% of total demand is lost due to items being out of stock.

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.

Source: Corsten and Gruen, Harvard Business Review (2004)
How customers react to stock-outs

”A study of more than 71,000 consumers worldwide shows that they have little patience for stock-outs. When consumers can’t find the precise product they’re looking for, fewer than half, on average, will make a substitute purchase, and nearly a third will buy the item elsewhere.”

– Corsten and Gruen, Harvard Business Review (2004)

[Optional] Costs of Stock Outs & Material Shortages
Watch this 6-minute explanation about stock-out costs:
5) Costs of the information processing system

Costs of the information processing system are usually treated apart from inventory models.

Cost of obtaining the necessary information required to manage the inventory system:
– Inventory control system cost and review cost
– Hardware: computers, scanners etc.
– Software
– 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.

[Optional] Inventory Total Cost Equation
Watch this 5-minute video in which Professor Bussom from Widener University, explains the inventory total cost equation:
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