Inventory 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.

– 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.

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).

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.

• 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.

• 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.

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 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 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)

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.