Inventory must be viewed as a positive contributor to corporate profitability. To that end, management must determine when various items should be ordered, how much to order each time, and how often to order to meet customer needs while minimizing associated costs.
There are three types of costs that must be considered in setting inventory levels:
1. Holding\Carrying cost:
They are expenses such as storage, handling, insurance, taxes, obsolescence, theft, and interest on funds financing the goods. These charges increase as inventory levels rise. To minimize carrying costs, management makes frequent orders of small quantities. Holding costs are commonly assessed as a percentage of unit value, rather than attempting to derive monetary value for each of these costs individually. This practice is a reflection of the difficulty inherent in deriving a specific per unit cost, for example, obsolescence or theft.
2. Ordering costs:
Ordering costs are those fees associated with placing an order, including expenses related to personnel in purchasing department, communications, and the handling of related paper work. Lowering these costs would be accomplished by placing small number of orders, each for a large quantity. Unlike carrying costs, ordering expenses are generally expressed as a monetary value per order.
3. Stock-out costs:
They include sales that are lost, both short and long term, when a desired item is not available; the costs associated with back ordering the missing item; or expenses related to stopping the production line because a component part has not arrived. These charges are probably the most difficult to compute, but arguably the most important because they represent the costs incurred by customers when an inventory policy falters. Failing to understand these expenses can lead management to maintain higher inventory levels than customer requirements may justify
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There are three types of costs that must be considered in setting inventory levels:
1. Holding\Carrying cost:
They are expenses such as storage, handling, insurance, taxes, obsolescence, theft, and interest on funds financing the goods. These charges increase as inventory levels rise. To minimize carrying costs, management makes frequent orders of small quantities. Holding costs are commonly assessed as a percentage of unit value, rather than attempting to derive monetary value for each of these costs individually. This practice is a reflection of the difficulty inherent in deriving a specific per unit cost, for example, obsolescence or theft.
2. Ordering costs:
Ordering costs are those fees associated with placing an order, including expenses related to personnel in purchasing department, communications, and the handling of related paper work. Lowering these costs would be accomplished by placing small number of orders, each for a large quantity. Unlike carrying costs, ordering expenses are generally expressed as a monetary value per order.
3. Stock-out costs:
They include sales that are lost, both short and long term, when a desired item is not available; the costs associated with back ordering the missing item; or expenses related to stopping the production line because a component part has not arrived. These charges are probably the most difficult to compute, but arguably the most important because they represent the costs incurred by customers when an inventory policy falters. Failing to understand these expenses can lead management to maintain higher inventory levels than customer requirements may justify
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