Inventory is an integral part of any business. It consists of raw materials, work-in-process and finished goods and supplies, that are used in the day-to-day operations of a business. Like any other aspect of a business, inventory also entails some costs. The costs associated with the inventory include the costs relating to the acquisition and storage of the inventory as well as the costs pertaining to the human resources managing the inventory. The losses on account of deterioration, damage, theft and obsolescence also form part of these costs.
The above costs can be broadly categorised as ordering costs, holding costs and shortage costs. For inventory management to be effective, these costs have to be optimised without losing business in the process. Let us now look at what these costs are and how they can be optimised.
Ordering CostsOrdering costs are costs that are associated with the acquisition of inventory, irrespective of the value of goods purchased. These costs include the salaries of the staff associated with the placing, processing and expediting of purchase orders. The freight and handling costs incurred with respect to every purchase also forms part of this. Therefore, it can be inferred that the ordering costs are directly proportional to the number of orders placed.
Let us look at the following example: A business requires 100,000 units of item-A annually. Ordering cost, inclusive of staff costs and freight & handling costs for each order is $100. If the firm places one order for 100,000 units of item A, the firms needs to spend $100 only, annually, towards the ordering costs. But, if the firm decides to place 4 orders of 25,000 each, then the annual ordering costs would be $400.
This shows that the more the number of orders, the higher the ordering cost. Hence ordering costs can be optimised by reducing the number of orders. Can inventory costs be contained simply by reducing the ordering costs? Let us examine this in detail.
Holding CostsHolding costs are costs incurred for carrying the inventory. These generally include: - Storage costs such as the rent of the warehouse - Handling costs such as the salaries of the stock-keeping staff and the wages of the staff associated with the inward and outward movement of the inventory - Insurance costs based on the value of the inventory - Interest on borrowings, if any, with respect to the capital tied up in the inventory and - Losses due to obsolescence, damages, deterioration or theft.
Therefore, while trying to reduce the ordering costs, it would be a good idea to consider the incremental holding costs that might have to be incurred in this regard.
Shortage CostsShortage costs can also be termed as opportunity costs. These are basically loss of business opportunities which occur due to paucity or non-availability of raw materials. These include under-utilisation of both the manpower and the installed capacity of the machinery. Non-availability of sufficient raw materials may result in non-delivery of orders as per the contractual obligations. Such breaches of contracts may invite lawsuits and liquidated damages, resulting in financial losses to the company. This may also result in loss of reputation and market share.
In summary, we can conclude that the art of inventory management lies in monitoring the position of inventory on a real-time basis. It is also important to strike a fine balance between carrying the appropriate amount of safety stock and optimising the ordering and holding costs. This can be achieved by deploying perpetual inventory management software, backed by periodic verification of physical stocks, and by using proven inventory methods such as economic order quantity (EOQ) or just-in time inventory.