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Operations Management

Inventory Costs

Submitted to: Prof. A.K. Agrawal FMS-BHU

Submitted by:Deepak Prakash Roll No. - 14 MBA IInd Sem. (2012-13)

Inventory Costs
There are several associated with inventory planning and control. These costs could be classified under three broad categories. First is the cost of carrying inventory. All costs related to maintain inventory in organisations will be classified under this. The second is the cost associated with ordering material and replenishing it in cyclic intervals. The third is the cost arising out of shortages. Inventory control models should take these into consideration and aim at minimising the sum of all costs.

Inventory Carrying Cost


Organisations need to spend a considerable amount of money to carry inventory. The most significant component is the interest for the short-term borrowals for the working capital required for inventory investment. The second significant cost relates to the cost of stores and warehousing and administrative costs related to maintain inventory and accounting for it. Investment in store space, storage and retrieval systems, software for maintaining the inventory status and accounting for it. Investment in store space, storage and retrieval systems, software for maintaining the inventory status and managerial and other administrative manpower to discharge various activities related to stores will form part of cost of stores and warehousing. The other costs of inventory carrying include insurance costs, cost of obsolescence, pilferage, damages and wastage. The components of inventory carrying costs exert considerable pressure on an organisation to reduce inventory depends on the nature of business processes in place, the lead-time for procurement and the quality of planning. It is easy to note that all these costs related to carrying inventory are directly related to the level of inventory. Graphically, it can be shown as simple linear relationship.

Cost of Ordering
Replenishment of cyclic inventory is achieved by ordering material with the suppliers. Organisations perform a series of tasks related to ordering material. These include search and identification of appropriate sources of supply, price negotiation, contracting and purchase order generation, follow-up and receipt

of material and eventual stocking in the stores after necessary accounting and verification. All these involve manpower, resources and time that could be classified under cost of ordering. Since, several of these costs are fixed in nature, placing a large quantity order could reduce the total costs of ordering. Sometimes components required for use in an organisation are sourced from within. A division or a department of the organisation may be specially manufacturing the required components for internal consumption. In such situations, the costs associated with setting up the required resources and machinery will represent the cost of ordering. Cost of carrying and cost of ordering are fundamentally two opposing cost structures in inventory planning. For instance, when the order quantity becomes smaller, the total cost of carrying inventory decreases. On the other hand, since a large number of orders are to be placed to satisfy the demand, the total ordering costs will go up. Conversely, when the order quantity is increased, while the total cost of ordering will come down owing to fewer number of orders being placed, the total cost of carrying inventory will increase due to an increase in the average cyclic inventory in the system. Balancing these two opposing costs will be central to inventory planning and control in any organisation.

Cost of Shortages
Despite careful planning, it is likely that organisations run out of stock. This disrupts production and has cascading effect down the supply chain. Delivery schedules are missed, leading to customer dissatisfaction and loss of goodwill. It also introduces additional costs arising out of pushing the order back and rescheduling the production system to accommodate these changes. Rush purchases, uneven utilisation of available resources and lower capacity utilisation escalate the costs further in the system. All these form part of cost of shortage.