Question

Six categories of costs associated with inventories are purchasing costs, ordering costs, carrying costs, stock out costs, quality costs, and shrinkage. Assume you are seasoned manager training new employees about the importance of inventory management. In 200 words or more, describe at least two of these inventory costs. Include specific examples in order to effectively explain these concepts

Answer 1

1. Inventory shrinkage is the excess amount of inventory listed in the accounting records, but which no longer exists in the actual inventory. Causes of shrinkage are theft, damage / obsolescence, misplaced goods, vendor fraud etc. Shrinkage affects profit i.e. if shrinkage is large, profits decrease.

To measure the amount of shrinkage, physical count of the inventory is taken and its cost calculated. Thereafter it is subtracted the cost of inventory as per books of accounts.

Inventory as per Books = Opening Inventory + Purchases ? Sales

Shrinkage = Booked Inventory ? Physical Counted Inventory

e.g. Samsung has $2,000,000 of inventory as per accounting records. To check shrinkage, it conducts a stock take, and identifies that actual amount of inventory available is $1,850,000. The amount of inventory shrinkage is therefore $150,000.

There are various ways for preventing inventory shrinkage -

• Installing CCTV camera
• Inventories protected under lock and key
• Preventing anyone except warehouse staff from entering the warehouse
• Assigning personal responsibility for inventory accuracy
• Counting all items when they arrive at the receiving dock
• Periodical and surprise stock take

2. Carrying cost is the cost for holding inventories in store. It includes cost of storage, rent, insurance cost, cost of fund invested in inventories, obsolescence, utilities, salaries etc.

Carrying costs are computed for a year and then expressed as a percentage of the cost of the inventory items. For example, company expresses that it’s holding costs is 15%. In such scenario, if company has $100,000 of inventory cost, its cost of carrying inventory is around $15,000 per year.

Following is the generally used formula to calculate carrying cost -

Annual holding cost = average inventory level x holding cost per unit per year

Following are the major reasons why companies hold inventory –

a. Safety limits: This would act like a buffer to make sure that the company would have excess products for sale / production if consumer demands exceed their expectation.

b. Cyclical and Seasonal Demand: Holding inventory is useful for predicable events that would cause a change in people’s demand. For example, ice cream companies starts to produce extra ice-cream during summers.

c. Transportation cost: Holding inventory would save company transportation cost and help transition process become less time-consuming. For example, if the company request a particular raw material from overseas market. Purchase in bulk will save them a lot transportation cost from overseas shipment fees.

Companies use following ways to reduce carrying cost –

a. Base the number of stocks on the situation of Economics: The number of stocks should be changed with consumers demand, the situation of the industry

b. Build long-term agreements with suppliers: Signing long-term contract with suppliers may increase the supplier’s financial security and the company may receive a lower price.

c. Creating an effective record system: The database should include things like date of purchase and sale, quantity, rate etc. This will make sure that the future employees can learn from the past experience while making decisions.