Question

ch. 13 Describe the major cost categories used in inventory analysis and their functional relationship to each other.

Answer 1

While it is not easy to establish a perfect defination of inventory cost but it can broadly be defined as the cost incurred by any organisation which is related to storing and maintaing the inventory of its products over a certain period of time.

Inventory cost can broadly be classify into 3 major categories-

a) ordering costs

b)carrying costs

c)stock-out costs

a) Ordering cost- It is also known as set-up cost and is the cost incurred every time orders are placed. it can also be split into two parts.

1)The cost of ordering process, which is a fixed cost and can include the fees for placing orders,accounting,clerical cost,communication cost etc.

2)The cost of inbound logistics which is a variable cost and includes transportation and reception cost.It is largely dependent on the volume of the order.

b) Carrying costs- It is also known as holding cost and is the major component of the inventory cost and can further be sub classified into four parts.

1)Capital cost- it is the largest component of carrying cost and includes everything related to the investment in inventory mangagement.

2)Storage space cost-It includes the cost of building the infrastructure needed for managing and inventory.foe example-lighting,cost of electricity,rent and lease.

3)Inventory services cost-These includes the cost of insurance , hardware , both electrical and IT , taxes , hr management etc.

4)Inventory risk cost-these kind of costs cover the risk that the items being stored might fall in value and depreciate.it is mostly related to perishable goods.

c) Stock out costs- This is also known as shortage cost.it is the cost incurred by a company when there is a shortage of stock and can include the cost of emergency shipment, paying higher value to the suppliers, premium payments done to the faster delivery etc.

Out of these 3 major categories the two dynamic category carrying cost and stock out costs are closly related.it can inferred that these two costs are inversely proprotional. An effort to reduce carrying cost ( by reducing the size of inventory) can increase the stock-out costs and vice-versa. To reduce the total inventory costs it is important to strike a fine balance between these two categories.