Inventory control is an essential aspect in business, holding impact on profit margins and has many aspects to consider. Of the attributes to be analyzed inventory holding costs and inventory ordering costs are the most impactful on profit margins. In essence the primary goal sought is “how much to order” and “when to order” (Durlinger, 2016). To best understand the different prospects defined the Economic Order Quantity (first introduced by Ford W. Harris in 1913) is one of the oldest formulas used for inventory management (Economic Order Quantity Model, 2011). There are numerous properties and aspects considered within the Economic Order Quantity model; of these aspects are inventory holding costs and inventory ordering costs. The primary goal of the Harris’ model lies in “minimizing the sum of carrying costs and ordering costs” (Economic Order Quantity Model, 2011). With this perceptive the companies will find the best equilibrium between holding and ordering costs. The Harris model delves far further into inventory analysis, for this document the focus shall remain in carrying and ordering costs.
Inventory holding costs are essentially all costs therein that encompasses the cost of having inventory on-hand. There are three aspects to consider with holding costs of inventory; 1) Cost of Capital (to finance the inventory), 2) costs of storing and shipping the inventory, and 3) cost of risk (i.e. insurance, damage, etc.) (Durlinger, 2016). The cost of capital can be screened through several defining characteristics; including financial interest that may be relevant through bank loans. The most commonly used formula for determining cost of capital is Weighted Average Cost of Capital (WACC). WACC proclaims a specific formula that determines the cost of capital underlying inventory holding costs. The formula includes calculations in market value, cost of equity, and cost of debt, tax rates, and further intricacies used in defining the company’s inventory cost (Durlinger, 2016).
The second aspect considered in determining a company’s inventory holding costs, cost of storing and shipping inventory, is fundamentally exactly that; the cost it takes to store and ship the company’s inventory. There are numerous mechanisms that may be considered for this cost, including warehouse costs, forklift expenditures that may be present, cargo containers, shipping rates, and more. Principally, storing and shipping costs of inventory “will be probably fixed costs” (Durlinger, 2016) once all disbursements have been considered. The final aspect to consider within inventory holding cost & the cost of risk, is dealing primarily with obsolescence in relations to the product or the product life-cycle. In other words, the cost that underlies the life span of the product once placed into storage (i.e. products with expiration dates or products in a phase out stage). This section may also include any insurance that the may be needed by the company to implement in order to save cost in the long run. In totality, inventory holding costs may not maintain the ability to be encompassed within a simplistic general percentage. As defined above, there are numerous capacities to consider when determining the actual inventory holding costs with each dimension varying per company.
The other aspect is inventory ordering costs. For better comprehension of this aspect inventory ordering costs are divided into four subcategories: 1) costs to place an order, 2) costs to transport the product, 3) costs to receive the order, and 4) costs to store the product. (Durlinger, 2016) The most important of these aspects lies in the purchasing department per company, as the purchasing department is the bulk of cost within ordering costs. Costs to place an order would include that of postage and insurance imposed on such postage. The second attribute points to the shipment cost being covered by the supplier. In order for a supplier to cover shipping costs there are usually stipulations (i.e. certain amounts of product purchased (bulk), or ordering multiple products to obtain free shipping) that need be adhered to by purchaser. In an attempt to maintain lowest possible costs it would be beneficial for a company to consider utilizing supply companies that offer such shipping arrangements. The third consideration in inventory ordering costs, the cost in receiving the order, is not definitive but is considered based on the employee salaries that are utilized to actually receive shipments. The fourth concept divulged, the cost in storing the product, is simplistically similar to the above shipping outlined in inventory holding costs. Each of these four concepts is normally found to be fixed amounts and do not vary per shipment amounts or company’s individual needs.
Conclusively, the most important aspects that need be considered through the defining inventory holding costs are that of “the cost of capital and the risk of obsolescence [being] the main drivers” (Durlinger, 2016). The other conclusive measure remains in inventory ordering costs as only shipment costs need be scrutinized and remain the only aspect that is not fixed. To apply a practical solution to lowering costs of inventory in totality one may consider purchasing from few suppliers as possible, and purchasing supply by full truck load (FTL) only. These methods along with efficient business processes allow companies to monitor and reduce the cost of ordering and holding inventory. Keeping costs low and finding ways to deal with fixed costs help a company to know what the costs are and if there is any unexpected cost fluctuation. When costs are known and expected a company can forecast and budget based on the known factors, when costs fluctuated is when a company may need to finance the inventory costs. This therein allows shipping to become a fixed rate and analysis of the best means in which to reduce inventory costs are easily determined through the basics of Harris’ Economic Order Quantity model referenced above.
- Durlinger, P. P. (2016). Inventory and Holding costs: A white paper approach for managers. Retrieved July 27, 2016, from http://www.durlinger.nl/files/artikelen/Inventory-and-Holding-Costs.pdf
- Economic Order Quantity Model (EOQ). (2011). Retrieved July 27, 2016, from http://www.readyratios.com/reference/analysis/economic_order_quantity_model_eoq.html