Inventory costs: ordering, carrying and shortage

In accounting terms, inventory is made up of raw materials, work-in-progress and finished goods. In the day-to-day running of a business, inventory can generally mean anything from pipes to pies to premium cars. However you view inventory, one thing is certain – it sits on the balance sheet as an asset to your business. Yet the true inventory costs to your business are often overlooked. Beyond the initial purchase price, your inventory costs also include the cost of making each purchase and the storing and maintenance of each item until sold or written off. Substantial costs are associated with the procurement, storage and management of inventory. To determine how much your inventory is really costing, you need to understand the three inventory costs: ordering, carrying and shortage.

Ordering inventory costs

The cost of acquisition and inbound logistics form part of the ordering cost of procuring inventory. These include:

• Time spent finding suppliers and expediting orders
• Clerical costs of preparing purchase orders
• Transportation costs
• Receipt of inwards goods, unloading, inspection and transfer.

One, or many people are responsible for sourcing products, processing orders and paying accounts. Add to that delivery, receipt of goods and movement of stock through the warehouse. Each step is a cost to the company.

Carrying inventory costs

Inventory carrying costs typically include the physical cost of storage such as building and facility maintenance related costs. These costs can include:

• Financing expenses
• The cost of storage space and warehousing
• Security, which may include securing restricted or hazardous materials
• Insurance against theft, loss or damage
• Opportunity cost – capital tied up in inventory that could be spent elsewhere
• Deterioration, theft, spoilage, or obsolescence.

Building rent and warehousing expenses, including overheads such as electricity, lighting and temperature control, are part of carrying costs.

Shortage costs

Shortage costs are those costs that are incurred when a business runs out of stock, including:

• Time lost when raw materials are not available
• Cost of shrinkage, pilferage and obsolescence
• Idle employees
• Lost sales
• Machinery set up costs,

Filling back-orders through expedited shipping or replenishing stock at higher than wholesale prices are some examples of shortage costs. The most damaging cost of shortage however is a dissatisfied customer and the temporary or permanent loss of sales through insufficient stock levels.

Reducing inventory costs

Understanding the three categories of inventory costs will help your business to identify what works and what doesn’t. You are then able to provide an analysis of your current position. Negative relationships will often exist between ordering costs and carrying costs. Larger orders, placed less frequently will minimize ordering costs but will lead to an increase in carrying costs. In turn, reducing your carrying costs means placing smaller more frequent orders, which subsequently increases ordering costs for the period. If that’s not enough to give you a headache, you can run into shortage costs if the smaller orders are not covering current demand. Sound confusing? It doesn’t need to be. A good inventory management system will give you a clear picture of where costs are being incurred with regards to inventory. An inventory management system can also streamline operations and monitor inventory levels in real-time to improve forecasting, increase efficiency and reduce the ordering, carrying and shortage costs of inventory.