Answer:
As inventory is a necessary but idle resource, inventory costs in manufacturing need to be minimized. The heart of inventory decisions lies in the identification of inventory costs and optimizing the costs relative to the operations of the organization. Therefore, an analysis of inventory is useful to determine the level of stocks. The resultant stock keeping decision specifies:
- When items should be ordered?
- How large the order should be?
- “When” and “how many to deliver?”
It must be remembered that inventory is costly and large amounts of stocks are generally undesirable. Inventory can have a significant impact on both a company’s productivity and its delivery time. Large holdings of inventory also cause long cycle times which may not be desirable as well. What are the costs identified with inventory? The following costs are generally associated with inventories:
1. Holding (or Carrying) Costs
It costs money to hold inventory. Such costs are called inventory holding costs or carrying costs. This broad category includes the costs for storage facilities, handling, insurance, pilferage, breakage, obsolescence, depreciation, taxes, and the opportunity cost of capital. Obviously, high holding costs tend to favor low inventory levels and frequent replenishment.
There is a differentiation between fixed and variable costs of holding inventory. Some of the costs will not change by increase or decrease in inventory levels, while some costs are dependent on the levels of inventory held.
2. Cost of Ordering
Although it costs money to hold inventory, it also, unfortunately, necessary to replenish inventory. These costs are called inventory ordering costs. Ordering costs have two components:
- One component that is relatively fixed, and
- Another component that will vary.
It is good to be able to clearly differentiate between those ordering costs that do not change much and those that are incurred each time an order is placed.
One major component of cost associated with inventory is the cost of replenishing it. If a part or raw material is ordered from outside suppliers, and orders are placed for a given part with its supplier three times per year instead of six times per year, the costs to the organization that would change are the variable costs, generally not the fixed costs.
There are costs incurred in maintaining and updating the information system, developing vendors, and evaluating capabilities of vendors. Ordering costs also include all the details, such as counting items and calculating order quantities. The costs associated with maintaining the system needed to track orders are also included in ordering costs. This includes phone calls, typing, postage, and so on.
Though vendor development is an ongoing process, it is a very expensive one. With a good vendor base, it is possible to enter into longer-term relationships to supply needs for perhaps the entire year. This changes the “when” to “how many to order” and brings about a reduction both in the complexity and costs of ordering.
3. Set up (or Production Change) Costs
In the case of sub-assemblies, or finished products that may be produced in-house, ordering cost is actually represented by the costs associated with changing over equipment from producing one item to producing another. This is usually referred to as set up costs.
Set up costs reflect the costs involved in obtaining the necessary materials, arranging specific equipment setups, filling out the required papers, appropriately charging time and materials, and moving out the previous stock of materials, in making each different product. If there were no costs or loss of time associated in changing from one product to another, many small lots would be produced, permitting reduction in inventory levels and the resultant savings in costs.
4. Shortage or Stock-out Costs
When the stock of an item is depleted, an order for that item must either wait until the stock is replenished or be canceled. There is a trade-off between carrying stock to satisfy demand and the costs resulting from stock out. The costs that are incurred as result of running out of stock are known as stock out or shortage costs. As a result of shortages, production as well as capacity can be lost, sales of goods may be lost, and finally customers can be lost.
In this context, it is important to understand the difference between dependent and independent demand. In manufacturing, inventory requirements are primarily derived from dependent demand; however, in retailing the requirements are basically dependent on independent demand.
Inventory systems are predicated on whether demand is derived from an end item or is related to the item itself. Because independent demand is uncertain, extra inventory needs to be carried to reduce the risk of stocking out.
To determine the quantities of independent items that must be produced, firms usually use a variety of techniques, including customer surveys, and forecasting. However, a balance is sometimes difficult to obtain, because it may not be possible to estimate lost profits, the effects of lost customers, or penalties for delayed order fulfillment.
Where the unfulfilled demand for the items can be satisfied at a later date (back order case), in such a case, the cost of back orders are assumed to vary directly with the shortage quantity (in rupee value) and the cost involved in the additional time required to fulfill the backorder ( / / year). However, if the unfulfilled demand is lost, the cost of shortages is assumed to vary directly with the shortage quantity ( /unit shortage). Frequently, the assumed shortage cost is little more than a guess, although it is usually possible to specify a range of such costs.