3.1.

9 INVENTORY CARRYING COSTS:

Inventory carrying costs refers to the costs associated with carrying a quantity of stored
inventory. This is one of the vital costs that needs to be optimized in any logistics system.
It is a well-known fact that the inventory carrying costs is a part of the total logistics costs
of the firm. Aspects of these vital costs can be described and evaluated from a variety of
perspectives. Knowledge of inventory carrying costs is likely to be important to the
success of any business. In general, knowledge of inventory carrying costs constitutes a
vital part of management information necessary to optimize the logistics system.
However, without specific and comparable measurement of inventory carrying costs
relative to a target level, knowledge of inventory carrying costs alone may not be
sufficient to contribute either to the optimization of the firm's logistic system or to its
total costs.

The objective of a firm's logistics system usually is to minimize total costs given a
specified level of customer service. The total costs include inventory carrying costs,
transportation costs, warehouse throughput costs, order-processing costs, and lot quantity
costs. These total costs are dependent upon the configuration of the logistics system. To
optimize the system, the component costs must be known and must be comparable. The
comparison of these costs is not a simple process.

The lack of a specific methodology by which to measure inventory carrying costs and the
lack of an established preferred target level of inventory carrying costs, makes things to
look further complicated. From the above, it is clear that several important decisions are,
or should be, predicated on knowledge of the firm's inventory carrying costs. Basic
questions concerning inventory strategy can be properly made only after knowledge of
the firm's costs of carrying inventory. Certain important questions that one might want to
answer would be:

• How much inventory should we carry?

• Should the inventory be placed close to the point of purchase, close to the point of
supply, or at some in--process mid-point?
• Should we institute a system of just-in-time supply?
• Should we build field warehouses?
• Should we divest ourselves of existing warehouses?
• Should we use a form of premium transportation for our distribution?
• Should we require our suppliers to use a for premium transportation for in
supply?

Inventory costs must be known to arrive at the level of customer service, which the firm
chooses to offer. However, one cannot provide this without having a thorough
understanding of the inventory carrying costs. Management must know how an increase
in customer service will impact inventory-carrying costs. Similarly, they must know the
cost interactions between lost sales and smaller levels of inventory. In general,
knowledge of inventory carrying costs, those costs associated with carrying a quantity of
stored inventory, constitutes a vital part of management information necessary to
optimize the logistics system. For example, if a business manager knew the typical level
of inventory carry costs according to firm size, type, industry and geographic region, the
manager may be able to make better judgments about how efficient his business
operations are. However, it is possible to develop specific and comparable measurements
of inventory carrying costs according to industry, firm size, type, and region can be
developed. These estimates would provide a target level of inventory carrying costs. This
would allow us to assess the efficiency of our operation relative to competitors.

3.1.10 ECONOMIC ORDER QUANTITY:

The basic function of inventory is to insulate the production process or the inbound
supply process (in our case) from changes in the environment (or demand fluctuations).

Hence the inventory function will not only be applicable to a manufacturing firm, but
also to other industries that have stock e.g. the stock of money in a bank available to be
distributed to customers, the stock maintained by distributors, retailers etc.

The major question that any distribution company has to address is this:

“How much stock should we have of a particular product at any point of time?”

It isn’t a simple question to answer. We use the inventory control theory in attempting to
answer to the question.

There are two ways of handling it:

Ordering in lots:

• Ensures that we never run out

• Easy way to manage stocks
• High Stock costs, less management costs

Carrying none/very little stock:

• Called the JIT (Just in Time Technique)

• More Complicated method
• Less Stock costs, more management costs

Let us just take into assumption we go with Ordering in lots. The cost that needs to be
considered to decide on the amount of stock to be carried is divided into Stock holding
costs and Ordering costs (or fixed costs for any order) as below. Note here that,
management costs are being ignored.
Holding costs (Variable costs – varies with quantity):

• Storage costs
• Rent/depreciation
• Labor
• Overheads (e.g. heating, lighting, security)
• Money tied up (loss of interest, opportunity cost)
• Obsolescence costs (if left with stock at end of product life)
• Stock deterioration (lose money if product deteriorates whilst held)

Ordering costs (Fixed Costs):

• Clerical/labor costs of processing orders

• Inspection and return of poor quality products
• Transport costs
• Handling costs

We have to consider “Stock outs” as well. Stock outs occur when we have insufficient
stock to supply customers. Usually stock outs occur during the order lead-time, the time
between placing an order and the arrival of that order. Two things can happen in such a
situation:

• Order may be lost completely

• Customer might be prepared to wait until the product arrives

To determine the stock level - considering the simple assumptions:

• Our company orders from an outside supplier

• Outside supplier delivers to us precisely the quantity we ask for
• We pass that stock onto our customers

Other assumptions:

• Stock used up at a constant rate (R units per year)

• Fixed set-up cost “co” for each order (Ordering costs)
• No lead time between placing an order and arrival of the order
• Variable Stock holding cost “ch” per unit per year

We now need to decide Q, the amount to order each time – (Called Batch/Lot size).
Fig.1 - Stock Level Vs. Time1: (based on above assumptions)

Draw a horizontal line at Q/2 in the above diagram. It is clear that the number of times
when stock exceeds Q/2 is exactly equal to the number of times the stock falls below Q/2.
Hence this is a constant stock level of Q/2 over time.

• Annual holding cost = ch(Q/2)

Q/2 is the average (constant) inventory level

• Annual ordering cost = co(R/Q)

(R/Q) - number of orders per year (R used, Q each order)

Total Annual cost = ch(Q/2) + co(R/Q)

Our goal is to minimize the Total annual cost by selecting the appropriate value of Q. The
diagram below illustrates how these two components (annual holding cost and annual
order cost) change as Q (the quantity ordered), changes. As Q increases holding cost
increases but order cost decreases. The total annual cost curve is as shown below - On
that curve lies a value of Q that corresponds to the minimum total cost. By differentiating
total cost with respect to Q and equating to zero, we get that corresponding value of Q.
 Fig.2 – Cost Vs. Ordering Cost1

d(total cost)/dQ = ch/2 - coR/Q² = 0 for minimization

(Or) Q² = 2coR/ch

Therefore the desired Q value is given by:

• Q =(2Rco/ch)0.5

This is known as the Economic Order Quantity (EOQ).

This is a simple version of the EOQ formula based on the simple assumptions as
explained above. But in the real world, with several complications it may not look so
simple. But still this basic formula gives us an idea of approaching the quantity to be
ordered for a particular SKU.

The total annual cost associated with the EOQ can just be computed by substituting
replacing Q with (2Rco/ch)0.5 in the Total Annual Cost formula discussed above.

Therefore the total annual cost is:

ch((2Rco/ch)0.5/2) + co(R/(2Rco/ch)0.5) = (Rcoch/2)0.5 + (Rcoch/2)0.5 = (2Rcoch)0.5

Directly Quoted From:
1 – (Fig # 1 & 2) – Courtesy: Source: http://mscmga.ms.ic.ac.uk/jeb/or/invent.html
All the formulas quoted above in the EOQ section also taken from the same web source.

References:
1. http://mscmga.ms.ic.ac.uk/jeb/or/invent.html
2. http://www.sbaer.uca.edu/docs - Article on Inventory Carrying Costs
3. http://www.herpersgowling.com/n_lower_inventory_carrying_costs.htm - Small
Business Newsletters: Article Titled: “Money saver: Lower Inventory Carrying
Costs”
4. Book Titled: “Factory Physics: Foundations of Manufacturing Management” by
Wallace J. Hopp & Mark L. Spearman. Publisher: Chicago: Irwin, c1996 (ISBN #
0256154643)