Page 174 - DMGT409Basic Financial Management

Unit 10: Inventory Management

However, incase of items manufactured in house the ordering costs would comprise the Notes
following costs:
(a) Requisitioning cost,
(b) Set-up cost,
(c) Cost of receiving and verifying the items,

(d) Cost of placing and arranging/stacking of the items in the store etc.
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Caution Ordering costs are fixed as per order placed, irrespective of the amount of the

order but ordering costs increases in proportion to the number of orders placed. If the

firm maintains small inventory levels, then the number of orders will increase, there by
ordering cost will increase and vice versa.
2. Inventory Carrying Costs: Inventory carrying costs are those costs, which are associated in
carrying or maintaining inventory. The following are the carrying costs of inventory:

(a) Capital cost [interest on capital locked in the inventories]
(b) Storage cost [insurance, maintenance on building, utilities serving costs]

(c) Insurance [on inventory - against fire and theft insurance]
(d) Obsolescence cost and deterioration
(e) Taxes

Carrying costs usually constitute to around 25 per cent of the value of inventories held.
3. Shortage: Costs [Costs of stock out]: Shortage costs are those costs that arise due to stock out,
either shortage of raw materials or fi nished goods.
(a) Shortage of inventories of raw materials affect the firm in one or more of the following

ways:
(i) The firm may have to pay some higher prices, connected with immediate (cash)

procurements.

(ii) The firm may have to compulsorily resort to some different production

schedules, which may not be as efficient and economical.
(b) Stock of finished goods - may result in the dissatisfaction of the customers and the

resultant lead, to loss of rules,
Thus, with a view to keep inventory costs of minimum level, we may have to arrive at the optional
level of inventory cost, its total order’s cost plus carrying costs are minimum.
In other words, we have to determine Economic Order Quantity (EOQ), at that level in which the
total inventory [ordering plus carrying less] cost is minimum.
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Did u know? What is the meaning of EOQ?
Economic order quantity refers to that level of inventory at which the total cost of inventory
is minimum.

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