Page 210 - DMGT551_RETAIL_BUSINESS_ENVIRONMENT

Unit 11: Physical Distribution and Inventory Management

Average Inventory Notes

Average inventory is defined as half the batch size plus safety stock.
Average inventory = (Order quantity + Safety stock)/2
The assumption made is that at any point in time, the cycle stock (stock planned to be used
excluding safety stock) is on an average half the recipient quantity, i.e. it is halfway in between
the receipt quantity and zero left. The practical implication of this is that it reduces order
quantity and the average cycle stock by half. If a part is manufactured in smaller batches the
inventory goes down.
Safety stock is determined from such factors as customer service level required, demand variability
and replenishment lead-time. Once the customer service level required is agreed upon, safety
stock is calculated.

Holding (or Carrying) Costs

The very fact that an item is held in stock accrues cost. These are the real costs to hold inventory.
Such costs are called inventory holding costs or carrying costs. This broad category includes the
costs for:
Storage and Handling: This includes the total warehousing facility. This is typically 6
percent. It is estimated that the total cost to the company is 35 percent per annum of the
value of inventory held, or 3 percent a month.
Insurance: Insurance accounts for a portion of the inventory costs. Since it is better to be
safe than sorry, companies generally get the material insured. It generally works out to 1
percent.

Pilferage and spoilage: This accounts for anything from 2 percent upwards, depending on
the industry and the type of inventory that is being carried.
Obsolescence and Deterioration: This is inventory which is classified as being unfit to sell,
or lying in the storage waiting for the appropriate use. It is typically estimated to be about
1 percent of the Inventory carrying cost.
The opportunity cost of capital: This is the cost to set up the warehousing facility. This is
charged at the “Lost opportunity cost” and not the interest rate. Typically rated at
25 percent, this “Lost opportunity cost” is the return that could have been obtained if the
capital had been invested in anything other than inventory.

Ordering Costs

What is the real cost of placing and processing a purchase order? The total cost includes the cost
of purchasing, receiving, incoming inspection and the accounts payable. Each of these departments
exists to satisfy continuous demand for material. We arrive at a simple equation to calculate the
Average cost per order as:
Average Cost per Order = Total Budget/Number of Orders placed per year
Although it costs money to hold inventory, it also, unfortunately, costs money to replenish
inventory, either through the purchase cycle or through the manufacturing cycle.

Inventory Ordering Costs are those costs that are incurred in the purchase cycle are called
procurement costs or inventory ordering costs. Ordering costs have two components:
(a) One component that is relatively fixed, and
(b) Another component that will vary.

LOVELY PROFESSIONAL UNIVERSITY 205