Page 156 - DMGT523_LOGISTICS_AND_SUPPLY_CHAIN_MANAGEMENT

Unit 7: Inventory Management

 Obsolescence and Deterioration: This is inventory which is classified as being unfit to sell, Notes
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.

Notes 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.

In addition, there are some other charges that may among other things include depreciation and
taxes.
As can be seen from Figure 7.2, holding costs is shown as a straight line. These costs increase
proportionately with the increase in the inventory level. Obviously, if the holding costs are
high, the organization should try to carry lower inventory and frequently replenish the stock.
Though holding costs are represented by a straight line, there are some fixed and variable costs
of holding inventory i.e. 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. The general breakdown
for inventory holding costs has been shown in Table 7.1.
Table 7.1: Fixed and Variable Holding Costs

Fixed Costs Variable Cost
 Capital costs of warehouse or store  Cost of capital in inventory
 Cost of operating the warehouse or store  Insurance on inventory value
 Personnel costs  Losses due to obsolescence, theft, spoilage
 Cost of renting warehouse or storage space

Source: Upendra Kachru, (2010), “Exploring the Supply Chain,” Excel Books
Capital costs and costs of operating the warehouse including the personnel are fixed, but interest
costs of capital held in inventory etc. are variable.

Did u know? The reason why the cost curve for holding inventory is a straight line is that
the contribution of the variable costs in the total holding costs is much greater than that of
the fixed costs.

7.2.3 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
Avg. cost per order as:
Avg. 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.

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