Page 158 - DMGT523_LOGISTICS_AND_SUPPLY_CHAIN_MANAGEMENT

Unit 7: Inventory Management

This includes all the costs that are not related to the order quantity (the costs incurred to prepare Notes
the order paperwork, processing and tracking the order operations, the cost of setting up the
machine, and first off inspection). This total ordering/processing cost is eventually passed on to
the products.
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.

Notes 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.

7.2.5 Shortage or Stock-out Costs

No manufacturing facility can afford to keep sufficient stock to meet every demand. Stock-outs
occur at some point. Stock-outs result in either a lost sale, or if the customer is prepared to wait,
a back order. Lost sale reflects the risk of losing the business to competition. In addition, back
orders cause additional costs, viz. extra paperwork, the time spent handling this extra paperwork,
a system to handle the back orders, extra delivery notes, and invoices, extra packing and delivery
costs.
When the stock of an item is depleted, an order for that item must either wait until the stock is
replenished or be cancelled. There is a trade-off between carrying stock to satisfy demand and
the costs resulting from stockout. The costs that are incurred as result of running out of stock are
known as stock out or shortage costs.
Understanding the cost of a stockout is critical to the implementation of any inventory model.
Unless these costs are known, the organization cannot balance the costs (and risk) of holding
inventory with the loss of profits when an item is out of stock.
For a retailer, the costs include both the lost profits from the immediate order because of
cancellations, and the long-run costs if stockouts reduce the likelihood of future orders. For a
manufacturer, these include the loss of production as well as capacity. In addition, the ultimate
consequence is that sales of goods may be lost, and finally customers can be lost.
If the unfulfilled demand for the items can be satisfied at a later date (back order case), in this
case, 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). When this is related to the total cost of inventory, the
cost decreases increasingly with the increase in inventory, as this cost is relatively fixed with
respect to the value of the inventory.
Frequently, the assumed shortage cost is little more than a guess, although it is usually possible
to specify a range of such costs.
Self Assessment

State whether the following statements are true or false:
4. Raw materials are converted to finished goods through a number of incremental processes.

LOVELY PROFESSIONAL UNIVERSITY 153