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Unit 8: Inventory Management

counting items and calculating order quantities. The costs associated with maintaining the Notes
system needed to track orders are also included in ordering costs. This includes phone calls,
typing, postage, and so on.
Though vendor development is an ongoing process, it is also a very expensive process. With a
good vendor base, it is possible to enter into longer-term relationships to supply needs for
perhaps the entire year. This changes the “when” to “how many to order” and brings about a
reduction both in the complexity and costs of ordering.

8.1.3 Setup (or Production Change) Costs

In the case of subassemblies, or finished products that may be produced in-house, ordering cost
is actually represented by the costs associated with changing over equipment from producing
one item to producing another. This is usually referred to as setup costs.

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. If there were
no costs or loss of time associated in changing form one product to another, many small lots
would be produced, permitting reduction in inventory levels and the resultant savings in costs.

8.1.4 Shortage or Stock-out Costs

The costs that are incurred as result of running out of stock are known as stock out or shortage
costs. As a result of shortages, production as well as capacity can be lost, sales of goods may be
lost, and finally customers can be lost.

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Caution When the stock of an item is depleted, an order for that item must either wait until
the stock is replenished or be canceled. There is a trade-off between carrying stock to
satisfy demand and the costs resulting from stock out.

In manufacturing, inventory requirements are primarily derived from dependent demand,
however, in retailing the requirements are basically dependent on independent demand.
Inventory systems are predicated on whether demand is derived from an end item or is related
to the item itself. Because independent demand is uncertain extra inventory needs to be carried
to reduce the risk of stocking out. To determine the quantities of independent item that must be
produced, firms usually use a variety of techniques, including customer surveys, and forecasting.
However, a balance is sometimes difficult to obtain, because it may not be possible to estimate
lost profits, the effects of lost customers, or lateness penalties.

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). Frequently, the assumed shortage cost is little more than a
guess, although it is usually possible to specify a range of such costs.

Task Prepare a presentation on the different inventory costs and their similarities and
differences.

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