June 7, 2016      3 min read

Inventories often represent a substantial portion of a company’s total assets, and a reduction in inventory levels will often directly affect the profitability of a business. While it is prudent to have excess stock on hand to cover any production or supply shortfalls, it also pays to keep in mind that there are significant costs associated with inventories, and the more stock on hand, the higher the cost.For a business to remain successful in the long run, a balance must be found between the benefits of holding excess stock (predominantly not losing out on sales) and the costs incurred. Three of the primary costs of inventory are holding, ordering and shortage costs.

Holding Costs of Inventory

These are costs that directly relate to physically having and storing stock. They can include the cost of storing the goods in a warehouse or storeroom, security, insurance and depreciation. Holding costs also include product deterioration, obsolescence, breakages and theft, while also taking into account interest on any loans used to secure the stock and the opportunity cost of the capital that could be applied elsewhere.

Ordering Costs of Inventory

Ordering costs are fairly straightforward and are made up of the costs related to ordering and receiving inventory, and often vary with the actual placement of orders. Such costs include determining what as well as how much is required, as well as preparing invoices and shipping manifests. They also include inspecting arriving goods for quality and quantity and the use of any temporary storage space if required, as well as transport. In the event a company produces their own inventory rather than ordering from a supplier, then the cost of machinery set up and maintenance is comparable to ordering costs in that they are expressed as a fixed charge per production run, irrespective of the order size.

Shortage Costs of Inventory

These typically occur when demand for a product exceeds the supply of available inventory levels. This can be for a number of reasons, from late supplier lead times, to market shortages to internal issues such as fixing or expanding an assembly line. The costs associated with supply chain delays can escalate quickly as businesses try to mitigate losses by placing emergency shipments or even changing to more expensive suppliers in order to get goods delivered on time. Where stock outs occur and a business can no longer provide goods, not only do they lose out on potential sales and customers, but they also still have to pay their fixed expenses such as electricity, interest and staff wages.

The bottom line is that the costs surrounding inventory levels can have a significant impact on business profitability and cash flow. By reducing inventory levels (for example by using lean principles such as just-in-time inventory) a business can reduce some of the associated costs such as carrying or transportation costs, but may increase the risk related to shortage costs if they run out of stock. A trade-off has to be made between holding, ordering and shortage costs in order to minimize all three, and maximize production efficiency.