Do You Know the True Costs of Inventory?

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Inventory is considered part of a company’s assets as it is the product of money that has been spent on it, and it represents money that could be procured when it is sold (whether in its current form or once it has been used for manufacture). As such, understanding inventory is incredibly important.

There are three costs of inventory that should be carefully considered as, all too often they can fly under the radar and drastically affect the bottom line without any apparent cause. These are the ordering, holding and shortage costs of ‘owning’ inventory.

Ordering Costs

When an item or inventory is ordered, a lot of behind-the-scenes work goes into it that requires a lot of time. And of course, time is money.

  • Suppliers have to be vetted and approached with sensible contracts in place for which there is extensive prior research required.
  • Purchase orders then have to be generated which utilizes clerical time.
  • The product is shipped which incurs transit insurance and transport costs.
  • The inventory needs to be receipted, unpacked and organized in the warehouse.

Holding Costs

When the inventory is unpacked, it is organized for storage. As soon as a ‘home’ as been found for an item and for as long as it stays there, a cost is generated. The costs associated with holding inventory can be broken up into the following categories:

  • Lease of the warehouse space where it is stored. The more inventory needing to be stored, the greater the space the company needs, incurring leasing costs.
  • Insuring of the inventory is a necessity (against theft or disaster) and can come at a premium.
  • Opportunity costs: these are incurred by capital being tied up in the inventory and therefore the opportunity to invest said capital elsewhere is lost.
  • Costs of inventory decreasing in value while stored. This is due to spoilage, decreased shelf-life or becoming obsolete for example.

Shortage Costs

Sometimes the answer to avoiding the two aforementioned costs is to ensure that the exact amount of required inventory is ordered, and no more. However, this isn’t the right answer necessarily. The reason for this is that there is an inherent cost associated to having a stock-out situation where the company cannot fulfill customer demand.

The first shortage cost encountered may be when the company has to quickly order the out-of-stock product, which due to short notice to the supplier, may come at a higher price. Additionally, the expedited shipping will also cost more. These costs cannot be added to the sale price and therefore the company must absorb them.

Secondly, not having enough inventory on hand can result in employees and machinery being under-utilized for the duration of the stock-out period. And thirdly, and possibly the most important cost of shortage, is the damage to the company’s reputation which can result in a loss of clientele. As can be imagined, this could result in massive losses and can be ongoing.

Considerations Going Forward

With regard to the costs of inventory highlighted, these considerations should be taken into account to avoid situations where the inventory costs are unnecessarily incurred.

  • Collate a prolific and well-researched list of approved suppliers who can be approached at a moment’s notice with no further investigation required.
  • Identify ordering incentives such as minimum order levels to optimize product cost and shipping.
  • Take time to formulate a structured receipting and warehousing system to save time later in unpacking and storage, and subsequent utilization of inventory.
  • Identify sales trends to generate reasonable minimum stock levels in order to both reduce inventory in storage and avoid shortage costs.
  • Research insurance companies and packages that cater for the company’s needs at a reasonable price.
  • Identify companies and shipping agents that can provide a last-minute service at the best price, in the event a shortage is encountered.
  • Formulate fallback protocols that can be implemented with confidence when shortages occur.
  • Identify agreed ways the company can compensate for shortages to the customer and thereby reinstate confidence and preserve the company reputation.

Many of these considerations require an intricate knowledge of inventory and sales, which can be tedious and somewhat unreliable without the use of a good inventory management system. Products such as Unleashed Software can be worth their weight in gold in understanding the company’s inventory.

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Melanie - Unleashed Software

Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.

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