April 28, 2016      5 min read

Order, Holding and Shortage Costs – What they are and how best to contain the cost

Inventory management plays a crucial role in the success or failure of any business. The downside associated with ineffective inventory management can be significant – up to 25% of the total inventory value according to the Reshoring Initiative. This is why it is essential to understand what the main costs related to inventory are and how to minimize them.

Inventory costs are generally grouped into three main categories: Ordering costs, Holding Costs and Shortage costs. By discussing each of these in detail, you’ll get a better understanding and appreciation of how your business could be operating below optimal profitability and what can be done about it.

Ordering Costs

Ordering costs are all the costs incurred by the business whenever an order for inventory or replenishment stock is placed. Typically, ordering costs are comprised of two main areas of concern: order processing costs and inbound logistic costs.

Order processing costs

These are defined as any cost that results from the actual order placement itself. The clerical costs of drawing up and placing the order, the hours spent securing reliable suppliers, accounting fees, bank charges and processing invoices all contribute to order processing costs. These costs are generally fixed, meaning they do not fluctuate drastically. This makes them easier to forecast and account for ahead of order placement and stock replenishment.

Inbound logistic costs

All expenses incurred as a result of the transportation, receipt of, or placement of inventory fall under this category. The type and cost of freight used, insurance, customs duties and import taxes as well as domestic transportation of goods can quickly pile up and contribute to driving up the true cost of inventory.

Unloading, unpacking and the materials handling costs (labor, equipment, packaging and security) are further costs that need to be taken into account to gain an accurate assessment of how much your inventory costs you to order and bring in.

Inbound logistics costs are variable and fluctuate according to a number of constantly changing factors. These include: order quantity, the supplier and shipping company used, the nature of the inventory and the location the inventory is bought from.

For instance, some countries have a Free Trade Agreement (FTA) in place, which means that the importer does not need to pay duties on goods being brought in. A company ordering from a supplier with FTA will enjoy a notable reduction in their cost of goods sold compared to a competitor with supply from a non-FTA country.

Managing order costs on inventory

There is no silver bullet solution to help businesses determine the ordering costs on their inventory. These costs are highly specific to the type of business and inventory being purchased and are vulnerable to a range of indeterminable variables.

However, while getting an exact appreciation on inventory order costs is challenging, it is still possible to implement sound inventory management strategies to ensure that these costs are kept to the necessary minimum.

By implementing and utilizing powerful inventory management software, a business will be able to determine the optimal inventory levels for its needs. Once inventory levels are accurately established it then becomes possible to determine the best purchase order quantities that will allow the business to capitalize on minimum order quantity discounts.

Holding or Carrying Costs

Any cost associated with the storage, insurance and protection on inventory as well as losses as a result of obsolescence can be classified as holding costs. The most common areas where costs are experienced on the storage of inventory are:

  • Warehousing or storage, including rent for the premises, materials handling and inventory service costs, equipment, utilities etc.
  • Security both in terms of IT or surveillance systems as well as on site security staff to secure the premises against theft, damage, fraud and other inappropriate business practices.
  • Insurance expenses.
  • Working capital tied up in on-shelf inventory as well as the lost interest as a result of not being able to invest that working capital in a way that would garner a return on investment.
  • Damage as a result of environmental deterioration and damage, theft, tampering and obsolescence.

Managing the holding costs of inventory is a notoriously challenging task. This is because in any typical business that handles a relatively wide variety of inventory or SKUs there is no uniform methodology to calculate holding costs. Differences due to sales volume, inventory turnover per SKU, size, volume, and weight as well as the difference in durability and shelf life of goods amalgamate to create an incredibly complex host of holding costs.

Getting a hold on holding costs

Having the ability to track, trace and account for each item of inventory in the supply chain enables a business to determine and bring down holding costs more effectively than a manual inventory management system. When process managers are able to pinpoint key inventory items that have high carrying costs but low turnover for instance, they can act to eliminate or reduce those items. This frees up working capital and resources to be better directed to inventory that has a bigger impact on the bottom line.

Shortage Costs

While holding costs can rise dangerously high if too much inventory is inefficiently stored and managed, the business also faces costs should it fail to hold enough stock to meet demand.

Stock outs are another inventory cost that must be taken into account in order to better foster effective supply chain management. While stock outs are something to be avoided at all costs, it is inevitable that they will occur from time to time.

Retailers incur heavier shortage costs when they have to place emergency orders. In doing so they pay higher than standard prices for both goods and shipping. If margins are low, then the business stands to sell product at a loss.

From a manufacturer’s standpoint, stock outs can signal a significant slowdown to production or worse still having to bring production to a halt until re-supply is brought in. This can result in deadlines being missed and customers pulling out and taking their business over to competitors.

While the tangible costs of stock outs can be accurately calculated, like paying a premium on shipping and production potentially coming to a halt, the intangible costs can be far more elusive. They can also be far more detrimental in the long run to the bottom line of the business. How do you put a numerical value on customer dissatisfaction, poor reviews and a diminished or eroded customer loyalty?

Implementing a cloud based Software-as-a-Service (SaaS) inventory management software solution allows process managers to maintain optimal inventory levels. This leads to notably decreased inventory costs as well as the ability to heighten supply chain operations efficiently and effectively.

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