September 23, 2015      3 min read

Ordering, holding, and shortage costs make up the three main categories of inventory-related costs. These groupings broadly separate the many different inventory costs that exist, and below we will identify and describe some examples of the different types of cost in each category.

Ordering costs

Ordering costs, also known as setup costs, are essentially costs incurred every time you place an order from your supplier. Examples include:

  • Clerical costs of preparing purchase orders — there are many kinds of clerical costs, such as invoice processing, accounting, and communication costs.
  • Cost of finding suppliers and expediting orders — costs spent on these will likely be inconsistent, but they are important expenses for the business.
  • Transportation costs — the costs of moving the goods to the warehouse or store. These costs are highly variable across different industries and items.
  • Receiving costs — these include costs of unloading goods at the warehouse and inspecting them to make sure they are the correct items and free of defects.
  • Cost of electronic data interchange (EDI) — These are systems used by large businesses and especially retailers, which allow ordering process costs to be significantly reduced.
  • There will be an ordering cost of some amount, no matter how small your order might be. The more orders placed, the greater the ordering costs. This ordering cost can be spread out if you placed a bulk order to use goods over a long period of time. However, if your business orders raw materials only as needed so that it keeps little stock on hand, you might be able to tolerate high ordering costs as this is balanced by an overall lower holding cost.

    Holding costs

    Also known as carrying costs, these are costs involved with storing inventory before it is sold.

    • Inventory financing costs — this includes everything related to the investment made in inventory, including costs like interest on working capital. Financing costs can be complex depending on the business.
    • Opportunity cost of the money invested in inventory — this is found by factoring in the lost alternatives of tying money up in inventory, such as investing in term deposits or mutual funds.
    • Storage space costs — these are costs related to the place where the inventory is stored and will vary by location. There will be the cost of the storage facility itself, or lease payments if it is not owned. Then there are facility maintenance costs like lighting, heating, and ventilation. Depreciation and property taxes are also included in this.
    • Inventory services costs — this includes the cost of the physical handling of the goods, as well as insurance, security, and IT hardware, and applications if these are used. Expenses related to inventory control and cycle counting are further examples.
    • Inventory risk costs — a major cost is shrinkage, which is the loss of products between purchasing from the supplier and final sale due to any number of reasons: theft, vendor fraud, shipping errors, damage in transit or storage. The other main example is dead stock.

    Shortage costs

    These costs, also called stock-out costs, occur when businesses become out of stock for whatever reason.

    • Disrupted production — when the business involves producing goods as well as selling them, a shortage will mean the business will have to pay for things like idle workers and factory overhead, even when nothing is being produced.
    • Emergency shipments — for retailers, stock-outs could mean paying extra to get a shipment on time, or changing suppliers.
    • Customer loyalty and reputation — aside from the loss of business from customers who go elsewhere to make purchases, the company takes a hit to customer loyalty and reputation when their customers are unhappy.

    As you’d have already noticed, the cost of inventory is substantial. If it’s not kept in check, it can eat into profits and impact cashflow.

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