Cost of inventory

Every firm maintains some stock of raw materials, work-in-progress and finished goods
depending upon the requirements and other features of the firm. Though are many benefits
of holding inventory, yet there are some cost associated with it, which are mentioned below:
[Link] cost: this is the cost incurred in the keeping or maintaining an [Link]
basic cost are associated with holding a units in [Link] are:
 cost of storage :This means and includes the cost of storing one unit of raw material or work in
progress or finished [Link] cost may include the rent of the space occupied, cost of the
people employed for security of the stock, cost of infrastructure required eg: cost of insurance,
warehousing cost, handling cost etc.
 Cost of financing:This is the cost of funds invested in the [Link] fund invested in the
inventories have an opportunity cost. Moreover, if the firm has to pay interest on borrowings
for the purchase of materials, then there is an explicit cost of financing.
 Cost of inventory
[Link] of ordering: the cost of ordering include the cost of acquisition of inventories. It is the cost
of preparation and execution of an order, including cost of paperwork and communicating with the
[Link] total annual cost of ordering is equal to the cost per order multiplied by the number
of orders placed in [Link] number of order determines the average inventory being held by the
[Link], the total ordering cost is inversely related to the average inventory of the firm.
The carrying cost and the cost of ordering are the opposite forces and they collectively determine
the level of inventory of any firm.
The carrying cost considerations require that the firms should maintain the inventories at the lowest
levels and should be replenished as frequently as [Link] will result in lowering carrying cost.
But this will also require frequent orders to be placed, therefore results in increase in the total cost
of [Link], afinance manager has to achieve atrade off between carrying cost and the
cost of ordering
[Link] of stock-out: Astock-out is a situation when the firm is not having units of an items in
store but there is a demand for that.
It refers to the demand for an item whose inventory level has reduced to zero or insufficient level. It
may be noted that the stock out does not appear if the item is not demanded even if the inventory has
fallen to zero.
 Techniques of inventory control
⚫ Inventory control refers to a process of ensuring that appropriate amount of stock are maintained by a
business,so as to be able to meet customer demand without delay while keeping the costs associated with
holding stock to a minimum. Inventory control signifies a planned approach of finding when to shift, what to
shift, how much to shift and how much to stock so that costs in buying and storing are optimally minimum
without interrupting production or affecting [Link] solve these problems of inventory management various
techniques are [Link] techniques are divided into two categories – modern techniques and traditional
techniques.
MODERNTECHNIQUES TRADITIONAL TECHNIQUES
(a) Economic Order Quantity (EOQ) (a) Inventory Control Ratios
(b) Re-Order Point (ROP) (b)Two Bin System
(c) Fixing Stock Levels (c) Perpetual Inventory System
(d) Selective Inventory Control: (d) Periodic Order System
• ABC Analysis
• VED Analysis (Vital, Essential, Desirable)
• SDE Analysis (Scarce, Difficult, Easy)
• FSN Analysis (Fast Moving, Slow, Moving and
Non-
moving)
 Modern Techniques
⚫ Modern techniques of inventory control refers to those techniques which are evolved
through a scientific [Link] techniques involve the use of a formula or a method
which is logically derived to keep control on the inventory levels.
 ECONOMIC ORDER QUANTITY (EOQ)
⚫ The EOQ refers to the order size that will result in the lowest total of order and carrying costs for an
item of inventory. If afirm place unnecessary orders it will incur unneeded order costs. If a firm
places too few order, it must maintain large stocks of goods and will have excessive carrying cost. By
calculating an economic order quantity, the firm identifies the number of units to order that result in
the lowest total of these two costs.
⚫ The limitations of this method are given below:
⚫ 1. Demand is known-- Using past data and future plans a reasonably accurate prediction of
demand can often be [Link] is expressed in unit sold in a year.
⚫ 2. Sales occur at a constant rate-- This model may be used for goods that are sold in relatively
constant amount throughout the year. Amore complicated model is needed for firms whose sales
fluctuate in response to there seasonal cyclical factors.
⚫ 3. Cost of running out of goods are ignored-- Cost associated with delays or lost sales are not
[Link] costs are considered in the determination of safety level in the re-order point
subsystem.
⚫ 4. Safety stock level is not considered-- The safety stock level is the minimum level of
inventory that the firm wishes to hold as a protection against running out. Since the firm must always
be above this level the EOQ need not be considered the safety stock level.
⚫ The optimal size of an order for replenishment of inventory is called economic order
quantity.
⚫ Economic order quantity (EOQ) or optimum order quantity is that size of the order where
total inventory costs (ordering costs + carrying costs) are minimized.
⚫ Economic order quantity can be calculated from any of the following two methods:
⚫ 1. Formula Method
⚫ 2. Graphic Method
 ECONOMIC ORDER QUANTITY (EOQ)- Formula Method
⚫ Formula Method: It is also known as‘SQUARE ROOT FORMULA’or ‘WILSON FORMULA’as given
below:
2𝑹𝑶
EOQ=
𝑐
Where,
EOQ = Economic Order Quantity
R = Annual Requirement or consumption in units
O = Ordering Cost per order
C = Carrying Cost per unit per year
𝑅
No. of orders =
𝐸𝑂𝑄
No. of days in a year
Time gap between two orders=
No. of orders

T𝑜𝑡𝑎𝑙𝐶𝑜𝑠𝑡= Purchase Cost + Carrying Cost+ Order Cost