Costs of Holding Inventory

One operating objective of inventory management is to minimize cost. Excluding the cost of merchandise, the costs associated with inventory fall into two basic categories: (i) Ordering or Acquisition or Set up costs, and (ii) Carrying costs. These costs are an important element of the optimum level or inventory decisions.

Ordering Costs

This category of costs is associated with the acquisition or ordering of inventory. Firms have to place orders with suppliers to replenish inventory of raw materials. The expenses involved are referred to as ordering costs. Apart from placing orders outside, the various production departments have to acquire materials from the stores. Any expenditure involved here is also a part of the ordering cost. Included in the ordering costs are costs involved in to preparing a purchase order or requisition form and (ii) receiving, inspecting, and recording the goods received to ensure both quantity and quality. The cost of acquiring materials consists of clerical costs and costs of stationery. It is, therefore, called a set up cost. They are generally fixed per order placed, irrespective of the amount of the order. The larger the orders placed, or the more frequent the acquisition of inventory made, the higher are such costs. From a different perspective, the larger the inventory, the fewer are the ·acquisitions and the smaller lower are the order costs. The acquisition costs are inversely related to the size of inventory: they decline with the level of inventory. Thus, such costs can be minimized by placing fewer orders for a larger amount. But acquisition of a large quantity would increase the cest associated with the maintenance of inventory, that is, carrying costs.

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