"Inventory generally refers to the materials in stock. It is also called the idle resource of an enterprise. Inventories represent those items which are either stocked for sale or they are in the process of manufacturing or they are in the form of materials, which are yet to be utilized." (1)
INVENTORY CARRYING COST:
"The costs that are associated with the quantity of inventory stored include a number of different cost components and generally represent one of the highest costs in physical distribution." (2)
Inventory carrying costs can also be defined as the cost related to hold / store in the inventory. The inventory costs are considered to be the highest hidden and unknown costs in the world of business. Most of the managers consider inventory holding costs normally from 15 to 35% of the inventory value, but on the other hand there are also some businessmen and co-operations which do not consider the inventory carrying cost even though these costs are real and substantial and matter a lot. The cost of carrying inventory has a direct relation with the number of ware houses that a company have but also on the firm's distribution polices, for example if we have same customer service level, low inventory carrying cost could result in the use of different ware houses which can also slows down the mode of transportation such as railroads. Whereas the high inventory carrying costs could lead in limited number of stock ware houses which save time and results in faster transportation by motor carriers or aircrafts in order to provide same service in both the cases. If we don't know the exact and accurate estimation of inventory carrying cost of a firm, then that firm or company will not be able to choose the distribution policies which would minimize its costs, but if we know the accurate total cost associated with carrying cost of inventory then we know the cost tradeoffs which can be made within the logistics system. (3)
NORMATIVE MODEL OF INVENTORY CARRINYG COST METHODOLOGY
Inventory Carrying Costs
Storage Space Costs
Inventory Service Costs
Capital Costs
Inventory Risk Costs
Inventory Investment
Insurance
Taxes
Plant Warehouses
Public Warehouses
Rented Warehouses
Company Owned Warehouses
Obsolescence
Damage
Pilferage
Relocation Costs
BASIC COST CATEGORIES:
There are 4 basic types of cost which should be considered wile calculating the inventory carrying cost which are:
Capital costs
Inventory service costs
Storage space cost
Inventory risk costs
These are explained in detail as follow
CAPITAL COSTS:
"Capital costs on inventory investment. Inventory requires capital that could be used for other types of investment and therefore the opportunity cost is the relevant cost of capital."
Most of the businessman is of the view that investing inventories is relatively liquid and riskless investment because they feel that they will get somewhat a lower return on the inventory investment. However holding inventory requires capital which could have been used in other investments and by investment money as inventory the company/ firm foregoes the rate of return that could be obtained by doing such type of investment. Therefore the company's opportunity cost of capital should be applied to the investment in inventory. Moreover this cost of capital should be made by out of pocket investment in inventory.
Many companies also use some variation of absorption for the inventory valuation; in this they consider only the manufacturing costs that are relevant which are cost of capital, the company's minimum acceptable rate of return should be applied to the variable costs which are directly related with the inventory.
The measurement of the cost of capital is very complex. Let's consider an example
"The coupon rate on bounds is not an accurate measure of cost of debt capital, so to measure the cost of debt capital; the impact of the marginal use of debt on the market price of common stock must be eliminated. Also from the fig. used for the cost of capital will depend on whether the security valuation is made on the basis of investment opportunities, stream of dividends, stream of earnings or discounted cash flow. What is required is a straightforward method of calculating the cost of capital that can be easily understood and applied by businessmen. In most business situations available capital must be rationed to the most attractive investments possibilities. James Moa has explained the concept of a "hurdle rate" the rate over which the projects will be accepted rate of return for use in the situations where capital is rationed. He defined the rate as the rate of return on the marginal investments, due to the principles of opportunity costs. Consider an example, a firm which pays 10% for funds that it acquires and because of capital rationing the marginal investments promising annual returns of 15%, although the cost of capital is only 10%. This means that relevant time value of money is measured by the return on the most profitable investments. Of course this 15% hurdle rate could also be selected as the cost of capital to the firm."
The hurdle concept should be used in order to calculate the actual cost involved. It must be used by the companies experiencing capital rationing, and where the capital rationing is not used the capital invested in inventory is expected to earn a rate competitive with a marketable security and other liquid investments of a firm. (4)
INVENTORY SERVICE COSTS:
"The inventory service costs are generated from taxes and insurance. Taxes apply to only the inventories which are held in the company. The inventory tax is a form of property tax."
The inventory service costs include the insurance and tax costs. The tax costs vary from state to state depending on the state the inventory is held. If the inventories are exempt to 19.8% of the assessed value than the tax rate may range from zero in those states like in Indiana State. Generally the taxes have a direct relation with the inventory levels like if the inventory level is increasing than the tax rate will also increase or vice versa. While on the other hand the insurance rates are not strictly proportional to the inventory levels, because insurance is usually purchased for a specified time period and insurance policy will be revised periodically based on the expected inventory changes. There are other different reasons that how the insurance rates vary like, they could be affected by the types of materials used in the construction of the building to house the inventory, the building's age and considerations such as the types of fire prevention equipment installed. (5)
SHORTAGE SPACE COSTS:
In storage space cost 4 types of facilities should be considered which are:
Plant warehouses.
Public warehouses.
Rented (leased) warehouses.
Company (private) owned warehouses.
These are explained in detail as follow:
PLANT WAREHOUSES:
The costs related to plant warehouses are mostly fixed in nature but there are some variable costs such as the cost the cost of taking inventory and other direct expenses should be included in inventory carrying costs. Incase if the warehouse space is rented or used for some productive purpose but not for storing inventory only then fixed charges and allocated costs are concerned otherwise they irrelevant.
PUBLIC WAREHOUSES:
The space in public warehouses is usually rented on a dollar per hundred weights or on a volume occupied basis. As the public warehouses is the most economical way to provide the desired level of customer service without incurring excessive transportation costs. Due to this reason mostly the costs related to public warehouses are considered as throughput costs and only charges for recurring storage that are explicitly or implicitly included in costs, and more the cost of capital related with holding inventory in public warehouses must be included in the cost of carrying inventory. This cost is equal to the variable manufacturing cost plus variable distribution cost, multiplied by the opportunity cost of capital or the hurdle rate.
RENTED (LEASED) WAREHOUSE:
Rented or leased warehouses are normally contacted or leased for a specified period of time. The amount of space which is rented depends upon the maximum amount needed for the period of contract. The warehouse rental charges are fixed and do not vary from day to day with the change in the inventory level, but while on the other hand the rental charges may vary to month to month or year to year until a new contract is made. In most case the rented warehouse charges are mostly fixed but some may vary with the amount of inventory held. In any case these costs could be abolished by not renewing the contract. However these costs should not be included in the inventory carrying cost but in the warehousing cost category.
COMPANY (PRIVATELY) OWNED WAREHOUSE:
The costs associated with company owned warehouses are primarily fixed although some may be variable with throughout. All operating costs that could be eliminated by closing a company owned warehouse. All the operating costs could be eliminated by closing down a privately owned warehouse or the net savings resulting from change to public warehouses should be included in warehousing costs and not in the inventory carrying costs. (6)
INVENTORY RISK COSTS:
The inventory risk costs vary from company to company, but typically will include charges for:
Obsolescence
Damage
Pilferage
Relocation of inventory
Obsolescence:
"The cost of obsolescence is the cost of each unit which must be disposed of at a loss because it is no longer possible to sell it at regular price. It is the difference between the original cost of the unit and its salvage value or the original selling price." (7)
Damage:
"The cost of damage should be included only for the portion of damage that is variable with the amount of inventory held. Damage incurred during shipping should be considered a throughout since it will continue regardless of inventory level." (8)
Pilferage:
"Cost that is closely related to company security measures than inventory levels, although it will definitely vary with the number of warehouse locations. Shrinkage has become an increasingly important problem for American can businesses." (9)
Relocation of inventory:
"Relocation costs are incurred when inventory is trans-shipped from one warehouse location to another to avoid obsolescence." (10)
For example:
Products that are selling well in Lahore may not be selling well in Karachi. By shipping the products to the location where they will sell. The firm avoids the obsolescence costs.
PROBLEMS ASSOCIATED WITH INVENOTRY RISK COST:
Shrinkage:
The problem of shrinkage occurs due to pilfering (i.e. inventory theft) for American businessmen. They consider this problem more an important than cash frauds or cash embezzlement, because it is hard to control and this cost may be closely related to company security measure than inventory level depending upon the number of warehouse locations.
Relocation cost:
Relocation costs are the cost associated with the transshipment of inventory from one warehouse to another to avoid obsolescence. Mostly these costs are the result of tradeoffs between transportation and warehousing costs and not relevant for the inventory holding cost. (11)
INVENTORY MODELS AND CARRYING COSTS
There is a phenomenon regarding a company's investment in inventory that is the inventory asset is usually made up of largest asset value in the balance sheet which constitutes about 20-40% of the total value of the company's assets.
There are 5 types of Inventory management models which examine the effectiveness and are concerned with the cost of holding inventory:
The EOQ Model( Economic Order quantity)
The Integration of credit and inventory policies
The Buffer Stock Model
Cost of minimization models.
These are explained in detail as follow:
The EOQ Model (Economic Order Quantity):
The EOQ models is used to minimize the total costs calculated with the inventory carrying cost, transaction cost (setup cost), unit cost and total consumption as inputs. Basically this method is used to determine a single point or quantity, but if a total cost analysis is done it is compulsory that over a range each side of this optimal point, the total for the firm does not change appreciably because of the damping effect of the square root. The EOQ model is mostly preferred and commonly used in practice because of its simplicity and small number of variables. As compared to other models the EOQ model gives a smaller cost penalty when demand is rising. (12)
The Integration of credit and inventory policies:
This model basically explains the difference in carrying costs between inventory and receivables. It examines the cost trade-offs between inventory and receivables policies with the relative profitability of:
Making large lots of materials and holding them for delivery to customers with short payment terms.
Delivering large lots to the customers and allowing them with longer payment plans.
This model is explained by "Schiff" he states "that the integration of account receivables and inventory management is important for the optimal financial performance of the company".
To maximize the utilization of resources and minimize the factory throughput consider the cost of production changes and the cost of carrying inventory , seeks to minimize the total of these two costs.
"A logical inventory reorder policy can have unexpected fluctuation driven to terminal demand on the manufacturing floor. For example, a traditional saw tooth reorder point system used for all the distribution points can have a crippling final effect on the floor of the factory.
In a case study, no orders were placed in the 60% of the weeks, in 30% one order and in 10% two or more orders were placed. Although there was a reasonable reorder plan from the stocking warehouses in place so the customer service level declined due to the lumpy demand the flow was smoothed out and a more optimal performance was attained when the cost of production changes were included and safety stock was increased at the branches." (13)
The Buffer Stock Model:
The buffer stock model is based on the two assumptions given by "Bivin" which are:
The firm should possess a target level of stock that increases with the expected sales and decreases with the increasing carrying costs.
The inventories should gradually be adjusted toward the target stock.
The Bivin model expands the traditional buffer stock model in the area of the relationship between the carrying and inventory investment. He assumes from the data that finished goods inventories are not sensitive to the short term interest rate changes, but rather lead to the longer term adjustment.
Cost of minimization models
Costs of minimization models are common in the area of determination of optimal inventory stocks. This model explains the dependency of carrying cost interest rates on factors such as the size of inventory stocks, the direction of economy in general and diversification of the investor. The summation of this model uses the new adjusted interest rate in the usual manner of cost minimization to determine the best inventory levels.
Minimization of factory throughput fluctuation is a phenomenon that most plant mangers dream about because only few factories know what their capacity is. The companies that are extremely capital intensive they have one benefit that capacity quantity and production is already known so therefore this schedule model is not required.
The common thing in all these models is the importance of knowing the accurate inventory carrying costs. These are real costs and can represent one third of the total distribution cost, or about 7.5% of sales of a manufacturing company. The inventory carrying costs includes storage space cost, service costs, inventory risk costs and capital costs. It is a combination of fixed and variable costs which is not calculated directly in routine. The inventory holding is said to be an evil and a waste can be accomplished if the inventory cost is high but it is an important concept which have been discussed in all these models.
The other common theme is maximizing good for the firm:
This model is accomplished either by minimizing the "bad" such as the cost as evidenced by the EOQ model and minimization of fluctuation in production demand, or by direct maximization of goods like profits for the integrated credits and inventory policies. (14)
Conclusion
To summarize, the importance finding the best inventory policy cannot be underestimated because inventories play a large role in the profitability of a firm. They constitute a large portion of assets, therefore needs much attention and planning is done in the inventory management. We can say that inventory control is two-edged sword, if too much inventory and the firm is not optimizing its performance and putting itself in a great risk of obsolescence and other quality issues. While on the hand if there is a dramatic reduction in the inventory is made without the improving the manufacturing process to decrease the lead time and firm can greatly damage its customer service responsiveness and reputation.
In all these models a coming theme is found that is as the carrying cost rose, the amount of inventory declined; but a great difference between these models is the relative elasticity of inventory with respect to the carrying cost. There the correct model should be selected for a particular industry and business to make sure the best performance and good output for that firm or company.
REFRENCES
Book: Operations Management, (S. Anil Kumar & N. Suresh) New Age International Publishers (Pg. 176)
Profit oriented inventory policies require a documented inventory carrying cost; Lambert, Douglas;Quinn, Robert (Business Quarterly (pre-1986); Autumn 1981; 46, 3; ProQuest Central)
INVENTORY CARRYING COSTS; Lambert, Douglas M;La Londe, Bernard J (Management Accounting (pre-1986); Aug 1976; 58, 2; ProQuest Central)
Profit oriented inventory policies require a documented inventory carrying cost; Lambert, Douglas;Quinn, Robert (Business Quarterly (pre-1986); Autumn 1981; 46, 3; ProQuest Central),
INVENTORY CARRYING COSTS; Lambert, Douglas M;La Londe, Bernard J (Management Accounting (pre-1986); Aug 1976; 58, 2; ProQuest Central)
Profit oriented inventory policies require a documented inventory carrying cost; Lambert, Douglas;Quinn, Robert (Business Quarterly (pre-1986); Autumn 1981; 46, 3; ProQuest Central),
INVENTORY CARRYING COSTS; Lambert, Douglas M;La Londe, Bernard J (Management Accounting (pre-1986); Aug 1976; 58, 2; ProQuest Central)
INVENTORY CARRYING COSTS; Lambert, Douglas M;La Londe, Bernard J (Management Accounting (pre-1986); Aug 1976; 58, 2; ProQuest Central)
Profit oriented inventory policies require a documented inventory carrying cost; Lambert, Douglas;Quinn, Robert (Business Quarterly (pre-1986); Autumn 1981; 46, 3; ProQuest Central)
Profit oriented inventory policies require a documented inventory carrying cost; Lambert, Douglas;Quinn, Robert (Business Quarterly (pre-1986); Autumn 1981; 46, 3; ProQuest Central)
Profit oriented inventory policies require a documented inventory carrying cost; Lambert, Douglas;Quinn, Robert (Business Quarterly (pre-1986); Autumn 1981; 46, 3; ProQuest Central)
Profit oriented inventory policies require a documented inventory carrying cost; Lambert, Douglas;Quinn, Robert (Business Quarterly (pre-1986); Autumn 1981; 46, 3; ProQuest Central)
INVENTORY CARRYING COSTS; Lambert, Douglas M;La Londe, Bernard J (Management Accounting (pre-1986); Aug 1976; 58, 2; ProQuest Central), A Comparison of Inventory Models And Carrying Costs; Ptak, Carol (A Production and Inventory Management Journal; Fourth Quarter 1988; 29, 4; ProQuest Central pg. 1),
A Comparison of Inventory Models And Carrying Costs; Ptak, Carol (A Production and Inventory Management Journal; Fourth Quarter 1988; 29, 4; ProQuest Central pg. 1), What's Your Inventory Carrying Cost, and Why Don't You Know It? Anonymous (Inventory Management Report; Jan 2005; 05, 01; ProQuest Central pg. 2)
A Comparison of Inventory Models And Carrying Costs; Ptak, Carol (A Production and Inventory Management Journal; Fourth Quarter 1988; 29, 4; ProQuest Central pg. 1), What's Your Inventory Carrying Cost, and Why Don't You Know It? Anonymous (Inventory Management Report; Jan 2005; 05, 01; ProQuest Central pg. 2)
