Inventory costs | How can you reduce inventory costs ?

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Inventory costs | How can you reduce inventory costs

Costs of inventory
Managing your inventory costs is a balancing act. You're balancing the cost of not having enough inventory with the cost of having too much inventory. Most inventory decisions are driven by the cost of not having enough inventory.

This is the most important of the traditional costs of inventory, and it's called shortage or stock out cost. When your customer places an order, you're out of stock. Sometimes your customer will wait by placing a back order, but, quite often, you will lose the sale. For example, we've all shopped for groceries at some time. If bread is on your list and you don't find the kind of bread you normally buy, you simply pick another brand. For the bread company, that's a lost sale. Let that happen about three times in a row, and you will switch brands permanently. That's a lost customer, possibly forever.

So a major goal of all companies is to hold enough inventory to reduce stockout costs and lost sales. These holding costs are part of the traditional costs of inventory and fall into five distinct categories. First and foremost is the cost of the item itself. Money you have tied up in inventory cannot be used elsewhere to benefit the company. Then you must consider cost for storage.

Inventory takes up space in a warehouse, and the cost of that space must be calculated. Inventory also accumulates handling costs, moving material into the factory, moving products to distribution centers and customers, and moving inventory in and out of warehouses. Dependent upon the location of all these facilities, this can be a considerable expense. Taxes and insurance and interest play an important role in this decision, also. The higher the inventory, the higher your insurance premiums, and your end-of-year taxes.

Many companies borrow their working capital for inventory and must pay interest on those loans. Lastly, losses from damage, theft, and spoilage can create costs that cause you to really want smaller inventory levels. The longer you hold inventory, the more likely you will have these losses. Ordering cost is the last of the traditional inventory costs.

This is what is costs you to place an order with a supplier. The cost is the same, regardless of the size of the order. If these costs are high, there is an incentive to place large orders, so you don't have to order as often. Doing this, of courses, increases all your holding costs. Again, you must find the right balance. In addition to the traditional cost of inventory, you also must consider what are often called the hidden costs of inventory.

The most important to consider is the cost of obsolescence. The consumer electronics industry is especially concerned with this cost. New models and new products are released so often that finished goods and components can become worthless almost overnight. Holding large inventories has great financial risk. Electronics manufacturers are also concerned about price decreases, which happen very quickly. Holding large inventories of components can mean you paid too much for your parts, which lowers your profits.

The final hidden cost is the cost of quality. Inventories can be bloated by customer returns and products reworked or scrapped in the factory. I've included a handout that lists all these costs of inventory for you to review. Managing inventory is all about appropriately balancing shortage costs with all the other inventory costs and risk. Different departments directly impact different costs. Purchasing, for example, influences the cost of the item and the ordering cost. Where in the company do you work? How can you reduce inventory costs for your department?

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