Inventory costs can amount to be a significant expense for your business operations. From an accounting perspective, you may classify them as inventory in raw material, work-in-process, or finished goods. These expenditures could be incurred in various ways like space, labor, damage, theft etc. In this post, we will talk about the major types of inventory costs and what they entail.
There are essentially two categories, and chances are you came across these at some point:
1. Ordering Costs
Ordering costs are the part of over inventory costs that are related to the procurement of inventory. These can start as soon as you decide to order inventory from your supplier. Some examples would be:
- Cost of creating and processing a purchase order
- Cost to expedite shipments if order was on a short notice
- Labor to receive, examine and put away shipments from the supplier
- Processing payments to your suppliers
Don’t forget that these will also include the shipping costs as well. Moreover, if your supplier is international, you incur additional charges like customs duty, taxes, in-transit insurance etc. if not a part of your contract.
It is important to note that ordering costs will be a part of your expenses regardless of the actual value of the goods.
2. Carrying Costs
Carrying costs of inventory relate to maintaining and holding the inventory that you receive. These are much more extensive than the former kind and include:
- Cost for storing the inventory (rental space)
- Depreciation, insurance or theft losses also add to the holding costs
- Labor cost associating with managing the inventory at the warehouse
- Writing off inventory after it becomes obsolete
In addition, an important type of cost that you should consider is the opportunity cost of holding inventory. This is the capital that’s tied up in your inventory and now you cannot use it elsewhere. Opportunity costs are different for each firm, depending on their scale and resources available.
It is vital to account both types when determining the total cost of your inventory. You may be leaning towards reducing either one as an organizational goal, depending on which is more significant. As a solution, you can potentially order a large quantity at once, lowering your ordering cost but then your holding costs will increase. Contrary to that, you can order less each time to reduce your holding costs. However, the increase in frequency of ordering will impact your ordering cost.
Remember, it will be a trade-off.
In conclusion, inventory costs can be a significant part of your product cost. You must factor in all variables to determine the Economic Order Quantity in order to find the optimal inventory level.