COST OF INVENTORY
Inventory is something that all companies need. The difficult question to
answer is ’How much do they need?’
In manufacturing companies, although there are a few exceptions, material
is usually between 60 - 85% of cost of sales, depending upon the industry.
In electronics, it would be about be about 85%, with overheads about 12%,
and direct labour 3%. These percentages indicate where management attention
should be directed!
As inventory is by far the single greatest cost, we need to examine the
four causes that contribute to that cost.
THE ORDER PROCESSING/SET-UP COST
Many people are not aware of the real cost of placing and processing a
purchase order. The total cost should include the cost of purchasing, goods
receiving, incoming inspection and accounts payable. Each of these
departments only exist because we need material. If you divide the total
budget for these four departments by the number of orders placed during a
year, it will give an average cost per order. Some divide by the number of
receipts to give the average cost of a receipt, as 3 out of the four costs
are related to a receipt. The average cost of a receipt for companies using
the traditional receiving process is usually between $40.00 and $80.00,
depending upon the process used.
For manufactured items the equivalent cost is known as set-up. This
includes all the costs that are not related to the order quantity, viz
preparing the order paperwork, processing and tracking the order
operations, the cost of setting up the machine, and first off inspection.
This total ordering/processing cost has to be carried by the quantity of
items resulting from the process.
INVENTORY CARRYING COST
Costs result from the fact that the item is in stock. These are real costs
which must be accounted for. The total cost is made up of several elements.
* Cost of capital
This is charged at the "Lost opportunity cost" and not the interest
rate. Typically 25% "Lost opportunity cost" is the return that could
have been obtained if the capital had been invested in other than
Because you have the material, it must be insured. Typically 1%
* Pilferage and spoilage
This varies by industry, but is usually a minimum of 2%
* Obsolescence and deterioration
This is inventory held for which there is no requirement or is unfit to
sell. Typically 1%.
* Storage and handling
This includes the total warehousing facility. Typically 6%
The total cost to the company is 35% per annum of the value of inventory
held, or 3% a month.
STOCK-OUT/BACK ORDER COST
Because a company cannot afford to keep sufficient stock to meet every
demand, stock-outs must occur. Stock-outs result in either a lost sale, or
the customer is prepared to wait, so his order goes on back order.
A lost sale results in the business going to the competition. Back ordering
a demand causes additional costs, viz extra paperwork, the time spent
handling this extra paperwork, a system to handle the back orders, extra
delivery notes, and invoices, extra packing and delivery costs. In many
cases, the average cost of processing an individual order line item that
has been back ordered can be as much as $20 to $30. Often more costly than
the sale value of the item back ordered.
EXCESS AND OBSOLETE STOCK
Excess inventory is the quantity of material in stock or on order that is
greater than the anticipated demand for an agreed time period.
Obsolete inventory is that for which there is no anticipated demand. This
inventory typically occurs due to model run outs, engineering change notes,
or suppliers minimum/multiple order quantities. Companies tend to be
reluctant to write off this value as it is a loss in the books of
accounting, and so affects the profit.
In simple terms, it tells us that inventory is our biggest cost and the
more we have, the higher our cost. To keep our costs down we should have
only what is needed, when it is needed. This is why many companies appoint
a Materials Management Specialist to control the company’s inventory.