Inventory Cost Analysis: Uncovering Inefficiencies and Maximizing Profitability
July 11, 2023
The stock of any item or resource that an organization uses is known as its inventory. Inventory levels are managed and maintained by a set of policies known as an inventory system. It decides how large orders should be and when stock should be replenished. Reducing overall costs and increasing profits is every manufacturing organization’s main goal. Inventory costs consist of four expenses: purchase, ordering, inventory carrying, and shortage.
Companies are increasingly looking at their business as a pipeline, which controls the flow of materials from the source to the ultimate consumer. The pipeline inventory concept is not entirely new in terms of substance—a similar framework, the total cost concept.
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When deciding how much to buy from vendors or how many lots to send to the company’s production facilities, it is necessary to find the lowest total cost that results from the combined impact of the four individual costs. Inventory cost managers often have to make important decisions about how to balance ordering and carrying costs. When the order quantity per unit time is small, the number of orders increases, which leads to a higher ordering cost. This may occasionally result in stockouts and market loss.
Inventory cost accounting
Physical inventory levels must be converted to inventory costs in almost every business analysis involving inventory costs. Although the precise determination of the cost rate to be applied is actually a matter of cost accounting, here are the primary components:
Capital Cost
This is typically an internal funding rate multiplied by the product’s value. When the product moves down the supply chain, its value (materials, labour, transportation, etc.) increases.
Storage Cost
Inventory units consume physical space and may incur heating, refrigeration, insurance, etc. In order to determine which parts of these costs are actually driven by inventory levels and which can be considered more or less, an activities-based cost (ABC) analysis is typically required. The magnitude of the inventory cost change you are studying will determine the answer.
Obsolescence Cost
Obsolescence cost is a bit harder to figure out. When technology or style changes happen, your current products may become obsolete. The more inventory you have, the more vulnerable you are to this kind of loss.
Quality Cost
The probability of product damage is usually increased when there are high inventory cost levels, which also leads to slower feedback loops between supply chain partners. The result: lower levels of quality and a rise in the myriad costs associated with low quality. Again, these expenses are hard to calculate precisely, but the current consensus is that they can be quite substantial.
It is inevitable that this method has numerous issues. For one, inventory costs are not solely caused by a product’s value. Other product attributes, such as size, the need for refrigeration, obsolescence risk, etc., determine major components of inventory cost. Applying a single cost rate to all products at all production and distribution stages can be a big oversimplification.
Secondly, when analyzing the inventory cost rate, one implicitly assumes that only minor inventory changes will occur. According to the original ABC analysis of the inventory cost rate, “a major structural change in the supply chain may eliminate all categories of expenses that were considered.”
Types Of Inventory Cost
Ordering costs
Every time your business buys something from a supplier, you must think about the associated ordering costs; There will always be ordering costs, even if the order in question is quite small. Estimate the cost of an order by tracking the purchase requisition, purchase orders and invoicing, labour costs, and transportation and processing fees. Although some of these expenses, like preparing invoices, will be minor, Others, such as purchase orders, will cost much more.
Carrying costs
Companies pay inventory costs, sometimes referred to as “inventory holding costs”, for keeping their inventory items in stock. Costs of carrying can truly range from taxes and insurance to employee expenses and the cost of replacing damaged goods. Knowing how much profit your current inventory can make requires having an accurate view of your carrying costs. Businesses, fortunately, can cut these costs by using a productive warehousing layout and using inventive inventory management.
Stockout costs
Stockout costs refer to any potentially lost sales due to a product’s lack of supply, or the loss of income and expenditure as a result of a supply shortage. For instance, if a customer orders the last unit of an SKU you have in stock, but that item is incorrect, this can happen. It will be considered a loss because you cannot ship a defective product or have enough inventory to fulfil the order. If a customer sees that the product they want is out of stock on your website and decides to buy it elsewhere, it may result in stockout costs.
Shortage Costs
A company incurs shortage costs when it does not have enough inventory on hand. These expenses include overnight shipping costs to get items that are not in stock, lost margins on unfinished orders, and lost revenue from customers who go elsewhere to buy things. When deciding how much inventory to keep on hand, this is very important, especially for businesses that compete on customer service.
Spoilage Costs
When perishable goods are not sold enough quickly, they can deteriorate or spoil; therefore, inventory control is crucial to prevent spoilage. Expiring products are a source of concern for many industries. Businesses like food and beverage, pharmaceutical, healthcare, and cosmetics are affected by the expiration and use-by dates of their products.
Inventory Cost Methods
Products, partially completed products, raw materials, and supplies are all part of an inventory that is waiting for the end of a sales transaction. Inventory cost is usually calculated using the four cost formulas below:
Specific Identification
Firms that have unique, valuable goods like automobiles, paintings, expensive jewellery, and custom-made furniture use the specific identification technique. But if items in inventory are interchangeable, specific identification becomes impractical. In such situations, firms typically use FIFO, LIFO, or Average-Cost cost flow methods to assume the sold items and remaining items in inventory.
First-In-First-Out (FIFO)
In most companies, the FIFO method is consistent with the physical flow of inventories. It is based on the assumption that the latest purchases remain in the ending inventory and the earliest purchases are sold first. This indicates that the FIFO method values end inventory cost at current. Some argue that this FIFO method’s chronological cost flow is in line with good business practices, especially for obsolete or deteriorating goods.
Last-In-First-Out (LIFO)
The LIFO approach does not correspond to the actual physical inventory flow. According to the LIFO method, the earliest purchases are sold first, so ending inventory is based on the costs of the earliest purchases. Since current costs are equal to current revenues, some claim that this method of valuation can lead to realistic reported profits. However, some contend that the value of inventories at the earliest prices can give an unrealistic representation of the current value of the inventory using the LIFO method.
Average-Cost/Weighted Average-Cost
The weighted-average cost method is an alternative to FIFO and LIFO methods. When the inventory is made up of identical, interchangeable units and does not flow in any particular physical pattern, the average-cost system is appropriate. According to this approach, the value assigned to inventory is the overall cost of all inventory items that are available for sale during the given period. This technique smoothens the fluctuations in the cost of inventory items due to the technique of assigning an average cost.
Conclusion
Inventory levels are managed and maintained by a set of policies known as an inventory system. It decides how large orders should be and when stock should be replenished. When deciding how much to buy from vendors or how many lots to send to the company’s production facilities, it is necessary to find the lowest total cost that results from the combined impact of the four individual costs. Physical inventory levels must be converted to inventory cost in almost every business analysis involving inventory. Although the precise determination of the cost rate to be applied is actually a matter of cost accounting.
