Most businesses overlook their real inventory cost. In reality, the inventory price is more than its purchase price. It is because it includes the cost of ordering, as well as the cost of storing and maintaining until sales happen, consumed or disposed of. For assessment of the total inventory value, every business must consider Carrying or Holding cost and Ordering cost, together with the purchase price.
As the name suggests, it is the cost of ordering or purchasing and receiving the inventory. It includes procurement and logistics costs. Some examples of ordering costs are the cost of readying purchase orders, cost and time that a company spends on finding suppliers, inspection cost, cost of transportation and more.
Carrying or Holding Cost
It includes the storage and maintenance costs for the inventory. The costs could be of in-house facilities or external warehouses for which the company has to pay rent. In both cases, the carrying cost would include the use of premises, hardware equipment, IT Software applications, Material Handling Equipment and human resources.
Holding costs include two types of costs:
- Inventory Storage Cost
It usually includes the cost of rental and facility maintenance and other related costs. It will also cover the costs of human resources, communication costs and utilities, operational costs, and more.
It includes the costs of investments, taxes on inventory, insurance expenses, as well as interest (if any) on the working capital. It would also cover any cost of legal liability.
Holding cost vs Ordering cost – Relation
Holding and ordering cost have an inverse relationship. It means if one of two rises, the other cost would drop. Suppose, if the ordering cost is less, it would mean the company is giving fewer orders in a period. Fewer orders, in turn, would mean the quantity of each order is larger. It would result in more inventories lying with the company, and thus, there would be an increase in the carrying cost. Similar will be the case if the carrying cost is low. In such a situation, the frequency of ordering and related costs are more.
Let us take an example to understand the relationship between Holding cost vs Ordering cost.
Company A needs 100 units of mobiles every month. It can order these units in several ways. For the sake of simplicity, we will discuss here two options.
In the first option, Company A orders once a month. It will order 100 units in one go. Its ordering cost will be less, but it would have to incur holding cost on full 100 units.
In the second option, Company A order five times a month, or 20 units per order. Since it needs to place five orders, its ordering cost would rise. On the other hand, its carrying cost would drop as at a time, and it would have to worry about just 20 units.
Holding cost, Ordering cost and EOQ
We can better understand the relationship between the Holding cost vs Ordering cost using the concept of EOQ (Economic Order Quantity). At the EOQ level, the carrying cost and the holding cost are at a minimum. Or, we can say, it is the level of inventory at which the sum of carrying and ordering costs is minimum. If a company orders more or less than the EOQ level, it will result in more inventory cost.
Let us understand this with the help of an example. Company A sells mobiles. On average, its annual sales are 10,000 units. The cost per order is $200, while the carrying cost is $5 per unit. Here, we first need to calculate the economic order quantity (EOQ).
The formula for EOQ is
D is the total demand, C is the carrying cost per unit, while O is the cost per order.
EOQ =√¯‾ (2* 10,000 * 200)/5 = 894.43 or 895 units.
Since the annual demand is 10,000 units, the company will have to place approx. 11 orders annually.
Total ordering cost will be $200 * 11 = $2,200.
For calculating the carrying cost, we need to find average inventory first. Average inventory is opening stock plus purchase divided by 2. We have no opening stock so that average inventory would be 895/2 = 447.5 units. So, the total carrying cost is (447.5 * 5) $2,237.5
Total inventory cost for company at EOQ is the ordering cost plus holding cost or $2,200 + $2,237.5 = $4,437.5.
Now, let’s see what happens if Company A orders more than the EOQ. Assume Company A orders 1,000 units at a time. The total number of orders will be 10 (10,000 / 1,000), and average inventory will be 500 (1,000/2). Now, total inventory cost would be (($200 * 10) + (500 * $5)) $4,500.
If Company A orders less than EOQ, say 800 units. The total number of orders will be 12.5 (10,000 / 800), and average inventory will be 400 (800/2). Total inventory cost will be (($200 * 12.5) + (400 * $5)) is $4500.
In both cases, the total inventory cost is the same, but it is still more than the EOQ level. Thus, it is now clear that a company should aim to minimize both costs and use the EOQ model.
We can say the study and analyses of both Holding costs vs Ordering costs help a business to decide how much to order and when to order. There is always a tradeoff between both the costs. Hence, the objective of the company should be to minimize the total of both costs, and for that, it should make use of economic order quantity (EOQ) model.1–3