Inventory Costs and Types Explained

The term “cost management” in inventory management signifies efforts to minimize the total cost involved in managing inventory without jeopardizing the supply chain. Many companies are facing theoretical challenges in reducing the total cost in inventory management when determining optimal production or order quantity.

First, let’s explore the types of costs in inventory management.

Many are already familiar with the saying “time is money,” and the importance of efficient inventory management deserves attention as how you manage your inventory can dramatically increase or decrease the time it takes to serve your customers.

1. Types of Inventory Costs

There are four types of inventory costs: order & purchase costs, preparation costs, inventory holding costs, and inventory shortage costs.

Order & Purchase Costs

Order & purchase costs encompass all costs of the ordering articles and/or items, purchase, procurement, and receipt. Additional costs covered under order & purchase costs can include costs of researching possible business relations or correspondents, transport costs, loading/unloading costs, and customs fees.

Preparation Costs

Typically, preparation costs are incurred when buying the necessary parts for product manufacturing from external suppliers, raw material warehouses, or from producing them internally.

Order costs represent various expenses or managing costs generated during the inventory purchase process from an external buyer, the wages of the procurement department and related payroll taxes and benefits, and similar labor costs for industrial engineering staff. The order cost does not have much relation with the order quantity.

The preparation costs also include the following: The costs of purchasing tools, the cost of replacing machinery or tools to produce special items, the cost incurred during machinery’s idle time, the labor cost of the preparation workforce, and the cost of tools.

Inventory Holding Costs

Various costs are included in inventory holding costs such as capital opportunity costs tied to the inventory, handling costs, storage facility costs, insurance costs, and costs related to shrinkage (damage or theft of inventory).

The largest share of inventory holding costs is capital opportunity cost tied to the inventory. This is the cost that is directly involved in maintaining a certain unit of inventory for a certain period of time. Therefore, it is important to verify that the higher inventory management cost is in fact, due to the higher stock level.

Inventory Shortage Costs

There aren’t too many scenarios that contribute to inventory shortage cost, but sometimes there are instances where the production cannot proceed due to lack of material. As such, various costs incurred due to a shortage of material can be included in inventory shortage costs.

Inventory shortage costs can be divided into two types.

The first type of cost is from the reduction in demand due to inventory shortage, which leads to out-of-stock costs, loss of credit, and loss of profit gained by fulfilling market demand.

The second type of cost is incurred when there is a delay from the period that inventory gets fulfilled and the demand is satisfied. This type of delay can add on additional costs of expedited production, loss of credit or buyer confidence, and costs related to untimely product arrival. Such cost is referred to as non-delivery inventory cost. Because it is generally difficult to objectively measure what inventory shortage cost is, experience or inference can often be determinant factors in measuring such cost.

2. Inventory Type

4 types of inventory: safety stock, anticipation inventory, cycle stock, stock in transit

Safety Stock

Safety stock is also referred to as buffer stock. It helps companies cope with unexpected changes in demand or helps retain a certain level of inventory when faced with uncertainty in the sales and production or procurement of materials. Safety stock prevents stock sellouts or unpaid purchase orders, helps meet deadlines, and improves customer experience.

Anticipation Inventory

Anticipation inventory is the stock that is set aside to meet increased seasonal demand. For example, anticipation inventory is to secure enough materials or products in advance to respond to varying seasonal demands or planned production downtime.

Cycle Stock

Cycle stock is the type of stock that is ordered at a constant rate to meet regular demand. It is also known as working stock: keeping just enough cycle stock to meet the business’s demand is an art of inventory management.

Stock In Transit (Moving Stock)

Stock in transit is also known as moving stock and consists of products currently in transit: purchases already paid for but still moving. If the stock is supplied from a distance, it requires a considerable support period and functional relationships with the transportation sectors.

Differences between Safety Stock and Cycle Stock

For instance, a business runs a promotion and the demand exceeds the business’s regular demand. In such a case, the business runs out of cycle stock and has to tap into safety stock. If the business doesn’t do a good job on inventory management, the company will lose sales, disappoint customers with unsatisfactory experience, or face reputational risks.