There are three types of inventory:
• raw material
• work-in-progress
• Finished goods.
These are 4 types of costs associated with inventory management:
- Holding (carrying) cost
- Ordering cost
- Purchase cost
- Stock out costs
Holding Costs
These include warehousing costs, security, maintenance, administrative, insurance, cost of capital tied up in inventory and so on. Generally such costs increase in direct proportion to the amount of inventory held.
Ordering Costs
These are costs of placing an order which may include transport costs, clerical costs for preparing and placing an order, insurance in transit, clearing and forwarding costs etc.
Purchase Cost
This is the cost of purchasing cash unit of stock.
Stock out cost.
These include loss of customer goodwill, lost sales, cost of processing back orders and so on. If we assume certainty, the relevant costs for decision making would be the holding and ordering costs. The objective of inventory management is too minimizing these relevant costs. This occurs when the company orders an economic order quantity.
Basic Inventory Management Model
This is the economic order quantity model which helps to manage inventory by minimizing the ordering and holding costs. Smaller inventories reduce holding or carrying costs but since smaller inventories imply more request orders they therefore involve high ordering costs.
