Ordering costs, also known as procurement costs or setup costs, are the costs that a company incurs when it orders inventory or raw materials from its suppliers. These costs are associated with the activities required to administer the purchasing process, and are incurred every time an order is placed, regardless of the size of the order.
Ordering costs can include a variety of expenses, such as:
- Purchase Order Costs: This includes the cost of preparing and processing the purchase order. It could include the labor costs of the personnel involved, the cost of the paperwork, and any related supplies.
- Delivery Costs: If the supplier does not include delivery in the price, the buyer may incur costs for transportation and shipping.
- Inspection Costs: When goods arrive, they may need to be inspected to ensure they meet quality standards. The cost of the inspection process, including labor and any necessary equipment, is part of the ordering cost.
- Supplier Evaluation Costs: Before placing an order, a company might evaluate different suppliers to ensure they can provide the needed goods at an acceptable level of quality and price. The cost of this evaluation process is part of the ordering cost.
These costs can have a significant impact on a company’s inventory management decisions. For instance, if ordering costs are high, a company might choose to order larger quantities less frequently to minimize these costs. However, this has to be balanced against holding costs, which are the costs of storing and managing inventory.
It’s important for companies to accurately estimate both ordering and holding costs to determine their optimal order quantity – the quantity that minimizes the total cost of inventory management.
Example of Ordering Costs
Let’s consider a company named XYZ Manufacturing that produces electronic gadgets. Here is how ordering costs might work for them:
- Purchase Order Costs: The purchasing department at XYZ Manufacturing spends time on preparing and processing each purchase order. Suppose it takes one hour to complete this process, and the personnel involved are paid $30 per hour. So, for each order, the purchase order cost would be $30.
- Delivery Costs: XYZ Manufacturing orders components from a supplier who charges $50 for delivery each time, regardless of the order size.
- Inspection Costs: When the components arrive, a quality control specialist inspects the components to ensure they meet the necessary standards. Suppose this process takes two hours and the specialist is paid $20 per hour. Therefore, the inspection cost per order would be $40.
- Supplier Evaluation Costs: This cost isn’t directly tied to each order, but it’s a part of the overall cost of procuring goods. Suppose XYZ Manufacturing spends $1,000 per year evaluating suppliers and typically places 20 orders per year. That would mean each order carries an implied supplier evaluation cost of $50 ($1,000 / 20 orders).
Adding these up, the total ordering cost for XYZ Manufacturing for each order would be $170 ($30 + $50 + $40 + $50).
This means every time the company places an order, regardless of its size, it incurs costs of $170. So, if the company places smaller orders more frequently, these costs will add up. On the other hand, larger orders placed less frequently can reduce the total ordering costs but may increase the holding costs. That’s why it’s important for XYZ Manufacturing to find the right balance to minimize the total costs of inventory management.