What is Inventory Cost?

Inventory Cost

Share This...

Inventory Cost

Inventory cost refers to the total cost associated with ordering, storing, managing, and accounting for a business’s inventory. This includes the cost of the goods themselves, as well as several other direct and indirect costs.

Here are the main components of inventory cost:

  • Purchase cost: This is the cost of acquiring the goods that a business plans to sell. For a manufacturer, it’s the cost of the raw materials, labor, and overhead needed to produce the goods.
  • Ordering cost: These are the costs associated with placing orders with suppliers. They can include administrative costs, shipping and handling fees, and any costs related to inspecting and receiving the goods.
  • Holding cost: Also known as carrying costs, these are the costs associated with storing inventory until it’s sold. They can include warehousing costs (like rent, utilities, and maintenance), as well as costs related to inventory financing, insurance, and depreciation.
  • Shortage cost: These are the costs that arise when a business runs out of a particular item of inventory. They can include lost sales, customer dissatisfaction, and the cost of emergency orders to replenish stock.
  • Obsolescence cost: These are the costs associated with inventory that becomes obsolete before it can be sold. These costs can be especially high for businesses that deal with fast-changing technologies or seasonal items.

Inventory costs can be significant, and effective inventory management is crucial to minimizing these costs and maximizing profitability. Companies often use techniques like just-in-time inventory management, economic order quantity models, and safety stock calculations to optimize their inventory levels and reduce costs.

Example of Inventory Cost

Let’s consider an example with a hypothetical small manufacturing company, ABC Widgets. Here’s how the different types of inventory costs might come into play:

  • Purchase Cost: ABC Widgets purchases raw materials to manufacture their widgets. Suppose they buy steel for $10,000, which will be enough to produce 1,000 widgets.
  • Ordering Cost: Every time ABC Widgets places an order with their steel supplier, they incur shipping fees, import duties, and the labor cost involved in creating the purchase order, receiving the goods, and checking their quality. Let’s say these costs add up to $500 per order.
  • Holding Cost: ABC Widgets stores the steel and the finished widgets in a warehouse. The costs of renting the warehouse, maintaining the proper storage conditions, insuring the inventory, and financing the upfront purchase of the goods could add up to, let’s say, $1,000 per month.
  • Shortage Cost: Occasionally, ABC Widgets receives a large order and runs out of stock before they can produce more widgets. The costs of expediting a new shipment of steel, the lost sales, and the potential damage to their reputation with customers could add up to significant amounts, although these can be hard to quantify.
  • Obsolescence Cost: Suppose ABC Widgets decides to upgrade their product, and the new widgets will require a different kind of steel. The old steel they have in stock, worth $2,000, can’t be used and becomes obsolete.

So, in this case, the total inventory cost for ABC Widgets would be the sum of all these costs. This doesn’t even take into account any potential discounts or incentives from suppliers for bulk purchases or early payments, which could also significantly impact the total cost of inventory.

This is a simplified example, but it illustrates the range of costs that can be associated with inventory. In reality, companies would need to use accounting and inventory management systems to track these costs accurately and make informed decisions about how to manage their inventory effectively.

Other Posts You'll Like...

Want to Pass as Fast as Possible?

(and avoid failing sections?)

Watch one of our free "Study Hacks" trainings for a free walkthrough of the SuperfastCPA study methods that have helped so many candidates pass their sections faster and avoid failing scores...