As mentioned earlier, the major problems of inventory control are two, i.e. (a) How much to order ? and (b) When to order ? These can be answered by developing a model. An inventory model is based on the consideration of two main aspects of inventory, viz. the demand and the costs associated with that. Many factors related with these main issues are discussed in subsequent paragraphs.
Economic Parameters
These parameters usually include the following :
Purchase Price or Production Cost
The cost of the item is the money paid to the supplier for the item received or the direct manufacturing cost, if produced. It is normally equal to purchase price. When the market prices go on fluctuating, planning for inventory is based on the average price mostly taken as a fixed price. The price factor is of special interest when price discounts can be secured or when large production runs may result in a decrease in the production cost.
Selling Price
In some inventory situations, the demand may be affected by the quantity stocked. In such cases, the inventory model is based on a profit maximization criterion which includes the revenue from selling the commodity. The unit selling price may be constant or variable, depending upon whether quantity discount is allowed or not.
Procurement Costs
These costs are those incurred on a purchase (known as ordering costs) or incurred as set up costs related with the initial preparation of a production system if manufactured. These costs vary directly with each purchase order placed or with the set up made and are usually assumed independent of the quantity ordered or produced. Procurement costs include costs of administration (such as salaries of the persons concerned, telephone calls, computer costs, postage etc.), transportation of items ordered, expediting and follow up, receiving and inspection of goods, processing payments etc. This cost is expressed as the cost per order or per set up.
Carrying (or Holding) Costs
The cost associated with carrying of stocks of items is called holding cost or storage cost or possession cost. Holding costs include handling cost, maintenance cost, wages, insurance, safety measures, warehouse rent, depreciation, theft, obsolescence, interest on the money locked-up, etc.
Considering all the above elements, the storage cost is expressed either as per unit of item held per unit of time or as a percentage of average rupee value of inventory held. The size of all these carrying costs usually, increases or decreases in proportion to the amount of inventory that is carried.
Cost of Operating the Information Processing System
As stock levels change, someone must update records either by hand or by computer. Where the inventory levels are not recorded daily, this operating cost is incurred in obtaining accurate physical counts of inventories. Such operating costs are more fixed than variable over a wide quantity (volume) range.
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| Nature of Shortage Costs |
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