Inventory Carrying Costs

Many of the articles we studied this week emphasized the importance of optimizing inventory levels.  This is because having too little inventory results in stock-outs, poor customer service and supply chain disruptions.  On the other hand, having too much inventory adds unnecessary operating expenses and ultimately affects the bottom line.  It may be simple to accept at face value that having too much inventory increases operating expenses, but I am curious about how expenses are broken down into different categories.  This objective of this blog is to explore the different categories of carrying costs associated with inventory.

Source: http://www.remassoc.com/portals/0/remprecc.pdf[2]

The figure depicts a typical breakdown of inventory carrying costs.  The Appropriate Order Quantity article from this week's readings creates three general categories  for costs[1]:

1. Capital costs: Cost of money
2. Possession Costs: Taxes, Insurance, Clerical & Inventory Control, Obsolescence, Deterioration & Pilferage
3. Facility Costs: Insurance, Taxes, Warehouse Expenses

It is important to note that this chart only represents the 25-55% of total inventory costs that carrying costs account for.  That is why the slices look disproportionately large.

I think that there is a lot of variation within individual costs because these costs seem to vary greatly depending on the industry.  For example, computer components have a much higher risk of obsolescence than steel.  Other costs that seem like they would vary greatly between industries are deterioration (food vs. furniture) and warehouse costs (items with high size to cost ratios will require more storage space, making warehouse expense account for a higher proportion of total inventory expenses).

As you can see, there are many different costs associated with carrying inventory.  Reducing inventory levels may help to control these cost, but it comes at a price.  If you reduce inventories too much you will experience stock-outs and be left with unhappy customers who may take their business elsewhere. In a trade-off between service and cost efficiency, you need to consider the goals and values of the business.  Personally, I would favor service over cost efficiency if I had my own business.  Which do you think is more important?

Sources:
[1] Freeland, James R. and Landel, Robert, Managing Inventories: What is the Appropriate Order Quantity?  Darden Case No. UVA-OM-1006
[2] REM Associates Management Consultants, Methodology of Calculating Inventory Carrying Costs. Accessed 12 Feb 2013 from http://www.remassoc.com/portals/0/remprecc.pdf