The True Cost of Inventory in Operations Management - dummies

The True Cost of Inventory in Operations Management

By Mary Ann Anderson, MSE, Edward J. Anderson, Geoffrey Parker

Maintaining inventory is expensive; it diverts resources from other areas of your operations. But not having enough inventory can lead to lost sales and inadequate customer service. Therein lies the rub. Getting too far off the delicate balance of appropriate inventory for your business puts you in dangerous territory.

When deciding how much inventory to carry, an operations manager must balance the costs of having too much with the risk of coming up short. The different costs of inventory touch every area of business:

  • Ordering costs: The costs of ordering and receiving inventory vary for each business, but these costs include the labor associated with placing an order and the cost of receiving the order. Ordering costs are usually expressed as a fixed dollar amount per order, regardless of order size.

  • Holding or carrying costs: The cost of physically having inventory on-site includes expenses to maintain the infrastructure needed to warehouse the goods and insurance to protect it.

    Additionally, the value of inventory can decline because of deterioration and obsolescence, which adds to the cost of storing inventory. This is particularly true of perishable goods such as food and medicine, but even nonperishable products can go out of style or become obsolete. And inventory can be damaged or “disappear” off the shelf when it’s being stored, which in operations lingo is called shrinkage.

  • Lost sales: If a product isn’t available, then you can’t sell it. Unless a customer is willing to wait for delivery while you produce and/or prepare the product of interest, you lose the sale and the resulting revenue and profit by not having an adequate supply to meet demand.

  • Goodwill costs: Alienating customers if your product is out of stock rolls back a considerable investment that your company has likely made in establishing goodwill in the market. Your loss in this situation includes other items that the customer doesn’t purchase when the product is unavailable as well as products he doesn’t purchase from you in the future because of perceptions about your company related to the initial shortage.

Though ordering and holding costs are usually easy to calculate, estimating the actual cost of lost sales and goodwill is more difficult. Many companies don’t have a way to track potential customers who wanted to buy a product that was unavailable and to determine whether the inventory snafu led to the loss of other sales. Accurately measuring these costs is important because they can significantly affect a company’s bottom line.

The best way to measure goodwill costs varies by industry and by the nature of your product, but good market research and acute familiarity with your customer base are critical.