There are a number of costs that make up the total inventory costs for a company. One of those costs is the carrying costs that a business expends while the material is in the warehouse, but there are other costs, such as the order and setup costs.
Order costs include the expenses involved in placing an order for a quantity of material, but this does not include the actual cost of the material itself. Setup costs are incurred when production or assembly lines are changed, for example when the manufacturing department has to change equipment for a different product or part to be manufactured.
When a business orders material there is a cost associated with the process. The cost is made up of two components: a fixed cost and a variable cost. The fixed cost remains the same for any order that is placed by the business to a vendor.
This type of fixed cost will include the cost of the company’s facilities and the maintenance cost of the computer system used to process purchase orders. These costs will remain the same if one or a thousand purchase orders are made.
The other component of order costs includes variable costs. These costs will vary depending on the number of purchase orders that are processed.
The variable costs can be significant and includes the cost of preparing a purchase requisition, the cost of creating the purchase order, the cost of reviewing inventory levels, the costs involved in receiving and checking items as they are received from the vendor, and the costs incurred in preparing and processing the payments made to the vendor when the invoice is received.
Order costs are often overlooked by companies as they perceive the actions of employees, such as checking inventory or testing the quality of incoming materials, as a part of an employee’s normal function.
However, when calculating the cost of ordering items, it is often a surprise to companies when they find out how much it actually costs to have an item of material purchased and available at their warehouse. Companies often forget that it costs far more to create 10 orders for five items each from a vendor than one order of 50.
It is easier for businesses to understand and appreciate the costs involved in production setups than the costs of ordering material from a vendor.
Manufacturing companies are often too aware of the costs of changing the manufacturing line from creating one item to creating another. There is often much discussion and analysis of the best way to minimize the time and cost of changing production on the shop floor. But with setup costs, there are still two component costs: fixed and variable.
In a production setup, the fixed costs will include the costs of the capital equipment used in tearing down the production line used for the old items and setting up the machine for the new items.
The variable costs in production setup include the personnel costs in changing over production, as well as the consumable material used in the teardown and setup. The longer the production tear down and setup takes, the higher the variable costs.
Carrying Costs and Order Costs
When a business is looking at its overall costs, it should examine the carrying costs of holding inventory against the cost of ordering material from vendors. It is clear that order costs are very high if a small number of items are ordered, while carrying costs are much lower when the inventory in the warehouse is very low.
The total cost of inventory is made up of carrying costs and order costs, and at a certain point, there is an optimum size of order where the total costs are at their very minimum. After that point, usually, when there are no more benefits gained in larger orders, due to the fixed costs of purchasing, the carrying costs of additional inventory continue to rise, forcing the total cost of inventory ever higher.