Inventory cost includes the costs to order and hold inventory, as well as to administer the related paperwork. This cost is examined by management as part of its evaluation of how much inventory to keep on hand. This can result in changes in the order fulfillment rate for customers, as well as variations in the production process flow.
Inventory costs can be classified as follows:
- Ordering costs. These costs include the wages of the procurement department and related payroll taxes and benefits, and possibly similar labor costs by the industrial engineering staff, in case they must pre-qualify new suppliers to deliver parts to the company. These costs are typically included in an overhead cost pool and allocated to the number of units produced in each period.
- Holding costs. These costs are related to the space required to hold inventory, the cost of the money needed to acquire inventory, and the risk of loss through inventory obsolescence. Most of these costs are also included in an overhead cost pool and allocated to the number of units produced in each period. More specifically, holding costs include:
- Cost of space. Perhaps the largest inventory cost is related to the facility within which it is housed, which includes warehouse depreciation, insurance, utilities, maintenance, warehouse staff, storage racks, and materials handling equipment. There may also be fire suppression systems and burglar alarms, as well as their servicing costs.
- Cost of money. There is always an interest cost associated with the funds used to pay for inventory. If a company has no debt, this cost represents the foregone interest income associated with the allocated funds.
- Cost of obsolescence. Some inventory items may never be used or will be damaged while in storage, and so must be disposed of at a reduced price, or at no price at all. Depending on how perishable the inventory is, or the speed with which technology changes impact inventory values, this can be a substantial cost.
- Administrative costs. The accounting department pays the wages of a cost accounting staff, which is responsible for compiling the costs of inventory and the cost of goods sold, responding to other inventory analysis requests, and defending their results to the company's internal and external auditors. The cost of cost accounting personnel is charged to expense as incurred.
As the preceding list reveals, the cost of inventory is substantial. If not properly monitored and adjusted, inventory costs can eat into profits and cash reserves.