Risks and Costs Associated with inventories

1. Risk of price decline

Holding Inventory may increase the risk of decline in price. This may be due to increase in the supply of products in market by competitors, introduction of a new competitive product, competitive pricing policy of competitors etc.

2. Risk of obsolescence

The is a risk of inventory becoming obsolescence. The inventory may become obsolete/outdated due to improved technology, improvements in product design, changes in customers’ taste etc.

3. Purchase cost

A firm has to pay high price for managing inventory. Inventory management has to take into account of the price paid to the suppliers and the expense of transport for bringing the material to stores, insurance and transportation cost.

4. Ordering cost

Cost of ordering is one another factor that a firm has to consider in Inventory management. Ordering costs includes cost of requisitioning, preparation of purchase order, transportation of inventory, receiving the supplies at the warehouse etc.

5. Carrying cost

Carrying cost includes the cost of storing the inventory in warehouse, handling expenses, insurance and rent paid for managing the inventory, opportunity cost locked up in stocks etc. Opportunity cost here refers to the alternative use of funds that the firm would have used to invest in stocks.

6. Stock out (shortage) cost

Stocks results in higher costs when they fall short of demand. Shortage of stocks also results in higher cost, dissatisfaction among customers, decrease in sales and increase of loss to firm.

Measurement of shortage cost is relatively difficult because of its intangible nature. In practice, the lost contribution resulting from failure to meet demand provides a reasonable approximation. In cases where stock out does not result in loss in business, additional cost for crash procurement etc. may be considered as shortage cost.

Costs of Holding Inventories:

However, holding inventories is not an unmixed blessing. In other words, it is not that everything is good with holding inventories. It is said that every noble acquisition is attended with risks; he who fears to encounter the one must not expect to obtain the other. This is true of inventories also. There are certain costs also associated with holding inventories. Hence, it is necessary for a firm to take these costs into consideration while planning for inventories.

These are broadly classified into three categories:

1. Material Costs:

These include costs which are associated with placing of orders to purchase raw materials and components. Clerical and administrative salaries, rent for the space occupied, postage, telegrams, bills, stationery, etc. are the examples of ordering costs. The more the orders, the more will be the ordering costs and vice versa.

2. Carrying Costs:

These include costs involved in holding or carrying inventories like insurance charges for covering risks, rent for the floor space occupied, wages to laborers, wastages, obsolescence or deterioration, thefts, pilferages, etc. These also include opportunity costs. This means had the money blocked in inventories been invested elsewhere in the business, it would have earned a certain return. Hence, the loss of such return may be considered as an ‘opportunity cost’.

The above facts underline the need for inventory management, i.e., to decide the optimum volume of inventories in the firm/enterprise during the period.