Wednesday, August 13, 2008

Effective inventory

Sometimes the cost of an item will be dependent on how much is purchased
Which quantity represents the best buy?But in coming up with this answer, the salespeople are ignoring the fact that it costs your company something to maintain inventory in your warehouse. We refer to this amount as the inventory carrying cost. The inventory carrying cost, also known as the "K" cost, is the accumulation of all of the expenses you incur maintaining stocked inventory in your warehouse. These costs include:

* Moving material to the proper bin location and shifting it to other warehouse locations as necessary.
* Insurance and taxes on the inventory.
* Approximately 40% of your warehouse rent and utilities. The balance of these warehouse expenses is considered as part of the cost of filling customer orders.
* Physical inventory and cycle counting.
* Inventory shrinkage and obsolescence.
* Opportunity cost of the money invested in inventory. That is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment.

The total cost of carrying inventory, in dollars, grows as the investment in inventory grows. If you have more inventory, you have more money tied up in your warehouse stock. Inventory taxes and insurance increase. You probably also experience more inventory shrinkage (lost, damaged, or stolen material) and product obsolescence.

Even apparently fixed expenses such as warehouse rent and utilities can vary with the amount of inventory maintained in your warehouse. Suppose you could eliminate 40% of your current inventory. Would you still need all of the warehouse space you now occupy? Could you lease or sub-lease part of the building? Remember that even if you own your warehouse building, you still have a rent expense. But instead of the rent being the amount of money you pay to the owners of the building, it is the amount of income you give up by not being able to lease the building to another business.

Because of the direct relationship between the total value of inventory and the cost of maintaining that warehouse stock, the inventory carrying cost is expressed as a percentage of the average value of stocked inventory. As a general rule, the annual inventory carrying cost will be between 25% and 35% of the average value of stocked inventory. For example, if a distributor has an average inventory investment of $1,000,000, the annual carrying cost will be between $250,000 and $350,000. Firms with lower operating costs, such as those that own their own building, should use a number close to 25%. Distributors with higher operating costs, such as those whose warehouse space is limited and very expensive, should use a higher carrying cost percentage.

In determining the quantity that results in the lowest total cost of inventory, we need to compare the net savings received at each discount level to the cost of carrying larger quantities of the product in your warehouse.
Carefully examine discounts for buying larger quantities of an item. A lower price doesn't always result in the best value!

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