Sunday, August 17, 2008

Inventory cost accounting

In almost any business analysis involving inventory, physical inventory levels must be converted to inventory costs. The exact determination of the cost rate to apply is really a cost accounting matter, but here
are the major components:
1. Capital Cost - This is usually an internal cost of funds rate multiplied by the value of the product.
Because value (materials, labor, transportation, etc.) is added to the product as it moves along the supply chain, this cost tends to increase as product moves downstream.
2. Storage Cost - Units in inventory take up physical space, and may incur costs for heating, refrigeration,
insurance, etc. An activities based cost (ABC) analysis is usually needed to determine which components of these costs are actually driven by inventory levels and which can be considered more-or-less fixed. The answer will depend on the magnitude of the inventory change you are analyzing.
3. Obsolescence Cost - A somewhat harder cost component to pin down is obsolescence cost. A technology or fashion shift may make your current products obsolete and severely deflate their value. The more inventory you have, the higher your exposure to this sort of loss.
4. Quality Cost - High levels of inventory usually increase the chance of product damage and create
slower feed-back loops between supply chain partners. The result: lower levels of quality and a rise in the myriad costs associated with low quality. Again, these costs are di±cult to quantify precisely, but the current consensus is that they can be quite significant.
Typically, all these costs are rolled together into a single inventory cost rate, expressed as a percentage
of the value of the product or material per unit time (e.g. 20% per year). Other equivalent terms for this
same cost rate are inventory holding cost rate and inventory carrying cost rate.
The value of a product is not the sole driver of inventory costs. Other product attributes, such as size, the need for refrigeration, obsolescence risk, etc., determine major components of inventory cost. Applying a single cost rate to all products at all stages of production distribution can be a gross oversimplification.
Secondly, in relying on an inventory cost rate in an analysis, one is implicitly assuming that only marginal
changes in inventory will occur. A major structural change in the supply chain may eliminate whole
categories of expenses that were considered "fixed" in the original ABC analysis of the inventory cost
rate. For example, a major reduction in inventory may eliminate the need for an entire warehouse, the
operating cost of which may have been considered fixed when the inventory cost rate was determined.

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