What will happen to the ordering cost and the holding cost as the order quantity increases for a material?

Inventory procurement, storage and management is associated with huge costs associated with each these functions.

Inventory costs are basically categorized into three headings:

1. Ordering Cost
2. Carrying Cost
3. Shortage or stock out Cost & Cost of Replenishment
   
   
   1. Cost of Loss, pilferage, shrinkage and obsolescence etc.
   2. Cost of Logistics
   3. Sales Discounts, Volume discounts and other related costs.

1. Ordering Cost

   Cost of procurement and inbound logistics costs form a part of Ordering Cost. Ordering Cost is dependant and varies based on two factors - The cost of ordering excess and the Cost of ordering too less.

   Both these factors move in opposite directions to each other. Ordering excess quantity will result in carrying cost of inventory. Where as ordering less will result in increase of replenishment cost and ordering costs.

   These two above costs together are called Total Stocking Cost. If you plot the order quantity vs the TSC, you will see the graph declining gradually until a certain point after which with every increase in quantity the TSC will proportionately show an increase.

   This functional analysis and cost implications form the basis of determining the Inventory Procurement decision by answering the two basic fundamental questions - How Much to Order and When to Order.

   How much to order is determined by arriving at the Economic Order Quantity or EOQ.

2. Carrying Cost

   Inventory storage and maintenance involves various types of costs namely:

   • Inventory Storage Cost
   • Cost of Capital
   
   

   Inventory carrying involves Inventory storage and management either using in house facilities or external warehouses owned and managed by third party vendors. In both cases, inventory management and process involves extensive use of Building, Material Handling Equipments, IT Software applications and Hardware Equipments coupled managed by Operations and Management Staff resources.

   1. Inventory Storage Cost

      Inventory storage costs typically include Cost of Building Rental and facility maintenance and related costs. Cost of Material Handling Equipments, IT Hardware and applications, including cost of purchase, depreciation or rental or lease as the case may be. Further costs include operational costs, consumables, communication costs and utilities, besides the cost of human resources employed in operations as well as management.

   2. Cost of Capital

      Includes the costs of investments, interest on working capital, taxes on inventory paid, insurance costs and other costs associate with legal liabilities.

      The inventory storage costs as well as cost of capital is dependant upon and varies with the decision of the management to manage inventory in house or through outsourced vendors and third party service providers.

Current times, the trend is increasingly in favor of outsourcing the inventory management to third party service provides. For one thing the organizations find that managing inventory operations requires certain core competencies, which may not be inline with their business competencies. They would rather outsource to a supplier who has the required competency than build them in house.

Secondly in case of large-scale warehouse operations, the scale of investments may be too huge in terms of cost of building and material handling equipments etc. Besides the project may span over a longer period of several years, thus blocking capital of the company, which can be utilized into more important areas such as R & D, Expansion etc. than by staying invested into the project.

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In practice, this means striking a balance between holding costs on the one hand and stockout and re-order costs on the other. The economic order quantity formula is one approach to striking this balance.

Economic order quantity (EOQ)

For businesses that do not use just in time (JIT) inventory management systems, there is an optimum order quantity for inventory items, known as the EOQ.

The aim of the EOQ model is to minimise the total cost of holding and ordering inventory. To do this, it is necessary to balance the relevant costs. These are:

• the variable costs of holding the inventory (holding costs)

• the fixed costs of placing the order (ordering costs)

Holding costs

The model assumes that it costs a certain amount to hold a unit of inventory for a year (referred to as CH in the formula). Therefore, as the average level of inventory increases, so too will the total annual holding costs incurred.

When new batches or items of inventory are purchased or made at periodic intervals, the inventory levels are assumed to exhibit the following pattern over time.

If x is the quantity ordered, the annual holding cost would be calculated as:

Holding cost per unit × Average inventory:

We therefore see an upward sloping, linear relationship between the re-order quantity and total annual holding costs.

Ordering costs

The model assumes that a fixed cost is incurred every time an order is placed (referred to as COin the formula). Therefore, as the order quantity increases, there is a fall in the number of orders required, which reduces the total ordering cost.

If D is the annual expected sales demand, the annual order cost is calculated as:

Order cost per order × no. of orders per annum.

However, the fixed nature of the cost results in a downward sloping, curved relationship.

Balance between holding costs and ordering costs

Because you are trying to balance these two costs (one which increases as re-order quantity increases and one which falls), total costs will always be minimised at the point where the total holding costs equals the total ordering costs. This point will be the economic order quantity (EOQ).

Assumptions

The following assumptions are made:

• demand and lead time are constant and known

• purchase price is constant

• no buffer inventory held (not needed).

The calculation

The EOQ can be more quickly found using a formula:

where:

CO = cost per order

D = annual demand

CH = cost of holding one unit for one year.

Quantity discounts

Discounts may be offered for ordering in large quantities. If the EOQ is smaller than the order size needed for a discount, companies must calculate if the order size should be increased above the EOQ.

The total inventory cost for the annual level of demand (including holding costs, ordering costs and purchase costs) should be compared:

• assuming the order size enabling the discount is used

The assumption is that the company would accept the discount and order in the larger quantity if the overall inventory cost is lower.

What happens when order quantity increases?

What happens to EOQ when order quantity increases?

What is the relationship between ordering cost and holding cost?

What will happen to ordering costs if more orders are placed?