Estimating Cycle Inventory-Related Costs in a Supply Chain in Practice

When setting cycle inventory levels in practice, a common hurdle is estimating the ordering and holding costs. Given the robustness of cycle inventory models, it is better to get a good approxi­mation quickly rather than spend a lot of time trying to estimate costs exactly.

Our goal is to identify incremental costs that change with the lot-sizing decision. We can ignore costs that are unchanged with a change in lot size. For example, if a factory is running at 50 percent of capacity and all labor is full time and not earning overtime, it can be argued that the incremental setup cost for labor is zero. Reducing the lot size in this case will not have any impact on setup cost until either labor is fully utilized (and earning overtime) or machines are fully utilized (with a resulting loss in production capacity).

1. Inventory Holding Cost

Holding cost is estimated as a percentage of the cost of a product and is the sum of the following major components:

• Cost of capital: This is the dominant component of holding cost for products that do not become obsolete quickly. The appropriate approach is to evaluate the weighted-average cost of capital (WACC), which takes into account the required return on the firm’s equity and the cost of its debt (see Brealey and Myers, 2000). These are weighted by the amount of equity and debt financing that the firm has. The formula for the WACC is

where

E = amount of equity D = amount of debt

Rf = risk-free rate of return (which is usually in the mid-single digits)

b = the firm’s beta, a measure of volatility of stock price MRP = market risk premium (which is around the high single digits)

R_b = rate at which the firm can borrow money (related to its debt rating) t = tax rate

Most of these numbers can be found in a company’s annual report and in any equity research report on the company. The borrowing rate comes from tables listing the rates charged for bonds from firms with the same credit ratings. The risk-free rate is the return on U.S. Treasury bonds, and the market risk premium is the return of the market above the risk-free rate. If access to a company’s financial structure is not available, a good approximation can be made by using numbers from public companies in the same industry and of similar size.

• Obsolescence (or spoilage) cost: The obsolescence cost estimates the rate at which the value of the stored product drops because its market value or quality falls. This cost can range dramatically, from rates of many-thousand percent to virtually zero, depending on the type of product. Perishable products have high obsolescence rates. Even nonperish­ables can have high obsolescence rates if they have short life cycles. A product with a life cycle of six months has an effective obsolescence cost of 200 percent. At the other end of the spectrum are products such as crude oil that take a long time to spoil or become obso­lete. For such products, a low obsolescence rate may be applied.

• Handling cost: Handling cost should include only incremental receiving and storage costs that vary with the quantity of product received. Quantity-independent handling costs that vary with the number of orders should be included in the order cost. The quantity- dependent handling cost often does not change if quantity varies within a range. If the quantity is within this range (e.g., the range of inventory a crew of four people can unload per period of time), incremental handling cost added to the holding cost is zero. If the quantity handled requires more people, an incremental handling cost is added to the hold­ing cost.

• Occupancy cost: The occupancy cost reflects the incremental change in space cost due to changing cycle inventory. If the firm is being charged based on the actual number of units held in storage, we have the direct occupancy cost. Firms often lease or purchase a fixed amount of space. As long as a marginal change in cycle inventory does not change the space requirements, the incremental occupancy cost is zero. Occupancy costs often take the form of a step function, with a sudden increase in cost when capacity is fully uti­lized and new space must be acquired.
• Miscellaneous costs: The final component of holding cost deals with a number of other relatively small costs. These costs include theft, security, damage, tax, and additional insurance charges that are incurred. Once again, it is important to estimate the incremental change in these costs on changing cycle inventory.

2. Ordering Cost

The ordering cost includes all incremental costs associated with placing or receiving an extra order that are incurred regardless of the size of the order. Components of ordering cost include the following:

• Buyer time: Buyer time is the incremental time of the buyer placing the extra order. This cost should be included only if the buyer is utilized fully. The incremental cost of getting an idle buyer to place an order is zero and does not add to the ordering cost. Electronic ordering can significantly reduce the buyer time to place an order.

• Transportation costs: A fixed transportation cost is often incurred regardless of the size of the order. For instance, if a truck is sent to deliver every order, it costs the same amount to send a half-empty truck as it does a full truck. Less-than-truckload pricing also includes a fixed component that is independent of the quantity shipped and a variable component that increases with the quantity shipped. The fixed component should be included in the ordering cost.

• Receiving costs: Some receiving costs are incurred regardless of the size of the order. These include any administration work such as purchase order matching and any effort associated with updating inventory records. Receiving costs that are quantity dependent should not be included here.

• Other costs: Each situation can have costs unique to it that should be considered if they are incurred for each order regardless of the quantity of that order.

The ordering cost is estimated as the sum of all its component costs.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.