The major portion of the working capital of a firm is blocked in inventory. If the inventory is in excess of the optimum level, more funds will be blocked that cannot be used for other productive purposes, resulting in opportunity loss. Hence these funds are tied up unnecessarily. There are other costs related to inventory. The incidence of those costs will also be higher if inventories are in excess of the optimum level.
Inventory-related costs are divided into the following six categories (see Figure 7.2).
Inventory Cost. Inventory blocks funds. Funds once blocked cannot be invested in any other productive activities. The lost opportunity cost is not so easy to quantify. However, the cost of blocked funds in excess of the optimum cost is computed in terms of inventory-carrying cost discussed below.
Carrying Cost. The second major cost contributor is carrying cost. Funds invested in inventory attract interest charges on working capital borrowed from the bank. The current bank rate of interest on working capital borrowring is 12-15 per cent. Thus, the interest charges investment on excess inventory will erode the bottom line.
Ordering Cost. This refers to the cost involved in the ordering process. The paperwork, faxes, phone calls, and so on will add to the inventory-related cost.
Warehousing Cost. This is the cost for product holding in the warehouse. Depending on the kind of warehouse (private, public or contract), there will be a cost related to space occupancy based on the duration of storage. This cost varies from 1.5 to 4 per cent and may be taken into consideration while computing inventory-related costs.
Damage, Pilferage and Obsolesce Cost. Material stored carries the risk of damage, shrinkage and loss of weight. A product also carries the risk of pilferage or obsolescence due to technology change or availability of substitutes. The percentage varies from 0.5 to 2 per cent depending on the product.
Exchange Rate Differentials. In case of imported inventories, the valuation is done based on the current currency exchange rates in the market. Any fluctuation may increase or decrease the value of the inventory. Due to exchange rate fluctuations, there is the risk of selling the material at prices lower than the landed cost.
Source: Sople V.V (2013), Logistics Management, Pearson Education India; Third edition.