Some examples of inventory ordering costs are costs of acquiring price quotes, costs of preparing and approving purchase orders, and costs of receiving shipments and verifying with purchase orders. Examples of inventory carrying costs are costs of funds invested in inventory, costs of utilities and depreciation for inventory storage facilities, costs of handling inventory, costs of insurance on inventory, costs of taxes on inventory, and costs of spoilage or theft. Some examples of inventory shortage costs are costs of lost sales, costs for substitution of more costly materials, penalty for late completion or delivery of products, and costs of inefficient production. Inventory ordering costs and carrying costs are important when figuring inventory order size, while inventory shortage costs are important in figuring the inventory reorder point.
An important term in inventory management is the economic order quantity, or the EOQ. The EOQ is the inventory order amount that will create the lowest inventory cost for the period in question. This is also called the optimum order quantity. The EOQ occurs when the inventory ordering cost is equal to the inventory carrying cost. The carrying cost of inventory increases when the order quantity is larger, while the ordering cost of inventory decreases with a larger order quantity.
Another important term is the reorder point. The reorder point is the inventory level where a new order should be placed. In order to avoid having shortages while waiting for orders to arrive, most companies do not wait until the inventory is completely depleted before placing a new order. The time frame between when an order is placed and when it is received is called lead time. Lead time demand is the amount of inventory that is used or needed during lead time. If lead time demand is known, the reorder point would be when the inventory level reaches an amount equal to the lead time demand.
If lead time and/or demand are unknown, it is more difficult to figure the reorder point. There would be a risk of running out of inventory, also called stockout. Related stockout costs would then be incurred. These are costs due to lost production, production inefficiencies, and lost sales. To avoid stockouts, some companies keep an extra amount of inventory available, which is called safety stock.
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