In Management Lite & Ezy 34, we learned that firms which adopt low-cost or differentiation strategy minimize inventory in order to hold down cost or to avoid obsolescence.
Inventory incurs a number of costs to a firm, for example:
- Housing costs – building rent or depreciation, operating cost, taxes, insurance
- Material handling costs – equipment lease or depreciation, power, operating cost
- Labor cost
- Investment costs – borrowing costs, taxes, insurance on inventory
- Pilferage, scrap, obsolescence
According to Jay Heizer and Barry Render, authors of the book listed below, annual inventory holding costs vary depending on the nature of business, location and current interest rates, but often approach 40% of the value of inventory! This is why minimizing inventory is so important.
To reduce inventory level of raw materials or components, one would expect that a firm should order in smaller quantity, and do so more often. However, there is a catch here. Every order incurs overhead – the ordering cost. The more frequent a firm places order, the higher the annual ordering cost.
How could we find a balance between inventory holding cost and ordering cost? We will examine this in the next post.
Jay Heizer & Barry Render, “Operations Management”, 8th edition