Inventory Costing

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Understanding the cost aspect of inventory is of prime importance for inventory management.

Inventory Cost Types and Affecting Factors

An inventory system may be defined as one in which the following costs are significant:

  • Cost of carrying inventories (holding cost)
  • Cost of incurring shortages (stock out cost)
  • Cost of replenishing inventories (ordering cost)

Cost of carrying inventory: This is expressed in Rs. /item held in stock/unit time. This is the opportunity cost of blocking material in the non-productive form as inventories. Some of the cost elements that comprise carrying cost are-cost of blocking, capital (interest rate); cost of insurances; storage cost; cost due to obsolescence, pilferage, deterioration etc. It is generally expressed as a fraction of value of the goods stocked per year.


Cost of incurring shortages: It is the opportunity cost of not having an item in stock when one is demanded. It may be due to lost sales or backlogging. In the backlogging (or back ordering) case the order is not lost but is backlogged, to be cleared as soon as the item is available on stock. In lost sales case the order is lost. In both cases there are tangible and intangible costs of not meeting the demand on time. It may include lost demand; penalty cost; emergency replenishment; loss of good-will etc. This is generally expressed as Rs. /item short/unit time.


Cost of replenishing inventory: This is the amount of money and efforts expended in procurement or acquisition of stock. It is generally called ordering cost. This cost is usually assumed to be independent of the quantity ordered, because the fixed cost component is generally more significant than the variable component. Thus it is expressed as Rs. /order.


These three types of costs are the most commonly incorporated in inventory analysis, though there may be other costs parameters relevant in such an analysis such as inflation, price discounts etc.

Costs and Inventory Decisions

In making any decision that affects inventory size, the following types of inventory costs should be considered:


Holding (or carrying) Costs – This broad category includes the costs for storage facilities, handling, insurance, pilferage, breakage, obsolescence, depreciation, taxes and the opportunity cost of capital. Obviously, high holding costs tend to favour low inventory levels and frequent replenishment.




Elements of inventory holding cost are

  • Capital cost: the cost of the physical stock. This is the financing charge that is the current cost of capital to a company or the opportunity cost of tying up capital that might otherwise be producing a better return if invested elsewhere. This is almost always the largest of the different elements of inventory cost.
  • Service cost: the cost of stock management and insurance.
  • Storage cost: the cost of space, handling and associated warehousing costs involved with the actual storage of the product.
  • Risk cost: this occurs as a consequence of pilferage, deterioration of stock, damage and stock obsolescence. With the reduction in product life cycles and the fast rate of development and introduction of new products, this has become a very important aspect of inventory cost. It is one that is frequently underestimated by companies. It is particularly relevant to high-tech industries, the fashion industry, and fresh food and drink.


Setup (or production change) Costs – To make each product different involves obtaining the necessary materials, arranging specific equipment setups, filling out the required papers, appropriately charging time and materials, and moving out the previous stock of material. If there were no costs or loss of time in changing from one product to another, many small lots would be produced. This would reduce inventory levels with resulting savings in cost. One challenge today is to try to reduce these setup costs to permit smaller low sizes. (This is the goal of a JIT system.)


Ordering Costs – These costs refer to the managerial and clerical costs to prepare the purchase or production order. Ordering costs include all the details, such as counting items and calculating order quantities. The costs associated with maintaining the system needed to track orders are also included in ordering costs.


Shortage Costs – When the stock of an item is depleted, an order for that item must either wait until the stock is replenished or be cancelled. There is a trade-off between carrying stock to satisfy demand and the costs resulting from stock out. This balance is sometimes difficult to obtain, because it may not be possible to estimate lost profits, the effects of lost customers, or lateness penalties. Frequently, the assumed shortage cost is little more than a guess, although it is usually possible to specify a range of such costs.


Factors Affecting Inventory Levels

It is often perceived that avoiding design, process, management and operational problems also avoids inventory, but this does not hold true. Some fundamental reasons contribute towards the growth of inventory, though not desirable by an organization. At the same time, there are factors that can lead to the inventory growth and need to be managed to avoid any future losses. Some factors can create a long term impact on inventories, so it is necessary to first identify them and thereafter, manage them by preventing inventory from rising.

Inventory is the source of demand arisen from the customers. Billing involving paperwork can result into rise in the rate of inventory. Further, scraps and rejects often increase the inventory level in an organization, regarded as a buffer on account of many uncertainties.

Therefore, at the same, it is important to recruit competent people for effective management of the supply and demand factors, and maintaining data integrity. This can be ensured through proper induction and training of employees on management.

Activity-Based Costing

Activity-Based Costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect cost (overhead) into direct costs.

The concepts of ABC were developed in the manufacturing sector during the 1970s and 1980s.During this time, the Consortium of advanced learning idea a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.

Activity-based costing was first clearly defined in 1987 by Robert S Kaplan and W.Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this.

  • Cost allocation
  • Fixed cost
  • Variable cost
  • Cost driver
  • Cost driver rate


Direct Labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product’s transactions takes at the counter and then by measuring the number of each type of transaction


  • It helps to identify inefficient product, department and activity
  • It helps to allocate more resources on profitable product, department and activity
  • It helps to control the cost at individual level and on departmental level
  • It helps to find unnecessary costs



Even in activity-based costing, some overhead costs are difficult to assign to products and customers, for example the chief executive’s salary. These costs are termed ‘business sustaining’ and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed. Although some may argue that costs untraceable to activities should be “arbitrarily allocated” to products, it is important to realize that the only purpose of ABC is to provide information to management. Therefore, there is no reason to assign any cost in an arbitrary manner.



ABC is considered a relatively costly accounting methodology, and whether it is good value is questioned. ABC has been found to be a very high-cost accounting technology. Installing an ABC system is technically complex, requiring talented personnel and a considerable amount of time and money.



Following initial enthusiasm, ABC lost ground in the 1990s, to alternative metrics, such as Kaplan’s balanced score card & economic score

Public Sector Use

ABC is widely used in the public sector, including by the United States and UK Police mandated since the 2003-04. An independent 2008 report concluded that ABC was an inefficient use of resources: it was expensive and difficult to implement for small gains, and a poor value, and that alternative methods should be used.

Materials Management in an R & D Set-up

In a typical R & D set up, the following characteristics are easily visible w.e.f.. an R&D (research) project particular project is pursued only once or rarely more than once the project duration is small enough to provide the results at the earliest for use Project conceiving may or may not be predetermined. It may be sudden and resultant of the brain wave of a scientist Project findings may get early implementation for commercial production Projects, mostly, are of pilot nature i.e. of low value and less time duration. Many projects may need materials as tools for diagnosis, tests and trials. Obviously, based on the above characteristics which are essentially a way of working for any industrial R & D set up, the material requirement too is peculiar with the following characteristics:


Item is not repetitive, it may be required only once Purchase function should ensure speedy procurement Element of proper planning w.e.f. timely raising of indent, exact specification, correct estimated price may be missing Quantity of items to be purchased is small Sourcing may not be easy as items are developmental in nature, mostly new Often, the requirement of materials and the nature of purchases are at cross purpose.


Considering that urgent need to procure the material that too on, say short notices at times is of primary concern in an R & D set up what should be the procurement system or put in other words, can there be a procurement system that can take care of urgent needs where exact specification, sources and likely delivery schedule are difficult propositions

Activity Based Costing Advantages

  • More accurate costing of products/services, customers, SKUs, distribution channels
  • Better understanding overhead
  • Easier to understand for everyone
  • Utilizes unit cost rather than just total cost
  • Integrates well with Six Sigma and other continuous improvement programs
  • Makes visible waste and non-value added
  • Supports performance management and scorecards
  • Enables costing of processes, supply chains, and value streams
  • Activity Based Costing mirrors way work is done
  • Facilitates benchmarking

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