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HOW TO CALCULATE TOTAL INVENTORY COSTS

In order to calculate EOQ, you’ll need to first find your total inventory costs. In this article we’ll cover how to do this by analyzing three essential areas:

1. Order costs

3. Inventory costs

Order Costs

These are all costs involved with ordering stock. Ordering costs include both fixed and variable costs, from fuel and fleet maintenance for transportation to the administrative costs of stock entering the warehouse.

Depending on your operations, defining all of your order costs may not be a difficult task. However, putting a fair value on each of them can be a titanic undertaking. We could assume that the cost of placing an order is equal to the total price of the purchasing department, divided by the total number of orders. With this information, we can calculate an approximate value for batch sizes. After using these broad calculations to establish a baseline amount, other cost variables can be added later to increase accuracy.

If you work in a production environment, adjustment costs must be added. These are the costs generated from producing a new batch of product in a machine. This may include administrative fees, although it usually refers to the costs incurred when the machine is not producing.

Adjustment costs also consist of the working hours required for machinery operators to produce different products using the same machinery. In addition to factoring in downtime, production line “heating” must be included as well. Heating used in this sense means the time it takes for your machinery to produce products to a desired level of quality.

Inventory Costs

These are made up of three components: rent, space and risk.

Rent:

For many companies, calculating this cost is a challenge, since it refers to the costs of maintaining working capital. In other words, what could you have done with the money you have tied up in inventory if it had been invested in something else? This is similar to opportunity cost in economics.

While your first thought may be to look to the Controller or finance team for this information, they often can’t provide discrete, quick answers due to the complexity involved in these calculations. A good guiding principle to use for Rent cost is that it should be higher than the current interest rate for the company, usually somewhere between 8% and 15% of the total.

Space:

This cost can also be challenging to calculate, since it is necessary to consider the myriad peripheral costs that it includes, e.g. storage, dispositions, personnel, automation, etc. However, the market value charged for renting the equivalent space as your warehouse is commonly used. This is considered a reliable number because it is assumed that warehouse operators have included the peripheral costs in their rental price.

Risk:

In calculating inventory costs, the risk is the potential for the unsold stock to become obsolete. For example, in a technology company, the risk levels will be considerably higher than those of raw material. The acceptable value can be around 10%, although it is much more efficient to calculate Risk using percentages specific to your industry or market. Risk costs include insurance costs, potential robberies, damages, losses, deterioration, seniority, etc.

Calculating total inventory costs with real values will allow you to calculate the optimal lot size for each item, and thus achieve the lowest total costs efficiently.

Is your company aware of these costs and their implications?

Does the company’s controller inform all interested parties of these values?

Is the optimum size of the production, purchase or sale lot calculated in your company?