Risk and Cost of holding inventory in a firm
Holding of inventory exposes the manufacturing and merchandising firms to a number of risks and costs. The various risks and costs of maintaining higher levels of inventory have been highlighted as follows:
1. Risk of price decline
Holding Inventory may increase the risk of decline in price. This may be due to increase in the supply of products in market by competitors, introduction of a new competitive product, competitive pricing policy of competitors etc.
2. Risk of obsolescence
The is a risk of inventory becoming obsolescence. The inventory may become obsolete/outdated due to improved technology, improvements in product design, changes in customers’ taste etc.
3. Purchase cost
A firm has to pay high price for managing inventory. Inventory management has to take into account of the price paid to the suppliers and the expense of transport for bringing the material to stores, insurance and transportation cost.
4. Ordering cost
Cost of ordering is one another factor that a firm has to consider in Inventory management. Ordering costs includes cost of requisitioning, preparation of purchase order, transportation of inventory, receiving the supplies at the warehouse etc.
5. Carrying cost
Carrying cost includes the cost of storing the inventory in warehouse, handling expenses, insurance and rent paid for managing the inventory, opportunity cost locked up in stocks etc. Opportunity cost here refers to the alternative use of funds that the firm would have used to invest in stocks.
6. Stock out (shortage) cost
Stocks results in higher costs when they fall short of demand. Shortage of stocks also results in higher cost, dissatisfaction among customers, decrease in sales and increase of loss to firm.
Measurement of shortage cost is relatively difficult because of its intangible nature. In practice, the lost contribution resulting from failure to meet demand provides a reasonable approximation. In cases where stock out does not result in loss in business, additional cost for crash procurement etc. may be considered as shortage cost.