Total cost analysis

- Controlling inventory cost is everyone's responsibility. And I mean everyone. The reason I think so is pretty straightforward. To properly manage the cost of inventory, you must take the more strategic view and consider the total cost of inventory. And because costs are spread throughout your organization, they are managed by people in purchasing, operations, distribution, finance, accounting, just about every function in your company. So it's important that everyone understand the components of total cost analysis and how they can be effectively managed. Total inventory cost has four different components. First, there's unit cost. This is the amount you paid for the inventory item, whether it is raw materials for your factory or components for your assembly line or finished products for your customer. Second is the cost of holding that inventory. This includes storage costs, insurance and interest paid for bank loans to purchase inventory. Some companies will also include the opportunity cost of interest you could have earned if your money was not tied up in inventory, like finished goods waiting to be sold. The third cost is the cost of ordering the inventory. This includes all administrative costs of placing an order, like the time spent by the buyer. This cost should also capture any expenses associated with finding and qualifying new suppliers, which can be quite expensive. Last are transportation and delivery costs. Inventory and transit incurs freight charges, insurance, and in some cases, also tariffs, duties and taxes. In managing inventory costs, it's very important to view each of these individual components together because there are several important trade-offs involved in your decision-making. The first trade-off is between ordering costs and holding costs. If you order in large quantities, you order less often. This lowers your ordering costs per year, but larger orders mean you must keep more inventory in stock longer. This increases your inventory holding costs. The key to managing these trade-offs is defined the optimal point at which the two costs are equal. This minimizes your total annual cost. Second, your supplier might offer a quantity discount. By taking advantage of a price discount, you lower your cost per item. Again, having extra inventory increases your holding costs. It must balance the savings from the purchase with the increased holding costs to determine if this is an advantage or not. Another trade-off involves the location of your suppliers. Global networks mean higher transportation costs due to increased distances and international tariffs. You must find the right balance between the cost savings offered by a foreign supplier and the increased transportation expenses. A fourth trade-off to consider involves the location of your customers. Again, global networks increase your delivery costs. Long distribution channels also mean you must hold more inventory of finished goods to ensure you can meet demand. Many companies consider regional supply chains as a solution to long supply and distribution channels. As opposed to global supply chains, a regional supply chain makes the product close to the final customer and sources from local suppliers as much as possible. To effectively control inventory and to manage these trade-offs, all functions within the company must be actively involved. Communication of information and coordination of decisions are the key to success here. A good way to understand how well your company is doing is to pick one major product or product line and one major customer for that product. How effective are you in managing your cost of ordering, holding and transporting inventory?