Cost Concept in Inventory Management

There are 3 costs, which one way or other

associated in inventory management and
effect inventory policies

Inventory carrying cost/ Stock holding cost

Ordering cost/set up cost.
Stock-out cost/ Non-availability cost.

Inventory carrying cost:

Inventory carrying cost:

Inventory is liquid asset like money, but it is
not so liquid as money in the bank. Money in
the bank earns interest while it actually costs
to maintain inventories.

Main elements of inventory carrying cost are:

Capital cost
This normally is the interest charges, which
are to be paid to the bank and may be 1215%.

Elements of Inventory Carrying Costs

But it will be more realistic to consider
opportunity cost of money.
- By opportunity cost is meant cost that is
incurred in withdrawing funds from a
productive activity to invest them in
inventories.
Opportunity cost of capital is rate of return
earned by the company on its total
investment. If this is considered then capital
cost may be around 20-25%.

Elements of Inventory Carrying Costs

Storage and handling cost:

Most obvious inventory carrying cost &

includes rent of storage facilities or
depreciation, salaries of personnel, handling
and insurance; security and preservation of
materials etc. Storage cost vary widely with
type of material stored/storage facilities
used and may be 2-5% of the value of the
materials stored per year.

Elements of Inventory Carrying Costs

Deterioration & obsolescence cost:

Usage of every material cannot be judged

very accurately and some material gets
stored for a longer time than what is
generally desirable.
- This results in deterioration of materials,
which is very high for certain type of
material
such as paints, rubber goods.

Elements of Inventory Carrying Costs

Obsolescence is one of prices paid for

industrial & technological advancements.
- With rapid changes in design &
engineering, obsolescence becomes, a very
alarming
problem.

Obsolescence cost is high in regard to store

and spares required for maintenance of
plants subject to rapid technological changes

Elements of Inventory Carrying Costs

- and low in regard to stabilized items of stores
and raw materials.
- Larger accumulation of inventory and higher
is the risk of wastage and obsolescence,
which may be 2-5%
o

If for capital cost, market rate of interest

may be adopted, inventory-carrying cost
may lie between 16-20%. On the other
hand if opportunity cost of capital is to be
considered, it may well lie between 2530%.

Elements of Purchasing Costs

Ordering cost:
Ordering cost covers cost of originating an
indent, calling of quotations, processing
tenders, placing the order, verifying the
invoices and payments.
Composition of buying cost can be
grouped as under:

Purchase:
- Cost of inviting quotations and fixing
most
suitable supplier for item.
- Cost of preparing and placing order.
Expediting & Miscellaneous costs.
-

Salary of purchase personnel.

Administrative and over-head costs

Elements of Purchasing Costs

-

Expediting cost
Other Misc. Cost.

Receipt & Inspection:

- Cost of receiving and handling
- Cost of inspection
- Cost of delivery from receiving to
Stores or
direct to using department.

Set- up Cost

Set-up Cost
When inventory control refers to manufactured
item, corresponding cost is set up cost.
Every time a production run is taken up, there
is loss of machine time, operator time etc.
which is included in set up cost. Set up cost
also includes cost of paper work, inspection,
etc. involved with every production run.
Set up cost increases when the batch size are
smaller and the number of batches is large.

Stock-out/ Non-Availability cost

When an item is required and is not available

in stock, it is called stock-out.
- As a result certain consequences follow and
there is a certain cost associated with those
consequences known as stock-out cost.
If consequences are serious such as break
down/ shut down of plant and machinery, men
idle time, loss of production and profit, failure
of customer services or loss of goodwill, stockout cost is considerable.

Stock-out/ Non-Availability cost

On the other hand, a stock-out may involve

a little more than an effort in expediting,
and in that event, cost would be negligible.

Unlike inventory carrying, stock-out cost is

highly variable from item to item and place
to place and depends upon both intangible
and tangible factors so that its
determination is much more complicated
than that of possession costs.

Stock-out/ Non-Availability cost

o

Each firm has to calculate its own stockout costs for different items.

Example, stock out of a critical spare not

readily available in market, may be
tremendous. On the other hand, stock-out
cost of a supply item of a non-critical
nature, readily available, may be
insignificance

Stock-out/ Non-Availability cost

Working out stock-out cost

In case of down time due to stock out of

production materials, another product or a
change in schedule can also be considered.
Alternative may not apply while considering
down time due to machinery itself.

It is necessary to calculate real stock-out cost

which is attributable to stock out of spares
(at site or at stores) and is only cost of
additional down time due to such stock-out.

Stock-out/ Non-Availability cost

Portion of down time directly attributable to

necessary maintenance work itself cannot be
shown as the stock out cost of spare part.

For example- If maintenance work has actually

been held up for a day for want of a spare, only
days time is attributed to stock out cost of
item.

Subsequent maintenance may require another

two days before machine is put into operation.
These two days down time cost cannot be part
of stock out cost of item.

Stock-out/ Non-Availability cost

It is further more realistic to base the stock

out cost on the actual loss in production
rather than merely on down time.

For example:
Another machine may have spare capacity to
take up load.
- Then only reduction in production can be
taken as stock out cost.
- Then stock out cost will only be cost of
stopping and restoring work.

Stock-out/ Non-Availability cost

The stock out cost is the sum of:

Actual loss of production, due to added down

-time or running at lower capacity.

Actual cost of additional set ups and other

costs associated with change in schedule etc.

The additional procurement costs incurred,

liked air freight, deputing a man to market
solely for this purpose etc. and;

Stock-out/ Non-Availability cost

Higher price paid for item itself. This includes

special pick up arrangements, procurement
of a higher quality, than actually required,
paying a higher price for quick availability.
V.E.D. analysis (Vital, Essential and
Desirable) is primarily based on the stockout cost of items. Items, which have very
heavy down time cost, are categorized as
vital items.

Stock-out/ Non-Availability cost

Since stock-out cost critical spares is very

high and attract immediate adverse
attention of Management, people tend to
stock more.

Left to themselves inventories have

tendency to grow and grow beyond
economic limits

Stock-out/ Non-Availability cost

Overstocking escape notice until

deliberately discovered

Additional units of stock reduce probability

of stock out but additional carrying cost
incurred gradually eat away profit of
organization

INVENTORY HOLDING NORMS OF NTPC

A) INVENTORY HOLDING NORMS
a) CONSTRUCTION STORES
INVENTORY LEVEL IN
MONTHS
CONSUMPTION
..

1. CEMENT
02 to 03 months
2. STEEL
09 months
3. OTHERS (VIZ. PIPE,
PIPE FITTING
09 Months
CABLE ETC.)

INVENTORY HOLDING NORMS OF NTPC

b) O&M STORES
1. COAL
15 days for all Projects
except BTPS & NCTPP
2. FUEL (EXCLUDING COAL) OS
shall fix inventory holding levels
station-wise

INVENTORY HOLDING NORMS OF NTPC

3.SPARES (EXCLUDING INSURANCE
SPARES)
i) INDIGENOUS
ii) IMPORTED

18 Months
24 Months

N.B. : List of insurance spares shall be

compiled and circulated by Operation
Services.

INVENTORY HOLDING NORMS OF NTPC

4. LOOSE TOOLS

06 Months

5. CHEMICALS GASES &

EXPLOSIVES
03 Months
6. OILS & LUBRICANTS

03 Months

INVENTORY HOLDING NORMS OF NTPC

7. STORES OTHER THAN
SPARES (CONSUMABLES
& GEN. STORES)
06 Months
8. SCRAP

year)

06 Months
arising
(Min. two
disposals in a

RETURN OF SCRAP MATERIALS

1.Wherever specific provision exists in the
contract, the same shall be applicable.
2.In case of ambiguity, following shall be
applicable.
a) Old Contracts : As regards the old
contracts where issue rate is lower than the
present scrap price, the cut pieces as well
as the scrap shall be taken back by NTPC

RETURN OF SCRAP MATERIALS

and credit shall be given to the Contractor
at the issue rate identified in the
respective
contracts. For this purpose the
present market price of scrap can be
ascertained by
the project.

b) New Contracts : In case of the contracts

where the present scrap disposal rate is
lower than contract issue rate, the
Contractor shall be allowed to take away
the
scrap.

RETURN OF SCRAP MATERIALS

3. In case of old contracts where Contractor

has already taken away part quantity of
scrap, such cases will be regularized
presuming that such quantities were
permitted to be taken away.
Ex-post facto approval from the GM of the
project, on case to case basis, may be taken
for regularizing such cases.

RETURN OF SCRAP MATERIALS

4. In case of 2 (b) and 3 above, no other

charges shall be levied on the
Contractor for the scrap materials taken
away by the Contractor other than
normal recovery of steel issued to the
Contractor on the specified issue rates
or penal rates, as applicable under the
contract, depending upon the extent of
wastage generated by him.