• Inventory Costs

    There are two basic types of costs associated with current assets.

    • Carrying costs
    • Shortage costs

    Carrying costs

    Carrying costs represent all of the direct and opportunity costs of keeping inventory on hand. These include:

    • Storage and tracking costs
    • Insurance and taxes
    • Loss due to obsolescence, deterioration, or theft
    • The opportunity cost of capital on the invested amount

    The sum of these costs can be substantial for some products like Crude Oil, Natural Gas etc. which require proper oil/gas tankers to carry the materials

    Shortage costs

    Shortage costs are associated with having in adequate inventory on hand. The two components of shortage costs include:

    • Restoring costs
    • Costs relating to safety reserves

    Depending on the firm’s business, restoring or order costs are either the costs of placing an order with suppliers or the cost of setting up a production run. The costs related to safety reserves are opportunity losses such as lost sales and loss of customer goodwill that result from having in adequate inventory.

    A basic trade-off exists in inventory management because carrying cost increases substantially with the increase in inventory levels, whereas shortage costs decline with higher inventory levels. The basic objective of inventory management is thus to minimize the sum of these two costs.

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