Inventory and Inventory Cost

Inventory can be defined as a stock on hand, at a given point of time, which may be held for the purpose of later use or sale. It has an economic value, which includes raw material, work in process inventory, semi-finished inventory and final products.

With the  inventory controller users aim is to manage inventory in such a manner that the day to day work runs smoothly without and delay, and also to see that it is done at minimum cost.

Inventory cost:

It is divided into five types

  • Purchase cost
  • Ordering
  • Setup cost
  • Holding or carrying cost
  • Stock out or shortage cost



Purchase cost:

It is cost of purchasing inventory item and depends upon the quantity or the bulk purchase.

PC= no. of units x cost/unit

Ordering cost:

It is the cost associated with bringing inventory item within the production system. It includes cost of tender, cost associated with processing and chasing of purchase order, inspection cost and the transportation cost.

OC = no. of order X cost/order
SC = no. of setup X cost /setup

Setup cost:

When the inventory items or produced internally the cost associated with bringing shutdown production system again into starting position is termed as setup cost.  It include maintenance cost of machine schedule chart, preparation cost, cost associated with bringing raw material arrangement of worker, tool, equipment etc.

Holding or Carrying cost:

It is the cost associated with storing, keeping and maintaining inventory item within the production system. It includes the storage cost, handling cost, damage and description cost, insurance cost, interest etc. This cost depends upon the quantity and the period for which inventory is solved.

HC= Average inventory for a period X holding cost/unit/time.


Shortage cost or stock out:

Shortage simply means absence of inventory and the loss associated with not saving the customer is termed as shortage or stock out cost. It includes potential profit loss, fast transportation cost and the discount cost.

SC= no.of units short X shortage cost/unit

Inventory classification:

  • Transit or pipeline inventory
  • Buffer or safety stock
  • Lead time
  • Seasonal inventory
  • Anticipation inventory

Transit or pipeline inventory

Inventory cannot provide service while in transportation; such inventory is called transit line inventory or pipeline inventory

Buffer or safety stock

It is a minimum amount of inventory kept throughout the year. It is held for protecting the fluctuations in the demands rate and lead time. It is not used under normal working conditions, and used only during adverse condition to prevent stock-out.

Lead time

It is the time gap between placing ordering and inventory on hand where it can used or consumed.

Seasonal inventory

The demand pattern for these inventory items changes with seasonal variable.

Anticipation inventory

These inventory items are building to meet anticipatory demand in future like big selling forecast, government policy change, price hike, strike, shut down etc.

Characteristics of inventory model:

1) Dependent:

The demand for these items is directly related or linked to the demand of any other item, usually of a higher level of which it becomes a part.

Independent demand item:

The demand for these items is not directly related or linked to any other item. It is difficult to compute and is projected with the help of forecasting.

2) inventory review system

Review system is dividing into two, types they are

Fixed order system and fixed period system

Fixed order system

In this system as inventory level reaches reorder level, and a fresh order for a fixed quality is placed at that point. In this system size of order is fixed while the time of order is variable.

Fixed period system:

In this system inventory level that is reviewed after a fixed period of time; fresh order is placed for a variable quantity at that point. In this system size of order is variable but the time of order is fixed

3) Deterministic and probabilistic


In these model demand rate and lead time remains fixed and constant, therefore we need not to have safety stock.


These models represent the real world condition where there is uncertainty of demand rate and lead time. Due to fluctuation and variations of demand rate and lead time in this model, one needs to carry safety stock to prevent stock out during adverse condition.

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