When cost accounting, inventory can be a big cost in your business, and inventory issues may be a factor in a decision to outsource. If your company carries inventory, you have to consider the carrying cost of inventory.
Assume you are a retailer buying inventory. Carrying cost of inventory is the cost to hold and store your inventory. Carrying cost is also an opportunity cost. As a retailer, when you choose to purchase inventory, you’re using an asset (cash) to buy inventory. Cash is an asset you could use for some other purpose. If you’re a manufacturer, finished goods inventory represents “dead money” (stored cash). It’s no good until you sell it.
Here are the primary factors to consider for carrying costs:
Interest cost: Interest you pay on dollars borrowed to buy inventory. This factor can be stated another way. If you didn’t have to borrow money to buy inventory, interest cost represents money you could have spent elsewhere or the interest you could have earned if you had invested the funds.
Ordering cost: The cost charged by your supplier for each inventory purchase.
Quantity discount: The percentage (or dollar amount) of discount you receive when you place a larger order for inventory.
Say you’re the purchasing manager for a national chain of gift shops. You sell a line of scented candles that retail for $10. The candles normally cost you $5 each. Your supplier has called you to explain a new quantity discount program. If you purchase more candles in each order, you receive a discount on each candle. Should you take advantage of the discount and buy more candles? This table lists the information to consider.
| Planned Buying | Discount Plan | |
|---|---|---|
| Orders placed annually (A) | 50 | 30 |
| Candles per order (B) | 2,000 | 3,400 |
| Total candles (A) x (B) | 100,000 | 102,000 |
| Cost per candle | $5 | $4.60 |
| Total cost | $500,000 | $469,200 |
Ordering candles at a lower price reduces total cost. Now consider the carrying cost factors, mainly the effect on cash. Assume that you can warehouse 3,400 candles just as easily as 2,000 candles.
Fortunately, your company has plenty of cash to operate. In fact, you’re able to invest extra cash. (Extra cash — a great problem to have!) You currently earn 5 percent annually on the cash.
Consider the cash you would save. The quantity discount proposal (discount plan) would allow you to invest another $30,800 cash ($500,000 – $469,200). At a 5 percent annual rate, you’d increase your earnings on investing extra cash by $1,540 ($30,800 x 5 percent).
Ordering cost is $150 per order. Your total orders placed would decline from 50 per year to 30 per year — 20 fewer orders. Therefore, ordering costs would go down by $3,000 ($150 x 20 orders).
Consider the quantity discount. You will save $.40 per candle. Now, to make an apples-to-apples comparison, look at the first 2,000 candles you plan to buy. You save $800 ($0.40 savings per candle x 2,000 candles).
Here’s the financial result, if you use quantity discount:
Total savings = interest earnings + ordering cost savings + price savings
Total savings = $1,540 + $3,000 + $800
Total savings = $5,340
Happy days are here again! You should take advantage of the quantity discount. But before you pick up the phone to call your supplier, consider one more issue. Think about how long it takes to sell the 2,000 extra candles that you buy over a year.
Because you were already buying 100,000 candles a year (2,000 a week for about 50 weeks), and the new quantity is 102,000, you’re essentially buying an extra week’s worth of inventory. Not a big deal — go ahead and take the quantity discount. The total amount ordered is only 2 percent more than you were purchasing before. You will probably be able to make these extra sales.