The ordering costs of inventory

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Ordering Costs of inventory:

Any manufacturing organization has to purchase materials. In that event, the ordering costs refer to the costs associated with the preparation of purchase requisition by the user department, preparation of purchase order and follow-up measures taken by the purchase department, transportation of materials ordered for, inspection and handling at the warehouse for storing. At times even demurrage charges for not lifting the goods in time are included as part of ordering costs. Sometimes, some of the components and/or material required for production may have facilities for manufacture internally.
If it is found to be more economical to manufacture such items internally, then ordering costs refer to the costs associated with the preparation of requisition forms by the user department, set-up costs to be incurred by the manufacturing department and transport, inspection and handling at the warehouse of the user department. By and large, ordering costs remain more or less constant irrespective of the size of the order although transportation and inspection costs may vary to a certain extent depending upon order size. But this is not going to significantly affect the behavior of ordering costs. As ordering costs are considered invariant to the order size, the total ordering costs can be reduced by increasing the size of the orders.

Suppose, the cost per order is $100 and the company uses 1200 units of a material during the year. The size of the order and the total ordering costs to be incurred by the company are given below.

Size of order (units) 100 150 200
Number of orders in a year 1 2 8
Total ordering costs @ $ 100 / order $1200 $800 $600

From the above example, it can be easily seen that a company can reduce its total ordering costs by increasing the order size which in turn will reduce the number of orders. However, reduction in ordering costs is usually followed by an increase in carrying costs to be discussed now.

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