Intended learning outcomes: Explain carrying cost and carrying cost rate. Produce an overview on costs of financing or capital costs, storage infrastructure costs and the risk of depreciation.
Continuation from previous subsection (11.4.1)
Carrying cost, or holding costs, are all costs incurred in connection with holding inventory.
Carrying cost rate, or holding cost rate, is the rate for the carrying cost, usually defined as a percentage of the dollar value of inventory per unit of time (generally one year).
See also Section 1.1.6. Carrying cost includes:
- The costs of financing or capital costs: Inventory ties up financial resources. Calculation using an interest rate yields the costs of immobilizing money in inventory. This rate corresponds to either the percentage of the mean return on investment if the inventories are financed using internal capital resources, or to the bank interest rate, if the inventories are financed by a third party. For calculation purposes, take interest rate values between 5 and 15% of the average value of the inventory.
- The storage infrastructure costs are incurred for the infrastructure necessary to store a particular product: buildings, installations, warehouse employees, insurance, and so on. The costs for inventory transactions, in contrast, are seen as ordering costs.
- The first cost driver for storage infrastructure costs is batch size, as enough surface area or volume for the whole batch size must be provided. In a first approach, it is possible to express storage infrastructure costs proportionally, as a percentage related to the average inventory, because the average inventory corresponds — apart from safety stock — to half of the batch size, according to the formula in Figure 11.3.1.2. More commonly used is a percentage related to the mean inventory value. In the machine tool industry, percentages between 1 and 3% are common.
- Further cost drivers are storage type and valuation basis (see Section 11.1.1). The storage infrastructure costs rate can be much higher for inexpensive and voluminous products (insulation materials and other construction materials) than for very expensive and possibly easy-to-store products. For more precise figures, then, the calculation should include at least some separate values, such as for information and documents, raw materials, purchased parts, semifinished goods, and end products. However, there are limits to diversifying storage infrastructure costs into as many different storage unit cost rates as possible, due to the expense involved in recording the incurred costs per separate category as well as for data maintenance, if, for example, a separate storage cost percentage were kept for each item.
- A large part of these costs is out of proportion to the value of the stored goods. Since warehouses involve specialized constructions, building a warehouse represents a long-term investment. A company will make the investment if it has exhausted existing warehouse volumes. This leads to a jump in costs. In contrast, reducing inventory value does not automatically lead to a reduction of personnel needed for warehouse management. Even so, in practice, a proportional relationship is common.
- The risk of depreciation: This is again expressed as a percentage of the inventory value. It includes, firstly, technical obsolescence that results from changes in standards or the emergence of improved products on the market. Secondly, it includes expiration due to perishability: Certain items can be stored only for a particular, limited period of time (shelf life). This is the case with “living” products such as groceries or biological pharmaceuticals, but also with “nonliving” products such as certain electronics items. Thirdly, it includes damage, spoilage,or destruction due to unsuitable handling or storage such as, for example, the rusting of sheet metals.
- The percentage of the risk of depreciation may be very large under certain circumstances. For short-lived items, it must be set at 10% or more. However, the percentage is generally dependent on the duration of storage.
It is not unusual for the carrying cost rate to be on the order of 20%. For goods with a high risk of depreciation, it may reach 30% and higher.
Course section 11.4: Subsections and their intended learning outcomes
11.4 Batch Sizing, or Lot Sizing
Intended learning outcomes: Produce an overview on production or procurement costs, batch-size-dependent unit costs, setup and ordering costs, and carrying cost. Explain optimum batch size, optimum length of order cycle, the classic economic order quantity formally and in practical application. Disclose extensions of the batch size formula.
11.4.1 Production or Procurement Costs: Batch-Size-Dependent Unit Costs, and Setup and Ordering Costs
Intended learning outcomes: Differentiate between batch-size-dependent production or procurement costs and batch-size-independent production or procurement costs.
11.4.1b Carrying Cost
Intended learning outcomes: Explain carrying cost and carrying cost rate. Produce an overview on costs of financing or capital costs, storage infrastructure costs and the risk of depreciation.
11.4.2 Optimum Batch Size: The Classic Economic Order Quantity (EOQ)
Intended learning outcomes: Explain the concept of the economic order quantity (EOQ). Explain variables for the EOQ formula.
11.4.2b The Economic Order Quantity (EOQ) Formula
Intended learning outcomes: Explain the economic order quantity (EOQ) formula. Describe the cost curves as a function of batch size.
11.4.2c Optimum Length of Order Cycle
Intended learning outcomes: Present the optimum length of order cycle.
11.4.3 Economic Order Quantity (EOQ) Formula: Sensitivity Analysis
Intended learning outcomes: Present in detail the sensitivity analysis of the EOQ calculation.
11.4.3b Economic Order Quantity (EOQ) and Optimum Length of Order Cycle in Practical Application
Intended learning outcomes: Produce an overview on the practical implementation of the EOQ formula. Identify several factors that influence a maximum or minimum order quantity.
11.4.4 Extensions of the EOQ Formula: Lead-Time Orientation and Discount Levels
Intended learning outcomes: Present lead-time-oriented batch sizing. Describe batch sizing considering discount levels.
11.4.4b Extensions of the EOQ Formula: Joint Replenishment
Intended learning outcomes: Produce an overview on joint replenishment: kit materials management and collective materials management.
