One very important component of the EOQ formula is the holding cost. In many situations, the calculation of carrying cost is just a guess and is often much lower than the real value.
Some questions are raised in the article “Why Buyers Need to Calculate the Real Cost of Carrying Inventory” from the Supplier Selection and Management Report Issue 04-07. The author claims that many of the costs associated with carrying inventory are overlooked. This results in a deflated cost of holding inventory, which allows managers to hold larger amounts of inventory thus masking underlying problems in the system.
The author suggests that inventory holding costs should be split into both variable and fixed costs. Most traditional systems attempt to account for variable costs such as the cost of money, taxes, insurance, and obsolescence. The costs that are often not included are the fixed costs such as the cost of storage space, capital equipment, and personnel. Often these fixed costs increase in a stepwise fashion, which brings another complication into calculating EOQ.
The image to the left illustrates a method and template for calculating inventory carrying cost. It also illustrates how carrying costs can be significantly larger than traditional estimates.
4 comments:
This is very good!! Good job in finding this article and sharing with us. Could you also provide a link to the website or pdf?
Since I found this article on Business Source Premier I can't provide a direct link. However if you search the Business Source Premier Database for the title "Why Buyers Need to Calculate the Real Cost of Carrying Inventory" it will populate. There was also a copy-write policy at the end of the document which prohibits the article from being posted on a public web site.
This is interesting. I think that companies should focus on more fixed costs as you stated in your post. Fixed costs such as storage space cost and other things will be easier to calculate and are clear-cut costs whereas other things are harder to identify. I would start with the fixed costs and then worry about things such as obsolescence and other factors, this will at least make sure that the base, physical costs are taken into consideration - Mark Brislin
To me it seems that the whole process is open to so many errors. I assume that from years of experience the defining of costs can be made accurate. But, they do appear to be point and shoot.
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