In my last article titled “The Mysterious Cost of Carrying Inventory”, we published a questionnaire that you can fill out, to have us calculate your specific company’s inventory carrying cost percentage. That is, what it costs to maintain a dollar’s worth of stocked inventory in your warehouse for an entire year. The carrying cost is used in many inventory analyses and planning formulas including the economic order quantity formula; the calculation that is designed to determine your best buy replenishment quantity.
Calculating True Carrying Costs for Distributors & Manufacturers
We published the questionnaire in response to many inventory consultants and “ inventory gurus” contention that it is too difficult to accurately calculate your company’s inventory carrying cost and that a rule of thumb (e.g. the prime rate plus 20%) or default value (e.g. 25% – 35%) should be used in all formulas requiring a carrying cost percentage.
Based on your response in sending completed questionnaires back to us, and the resulting carrying cost percentages, we have concluded that:
- It’s fairly easy to calculate a distributor’s or manufacturer’s inventory carrying cost.
- There is no single accurate default value for the inventory carrying cost.
Economic Order Quantity (EOQ)
The carrying cost percentages we calculated from the questionnaires ranged from a low of 16% to a high of 42%. This is very significant as the cost of carrying inventory is an integral part of many inventory analyses, including the economic order quantity (EOQ) formula:
Use EOQ to Determines Replenishment Quantities
How much of an effect does the carrying cost percentage have on calculated replenishment quantities? Well, using a 25% carrying cost in the EOQ formula results in 20% greater replenishment quantities than a 35% carrying cost.
Just think of what 20% more inventory would cost your company. Remember that the EOQ is supposed to be the quantity that provides you with the lowest total cost. Replenishing inventory with quantities other than this best buy quantity will cause your company to experience higher costs and/or excess inventory.
What Order Quantity is Your Best Buy?
There is no way to determine which order quantity represents the best buy without accurately calculating your company’s specific carrying cost percentage and cost of ordering stock. The cost of ordering stock is the cost of issuing and processing a line item on replenishment order.
I have read many articles stating, as with the inventory carrying cost, that this number is also too hard to calculate. Many analysts suggest that you should just pick a value between $5.00 and $6.00. As with using rules of thumb for the inventory carrying cost, if you just guess at your company’s cost of ordering stock, the resulting economic order quantity will not represent your company’s best buy quantity. If fact utilizing rules of thumb for the carrying cost percentage and cost of ordering stock results in an economic order quantity formula that probably won’t maximize your company’s profits:
The Cost of Ordering a Line Item
So this month we publish a questionnaire that allows us to calculate your company’s cost of ordering a line item of stock material.
To discover the primary factors you must consider when calculating ordering a line item of stock material, complete the form to the right to receive our exclusive Questionnaire for Calculating the Cost of Replenishing Inventory from Effective Inventory Management Expert, Jon Schreibfeder.
Find out more on how to Utilize Your Working Capital to Grow Your Business by downloading the exclusive Software ThinkTank whitepaper, by yours truly, Jon Schreibfeder.