Inventory ordering cost is a cost that is incurred when an entity places an order to acquire inventory from suppliers. This cost doesn’t only include the purchase price of inventory but the costs incurred to transfer goods from the supplier to the company’s warehouse. So, ordering cost depend on the type of material purchased, quantity, and origin of suppliers.
Just in time system of inventory management aims to control the inventory cost. Its approach is to control the cost by changing pattern operations. So, the cost can be minimized and profit maximized.
Reorder cost includes:
- The administrative cost of placing an order – such as clerical costs to prepare material requisition
- Cost of inspection – labour costs to inspect the condition of goods received. Sometime, it can be higher due to nature and complexity of the goods.
- Inward delivery cost
- Documentation costs etc
However, while calculating the economic order quantity it is assumed that the cost per order is constant. Variable ordering costs are accounted for to calculate the economic order quantity. Fixed ordering costs are irrelevant in the calculation of EOQ. It means that fixed ordering costs are not considered in an EOQ decision. Some examples of fixed ordering costs are:
- Salaries of purchasing staff
- Allocated or absorbed overheads cost of purchase department
Ordering cost formula
The formula used for the calculation of annual ordering costs is:
Annual ordering cost= Ordering cost per order * (Annual demand/order size)
The ordering costs may be different based on facts such as the purchase of material by using the free delivery option or import from overseas. Some of the major ordering costs are:
- Taxation expense- It may include certain taxes such as import tax, or custom duty.
- Insurance cost- to avoid the risks of damage during the transportation of goods, it is a normal practice to insure goods.
- Admin staff cost-It refers to the cost of placement of an order, preparation of purchase invoice, or selection of appropriate suppliers.
- Fee- ordering costs may also include fees such as bank charges.
- Other costs- Other relevant costs like legal fees, advertisement expenses for bidding are also a form of ordering costs.
So, we can deduce a formula for ordering costs as:
Ordering cost= Taxation expense + insurance cost + admin staff cost + fee + other costs
Example
Suppose X Company buys material for its manufacturing facilities from overseas markets. After purchasing inventory, it allocates a task to its labor to check the physical condition of the material received. The officers of the company submit the final report to the company after verifying that the ordered material meets the criteria of the company. The staff costs associated with purchasing goods are $15,000. Insurance costs and transportation costs for safety and timely delivery of materials are $6,000 and $17,000 respectively. The rental costs of the warehouse are $7,500 per month and material is bought 2 months earlier before its actual usage in production. Calculate the ordering costs for X company and specify which cost is not considered and why?
Ordering Costs = staffs cost + transportation expense + insurance costs
= 15,000 + 17,000 +6,000
= $ 38,000
Note 1:
The rental costs per month are the carrying costs. That’s why we have ignored it in the calculation of ordering costs.
Relationship between ordering cost and holding cost
Ordering costs and holding costs are essential figures for the calculation of Economic Order Quantity (EOQ). At EOQ, the total cost of ordering and holding is equal. If ordering and holding costs are not equal, then the total cost of inventory increases. Economic order quantity is an order size where the overall cost of buying inventory is minimum due to the balance between ordering and holding (also known as carrying cost) costs.
There is an inverse relationship between ordering and holding cost i.e., the lower the ordering costs, the higher will be the ordering costs. Therefore, it is the main objective of firms to minimize their ordering and holding costs. So, as to maximize the p
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