Inventory Costs
Set-up or ordering costs are any expenses associated with ordering and receiving the product from the supplier. These costs can include the typical packaging, delivery, handling, and insurance of the product, as well as any associated labor costs that are not outsourced. Holding costs are any expenses associated with the storage of inventory that remains unsold. These include warehousing costs (storage space), labor, insurance, and any potential price of spoiled or damaged goods. Minimizing inventory costs, particularly holding costs is a critical element of supply chain management for a company (Stevenson, 2014).
The trade-off between the two is that each responds differently to the number and size orders. For example, an increase in demand results in the increase of orders and set up costs while decreasing holding costs, and vice versa. Organizational functions may have different inventory management objectives as well. Sales and marketing may wish to maintain sufficient inventory for continuous consumer demand, while those responsible for fiscal control seek to minimize holding costs which result in lower inventory levels. The trade-off is that ordering a large quantity of inventory decreases order frequency and set-up costs, but the amount of stored inventory will increase, therefore raising the holding cost. The opposite effect occurs if the company makes small frequent orders raising set-up costs. Commonly, an EOQ system helps to identify order quantities and manage inventory to find the balance in annual holding and set up costs for the company.
A-B-C Classification
The A-B-C classification is an inventory categorization method that assigns a class to items, products, or SKUs based on some measure of importance. The classification helps inventory managers to identify the most important products and focus on prioritizing them above the less valuable ones. It is meant to follow the Pareto Principle which suggests that 20% of stock commonly accounts for 80% of revenue. Therefore, inventory is split into three (potentially slightly more) categories based on criteria of importance, which is usually the total number of units sold or annual dollar value (Stevenson, 2014). A-B-C classification has several advantages including keeping low capital costs since the data identifies which items should be kept in stock while reducing obsolete inventory. Overall, the method allows for effective forecasting and highly optimizing inventory turnover which both increases profits and reduces storage and supplier costs. Disadvantages for A-B-C classification is that it is more costly to maintain in comparison to traditional costing systems, to consistently analyze class A inventory priority. Furthermore, A-B-C inventory does not meet the Generally Accepted Accounting Principles (GAAP) standards which may require having to externally run a traditional costing system simultaneously which allocates cost drivers by unit cost rather than activity percentage.
References
Stevenson, W. (2014). Operations management (12th ed.). McGraw-Hill.