orders increases, the ordering cost increases).

Costs incurred each time an order is made can

include requisition costs, purchase orders, transportation and shipping, receiving, inspection,
handling and placing in storage, and accounting and auditing.
Ordering costs generally react inversely to carrying costs. As the size of orders increases,
fewer orders are required, thus reducing annual ordering costs. However, ordering larger
ELEMENTS OF INVENTORY MANAGEMENT 755

Management Science Application

Evaluating Inventory Costs at Hewlett-Packard

H ewlett-Packard, with annual revenues exceeding $90 billion

and 150,000 employees worldwide, is the Fortune 500 11thranked
company. Although demand for PCs increased by fivefold
in the 1990s, becoming a veritable household product,
many PC companies struggled to remain profitable. By the
end of the 1990s HP was struggling to make a profit in the
increasingly competitive global PC market because of
price cuts throughout the decade. Because prices were not
really controllable, inventory costs became especially critical
in the PC profit equation. Rapid technological advancements
render new PC products obsolete in a few months, and, in
general, it’s believed that the value of a PC decreases at the
rate of 1% per week. Consequently, holding any excess
inventory is very costly.
In the late 1990s, to return its PC business to more sustainable
profitability, HP undertook an extensive evaluation of
its inventory costs. It discovered that inventory-related costs
were the main determinants of overall PC cost, and, in fact, in
1 year alone inventory-related costs equaled the PC business’s
total operating margin. Further, HP determined that the traditional
inventory carrying (or holding) costs (which encompass
capital costs plus storage, taxes, insurance, breakage, etc.) accounted
for less than 10% of the total inventory-related costs.
HP identified four additional inventory costs in their PC business
that were a major factor in overall supply chain costs. The
single biggest inventory cost was determined to be the “component
devaluation cost.” This is the penalty cost HP incurred
when the price dropped for excess components and parts (for
example, CPUs, memory, and chips) being held in inventory.
HP held inventories of parts and components in factories, in
distribution centers, and in transit and incurred a devaluation
cost at all these points in its supply chain whenever a price reduction
occurred. Another inventory cost is the “price protection
cost,” which occurs when the retail price of a product
drops after it has already been shipped to the sales outlet. HP
had to reimburse its sales partners for the difference in price
for any unsold units so its partners wouldn’t incur a loss. Given
how fast PC products lose their value, excess inventory can result
in large protection costs. A third inventory-related cost in
the PC business is the “product return cost.” This is the cost
of a full refund HP paid its distributors when unsold products
were returned; essentially it is a 100% price protection cost.
In some cases sales partners and distributors returned excess
unsold inventory valued at more than 10% of a product’s revenue.
The fourth inventory cost is “obsolescence cost,” which
is the cost of writing-off unsold products in inventory after the
life of the product ends. Because PC products’ life cycles are
so short, there is the potential for large costs if excessive inventories
are held. Related costs include price discounts for
products that are about to be discontinued and the marketing
costs to quickly reduce inventory. The Mobile Computing Division
(which manufactures notebooks) was the first HP PC business
unit to focus on all these inventory-related costs in
redesigning its supply chain. The original supply chain consisted
of a central manufacturing facility with local product
configuration occurring at regional sites. (In this configuration
about 40% of the total supply chain cost was related to inventory.)
In the redesigned supply chain there is a central manufacturing
facility, and products are air freighted directly to
customers around the world. Positive results were immediate;
in a 2-year period inventory-related costs dropped from almost
19% of total revenue to less than 4%, and the notebook division
became profitable. As a result, all other HP PC operations
began using these inventory costs to evaluate and redesign
their supply chains.
Source: Based on “Inventory Driven Costs,” by G. Callioni, X. de
Montgros, R. Slagmulder, L. N. Van Wassenove, and L. Wright.
Harvard Business Review, March 2005.
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