2.

3 Objectives and Constraints of Inventory

Decision Making
• The possible objectives of concern to inventory
managers include:
i. Cost minimization (with or without discounting)
ii. Profit maximization (with or without
discounting)
iii. Maximization of rate of return on stock
investment
iv. Determination of a feasible solution
v. Keeping at an acceptable level the amount of human
effort expended in the management and control of
inventories
vi. Ensuring flexibility to cope with an uncertain future
vii. Minimizing political conflicts (in terms of the
competing interests) within the organization
viii.Maximizing the chance of survival of the individual
manager’s position or of the firm itself
• Most inventory management models and approaches
focus on only the first objective.
 Constraints
• The several possible constraints include:
i. Supplier constraints – minimum order sizes, restrictions to
certain pack sizes, maximum order quantities (particularly
under allocation schemes in times of tight supply), restrictions
on replenishment times.
ii. Marketing constraints – minimum tolerable customer service
levels, where service can be measured in a number of ways.
iii. Internal constraints – storage space limitations, maximum
budget to be used for purchases during a particular period,
maximum workload (number of replenishments per period),
personnel involved (capabilities and attitudes).
• It should be remarked that there is often little
difference between certain objectives and
internally imposed constraints.
 2.4 Costs of Inventory

• All stocks incur costs.

• These vary widely, but are typically around 20 per cent of the
value held a year.
• It is not surprising that organizations want to minimize their
inventory costs but they cannot do this by simply reducing
stock.
• Sometimes low stocks give a minimum cost, but this is not
inevitable and low stocks can lead to shortages that disrupt
operations and have very high costs.
• To look at this balance more closely, we need to describe
some details of the costs involved.
• Basically there are four categories of costs
relevant to inventory decision making,
namely:
i. Purchase (item) cost
ii. Ordering (setup) cost
iii. Carrying (holding) cost
iv. Stock-out (depletion) cost.
i. The purchase cost
• The purchase cost of an item is the unit
purchase price if it is contained from an
external source.
• Or the unit production costs if it is produced
internally.
• For the purchased items, it is the purchase
price plus any freight cost.
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ii. Ordering cost (setup cost):
• The other cost affecting total inventory cost is ordering cost
or set up cost.
• Ordering cost sometimes called as procurement cost or
acquisition cost.
• Ordering cost refers to the expense of placing an order for
additional inventory, and does not include the cost or
expense of the product itself.
• Setup cost refers more specifically to the expense of
changing or modifying a production or assembly process to
facilitate product line changeovers, for example.
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• Generally speaking, when an order is placed, a number of
costs can be incurred as a result of order processing and
preparation including:
 The cost of processing an order through the order-
processing, accounting and/or purchasing departments;
 The cost of transmitting the order to the supplier, usually by
mail or electronic means;
 The cost of setting up production to produce or setting up
handling procedures to fill the order quantity;
 The cost of any material handling or processing of the order
at the receiving dock .
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iii. Inventory carrying costs (holding cost):
• Carrying refers to all the costs associated with holding a quantity of
goods for a period of time.
• Carrying costs refer to all the costs associated with keeping items in
inventory for a period of time.
• As the usual period for calculating stock costs is a year, a holding cost
might be expressed as, say, Birr 10 a unit a year.
• The four major components of inventory carrying cost are:
 capital cost,
 inventory service cost,
 storage space cost, and
 inventory risk cost.
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a. Cost of capital:
• Sometimes called the interest or opportunity cost. This cost type
focuses upon what having capital tied up in inventory costs a
company.
• It refers inventories tied-up capital that could be put to use in other
ways inside or outside the firm.
• When items are carried in inventory, the capital invested is not
available for other purposes.
• Inventories tie up capital that could be put to use for other
purposes inside or outside the organization.
• This represents a cost of foregone opportunities for other
investments.
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b. Inventory-service costs:
• Another component of inventory carrying cost includes
insurance and taxes.
• Depending upon the product value and type, the risk
of loss or damage may require high insurance
premiums.
• Tangible-personal-property taxes levied on all or a
position of the goods stored.
• Insurance costs for fire and theft protection of
inventories.
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c. Storage-space costs:
• This category includes handling costs associated with moving
products into and out of inventory, and storage costs such as rent,
heating, and lighting.
• They also include space cost, salary of store personnel, and
supplies.
• Storage space costs are relevant to the extent that they either
increase or decrease as inventory levels rise or fall.
• Thus, firms should include variable rather than fixed expenses
when estimating space costs as well as capital costs.
• Generally, storage costs are the recurring costs for storage that
relate to the amount of inventory on hand.
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d. Inventory-risk costs:
• This final major component of inventory carrying cost
reflects the very real possibility that inventory birr value
may decline for reasons largely beyond corporate control.
• For example, goods held in storage for some time may
become obsolete and thus deteriorate in value.
• Also, fashion appeal may rapidly deteriorate in value once
the selling season is actively underway or over.
• These costs include the costs of obsolescence, shrinkage,
deterioration, and damage.

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• Obsolescence is loss of value of inventories because of shift in
style or consumer preference.
• Shrinkage is the decrease in inventory quantities over time
from loss, theft or pilferage.
• Deterioration is change in properties due to age or other
factors such as environmental degradation.
• The risk associated with these factors it directly proportional
with the level of inventories.
• In short, inventory risk costs are the costs of the stock
becoming unsaleble due to deterioration or obsolescence,
damage, and pilferage.
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•  It is difficult to suggest values for these, but
one view has percentages of unit cost, as: 
iv. Stock out/Depletion costs
• Stocks out costs reflect the economic consequences of
running out of stock.
• The costs are based on the concept of foregone profits.
• They result from external and internal shortages.
 External shortage occurs when a customer does not
have his order filled;
 An internal shortage occurs when users within the
organization do not have their orders filled.

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• External shortages result in backorder costs,
present profit loss (lost sales), and future
profit loss (loss of potential sales and erosion
of goodwill).
• Internal shortages can result in lost production
(idle men and machines) and a delay in
completion date.

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• Generally, the three principal results of a
finished goods stock out are as follow ranked
from best to worst in desirability:
a. Backorders,
b. Lost sales, and
c. Lost customers

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