How to Calculate Inventory Ordering and Carrying Costs
Inventory costs include not only the price of goods, but also costs associated with placing orders and physically holding stock on the business premises or in an offsite warehouse. Your yearly ordering and carrying costs depend on the consumer demand for your merchandise, number of items per order, the fixed ordering costs, and the fixed holding costs. You can use the calculator on the left to compute this portion of your inventory costs and see the formula and explanation below. To find the order size that minimizes your ordering and holding costs, see the Economic Order Quantity (EOQ) Calculator.
Ordering and Carrying Cost EquationLet Q be the number of items ordered per shipment, D be the annual demand for the item, Fo be the fixed costs associated with placing an order, and Fc be the cost of holding an item for one year. Then the total annual ordering cost is
and the total yearly carrying cost is
Thus, the total annual inventory ordering and holding cost is
Fo*D/Q + Fc*Q/2
How is this equation derived? The number of orders that need to be placed per year is annual demand divided by number of items per order, or D/Q. Each of these orders has a fixed cost of Fo, so the annual ordering cost is Fo*D/Q. The cost of holding an item in inventoy for a year is Fc and the average amount of inventery in stock is Q/2 (halfway between empty and full), thus the carrying cost is Fc*Q/2. The sum gives you the formula for total inventory ordering and carrying costs. This formula assumes there is no discount for ordering items in bulk.
Example: A business has an annual demand of 10,000 for a particular item. They order the item in batches of 1,000 and each order placement has a fixed cost of $120. The cost to hold an item in inventory is $0.80. Since we know D = 10000, Q = 1000, Fo = 120, and Fc = 0.8, we can compute the total cost:
$120*10000/1000 + $0.80*1000/2 = $1200 + $400 = $1600.
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