Inventory system costs: Source data for analysis

Engineering Costs and Production Economics, 13 ( 1987 ) I- 12

Elsevier Science Publishers

.V., Amsterdam - Printed in The Netherlands

taRiey

ing

Department of Management, University of Southern Mississippi, Box 5077, Hattiesburg, MS 39406-5077

This paper presents a scheme of inventory system cost classificationand a set of equations for separating the fixed and variable components of the costs. The purpose of ckzssifyingthe

When inventory costs are considered, there is an almost automatic assumption ihat one is considering those costs used I., calculate order quantities. The principle purpose of the present paper is to consider how inventory system costs can be collected to enable analysis of the inventory system in order to achieve enhanced system-operating efficiency. Since some of this same data is needed to determine order quantities, a secondary purpose will be to collect the data in such a way that determination of the values for the ordering cost, holding cost and the stockout cost is facilitated. The topic of inventol-y-system cost collection for analysis purposes is relevant for several reasons. First, a review of the literature does not reveal a similar s the following statement by entory invent of cost ered in most inventory texts. It is one of the most fertile areas for more research.”

{U.S.A.)

costs is to enable system improvementsthrough cost analysis and to suggest a format for cost data storage in an automatic data collection environment.

it can be seen that there is a need not only to expand the discussion of inventory costs in most inventory texts, but to provide a better understanding of these costs. Third, on the basis of the statement of Fogarty and Hoffman [2, p. 1751: “Costs are the crux of inventory management decisions at all levels.”

it can be seen that if management is to seek improvement of, or properly manage, the inventory system, it must utilize inventory cost information. Fourth, there is a lack of agreement about the categorization of some of the inventoj costs, e.g. transportation costs. Some of transportacntory. Others [ 5-71 include the cost of transportation as a

“Since the purpose reduce costs, the co

automatic data-collection systems, it seems appropriate to begin now the process of determining what data is to be collected, and how it

2 is to be stored and classified to preclude having to redesign operative systems. The scope of the present study will be limited, as follows. First, a rethod of separating inventory system costs from other maaufacturing costs will be presented. The purpose of this step is to enable identification of those costs which should be included in the inventory system, and the manufacturing subsyso which other manufacturing costs should be assigned, such that cost analysis of the various manufacturing systems (here, principally the inventory system, i.e. a subsystem of the manufacturing system) can be achieved. Second, a categorization of Inventory-system costs will be presented. The purpose of this step is to create subsets of inventory costs which can be readily used for system analysis aterial-ordering purposes. If, for n automatic data-gathering system used, it could collect and storecost gory and thus preclude the need of data segregation for analysis or oses. Data can always be aggregated, but once data are mixed, it is not always possible to segregate them. Third, a table of illustrative cost sources will be presented. The purpose of this table is to indicate likely sources of inventory-system costs by category. Also included in the table are -system costs, but whit

Separation of inventory-system costs from the o&s of other of the manufacturing sys-

tem’s subsystems is most easily accomplished using a systems approach. Specifically, a start can be made by classifying the manufacturing subsystem s into two categories. T operating subsystems, i.e. those which directly impact (physically handle) products, and supportive subsystems, i.e. those which support the operating subsystems. are four operating subsystems: ri,raterial-conversion system; (2) the material-handling system; ( 3) the quality control system; and (4) the inventory system. There are, of course, other subsystems within the manufacturing system, e.g. personnel, finance, maintenance, etc., but these other subsystems exist to support the four operating subsystems. For example, maintenance personnel do not directly work on a particular part being manufactured, rather they work on the equipment utilized by the operating sub terns. Similar relationships exist for the o supportive systems. People assigned to the operating subsystems, however, do work directly on a part being manufactured. At any point in time, a part can be viewed as residing in one or another of the operating subsystems or in one work center within an operating subsystem. For example, suppose that a

version system. As the part is

another. If, for example, the product is being painted, it is in the control of the material-conversion system, and costs incurred should be

3

stem

MANUFACT'URINCSYSTEM

Fig. 1. Operatingsubsystemsof the manufacturingsystem.

attributed to the painting process. Note that, if a long drying time is required, it is due to the design of the painting process. Conceptually, then, exit from control of the material-conversion system and entry into 01:;: of the other operating subsystems does not occur until the paint is dry enough for the next operation to be performed. This is an importa.nt concept since it enables costs to be assigned to the proper operating subsystem. The cost-assignnt rule is simple and straightforward: “All ts incurred by the product when it is under the control of a given operating subsystem are assigned to that controlling subsystem.” What is needed, then, is a definition of the cost boundaries of the four operating subsystems. It would appear, at first sight, that the cost boundaries could be defined on the basis of labor, i.e. who is doing the work. However, this is not always possible. For example, machine operators are often responsible for inspecting parts they produce. In this example, the machine operator is assigned to the materialion system but, when doing inspection

the: material-conversion syse configuration and/or composition of a given product. This would include, for example, such operations as machining, cutting, assembly, coating and curing. Operations like curing are often not considered as operations per se, since no labor effort is added to the product. However, when the next operation cannot begin until after a given curing time has elapsed, there is a cost associated with the operation, i.e. a holding cost, the principle element of which is the alternative cost of money invested in the product. This cost ought to be charged to the curing operation, not to the inventory system as is often the case, especially where the product is temporarily stored in some warehouse during the curing period. In short, when the composition and/or configuration of a product is being changed, the costs incurred as a result of having to perform the operation, and including holding costs, e.g. material shrinkage and the cost of money, should be chahged to the material-conversion system.

The purpose of quality control is to insure that the final product conforms to some specified level of qualitv. . The timing and location of quality control work is contingent on many factors. For example, parts may be inspected at time of receipt IO facilitate return/credit

is to define the cost

ple, all costs incurred in the actual inspection

system whose purpose is the same as that of the operation under consideration. Thus, to complete the first step, the purpose of each of the operating subsystems needs to be defined.

person. The fact that inspection, a quality control function. and part counting, an activity performed to maintain accurate inventory records and hence an inventory system cost, are

combined into a single task does not change the purpose of each of the activities. The inspection activity is still for quality control purposes and part counting is for inventory purposes. Further, the fact that inspection reduces future assembly costs by removing substandard comonents does not somehow make the cost of performing the inspection an assembly cost, i.e. a material-conversion system cost. Inspection activities and hence their costs, regardless of when or where they are incurred, exist to maintain some estaWshed level of quality, and hence should be assigned to the quality control system. ateriai-

The purpose of material handling is to move material from one operation to another to include from a material-conversion station to an inventory location, a quality control station or another material-conversion station. In certain cases, e.g. where the marketing and/or distribution functions are included in the manufacturing accounting entity, the material-handling system may be extended to include the transportation system. Like the painting process example above, k.ow long an item is in the sphere of control of rhe materialhandling system is a nction of the method used to move the rial is being mov ssociated with the movement itself an associated with the time value of money,

Inventory system

The sole purpose of inventory in the inventory system is to uncouple work centers beionging to the other t terns. Material is in the invent it is in a queue where at times the queue exists in a warehouse area and at other times on the shop floor. Note that material is considered to be in the inventory system only part of the time, i.e. when it is not in one of the other three operating subsystems. This position is at variance with the viewpoint of financial accounting, but need not adversely impact financial accounting since all the segregated cost data can be aggregated and distributed according to accepted financial accounting practices. The important aspect of whether or not material is considered to be in the inventory system is that only when material is in the inventory system does it accrue inventory holding costs. Since the above defined purpose of inventory represents an apparent departure from some existing literature, a brief discussion of the purpose/function of inventory, as it appears in some of the literature, is necessary. Plossl [ 81, defines six functions of inventory: (1) Lot-size (or order quantity) - uncouple manufacturing operations, (e.g. screw machines vs. assembly; supplier vs. user). (2) Demand-fluctuation (or safety stock) insurance against unexpected demand. (3) Supply-fluctuation - insurance against interrupted supply (e.g. strikes, vendor lead icipation - level-o promotion).

production (e.g. to ales, marketing

they deal with. Lot-size quantities exist to average demand. The economic o tity (EOQ) equation, which is often u calculate this quantity assumes constant cr lot-size orde ax or periodic, assume constant demand du cycle. The second, third an all deal with variable components of e second and t ned to establish safety sto by combining the demand and lead time distributions. This combination is designed to insure availability of inventory during the ordering lead time and hence might be considered coverage for short time variation. The fourth purpose, anticipation, is also a form of variation from the average demand rate, but in this case, it is known and enables long term preparation to meet the variation. While actual demand is normally a lump demand, i.e. it occurs all at once, we might consider it a long term variation since inventory established to meet the demand is created on a long term basis. Referring to Plossl’s statement about the urpose, anticipation inventory certainly ples the supplier who wants constant production from the user who wants a lump supply. Thus, it can be seen that if Plossl combined all his elements of demand/supply, the underlying reason is to uncouple work centers belonging to the other three operating subsystems. Plossl’s fifth purpose, transportation, as he describes it, actually refers to base pipeline stock [4, p. 21. Included in this base pipeline stock is the material between manufacturing and the customer that exists in distribution

regardless of how the accounting entity is defined, material under the control of the inventory system has but one function, i.e. uncoupling the other operating subsystems. The final function (purpose) of inventory defined by Plos de a hedge against price increases. ed in this manner has nothing to do with increasing the efficiency of the manufacturing system, which is what material in the inventory system does, rather, it is the utilization of production material as an investment alternative. One would invest in production material under the same conditions as he would invest in stock, land or any other commodity, i.e. so long as the return on investment is greater than the return he could earn on his next best investment alternative. Conceptually, material purchased as a price hedge should be placed in accounting records as a short term investment during the period beginning with when it enters accounting records and ending with when it would have nting records if it had bezn which is the time it should enter the inventory syste point is that only when th be an investment altemati ciated ith the inventory system.

6 TABLE 1

INVENTORY SYSTEtlCOST CATEGORIES

Purpose of thz operating subsystems of the manufacturing system Subsystem

Purpose

Material-conversion sysienl

To alter the configuration and/or composition of a given product.

Quality control system

To insure that the final product conforms to some specified level of quality.

Material-handling system

To move material from one location to another.

Inventory system

To uncouple the three other operating subsystems.

create manufacturing system synergy in terms of minimizing manufacturing system costs. Finally, as further justification of this position on the purpose of inventory refer to [ 91 and [ lo] and the definition of inventory in ref. [ 4, p. 151: “Items which are in a stock point or work-in-process and which serve to decouple (sic.) successive operations in the process of maubfacturing a product and distributing it to the customer.”

Table 1, Purposes of the Operating Subsystems of the Manufacturing System, summarizes the purpose of each of the operating subsystems of the manufacturing system.

With inventory system costs now separated from other manufacturing subsystem costs, it is possible to consider how the inventory system costs should be segregated (categorized) to maximize their usefulness. It is noted that how costs should be categorized for a specific case is dependent upon how the accounting entity is defined, i.e. what included in the entity. The assu

PURCHASED ITEnS

HANUFACTURED ITENS

SPECIAL PURPOSE

Raw blateriels

Vork-In-Process

tlaintenanceInventory

Purchased Parts

Finished Goods

Anticipation Inventory

Safety Stocks

Safety Stocks

INVENTORY OUTSIDE THE INVENTORY SYSTEM HATERIAL HANDLING SYSTEII

QUALITY CONTROL SYSTEM

MATERIAL CONVERSION SYSTEM

SPECULATIVE INVENTORY

Fig. 2. Inventory cost categories.

material delivered to a finished goods warehouse. Thus movement of material from the finished goods warehouse is outside the accounting entity. Expansion of the accounting entity would not alter the approach to cost categorization; however, it would add to the number of categories that would have to be considered. Recall that the purpose of categorizing (segregating) the inventory system costs is to enable one to analyze the inventory system on a cost basis to develop a more efficient inventory system and to accurately determine cost values for ordering purposes, i.e. controlling inventory levels. Also recall that is is assumed that data will be collected using an automatic data collecting system. Without such a system of gathering and storing cost data, the cost of operating the system would probably be prohibitive. Figure 2, Inventory System Cost Categories, shows the minimum major categories required. To facilitate cost analysis of the system for system improvement and operational control purposes further segregation would be desirable. For example, inventory holding costs could be segregated into the various elements of olding costs, e.g. space costs, taxes, inventorying costs, pilferage costs, etc., to enable anal-

ion and will be suffi-

inventory, quality control system inventory, material-conversion system inventory and speculative (hedge) inventory. This is done to emphasize that material at time resides in these systems or accounts and that costs - primarily costs - which are normally aggregated into one value for inventory per se should be assigned to these systems or accounts and not to the inventory system. Inventory within the inventory system can be separated into three groups for cost collection purposes: purchased material, manufactured material, and material ordered for special purposes. The special purpose ‘nventories will be considered first. ce inwen

The costs of ordering and maintaining inventories purchased to support maintenance activiies should be segregated for several reasons. First, this inventory is not production inventory. Hence, its costs are not directly allocated to an end item, rather they are first allocated to some piece of production equipmen? and then? based on equipment utilization, its costs are allocated to an end item or component of an end item. Second, maintenance inventory is often separated both physically and for accounting purposes. Finally, the ordering policy and the ordering and holding costs for this inventory are different than what is used for production inventories. In short, maintenance inventory represents a separate inventory system and should be handled as such. ici

The definition of anticipation inventory is: “Additional inventory a ove basic pipeline stock to cover projected trends of increasing sales, planned sales promotion programs, seasonal fluctuations, plant shutdowns and vacations” [4, p. 21.

’

costs nor the ordering criteria, i.e. balancing holding and ordering costs, are the same for anticipation inventory as is used for lot-size inventory or other elements of base pipeline stock. Basically, one uses this type inventory to level production such that it will remain within existing capacity and/or to minimize changes in capacity. Hence, the pertinent costs to balance (minimize) are the costs of changing capacity added to the ordering cost and the cost of holding the anticipation inventory. If one is interested in determining whether or not such inventory is justified or to what extent it is justidied, the associated costs must be separated from the costs of inventory which would exist if anticipation inventory did not exist. Thus, the costs of this type inventory should be separated from other types of inventories’ costs. Establishment of the other two groups, namely, purchased items and manufactured items, is justified, among other reasons, because both the sources of and the values of the ordering costs are different. For the purchased items, a key source is the purchasing department. The equivalent source for manufactured items would be the production plannirg and control department. Thus, regardless of whether one is seeking to perform cost analysis or determining order quantities, the costs associated with these two groups of inventory should be separated for cost collection purposes.

The purchased items are separated into three sub-groups; ra\lvmaterials, purchased parts and safety stocks. In relation to raw materials and purchased parts, a separation should be made for cost-collection purposes because of the tial differences in h ding costs and, pasolding costs can be

can be expected to be greater than for purchased parts because of the difficulty encountered in issuing from bulk quantities. For example, issuing wire from a roll creates problems because one tends to cut off a little more than is called for. Safety stocks should be separated from raw materials and purchased parts for cost collection purposes because ordering costs can be expected to be significantly different. Safety stocks are ordered to cover variations from average demand and average lead time. The cost components one seeks to minimize is the holding cost, which can be expected to be the same as for base stock, and the ordering cost which can be expected to be significantly greater than for normally ordered items. For example, one can expect single item orders with greater expediting effort for special (stockout) orders as opposed to multiple lineitem orders with little expediting effort in the case of normally ordered items. To mix the ordering cost of special ordered items with the ordering cost of normally ordered items will result in overstated order quantities for normally ordered items and hence in greater than necessary inventory levels.

Manufactured items are separated in a manner similar to purchased items. One can expect that holding costs for work-in-process will be different than for finished goods. For example, work-in-process, if in the shop, will have no storage costs associated with it, but the material shrinkage costs due to material damage, engineering changes and lost expected to be both different t than for finished

cost categorization should be considered to be the minimum segregation of inventory system costs. There is no reason why the cost collecting system could not be designed to collect data in smaller sets, e.g. by source as shown in Table 2. As the amount of cost segregation increases, one will be better able to perform detailed cost analysis. Where the breakeven point for cost segregation is will be a function of what the particular inventory system is comprised of. While one may not find it economical to collect data on a item-by-item basis, one may find it cost effective to do so down to say some ‘“ABC” subcategory.

Table 2, Inventory Cost Sources, identifies the allocation of costs by the activity creating the cost. Inventory system costs are separated into three basic sets: holding costs, ordering costs and stockout costs. Separation of these costs are achieved with the following three rules: (1) If the cost is incurred because items of inventory physically exist, the cost is assigned as a holding cost. (2) If the cost is incurred because items have to be ordered in specific quantities and at specific times to meet normal (expected) demand, the cost is assigned as an ordering cost. (3) If the cost is incurred because of random variation in demand and/or random variation in lead times or because of normal order system failure, the cost is assigned as a stockout cost. Table 2 does not seek to include all the spe-

9 TABLE 2 Inventory cost sources Cost description

Materialconversion system costs

Inventory system costs Purchased items

Manufactured items

Materialhandling system costs

Quality Other control costs system costs

Holding Ordering Stock- Holding Ordering Stockout costs out costs costs costs costs costs Physical inventory costs Cycle counting Year-end inventorying

*

Warehouse operations Personnel: + Area maintenance Receiving activities: Material counting Form processing Material inspection Defective material return activities Issue activities: Internal: Form processing Staging External Q Janitorial Equipment: Recc ing activities + Arez .taintenance Issue activities (internal) Issue activities (external) Defective material return * Utilities Q Storage supplies (e.g. pallets) Space: + Owned (depreciation) * Rented Inventory shrinkage Pilferage Breakage Deterioration Obsolescence Computer costs Locator records Perpetual record maintenance Reorder point maintenance Reorder point process;.ng Forecasting Production planning Production control

Q

+

Q

*

*

Q

+

Special order releases

*

Q

Q

Q Q

*

Q Q Q Q

+ *

* Q * *

Q

Q Q Q Q Q Q Q

Production planning and control Expenditures Scheduling: Norm al order releases Special order releases

*

Q

Q

Q

Q

+

Q

*

10 TABLE 2 (continued) Materialconversion system costs

Inventory system costs

Cost description

Manufactured Holding costs

Work center set-up: Normal order releases Special order releases and resulting normal order splitting Expediting: Normal order releases Special order releases Anticipaticn inventory order Processing

Purchased items

items

Ordering costs

Stock- Holding costs out costs

Ordering costs

Materialhandling system costs

Quality contra! system costs

Other costs

Stockouf costs

+ *

*

Taxes Insurance Material handling Interplant Normal transportation Priority transportation

+

(diff.)

Purchasing department expenditures Manufacturing inventories Capital equipment Maintenance inventories Speculative inventories Defective materia! return activities Alternative investment cost of money Time in material-conversion system Time in quality control system Time in material-handling system Time in queue: Shop floor Warehouse

*

*

+ * + 0

(2) What classes of inventory one establishes (see Fig. 2). (3) What the source of the cost is (see Table 2).

*

ing the fixed and variable components of the various inventory-system costs.

11

point systems and time-phased systems utilize only the variable ortions of the costs in determining order quantities. Instead of attempting to determine which costs are “out-of-pocket” costs, it is suggested that costs be collected on a period basis and that the technique of linear regression be employed to separate the variable cost components from the fixed cost components. The following equations of the general form y=a+bx

(1)

can be used where: Y will represent the total period cost, a will represent the fixed component of the cost, b will represent the variable component of the cost, and X will represent either the average dollar value of inventory for holding cost equations or the number of orders placed in some period for ordering cost equations. Equations 2 and 3 can be used to determine the value of the holding cost V” for the various inventory categories. Equation 4 can be used to determine the ordering cost “SO” for vendor items. Equations 5 and 6 can be used to determine the ordering cost “S for manufactured items. C,=F,+IJ,

(2)

where: is a period’s total holding cost for some category with units of $ per period ($/time). would be the fixed portion of the catego-

The value to use for the holding cost then would be: I= IC+Im

where: I,,, would be the alternative investment cost of money invested in inventory. Oi=Fo+SoNi

(4)

where: Oi would be the period’s total vendor ordering cost with units of dollars per period ($/time). would be the fixed portion of the vendor ordering cost with units of dollars per period. would be the variable portion of the vendor’s ordering cost with units of dollars per line-itcrn order ($/line-item order). Ni would be the total number of line items ordered (not necessarily orders) during the period with units of line-items order (lineitem order). P,=F,,+S',M,

where: would be the period’s total cost for producPi tion ordering with units of dollars per period ($/time). would be the fixed portion of the production ordering cost with units of dollars per period. would be the variable portion of the production ordering cost with units of dollars per line-item ordered ($/line-item order). er of line-items ring the period with units of line-item order (line-item er).

s=d,, 4-16,

category’s lot-size inventory for the period. Its units are simply dollars ($).

(3)

where:

(6)

12 Ss is the total production setup cost for the

line-item. One word of caution about this approach is in order. Where cost reduction programs and/or system changes occur that affect the system’s fixed costs, e.g. changes in the number of personnel, amount of equipment, and space utilized, the changes will have to be either deducted from or added to all periods included in the calculations. If they are not, they will show up as a portion of the variable cost. In fact, large reductions could theoretically result in a negative variable cost. CONCL

The key to resolving questions of whether a given cost is an inventory system cost or a cost belonging to some other manufacturing subsystem, e.g. transportation costs, is the identification of the operating systems and the definition of their purposes. For a given cost, one need only determine why it exists - i.e. what function requires the activity that creates the cost to properly and logically assign the cost to the appropriate operating system (or to the proper support system). Effective cost analysis of some activity requires the collection of data relevant only to the activity in question, thus there is a need to separate data at time of collection to prevent the need for industrial engineering type studies to gather cost data for cost analysis purposes. The separation of costs - in accordance wit the categories identified in Fig, 2, Inventory cost Categories, and ssibly, by source - will

for the design of an automatic data-collection system. Finally, while the proposed system may impact managerial accounting practices existing in a firm, it is the managers, not the accountants who should define what data and in what form the data is gathered in terms of managerial accounting. In the case of financial accounting, where management is not free to choose how data is collected or presented, the proposed system would not reclassify data but would create many subclasses for analysis purposes which could be aggregated for financial reporting. Thus the proposed system should not have any impact on financial accounting practices.

1 I. Morgan. 1963. Questions for solving the inventory problem. Harvard Bus. Rev., 41(4): 103. 2 D.W. Fogarty and T.R. Hoffmann, 1983. Production and Inventory Management. South-Western Publishing Co., Cincinnatti, OH. 3 G. Hadley and T.M. Whitin, 1963. Analysis of Inventory Systems. Prentice-Hall, Englewood Cliffs, NJ., p. 11. 4 T. Wallace ( Ed.), 1984. Dictionary, 5th edn. American Production and Inventory Control Society, Inc., Falls Church, VA. 5 S. Love, 1979. Inventory Control. McGraw-Hill, New York, p. 236. 6 A.C. Laufer, 1984. Production and Operations Management, 3rd Edn. South-Western Publishing Co., OH, U.S.A., p. 5 15. 7 D.R. Anderson, D.J. Sweeney and T.A. Williams, 1982. An Introduction to Management Science, 3rd Edn., West Publishing Co., St. Paul, MN, p. 456. 8 G.W. Plossl, 197 1. How much inventory is enough? Prod. Inventory Manage., I2( 2): 4. 9 N. Gaither, 1984. Production and Operations Management, 2nd Edn., Dryden Press, New York, N.Y., p. 404. 10 E.E. Adam Jr. and J.R. Ebert, 1982. Production and