Total Inventory Cost Formula: Essential 2023 Guide
In this article, we explain what the total inventory cost formula is and how you can calculate it. We will also walk you through our simple real-world examples to illustrate how it works. Read on to learn more.
Total Inventory Cost Formula Explained
The total inventory cost formula is a financial calculation used to determine the complete cost associated with ordering, holding, and purchasing inventory in a business. The formula sums up three major costs: ordering costs, holding costs, and purchase costs.
Example: In 2019, Toyota reported spending roughly $1.5 billion on ordering parts for its vehicles. Coupled with holding costs of $300 million and purchase costs of $90 billion for these parts, Toyota's total inventory cost for that year was approximately $91.8 billion.
Components of the Total Cost of Inventory Formula
The total inventory cost formula is broken down into three main components that represent the various expenses involved in handling inventory:
Ordering Costs (OC)
This pertains to the expenses that arise every time a business places an order. Whether it's the administrative burden, shipping, or handling, all these costs accumulate. The general formula for ordering costs is:
OC = (Order Quantity / 2) * Carrying Cost per Unit
Holding Costs (HC)
Keeping inventory in warehouses or storage isn't free. There's rent, insurance, possible depreciation, and even spoilage. The formula to represent this is:
HC = (Annual Demand / Order Quantity) * Ordering Cost per Order
Purchase Costs (PC)
This represents the fundamental cost of acquiring the inventory items.
PC = Unit Purchase Cost * Annual Demand
Total Inventory Cost Formula and Calculation
The total inventory cost formula is simple:
Total Inventory Cost = OC + HC + PC
The key variables here are:
Order Quantity: The number of units ordered each time.
Carrying Cost per Unit: The cost associated with holding a single unit of inventory for a given period.
Annual Demand: The total number of units needed annually.
Ordering Cost per Order: The cost associated with placing a single order, irrespective of order size.
Unit Purchase Cost: The cost of acquiring a single unit of the product.
Example #1
Bloom Floral needs to accurately calculate its total inventory cost to optimize stock levels, reduce overheads, and ensure profitability in the competitive floral industry.
To calculate the total inventory cost for Bloom Floral, let's break it down step by step:
Given:
Order Quantity = 1000 bunches
Carrying Cost per Bundle = $2
Annual Demand = 10,000 bunches
Ordering Cost per Order = $50
Unit Purchase Cost = $10 per bunch
Step 1: Calculate the Ordering Costs (OC)
Use the formula: OC = (Order Quantity / 2) * Carrying Cost per Unit
OC = (1000 bundles / 2) * $2
OC = 500 bundles * $2 = $1000
Step 2: Calculate the Holding Costs (HC)
Use the formula: HC = (Annual Demand / Order Quantity) * Ordering Cost per Order
HC = (10,000 bundles / 1000 bundles) * $50
HC = 10 * $50 = $500
Step 3: Calculate the Purchase Costs (PC)
Use the formula: PC = Unit Purchase Cost * Annual Demand
PC = $10 * 10,000 bundles
PC = $100,000
Step 4: Find the Total Inventory Cost:
Total Inventory Cost = OC + HC + PC
Total Inventory Cost = $1000 + $500 + $100,000 = $101,500
Hence, based on the given costs, the company will need to spend $101,500 annually to order, hold, and purchase its inventory.
Example #2
Novel Print Publishers is a renowned firm in the book publishing industry. To optimize their production, distribution, and budgetary strategies, it's important for them to determine their Total Inventory Cost.
To understand the Total Inventory Cost for Novel Print Publishers, let's delineate the process:
Given:
Order Quantity = 5,000 books
Carrying Cost per Book = $0.50
Annual Demand = 50,000 books
Ordering Cost per Order = $100
Unit Purchase Cost = $5 per book
Step 1: Calculate the Ordering Costs (OC)
Use the formula: OC = (Order Quantity / 2) * Carrying Cost per Book
OC = (5,000 books / 2) * $0.50
OC = 2,500 books * $0.50 = $1,250
Step 2: Calculate the Holding Costs (HC)
Use the formula: HC = (Annual Demand / Order Quantity) * Ordering Cost per Order
HC = (50,000 books / 5,000 books) * $100
HC = 10 * $100 = $1,000
Step 3: Calculate the Purchase Costs (PC)
Use the formula: PC = Unit Purchase Cost * Annual Demand
PC = $5 * 50,000 books
PC = $250,000
Step 4: Find the Total Inventory Cost
Total Inventory Cost = OC + HC + PC
Total Inventory Cost = $1,250 + $1,000 + $250,000 = $252,250
Consequently, given the stipulated values, the Total Inventory Cost for Novel Print Publishers annually amounts to $252,250.
Example #3
Sky Drive Motors is a rising name in the electric vehicle (EV) market, known for its innovative designs and sustainable approach. As they gear up to launch their latest model, Eco Flyer, understanding the Total Inventory Cost becomes pivotal.
Unlike traditional cars, electric vehicles like the "Eco Flyer" require specialized components, some of which have longer lead times due to their intricate manufacturing processes. Sky Drive aims to keep these components readily available without overstocking and incurring unnecessary holding costs.
Given:
Order Quantity for specialized EV components = 500 units
Carrying Cost per Component = $10
Annual Demand for "Eco Flyer" = 4,000 units
Ordering Cost per Order for these components = $200
Unit Purchase Cost for the specialized component = $500
Step 1: Calculate the Ordering Costs (OC)
Use the formula: OC = (Order Quantity / 2) * Carrying Cost per Component
OC = (500 units / 2) * $10
OC = 250 units * $10 = $2,500
Step 2: Calculate the Holding Costs (HC)
Use the formula: HC = (Annual Demand / Order Quantity) * Ordering Cost per Order
HC = (4,000 units / 500 units) * $200
HC = 8 * $200 = $1,600
Step 3: Calculate the Purchase Costs (PC)
PC = Unit Purchase Cost * Annual Demand
PC = $500 * 4,000 units
PC = $2,000,000
Step 4: Find the Total Inventory Cost
Total Inventory Cost = OC + HC + PC
Total Inventory Cost = $2,500 + $1,600 + $2,000,000 = $2,004,100
Given this analysis, Sky Drive Motors' total inventory cost for their specialized components in the production of "Eco Flyer" stands at $2,004,100 annually.
We hope this article has given you a better understanding of the total inventory cost formula and how to calculate it for your business.
