The Monthly Metric: Inventory Ordering Cost

With final backlogs from the coronavirus pandemic-induced overordering spree being worked off, inventory management is largely returning to normal. That presents an opportunity for companies to reexamine processes and metrics.

On an inventory management dashboard, ordering cost is not likely to be one of the most important or used analytics, especially for a smaller company, says Tracey Smith, MBA, MAS, CPSM, president of Numerical Insights LLC, a boutique analytics firm in Williamsville, New York. “It’s probably not in the top five in terms of your inventory strategy,” she says.

However, inventory ordering cost (IOC) is a useful measurement. It factors into the economic order quantity (EOQ) calculation and can work in tandem with inventory carrying cost, a metric IOC is often confused with. A key component of the fundamental determination of how much and when to order, IOC can help uncover inefficiencies and lost revenue opportunities.

IOC measures the paperwork, labor and shipping costs associated with an order from a supplier. Like all inventory metrics, it can be subject to the whims of demand variability, as well as shipping spot rates. Smith recommends tracking the metric as a percentage of revenue.

“It’s good advice for just about any expense line — track the trend over time and as a percentage of revenue,” she says. “If it’s increasing as a percentage of revenue, that tells you those costs are eating more into your bottom line.”

Meaning of the Metric

The first step in measuring IOC, Smith says, is getting company stakeholders and suppliers in agreement on the costs that are included. “Some costs we want to factor might be more difficult to get a handle on from an accounting point of view,” she says. “Also, different companies will include different components in the cost. So, everyone needs to agree on the definition.”

Examples of IOC include (1) labor associated with issuing and processing requests, orders, invoices, payments and other paperwork, (2) shipping and transportation, (3) third-party customs and (4) inspection on arrival. A common formula to estimate IOC involves dividing orders demanded annually (D) by the volume per order (Q), then multiplying that with the cost per order (S).

The “S” is often considered a fixed cost, but that’s not necessarily the case, Smith says. Larger companies with automation capability and long-term logistics contracts can enjoy the comforts of fixed order costs, but they also can be dynamic, she says: “Labor rates change, and shipping rates can as well, especially if you have to unexpectedly use airfreight.”

IOC can work in tandem with inventory carrying cost. The former measures expenses before a product or component is placed in stock at a warehouse, the latter afterward. But for companies that have their own warehouse and don’t rely on third-party storage, carrying cost would be a more useful metric, Smith says.

“It’s very easy to confuse the two because they have some of the same costs,” Smith says. “There can be some (conflation) of the labor costs of ordering and carrying inventory. You need to make sure you’re separating the labor associated with ordering and receiving from the labor associated with carrying it.”

Bringing Order to IOC

While much less exasperating than during the COVID-19 era, inventory management is still one of the more challenging supply chain disciplines, even in the best of times. Demand variability remains formidable, and IOC can be quickly impacted by a stockout threat necessitating an unexpected order.

A company can be on top of its demand forecasting and supply chain operations. But if, for example, geopolitical turbulence in the Red Sea causes an overseas supplier’s lead times to extend, necessitating a more expensive airfreight shipment, that will lead to IOC indigestion.

Working with suppliers can help relieve that pain, Smith says. Barcodes on packages and EDI for paperwork are among efficiency improvements that can lower costs.

“Those moves can help minimize the amount of time it takes to receive things on the dock and therefore reduce the amount of labor associated with the cost of that shipment,” Smith says. “That’s where a good partnership with your suppliers can pay off.”

Though a supplementary metric at many companies, IOC can help inventory managers find balance on the never-ending tightrope between controlling costs and ensuring supply.

To suggest a metric to be covered, email me at dzeiger@ismworld.org.

(Photo credit: Getty Images/M.Czosnek)