10.2 Inventory Costs, Accounting, Costing, and Metrics

Inventory decisions are cost decisions. Domain VI expects you to quantify tradeoffs: order less often and you save ordering cost but raise average cycle stock; cut safety stock and you save carrying cost but raise stockout risk. Accounting systems also shape behavior — what gets valued, how variances are reported, and which KPIs operations is scored on.

The Three Cost Families

Ordering cost — simple annual model

If each order costs S and annual demand is D with order quantity Q:

Orders per year = D / Q Annual ordering cost = (D / Q) × S

Example: D = 12,000 units/year, S = $75/order, Q = 500.

• Orders/year = 12,000 / 500 = 24
• Annual ordering cost = 24 × 75 = $1,800

If Q rises to 1,000, orders fall to 12 and ordering cost falls to $900 — but average cycle stock doubles.

Carrying cost

Carrying cost rate i (or H as $/unit/year) captures the opportunity cost of capital plus physical holding costs.

H = i × C

where C is unit cost.

Average cycle inventory ≈ Q/2 (ignoring safety stock for a moment):

Annual carrying cost (cycle) = (Q / 2) × H

Example: Unit cost C = $40, carrying rate i = 25%/year, Q = 800.

• H = 0.25 × 40 = $10/unit/year
• Average cycle stock = 400
• Annual cycle carrying cost = 400 × 10 = $4,000

Add safety stock of 150 units:

• Extra carrying cost = 150 × 10 = $1,500
• Combined carrying ≈ $5,500/year

Stockout cost — expected value thinking

Stockout cost is harder to observe but still real. A practical expected-cost framing:

Expected annual stockout cost ≈ (stockout events/year) × (avg units short) × (cost per short unit)

Example: A firm estimates 8 stockout events/year, averaging 40 units short, with shortage cost $18/unit (expedite + margin loss).

• Expected annual stockout cost = 8 × 40 × 18 = $5,760

Raising safety stock might cost $1,500/year in extra carrying cost but could cut stockout events in half — an expected savings of $2,880. That tradeoff is the heart of service-level policy.

Combined cost sketch

Using the earlier numbers with Q = 500, D = 12,000, S = 75, H = 10:

• Ordering = (12,000/500) × 75 = $1,800
• Cycle carrying = (500/2) × 10 = $2,500
• Total of these two = $4,300

At Q = 800:

• Ordering = (12,000/800) × 75 = $1,125
• Cycle carrying = 400 × 10 = $4,000
• Total = $5,125 (worse than Q = 500 in this illustration)

You do not need EOQ yet to see the U-shape: too small Q inflates ordering cost; too large Q inflates carrying cost. Section 10.3 formalizes the minimum.

Inventory Accounting Snapshot

Manufacturing inventories typically flow:

Raw materials → WIP → Finished goods → Cost of goods sold (COGS)

Purchases and issues hit raw materials. Labor and overhead applied in production increase WIP. Completed units transfer to FG. When sold, FG is relieved and COGS is recognized. CPIM does not turn you into a CPA, but you must know that inventory is capitalized on the balance sheet until sold, and that excess inventory ties up cash and raises write-off risk.

Valuation methods (awareness level)

Organizations may use FIFO, LIFO (where allowed), weighted average, or specific identification. Rising prices under FIFO generally mean lower COGS and higher ending inventory than LIFO. Exam items usually test direction of effect, not journal-entry mechanics.

Transfer pricing is the fourth valuation concept the ECM names, and it is the one planners actually collide with. A transfer price is the internal price charged when one unit of the same company ships to another — plant to plant, plant to a distribution subsidiary, or across a border between legal entities. It can be set at standard cost, cost plus a markup, or market price.

Why a planner cares: transfer price is an accounting allocation, not a real economic cost to the enterprise. When an interplant transfer carries a 20% markup, the receiving site sees a $120 part that costs the corporation $100. Sourcing that part externally at $110 looks like a saving on the receiving plant's P&L and is a $10 loss to the company. The same distortion inflates the receiving location's inventory value and its carrying-cost calculation, which can push an EOQ or stocking decision the wrong way. On the exam, treat interplant demand as dependent demand to be planned, and treat transfer price as a reporting artifact to be recognized rather than optimized.

Standard Costing Overview

Standard costing assigns predetermined unit costs for material, labor, and overhead. Actual results create variances:

Mini calculation — material variances

Standard: 2.0 lb/unit at $5.00/lb. Actual for 1,000 units: 2,100 lb purchased/used at $5.20/lb.

• Material price variance = (5.20 − 5.00) × 2,100 = $420 unfavorable
• Material usage variance = (2,100 − 2,000) × 5.00 = $500 unfavorable

Operations owns usage more often; purchasing owns price — but causes interact (cheap material may scrap more). For inventory planning, standard cost is often the C used in carrying-cost estimates, so inflated standards distort EOQ and turns targets.

Core Metrics: Turns and Days of Supply

Inventory turnover

Inventory turns = COGS / Average inventory

Average inventory is typically (beg + end)/2 for the period, or a more frequent average if available. Use cost consistently — do not mix retail sales with cost inventory.

Example: Annual COGS = $9,600,000. Beginning inventory $1,100,000; ending inventory $900,000.

• Average inventory = (1,100,000 + 900,000) / 2 = $1,000,000
• Turns = 9,600,000 / 1,000,000 = 9.6 turns/year

Days of supply (days on hand)

Days of supply = (Average inventory / COGS) × 365 = 365 / Turns

Using the same data:

• Days of supply = 365 / 9.6 ≈ 38.0 days

Alternatively: (1,000,000 / 9,600,000) × 365 ≈ 38.0 days.

Forward-looking days of supply (operations form)

Planners often compute:

Days of supply = On-hand units / Expected daily demand

Example: On-hand = 4,800 units; forecast = 160 units/day → days of supply = 4,800 / 160 = 30 days.

This operational metric can diverge from the accounting days-of-supply figure because one uses units/forecast and the other uses cost/COGS.

Interpreting turns

Example comparison: SKU A turns 12× (≈30 days); SKU B turns 4× (≈91 days). Before celebrating SKU A, verify fill rate. A 12-turn SKU with 91% fill rate may destroy more value than a 6-turn SKU at 99% fill rate.

GMROI (optional but useful)

Some retailers track Gross Margin Return on Inventory:

GMROI = Gross margin $ / Average inventory cost

Example: Gross margin $2,400,000; average inventory $800,000 → GMROI = 3.0. It links margin quality to inventory investment — complementary to turns.

Putting Costs and Metrics Together

Suppose a DC holds average inventory of $2,500,000, COGS $15,000,000, carrying rate 22%.

• Turns = 15,000,000 / 2,500,000 = 6.0
• Days of supply = 365 / 6 ≈ 60.8 days
• Annual carrying cost ≈ 2,500,000 × 0.22 = $550,000

A project that cuts average inventory 10% without hurting service saves about $55,000/year in carrying cost and lifts turns to 15,000,000 / 2,250,000 ≈ 6.67. If the same cut causes $80,000 in added expediting and lost margin, the "improvement" failed. Metrics without cost tradeoffs mislead.

Exam Focus

Memorize the formulas, then practice units: annual vs. daily demand, cost vs. units, average vs. ending inventory. CPIM items often hide a mismatch (e.g., using sales at retail in the turns denominator). Keep COGS with inventory at cost, and keep purpose of the inventory visible when someone demands "higher turns" as a slogan.