Inventory Management in Retail Organizations

Learning Objective 1 Identify six categories of costs associated with goods for sale

• purchasing, ordering, carrying, stockout, quality, and shrinkage

Inventory management includes planning, coordinating, and controlling activities related to the flow of inventory into, through, and out of an organization. Consider this breakdown of operations for three major retailers for which cost of goods sold constitutes their largest cost item.

The low percentages of net income to revenues mean that improving the purchase and management of goods for sale can cause dramatic percentage increases in net income.

Costs Associated With Goods for Sale

In addition to the costs of the actual goods purchased, there are a number of different types of costs associated with inventory. These costs fall into the following six categories:

1. Purchasing costs are the costs of goods acquired from suppliers, including incoming freight costs. These costs usually make up the largest cost category of goods in inventory. Discounts for large purchase-order sizes and faster supplier payment terms reduce purchasing costs.
2. Ordering costs are the costs of preparing and issuing purchase orders, receiving and inspecting the items included in the orders, and matching invoices received, purchase orders, and delivery records to make payments. Ordering costs include the cost of obtaining purchase approvals, as well as other special processing costs.
3. Carrying costs are costs that arise while goods are being held in inventory. Carrying costs include the opportunity cost of the investment tied up in inventory (see Chapter 12) and the costs associated with storage, such as space rental, insurance, and obsolescence.
4. Stockout costs are costs that arise when a company runs out of a particular item for which there is customer demand, a stockout. The company must act quickly to replenish inventory to meet that demand or suffer the costs of not meeting it. A company may respond to a stockout by expediting an order from a supplier, which can be expensive because of additional ordering and manufacturing costs plus any associated transportation costs. Or the company may lose sales due to the stockout. In this case, the opportunity cost of the stockout includes the lost contribution margin on the sale not made plus any contribution margin lost on future sales due to customer ill will.
5. Costs of quality are the costs incurred to prevent and appraise, or that arise as a result of, quality issues. Quality problems arise, for example, because products get spoiled or broken or are mishandled while being moved in and out of the warehouse. There are four categories of quality costs (also discussed in Chapter 20): prevention costs, appraisal costs, internal failure costs, and external failure costs.
6. Shrinkage costs result from theft by outsiders, embezzlement by employees, and misclassification or misplacement of inventory. Shrinkage is measured by the difference between (a) the cost of inventory recorded on the books (after correcting errors) and (b) the cost of inventory when physically counted. Shrinkage can often be an important measure of management performance. Consider, for example, the grocery business, where operating income hovers around 2% of sales. With such small margins, it is easy to see why one of a store manager’s prime responsibilities is controlling inventory shrinkage. A $1,000 increase in shrinkage will erase the operating income from sales of $\$\text{50,000}\hspace{0.17em}(2\%\times \$\text{50,000}=\$\text{1,000}).$ Because shrinkage costs generally increase when a firm’s inventory increases, most firms try not to hold more inventory than necessary.

Note that not all inventory costs are captured in financial accounting systems. For example, opportunity costs are not recorded in financial accounting systems but are a significant component in several of the inventory cost categories.

Information-gathering technology increases the reliability and timeliness of inventory information and reduces the costs related to inventory. For example, barcoding technology allows a scanner to record individual units purchased and sold. As soon as a unit is scanned, a record of its movement is created, which helps a firm better manage its purchasing, carrying, and stockout costs. In the next several sections, we consider how relevant costs are computed for different inventory-related decisions in merchandising companies.