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The cost of holding inventories may include the following:

1. Carrying cost:

This is the cost incurred in keeping or maintaining an inventory of one unit of raw material or work-in-progress or finished goods. Two basic cost are associated with holding a unit in inventory. These are

a) Cost of storage:
This means & include the cost of storing one unit of raw material by the firm.

b) Cost of financing:
This cost includes the cost of funds invested in the inventories. The funds used in the purchase/ production of inventories have an opportunity cost i.e., the income which could have been earned by investing these funds elsewhere.

Total carrying cost is entirely variable & rise in direct proportion to the level of inventories carried. The total carrying cost move in the same direction as the annual average inventory.

2. Cost of ordering:

The cost of ordering include the cost of acquisition of inventories. It is the cost of preparation & execution of an order, including cost of paper work and communicating with supplier .There is always minimum cost involved whenever an order for replenishment of goods is placed. The total annual cost of ordering is equal to the cost per order multiplied by the no. of order placed in a year. The ordering cost may have fixed component which is not affected by the order size & a variable component which is changes with the order size.

NOTE: The carrying cost & the cost of ordering are the opposite forces & collectively they determine the level of inventory in a firm.

3. Cost of stock-outs(A hidden cost):

A stock-out is a situation when the firm is not having units of an item but there is a demand for that either from the customers or the production department. The stock-outs refers to the demand for an item whose inventory level has already reduced to zero or insufficient level. It may be noted that the stock-out does not appear if the item is not demanded even if the inventory level has fallen to zero. Stock-outs are quite often expensive. Stock-outs of raw material or work in progress can cause the production process to stop.

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