Even though there are literally millions of different types of products produced in our society, there are only two fundamental decisions that you have to make when controlling inventory:

1. How much to order

2. When to order

The purpose of all inventory models and techniques is to determine rationally how much to order and when to order. As you know, inventory fulfills many important functions within an organization. But as the inventory levels go up to provide these functions, the cost of storing and holding inventory also increases. Thus, you must reach a fine balance in establishing inventory levels. A major objective in controlling inventory is to minimize total inventory costs. Some of the most significant inventory costs follow:

1. Cost of the items (purchase cost or material cost)

2. Cost of ordering

3. Cost of carrying, or holding, inventory

4. Cost of stockouts

The most common factors associated with ordering cost and holding cost are shown in Table 6.1. Notice that the ordering cost is generally independent of the size of the order and often involves personnel time. An ordering cost is incurred each time an order is placed, whether the order is for 1 unit or 1,000 units. The time to process the paperwork, pay the bill, and so forth does not depend on the number of units ordered.

On the other hand, the holding cost varies as the size of the inventory varies. If 1,000 units are placed into inventory, the taxes, insurance, cost of capital, and other factors in the holding cost will be higher than if only 1 unit was put into inventory. Similarly, if the inventory level is low, there is little chance of spoilage and obsolescence.

The cost of the items, or the purchase cost, is what is paid to acquire the inventory. The stockout cost indicates the lost sales and goodwill (future sales) that result from not having the items available for the customers. This is discussed later in the chapter.