stockholding (inventory) costs

the cost to firms of holding STOCKS of finished products and raw materials in order to provide immediate customer service or to prevent disruptions to production caused by lack of materials. Stockholding costs include costs of warehouse space, insurance, deterioration and obsolescence of stored items and interest on capital tied up in stocks. Such costs are roughly proportional to the value of the stock held, and to contain such costs stock levels need to be kept low.

On the other hand, firms also have costs for ordering and delivering goods for stock, such as communicating with suppliers, accounting transactions, transport and unloading and inspecting goods. Many of these ordering and delivery costs will remain the same irrespective of the size of the order.

Since many order and delivery costs are fixed costs, in order to reduce these costs the firm should place large orders at infrequent intervals, and such a policy would have the additional benefit of allowing the firm to earn price discounts for bulk purchase. However, if orders are placed at infrequent intervals then stocks, and thus stockholding costs, will be high. It is desirable to strike a balance between these two groups of costs by determining the economic or optimum order quantity, which minimizes total stock cost, and adopting appropriate STOCK CONTROL procedures to maintain stocks at this level.

See JUSTIN-TIME SYSTEM.