Inventory Management Costs and Lot-by-Lot Ordering Strategy

Introduction

Seismic Testing is a company involved in testing subterranean areas for the presence of oil and other minerals. In its operations, it uses a highly specialized and very dangerous explosive to generate the subterranean sound waves it interprets to determine what lies underground in a specific area. Because the explosive is so specialized and difficult to obtain, the company keeps a large supply on hand. This strategy of maintaining a large inventory is a costly one. The costs associated with this storage are examined below, along with suggestions for how Seismic Testing could reduce those costs.

Holding Costs of Storing Explosive Inventory

There are several costs associated with storing inventory. Schermerhorn (1997, p. 497) refers to these as holding costs and describes them as "the costs of storing and insuring the items in inventory against loss plus the opportunity cost of the funds tied up in inventory." For Seismic Testing, the first significant cost is related to the facilities needed to store the explosives. Inventory management of hazardous materials introduces additional complexity beyond standard warehousing. Lockyer, Muhlemann, and Oakland (1988, p. 392) note that storing materials also includes a need to ensure they are stored safely. Given the nature of the product, it can be assumed that precautions must be taken for it to be stored safely, meaning the actual storage area would be more costly than for other types of materials.

Maintenance costs would also likely be higher, since Seismic Testing must ensure that facilities remain suitable for storing the product at all times. In addition, there would be labor and time costs involved, such as the cost of having the storage area and the explosives regularly checked to ensure safety. As Schermerhorn noted, insurance of inventory is also a significant cost. In the case of explosives, insurance may need to extend not only to loss of the product, but also to damage to the facility and injury to personnel, since an explosion could potentially cause widespread damage and injuries. Finally, there is the opportunity cost, which refers to the income tied up in the inventory that could otherwise have been utilized elsewhere in the business.

Conclusion

The lot-by-lot delivery approach would reduce the opportunity cost, since Seismic Testing would be paying for the material as it is needed rather than far in advance. The company would also reduce its storage costs, as it would not need to store large amounts of the explosive at any one time. This would create cost savings by requiring a smaller storage area to maintain and fewer human resources to manage it. In addition, because the explosives would be stored for a shorter period, fewer safety checks would need to be carried out. The smaller storage volume would also reduce insurance costs. Finally, this solution would lower the costs involved in sourcing and purchasing the explosives, since the supplier would be responsible for sourcing the material, thereby reducing Seismic Testing's workload and administrative burden.

Overall, this analysis highlights the high costs associated with storing a large amount of inventory, particularly for a dangerous product such as explosives. It also demonstrates how those costs can be substantially reduced by adopting a more effective supply strategy — specifically, a lot-by-lot ordering arrangement supported by a long-term supplier agreement.

Lockyer, K., Muhlemann, A., & Oakland, J. (1988). Production and Operations Management. London: Pitman.

Schermerhorn, J. R. (1989). Management for Productivity. New York: John Wiley & Sons.