Ordering costs definition
/What are Ordering Costs?
Ordering costs are the expenses incurred to create and process an order to a supplier. These costs are included in the determination of the economic order quantity for an inventory item. Examples of ordering costs are as follows:
Cost to prepare a purchase requisition and a purchase order. This cost includes preparing the necessary paperwork, which can be reduced through the use of online forms.
Cost of the labor required to inspect goods when they are received. This can be a substantial cost if suppliers have not been pre-certified as being high-quality providers who can bypass the inspection process.
Cost to put away goods once they have been received. This cost can be substantial if cases are broken down for storage in smaller-sized bins, or if the designated bins are in distant locations within the warehouse that call for extended transport times.
Cost to process the supplier invoice related to an order. This can incorporate substantial delays if the accounting staff is using three-way matching to ensure that the supplier invoice matches the associated purchase order and receiving documentation.
Cost to prepare and issue a payment to the supplier. Payment processing tends to be relatively low-cost, but can be higher if checks are manually prepared.
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How Ordering Costs Change With Volume
Ordering costs generally decrease per unit as order volume increases. However, the total ordering cost behavior depends on several factors. Here’s how ordering costs change with volume:
Per-unit ordering cost decreases. When a company places larger orders, the fixed costs associated with processing each order (such as administrative expenses, supplier communication, and purchase approvals) are spread across more units, reducing the per-unit ordering cost.
Total ordering cost depends on order frequency. If a company increases order volume per order (ordering in bulk), the total number of orders placed decreases, leading to lower total ordering costs over time. Or, if the order volume per order remains the same but total demand increases, total ordering costs may increase since more orders are placed.
Economies of scale in procurement. Larger order volumes may lead to supplier discounts, thereby reducing the overall cost per unit. However, ordering in bulk may require more storage space, leading to higher holding costs.
Diminishing returns on cost reduction. While per-unit ordering costs decrease with higher volumes, the rate of reduction slows down at very high order levels because fixed costs are already spread efficiently.
How Ordering Costs Relate to Inventory Carrying Cost
An entity may be willing to tolerate a high aggregate ordering cost if the result is a reduction in its total inventory carrying cost. This relationship occurs when a business orders raw materials and merchandise only as needed, so that more orders are placed but there is little inventory kept on hand. A firm must monitor its ordering costs and inventory carrying costs in order to properly balance order sizes and thereby minimize overall costs.