Question

Give an example of lost opportunity cost and obsolescence and discuss their impact on inventory carrying costs.

Answer 1

A typical example of lost opportunity cost is backorders or order backlogs. The opportunity cost is incurred when the organization had the opportunity to make additional revenue/profit but missed out on that opportunity due to any factor. One such factor is not having enough inventory on-hand. This could be likely due to underestimated demand forecast or a spike in demand because of external factor, or any other matter. However, if the organization does not have ready inventory when the demand comes up, it is recorded as backorder. In many cases, these does not eventually result in future sales as customer chooses to an alternative or rival’s product. This is how opportunity cost is incurred. Opportunity costs in such scenarios does not impact on inventory carrying cost. It usually reduces the inventory carrying cost when organizations take risk and hold smaller safety stocks. However, such decision increases the risk of opportunity cost.

Obsolescence is a situation when a product is kept in the inventory for a long duration and eventually goes obsolete. A classic example of this can be found often in food and beverage industry. The shelf life of products in these categories are quite low. If the distributor or the warehouse decides to maintain a high level of safety stock, then there is a high risk that the product will face obsolescence. This is particularly a damaging situation for the organizations. Unlike opportunity cost, these are costs that are immediately realized and accounted for on financial records. Not only are these waste of resource, space and money but it also adds indirect costs to the companies such as inventory carrying cost and overhead costs.