If your profit margins aren’t as high as they should be—even when sales are strong—the culprit might be hidden costs in your ordering process.
Ordering costs can quietly drain your profits if left unchecked, hiking up overall business expenses and dragging down supply chain efficiency, which can snowball into bigger (see: more expensive) issues later on.
Below, we’ll cover how to calculate and get ahead of them so you can see a significant difference in your bottom line.
What are ordering costs?
Ordering costs are the expenses your business incurs each time you order inventory.
These costs are a key piece of your overall inventory management strategy because they directly affect your business’s day-to-day operations and profitability.
Let’s break down some of the most common examples of ordering costs and how they can impact your expenses:
| Component | Description | Impact on costs |
|---|---|---|
| Administrative costs | Expenses related to processing orders, including the labor and resources used for tasks like preparing purchase orders and communicating with suppliers. | High if your business places frequent orders; increases with the complexity and volume of orders. |
| Shipping costs | Fees associated with transporting goods from suppliers to your warehouse, including carrier fees, expedited shipping, customs duties, and handling fees. | Varies significantly based on order volume, shipping distance, and speed; directly impacts cost of goods sold (COGS). |
| Inspection costs | Costs involved in inspecting received goods to ensure they meet quality standards, including labor costs and fees for resources used in verification processes. | Can lead to additional costs if discrepancies are found, such as returns or reordering, further increasing overall ordering costs. |
| Setup costs | Costs related to preparing machinery or equipment for production, especially for customized or small-batch orders. | Can be high for small or customized orders due to the time and resources needed to adjust machinery or processes; impacts production efficiency and unit costs. |
How are carrying costs related to ordering costs?
Carrying costs, also known as holding costs, represent the total expenses associated with storing and maintaining inventory over time. These costs include factors like:
- Warehousing or storehousing
Storage costs related to renting or owning warehouse space where inventory is kept. - Insurance
The cost of insuring the inventory against risks like theft, damage, or loss. - Depreciation
The reduction in value of inventory items over time, particularly for perishable goods or items that may become obsolete. - Opportunity
The potential income lost when capital is tied up in inventory rather than being invested elsewhere.
The key to effective inventory management is finding the right balance between ordering and inventory carrying costs. If your ordering costs are low, you might be tempted to place frequent, small orders, which can reduce your carrying costs by minimizing the amount of inventory held at any given time.
However, frequent ordering can increase overall ordering costs, including hidden fulfillment costs, and lead to inefficient inventory management, picking and packing, and administrative tasks (invoicing, order entry, payment processing, etc.).
On the other hand, minimizing ordering costs by placing large, infrequent orders can lead to higher carrying costs, as you’ll need to store more inventory for longer periods. This approach risks overstocking, which can tie up capital and increase the likelihood of inventory obsolescence or spoilage.
How to calculate ordering costs
Before you can address problematic spending, you need to know what you’re spending. Here’s a simple two-step guide to help you determine your ordering costs:
Step 1: Identify the key components of ordering costs
First, identify all the components that contribute to your ordering costs. These may vary depending on your business but will typically include:
- Administrative costs: The costs associated with processing purchase orders.
- Shipping costs: The fees incurred for transporting goods.
- Inspection costs: The expenses related to inspecting and verifying the quality of received goods.
Step 2: Use the ordering cost formula
Ordering Cost Formula: Ordering cost = (Number of orders per period) × (Cost per order)
- Number of orders per period
The number of units you place orders for during a specific period (e.g., monthly or annually). - Cost per order
The total cost incurred for processing, shipping, and inspecting each order.
For example: Let’s say your business places 20 orders per month. If your administrative costs are $50 per order, shipping costs are $100, and inspection costs are $30, then your total Cost per Order would be $180.
Example: Let’s say your business places 20 orders per month. If your administrative costs are $50 per order, shipping costs are $100, and inspection costs are $30, then your total Cost per Order would be $180.
Using the formula: 20 orders per month × $180 per order = $3,600 per month in ordering costs.
If you don’t want to break out a calculator, you can use our custom Ordering Cost calculator:
Ordering Costs Calculator
How ordering costs impact inventory management on a broad scale
Ordering costs aren’t just a line item in your financial statements—they play a critical role in how you manage your inventory and run a healthy and profitable fulfillment operation.
Here are some of the ways that ordering costs will influence how you handle inventory levels:
Overall business expenses
Each order incurs costs related to processing, shipping, and receiving inventory, which means costs can add up quickly if you place frequent orders. If not managed carefully, high ordering costs can erode profit margins and strain your cash flow and other financial resources. Keeping these costs under control is crucial for maintaining profitability, especially in industries with tight margins.
Influence on decision-making
When deciding how much inventory to order, the economic order quantity is a helpful tool for finding the right balance between ordering and holding costs.
The economic order quantity (EOQ) formula helps you determine the optimal order size to minimize total inventory costs.
Economic Order Quantity Formula: EOQ = √((2DS) / H)
Where:
D = Customer demand (units sold per year)
S = Ordering cost per order
H = Holding cost per unit per year
Example: Let's say your business sells 10,000 units per year (D = 10,000), the cost to place each order is $50 (S = $50), and the annual holding cost per unit is $2 (H = $2).
Using the EOQ formula:
EOQ = √((2 * 10,000 * 50) / 2)
EOQ = √(1,000,000 / 2)
EOQ = √500,000
EOQ ≈ 707 units
In this example, the most cost-effective order size for your business would be around 707 units per order to minimize total ordering and holding costs.
Here's a calculator you can use to calculate EOQ:
Economic Order Quantity (EOQ) Calculator
By using the EOQ formula, you can calculate the most cost-effective order size, reducing both ordering and carrying costs and boosting your bottom line.
PRO TIP: EOQ also helps you avoid stockouts by aligning your inventory levels with the reorder point—the point at which it’s time to place a new order to maintain stock levels. Plus, with EOQ, you can better manage the opportunity cost of holding excess inventory.
Supply chain efficiency
Efficiently managing ordering costs minimizes unnecessary expenses and ensures timely restocking, which reduces delays and improves overall supply chain performance. This efficiency can also enhance relationships with suppliers, as consistent and well-timed orders build trust and reliability.
Inventory turnover rates
Ordering costs also influence inventory turnover rates, which is the speed at which inventory is sold and replaced. Frequent, small orders may lead to higher ordering costs and lower turnover rates because holding smaller amounts of inventory can result in more frequent restocking.
Strategies to reduce and manage ordering costs more efficiently
It’s clear that businesses will save on total inventory costs by optimizing their ordering processes. But effectively managing ordering costs requires a strategic approach that balances cost control with efficiency.
Businesses can significantly reduce their ordering costs by:
- Negotiating with suppliers
- Automating the ordering process
- Improving warehouse layout and space utilization
- Consolidating orders when possible
Negotiating with suppliers
Bulk discounts, reduced shipping fees, and favorable payment terms are all potential areas for negotiation.
Maintaining strong relationships with your suppliers is key to successful negotiations; by consistently placing well-timed and sizable orders, you build trust, which can lead to better deals and cost savings over time.
Automating the ordering process
Automation tools like enterprise resource planning (ERP) software and inventory management software can handle repetitive tasks like purchase order creation, approval workflows, and inventory tracking, which reduces administrative costs and minimizes human error. These tools also allow for better data accuracy and can provide insights that help you optimize your order processes further, which leads to cost savings.
Improving warehouse layout and space utilization
A well-organized warehouse minimizes the time and labor required to process incoming orders, which can lower administrative and inspection costs.
Plus, better space utilization can reduce the need for frequent orders by allowing you to hold more inventory without increasing carrying costs, thus striking a better balance between ordering and holding costs.
PRO TIP: If you’re just starting out or don’t have the capital to invest in your own logistics, an experienced third-party logistics company can help.
Consolidating orders when possible
By combining multiple smaller orders into a single larger order, you can minimize the number of shipments and associated fees, such as transportation and handling costs.
PRO TIP: Instead of placing weekly orders for raw materials with a supplier, consider ordering bi-weekly or monthly if that aligns with your inventory needs. This approach reduces the frequency of shipments and takes advantage of bulk discounts, leading to greater cost efficiency over time.
Take control of expenses and optimize your inventory management
Ordering costs can add up quickly, so understanding and managing how they work is essential if you want a profitable and efficient business. Optimizing order frequency, negotiating with suppliers, automating processes, and consolidating orders can significantly reduce these costs and improve your overall inventory management.
Red Stag Fulfillment can help you take control of your ordering costs while also allowing you to focus on developing your business. With our expertise in efficient inventory management and order fulfillment, we help you reduce expenses and grow faster.
Reach out to Red Stag Fulfillment to learn how we can help your business achieve greater efficiency and profitability.
