zaro

What is the Formula for Total Inventory Cost (TIC) in Cost Accounting?

Published in Inventory Cost Accounting 4 mins read

In cost accounting, the formula for Total Inventory Cost (TIC) represents the comprehensive expense associated with managing inventory, encompassing both the costs of ordering and holding goods.

The exact formula for Total Inventory Cost (TIC) is:

*TIC = (FOC (U/Q)) + ((U/2) CC PP)**

This formula can also be understood as:

TIC = Total Ordering Cost (TOC) + Total Carrying Cost (TCC)

Breakdown of the TIC Formula Components

The Total Inventory Cost (TIC) comprises two primary categories of costs: Total Ordering Cost (TOC) and Total Carrying Cost (TCC).

  • Total Ordering Cost (TOC): This component accounts for all expenses incurred in placing and receiving inventory orders throughout a period. It is calculated by multiplying the fixed cost per order by the number of orders placed annually.
  • Total Carrying Cost (TCC): This component represents the expenses associated with holding inventory in stock. These costs include storage, insurance, obsolescence, and the opportunity cost of capital tied up in inventory.

Variables in the TIC Formula

To fully understand and apply the TIC formula, it's essential to know what each variable represents:

Variable Description
TIC Total Inventory Cost
FOC Fixed Ordering Cost (cost per order)
U Annual Usage or Demand (total units needed per year)
Q Order Quantity (number of units ordered each time)
CC Carrying Cost Percentage (as a decimal or percentage)
PP Purchase Price Per Unit

Understanding Each Variable's Role:

  • FOC (Fixed Ordering Cost): This is the cost incurred every time an order is placed, regardless of the quantity ordered. Examples include administrative costs for processing orders, transportation costs per order, and inspection costs upon arrival.
  • U (Annual Usage/Demand): This represents the total quantity of a specific inventory item that a business needs or uses over a year.
  • Q (Order Quantity): This is the number of units purchased in a single order. The ratio (U/Q) calculates the total number of orders placed annually.
  • CC (Carrying Cost Percentage): This is the annual cost of holding one unit of inventory, expressed as a percentage of the unit's purchase price. It covers costs like warehousing, insurance, spoilage, and the cost of capital.
  • PP (Purchase Price Per Unit): This is the direct cost paid for each individual unit of the inventory item.

Relationship with Economic Order Quantity (EOQ)

The concept of Total Inventory Cost (TIC) is foundational to determining the Economic Order Quantity (EOQ), often denoted as Q*. The EOQ is the ideal order quantity that minimizes the total inventory costs by finding the optimal balance between ordering costs and carrying costs.

Mathematically, the EOQ is derived by setting the first derivative of the Total Inventory Cost (TIC) formula with respect to the order quantity (Q) to zero. This derivative identifies the point where the incremental increase in carrying costs equals the incremental decrease in ordering costs, thus achieving the lowest possible total inventory cost for a given demand and cost structure.

Practical Insights for Inventory Management

  • Cost Optimization: Businesses leverage the TIC formula to identify opportunities for reducing overall inventory expenses. By analyzing each component, they can make strategic adjustments to order sizes and inventory levels.
  • Informed Decision-Making: A clear understanding of TIC supports better decision-making in procurement, warehousing, and logistics, ensuring resources are allocated efficiently.
  • Balancing Act: The formula highlights the inherent trade-off in inventory management:
    • Larger order quantities lead to fewer orders (reducing total ordering costs) but increase average inventory levels (increasing total carrying costs).
    • Smaller, more frequent order quantities lead to higher total ordering costs but lower average inventory levels (reducing total carrying costs).

By continuously monitoring and analyzing TIC, companies can optimize their inventory policies to minimize expenses while ensuring sufficient stock to meet operational needs.