# Supply Chain Costs

Cost optimization based on supply chain policies involves first understanding how costs 💰 are related to the order quantity, then optimizing the order quantity 🚚 that minimizes cost.

Let's start by evaluating a simple supply chain where:

Goods are provided by a single supplier,
To a single stocking site / inventory location,
For a single product,
At a fixed order quantity Q,
Instantaneously when the stock is 0 (e.g. the lead time is zero),
and the yearly demand D and demand per period d are both constant.

In this simplified model, we will on average have Q/2 units in stock on average throughout the year, as stock will deplete linearly from Q to 0 during every cycle.

Cycle stock:
Average stock through the order cycle to fulfill demand.

Order cycle:
The time that elapses between two consecutive orders.

Holding costs:
Costs related to storing products.

Holding costs typically come in two flavors:

Fixed holding costs: employee salaries, rent, equipment, etc.
Variable holding costs: product cost (labor, burden, material), scrap, obsolecence, loss, inventory costs.

Typically, fixed holding costs are excluded or added at the end to simplify estimation.

The yearly holding cost for keeping one single piece in stock can be defined as the holding cost h as a % of cost of goods sold (COGS) c, times the average cycle stock Q/2, or:

\displaystyle {\text{Holding costs} = (h \cdot c)\frac{Q}{2}}

Where:

h = % of c (typically between 10% and 25%), mostly related to cash tied up as inventory (cost of capital) and the cost of storage.
c = cost of goods sold ($, or COGS), typically derived from the labor costs, manufacturing burden, and material costs of the product.

Transaction costs:
Costs of transaction (labor, freight, etc)

See also: Inventory Policies for the stocking policies these costs apply to, and Financial Planning for how supply chain costs feed into IBP financial reconciliation.