Inventory Management
| Site: | Saylor Academy |
| Course: | BUS202: Principles of Finance |
| Book: | Inventory Management |
| Printed by: | Guest user |
| Date: | Tuesday, May 13, 2025, 8:12 PM |
Description
Manufacturing companies take raw materials and turn them into finished products. Merchandising companies buy product and resell it. Both types of companies must manage their inventory. If you order too much, you risk obsolescence, spoilage, or inability to sell. If you order too little, you may lose sales you could have made and risk upsetting your customers. This section will help you understand how companies manage their inventory to minimize overall costs.
Inventory Types
Most manufacturing organizations usually divide their inventory into raw materials, work in process, finished goods, and goods for sales.
Learning Objective
-
Differentiate the different types of inventory based on it stage of proudction
Key Points
- 1. Raw materials: Materials and components scheduled for use in making a product.
- 2. Work in process, WIP: Materials and components that have began their transformation to finished goods.
- 3. Finished goods: Goods ready for sale to customers.
- 4. Goods for resale - returned goods that are salable.
Key Terms
- supply chain: A system of organizations, people, technology, activities, information, and resources involved in moving a product or service from supplier to customer
Manufacturing process From raw materials to work in process to finished goods.
1. Raw materials: Materials and components scheduled for use in making a product.
2. Work in process, WIP: Materials and components that have began their transformation to finished goods. These items are not yet completed but either just being fabricated or waiting in a queue for further processing or in a buffer storage. The term is used in production and supply chain management. Optimal production management aims to minimize work in process. Work in process requires storage space, represents bound capital not available for investment, and carries an inherent risk of earlier expiration of shelf life of the products. A queue leading to a production step shows that the step is well buffered for shortage in supplies from preceding steps, but may also indicate insufficient capacity to process the output from these preceding steps. Just-in-time (acronym: JIT) production is a concept to reduce work in process with respect to a continuous configuration of product. Sometimes, outside of a production and construction context "work in process" is used erroneously where the status "work in progress" would be correctly used to describe more broadly work that is not yet a final product.
3. Finished goods: Goods ready for sale to customers. Finished goods is a relative term. In a supply chain management flow; the finished goods of a supplier can constitute the raw material of a buyer.
4. Goods for resale: Returned goods that are salable.
Source: Boundless, https://courses.lumenlearning.com/boundless-finance/chapter/inventory-management/
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.
Inventory Techniques
FIFO, LIFO, and average cost methods are accounting techniques used in managing inventory.
Learning Objectives
- Differentiate between the different type of inventory accounting techniques
Key Takeaways
Key Points
- FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold.
- LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.
- Average cost method takes the weighted average of all units
available for sale during the accounting period and then uses that
average cost to determine the value of COGS and ending inventory.
Key Terms
- taxable income: Taxable income refers to the base upon which an income tax system imposes tax.
Inventory: Inventories U.S. Army unit badges from a wall of military uniform items
FIFO
FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold. This expression describes the principle of a queue processing technique or servicing conflicting demands by ordering process by first come, first served (FCFS) behavior, where the persons leave the queue in the order they arrive, or waiting one's turn at a traffic control signal.
LIFO
LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States,
LIFO Reserve
The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.
Average Cost
Average cost method is quite straightforward. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. There are two commonly used average cost methods: Simple weighted average cost method and moving average cost method.
Weighted average cost method: It takes Cost of Goods Available for Sale and divides it by the total
amount of goods from Beginning Inventory and Purchases. This gives a
Weighted Average Cost per Unit. A physical count is then performed on
the ending inventory to determine the amount of goods left. Finally,
this amount is multiplied by Weighted Average Cost per Unit to give an
estimate of ending inventory cost.
Moving average cost method: Assume that both Beginning Inventory and beginning inventory cost are
known. From them the Cost per Unit of Beginning Inventory can be
calculated. During the year, multiple purchases are made. Each time,
purchase costs are added to beginning inventory cost to get Cost of
Current Inventory. Similarly, the number of units bought is added to
beginning inventory to get Current Goods Available for Sale. After each
purchase, Cost of Current Inventory is divided by Current Goods
Available for Sale to get Current Cost per Unit on Goods. Also during
the year, multiple sales happen. The Current Goods Available for Sale is
deducted by the amount of goods sold, and the Cost of Current Inventory
is deducted by the amount of goods sold times the latest (before this
sale) Current Cost per Unit on Goods. This deducted amount is added to
Cost of Goods Sold. At the end of the year, the last Cost per Unit on
Goods, along with a physical count, is used to determine ending
inventory cost.
ABC Technique
The ABC analysis is an inventory categorization technique often used in material management wherein accuracy and control decreases from A to C.
Learning Objective
-
Differentiate different types of inventory items based on \(ABC\) inventory analysis
Key Points
- \(A\) items: very tight control and accurate records; \(B\) items: less tightly controlled and good records; \(C\) items: simplest controls possible and minimal records.
- The \(ABC\) analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls.
- The \(ABC\) analysis suggests that inventories of an organization are not of equal value.
Key Terms
- Just in Time: Just in time (JIT) is a production strategy that strives to improve a business return on investment by reducing in-process inventory and associated carrying costs.
- \(A\) ITEMS: very tight control and accurate records
- \(B\) ITEMS: less tightly controlled and good records
- \(C\) ITEMS: simplest controls possible and minimal records
The \(ABC\) analysis suggests that inventories of an organization are not of
equal value. Thus, the inventory is grouped into three categories (\(A\),
\(B\), and \(C\)) in order of their estimated importance.
\(A\) items are very important for an organization. Because of the high
value of these \(A\) items, frequent value analysis is required. In addition
to that, an organization needs to choose an appropriate order pattern
(e.g., "Just- in- time") to avoid excess capacity.
\(B\) items are important, but of course less important, than \(A\) items and
more important than \(C\) items. Therefore, \(B\) items are intergroup items.
\(C\) items are marginally important.
The following is an example of the Application of Weighed Operation
based on \(ABC\) class in the electronics manufacturing company with \(4,051 \)
active parts.
ABC analysis Actual distribution of ABC class in the electronics manufacturing company with \(4051\) active parts.
Using this distribution of \(ABC\) class and change total number of the parts to \(4,000\).
ABC techniques Distribution of ABC class
- Uniform Purchase: When you apply equal purchasing policy to all \(4,000\) components, example weekly delivery and re-order point (safety stock) of two-week supply assuming that there are no lot size constraints, the factory will have a \(16,000\) delivery in four weeks and the average inventory will be \(2.5\) weeks supply.
- Weighed Purchase: In comparison, when weighed purchasing policy applied based on \(ABC\) class, example \(C\) class monthly (every four weeks) delivery with re-order point of three-week supply, \(B\) class \(Bi\)-weekly delivery with re-order point of two-week supply, \(A\) class weekly delivery with re-order point of one-week supply, total number of delivery in four weeks will be \((A\ 200 \times 4=800)+(B\ 400 \times 2=800) + (C\ 3400 \times 1=3400)=5000\) and average inventory will be \((A\ 75\% \times 1.5 weeks)+(B\ 15\% \times 3 weeks)+ (C\ 10\% \times 3.5 weeks)= 1.925\) week supply.
By applying weighed control based on \(ABC\) classification, required man hours and inventory level are drastically reduced.
Seasonal Production
Seasonal trends and internal projections of consumption in certain goods can have a significant impact on opportunity cost and potential profit for an organization.
Learning Objective
-
Recognize the relevance in time of year to overall demand
Key Points
- Many industries do better in some months than others, for a wide variety of reasons. This can have opportunity costs from a production and inventory stand point, if not planned for properly.
- Timing, uncertainty, economies of scale, and potential appreciation are all good reasons to have extra inventory on hand.
- When it comes to seasonality of demand, production and inventory can be managed based upon data points from the past.
- Perishable goods,
from food to fashion to technology, are worth noting when it comes to
seasonal production and storage. Minimizing over production by making
accurate projections can create serious cost savings.
Key Terms
- seasonality: From the business perspective, this refers to fluctuations in demand based upon time of year.
- perishable goods: Goods that will expire. This isn't just limited to food, clothes go out of fashion and technology becomes rapidly outdated.
Reasons to Keep Inventory
In an ideal world, a business would avoid the need for inventory through perfect operational management and completely accurate projections. Of course, this is impossible. As a result, business must balance risk and opportunity to ensure that inventory is available when it is needed and waste is minimized. Inventories are kept due to:
- Time - No supply chain is perfect, and often enough time lags can ruin potential business opportunities. Playing it safe and have certain items in stock ahead of time can avoid opportunity costs.
- Uncertainty - Supply and demand are not perfectly predictable. Uncertainty means keeping enough on hand to fill fluctuations in demand.
- Economies of scale - Many business exist solely because they take the risk of buying a high volume a given product at a lower price in hopes of marking up the price and selling each one individually to customers. This is called economies of scale, and by nature it requires some storage and inventory. Grocery stores function this way.
- Appreciation in Value - Some business keep inventory as an investment. Fine wines and cheese, for example, will appreciate in value over time. The downside is it will cost money to keep them (both require appropriate temperature conditions, for example).
Determining Seasonality
Among the many reasons to keep inventory is planning for seasonality. Businesses should first measure whether or not consumer demand and subsequent inventory requirement are subjected to predictable seasonal trends. There are a number of ways to do this utilizing existing historical sales data as well as data from external research on the industry itself. There are countless models and methods of organizing seasonal data to determine, but from the managerial frame mostly analysts preferred distribution of data should ultimately communicate the same correlations (or lack thereof) for differences in sales on a monthly basis.
Once seasonality is determined, business should measure the fluctuations
from year to year and the opportunity costs of having too much or too
little on hand. Once this is accomplished, the business can order the
ideal amount based on data-driven projections to capture as much
opportunity as possible without taking the risk of over ordering (and
thus overpaying for storage).
Perishable Goods
An important aspect of seasonal inventory management is the concept of perishable goods. From food to fashion to technology, many goods simply either go bad or lose most of their value for no other reason that culture has passed it by. This is called a perishable good. Perishable goods have an even greater opportunity cost when it comes to mismanaging (and erroneously predicting) demand. If too much of a perishable good is ordered, not only will it cost the organization in unnecessary inventory fees, but also adds the risk of never been sold at all (a complete sunk cost at that point).
As a result, understanding the shelf life of a good, the risk of over or
under stocking, and recognizing the ebb and flow of seasonal demand can
add a great deal to the profitability of an organization.
Seasonality Plot Example In this chart, consumption (demand) of electricity over a twelve month time frame is illustrated over time. Higher capacities are required in certain months (in this case - August) and capacity must be expanded to take this into account.
Impact of Inflation on Inventory Management
High inflation encourages companies to keep a high level of inventories.
Learning Objectives
- Explain how inflation influences inventory levels
Key Takeaways
Key Points
- Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. It reflects an erosion in the purchasing power of money.
- If inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Therefore, high inflation encourages companies to keep a high level of inventories.
- The Mundell-Tobin effect also suggests a rise in inventory level in case of high inflation.
Key Terms
- physical capital: In economics, physical capital, or just capital refers to a factor of production (or input into the process of production), such as machinery, buildings, or computers.
- purchasing power: Purchasing power (sometimes retroactively called adjusted for inflation) is the amount of goods or services that can be purchased with a unit of currency.
Inflation's effects on an economy are various and can be simultaneously
positive and negative. Negative effects of inflation include an increase
in the opportunity cost of holding money; uncertainty over future
inflation which may discourage investment and savings; and if inflation
is rapid enough, shortages of goods as consumers begin hoarding out of
concern that prices will increase in the future. Therefore, high
inflation encourages companies to keep a high level of inventories.
Inflation: Inflation in France in 2002
The Nobel laureate Robert Mundell noted that moderate inflation would
induce savers to substitute lending for some money holding as a means to
finance future spending. That substitution would cause market clearing
real interest rates to fall. Nobel laureate James Tobin noted that
moderate inflation would cause businesses to substitute investment in
physical capital (plant, equipment, and inventories) for money balances
in their asset portfolios. That substitution would mean choosing the
making of investments with lower rates of real return. (The rates of
return are lower, because the investments with higher rates of return
were already being made before). To put it in a word, companies
purchase more inventories in case of high inflation. The two related
effects are known as the Mundell-Tobin effect. Unless the economy is
already over-investing according to models of economic growth theory,
that extra investment resulting from the effect would be seen as
positive.
Inventory Costs
Inventory costs depends on methods used, which include Specific Identification, Weighted Average Cost, Moving-Average Cost, FIFO, and LIFO.
Learning Objective
-
Identify the different types of assumptions a company can make when valuing its inventory
Key Points
- There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of 'adjusting' assumptions may be used. These include: Specific Identification, Weighted Average Cost, Moving-Average Cost, FIFO, and LIFO.
- Specific identification requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year end inventory.
- Weighted Average Cost is also known as AVCO. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases.
- Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated.
- FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.
- LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.
Key Terms
- \(ABC\) analysis: The \(ABC\) analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. Policies based on \(ABC\) analysis: \(A\) ITEMS, very tight control and accurate records; \(B\) ITEMS, less tightly controlled, and good records; and \(C\) ITEMS, simplest controls possible and minimal records.
Inventory management involves a retailer seeking to acquire and maintain
a proper merchandise assortment while ordering, shipping, handling, and
related costs are kept in check. It also involves systems and processes
that identify inventory requirements, set targets, provide
replenishment techniques, report actual and projected inventory status,
and handle all functions related to the tracking and management of
material. This would include the monitoring of material moved into and
out of stockroom locations and the reconciling of the inventory
balances. It also may include \(ABC\) analysis,
lot tracking, cycle counting support, etc. Management of the
inventories, with the primary objective of determining/controlling stock
levels within the physical distribution
system, functions to balance the need for product availability against
the need for minimizing stock holding and handling costs.
Inventory The inventory costs depend on which method is used.
There are, in fact, so many things that can vary hidden under this
appearance of simplicity that a variety of 'adjusting' assumptions may
be used. These include:
Specific Identification
Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at the yearend inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost.
This method is also a very hard to use on interchangeable goods. For
example, it is hard to relate shipping and storage costs to a specific
inventory item. These number will need to be estimated, therefore
reducing the specific identification's benefit of being extremely specific.
Weighted Average Cost
Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as AVCO. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.
Moving-Average Cost
Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to beginning inventory cost to get Cost of Current Inventory. Similarly, the number of units bought is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.
Also during the year, multiple sales happen. The Current Goods Available
for Sale is deducted by the amount of goods sold. The Cost of Current
Inventory is deducted by the amount of goods sold times the latest
(before this sale) Current Cost per Unit on Goods. This deducted amount
is added to Cost of Goods Sold.
At the end of the year, the last Cost per Unit on Goods, along with a
physical count, is used to determine ending inventory cost.
FIFO and LIFO
FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.
LIFO stands for last-in, first-out, meaning that the most recently
produced items are recorded as sold first. Since the 1970's, some U.S.
companies shifted towards the use of LIFO, which reduces their income
taxes in times of inflation.
However, with International Financial Reporting Standards banning the
use of LIFO, more companies have gone back to FIFO. LIFO is only used in
Japan and the U.S.
The difference between the cost of an inventory calculated under the
FIFO and LIFO methods is called the LIFO reserve. This reserve is
essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.
Economic Order Quantity Technique
Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs: \(Q^{*}=\left(\frac{2 D S}{H}\right)^{\frac{1}{2}}\)
Learning Objective
-
Calculate a company's optimal order quantity
Key Points
- Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs.
- EOQ determines the optimal number of units to minimize the total cost associated with the purchase, delivery, and storage of the product.
- \(\mathrm{Q}^{*}=(\mathrm{DS} / \mathrm{H})^{\wedge} 1 / 2\) where \(\mathrm{Q}=\) order quantity, \(\mathrm{Q}^{*}=\) optimal order quantity, \(\mathrm{D}=\) annual demand quantity, \(\mathrm{S}=\) fixed cost per order, \(\mathrm{H}=\) annual holding cost per unit.
Key Terms
- holding cost: In business management, holding cost is money spent to keep and maintain a stock of goods in storage.
We want to determine the optimal number of units to order so that we
minimize the total cost associated with the purchase, delivery, and
storage of the product. The required parameters
to the solution are the total demand for the year, the purchase cost
for each item, the fixed cost to place the order, and the storage cost
for each item per year. Note that the number of times an order is placed
will also affect the total cost, though this number can be determined
from the other parameters.
Underlying assumptions are:
- The ordering cost is constant.
- The rate of demand is known, and spread evenly throughout the year.
- The lead time is fixed.
- The purchase price of the item is constant (i.e., no discount is available).
- The replenishment is made instantaneously; the whole batch is delivered at once.
- Only one product is involved.
The single-item EOQ formula finds the minimum point of the following cost function:
\(T C=P D+\frac{D S}{Q}+\frac{H Q}{2}\)
Economic order quantity Economic order quantity function solving for Q.
\(\text{Total Cost = purchase cost + ordering cost + holding cost}\)
- Purchase cost: This is the variable cost of goods: purchase unit price \(x\) annual demand quantity. This is \(\mathrm{P} \times \mathrm{D}\).
- Ordering cost: This is the cost of placing orders: each order has a fixed cost \(S\), and we need to order \(\mathrm{D} / \mathrm{Q}\) times per year. This is \(\mathrm{S} \times \mathrm{D} / \mathrm{Q}\).
- Holding cost: the average quantity in stock (between fully replenished and empty) is \(\mathrm{Q} / 2\), so this cost is \(\mathrm{H} \times \mathrm{Q} / 2\).
To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to \(Q\) (assume all other variables are constant) and set to \(0\):
\(0=-\frac{D S}{Q^{2}}+\frac{H}{2}\)
Equation Equation to determine the minimum point of the total cost curve.
Solving for \(Q\) gives \(Q^{*}\) (the optimal order quantity):
\(Q^{*}=\sqrt{\frac{2 D S}{H}}\)
Equation 3 Equation solving for \(Q^*\)
Just-in-Time Technique
Just in time (JIT) is a production strategy that strives to reduce in-process inventory and carrying costs in a manufacturing system.
Learning Objective
-
Discuss the benefits and disadvantages of using a Just-In-Time (JIT) inventory system
Key Points
- JIT focuses on continuous improvement and can improve a manufacturing organization's return on investment, quality and efficiency.
- JIT relies on efficient coordination of elements in the inventory chain.
- There are many benefits of JIT. It improves the flow of goods from warehouse to shelves, reduces set up time and efficiently uses human resources.
Key Terms
- carrying costs: carrying cost refers to the total cost of holding inventory. This includes warehousing costs such like utilities and salaries; financial costs like opportunity cost; and inventory costs related to perishability, shrinkage and insurance.
- flow
- employee involvement
- quality.
Benefits of JIT:
- Reduced setup time. Cutting setup time allows the company to reduce or eliminate inventory for "changeover" time.
- The flow of goods from warehouse to shelves improves. Small or individual lot sizes reduce lot delay inventories, which simplifies inventory flow and its management.
- Employees with multiple skills are used more efficiently. Having employees trained to work on different parts of the process allows companies to move workers where they are needed.
- Production scheduling and work hour consistency are synchronized with demand. If there is no demand for a product at the time, it is not made. This saves the company money, either by not having to pay workers overtime or by having them focus on other work.
- Increased emphasis on supplier relationships. A company without inventory does not want a supply system problem that creates a part shortage. This makes supplier relationships extremely important.
- Supplies come in at regular intervals throughout the production day. Supply is synchronized with production demand and the optimal amount of inventory is on hand at any time. When parts move directly from the truck to the point of assembly, the need for storage facilities is reduced.
- Minimizes storage space needed.
- Smaller chance of inventory breaking/expiring.
Drawbacks
Just-in-time operation can leave suppliers and downstream consumers open to supply shocks and large supply or demand changes. In addition, very low stock levels means shipments of the same part can come in several times per day. This means firms favoring JIT are especially susceptible to flow interruption.
Benefits of Inventory Management
Improved inventory management can lead to increased revenue, lower handling and holding costs, and improved cash flows.
Learning Objective
-
Discuss the benefits of inventory management
Key Points
- Inventory management is primarily about specifying the shape and percentage of stocked goods.
- Inventory management leads to optimal inventory levels.
- Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs.
- Inventory management can also help companies improve cash flows.
Key Terms
- holding cost: In business management, holding cost is money spent to keep and maintain a stock of goods in storage.
- ABC analysis: The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. Policies based on ABC analysis: A ITEMS, very tight control and accurate records; B ITEMS, less tightly controlled, and good records; and C ITEMS, simplest controls possible and minimal records.
Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials.
Inventory management Female clerk doing inventory work using a handheld computer in a Tesco Lotus supermarket in Sakon Nakhon, Thailand.
The intent of inventory management is to continuously hold optimal
inventory levels. The scope of inventory management concerns the fine
lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation,
inventory visibility, future inventory price forecasting, physical
inventory, available physical space for inventory, quality management,
replenishment, returns
and defective goods, and demand forecasting. Balancing these competing
requirements leads to optimal inventory levels, which is an on-going
process as the business needs shift and react to the wider environment.
Management of the inventories, with the primary objective of
determining/controlling stock levels within the physical distribution
system, functions to balance the need for product availability against
the need for minimizing stock holding and handling costs. Inventory
management involves systems and processes that identify inventory
requirements, set targets, provide replenishment techniques, report
actual and projected inventory status, and handle all functions related
to the tracking and management of material. This would include the
monitoring of material moved into and out of stockroom locations and the
reconciling of the inventory balances. It also may include ABC analysis,
lot tracking, cycle counting support, etc. All of these practices leads
to optimal product storage, helping minimize holding and handling
costs.
Inventory management also can help companies improve cash flows.
Companies with effective inventory management do not have to spend large
capital balances for purchasing enormous amounts of inventory at once. This also saves handling and holding costs.
Dangers Involved in Inventory Management
Excessive inventory means idle funds which earn no profits; inadequate inventory means lost sales.
Learning Objective
-
Discuss the difficulties of managing inventory
Key Points
- Excessive inventory means the firm has idle funds which earn no profits for the firm. In addition, excessive inventory incurs extra handling and holding costs.
- Inadequate inventory means the firm does not have sufficient raw materials for production. This also means insufficient ample goods to sell for merchandising companies.
- Inventory management will be more complicated as moderate inflation and seasonality get involved.
Key Terms
- seasonality: Variation with the seasons
- holding cost: In business management, holding cost is money spent to keep and maintain a stock of goods in storage.
The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns, and defective goods and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.
Inventory control Inventory control - inventory cost elements (holding cost, order cost, total) Parameters: Order-cost \((C)\) \(10\), demand \((D)\) \(1000\), holding cost (i) \(20 \%\) (of price), price \((p) 10 = > E O Q=100\)
Excessive inventory means the firm has idle funds which earn no profits
for the firm. In addition, excessive inventory incurs extra handling
costs and holding costs. However, it is not well advised for the firm to
keep low inventory levels, since inadequate inventory means the firm
does not have sufficient raw materials for production. When items are
required on a breakdown basis and find out that there is not enough stock
as a result of reducing it, this could lead to loss of production.
Inadequate inventory also means not ample goods to sell. The company, as
a result, faces the risk of losing customers to competitors.
Inventory management will be more complicated as moderate inflation and
seasonality gets involved. Inflation encourages the firm to purchase
more inventory, exposing them to excessive inventory. Without an
accurate sales forecast,
companies operating in sectors affected by seasonality face shortage
during high time and excess of inventory during low time of the year.