- Inventory of a company refers to finished goods available for sale and raw materials used to produce the final goods in the company. Inventory is a current asset on the balance sheet that turns to cash upon selling.
- Every company requires maintaining a certain level of inventory to keep its business running, a low inventory may have an impact on the sales or production of goods. Excess of inventory may impact the profitability of the company as the goods lying in for long may have reduced values in the market.
- Low inventory may also lead to loss of customers due to delays in delivery. A company maintains a marginally higher inventory to keep itself safe from the price rise of the raw material in the future.
- Efficient inventory management is the one that always ensures sufficient inventory available to manage the day to day operations without creating an excess of inventory and its associated losses.
Motive
- A company has the motive to hold inventory may be to support its sales and production or to procure raw material at cheap cost, all the motives of a company behind holding an inventory fall in the following three categories:
- Transactions Motive: This motive holds the inventory to perform day to day activities in the company, the amount of inventory will be proportional to the volume of targeted manufacturing.
- Precautionary Motive: This motive holds the inventory as a buffer to support the transaction motive if in any case, the normal inventory gets over and/or new inventory cannot be received on time, this motive acts as a cushion to the company and stops any loss of sales/production.
- Speculative Motive: This motive holds an inventory for speculation purposes, a company may very high inventory of a particular raw material to create a deficit in the market and increase the price.
Managing Inventory
To maintain a balanced level of inventory, the following strategies are used by the companies:Economic Order Quantity- Reorder Point (EOQ-ROP)
- This method is based on the demand and level of inventory, the demand is obtained from the manufacturing forecast of the company and the level of inventory is determined as the minimum level of inventory at which the company re-fills the inventory.
- Economic Order Quantity implies the quantity of inventory ordered and the Reorder Point is the level of inventory at which the new inventory is ordered, these points are decided after considering the cost in the procurement of inventory. ROP is selected such that below this level there is a safety buffer of inventory till the time new inventory comes in. The following graph clarifies the EOQ-ROP process.
II. Just in Time (JIT) Method
- This method does not follow the process of inventory maintenance, rather it emphasizes creating an inventory in parallel with the production schedule. As per this method, the inventory is created just to meet the actual demands instead of a forecast. The main intention of companies using this method is to restrict themselves from overproduction.
Inventory Costs
Many costs are associated with an inventory, they are referred to as component costs and they include:- Ordering: This is the cost of procuring the inventory. E.g. Transport, Labour Handling, etc.
- Carrying: This is the cost of maintenance of inventory level. E.g. Storage, Safety, Insurance, etc.
- Stock-Out: This includes the loss incurred by the company due to a shortage of inventory. E.g. Lost Sales
- Policy: This includes the general operating cost of inventory. E.g. Training
