Inventory

What are the reasons for holding inventory?

Let's take a look at why companies might decide to hold inventory.

Allow more efficient production

The lack of raw materials not only slows down production but also affects other stages of the supply chain. Limited supplies could lead to products not being finished on time, which may result in the cancellation of orders and loss of sales. Keeping stock can prevent this by making sure materials needed are available at all times.

Safeguard against late delivery

Having inventory in stock allows the company to keep the production going while waiting for new materials to arrive. Safety stock can provide a buffer for events such as natural disasters or loss of goods.

Reduce buying costs

Suppliers tend to offer discounts for a large number of goods. By buying in bulk, the company can take advantage of lower prices, which reduces the amount that customers have to pay for the final products. However, the high level of inventory will result in more expensive storage and maintenance.

Meet an unexpected demand

The demand for goods is not consistent but fluctuates wildly over the year. For example, special occasions such as Christmas, Valentine's, and Halloween may ramp up the demand for certain goods. Keeping inventory allows businesses to meet customer needs during the high seasons. The key is to make the right order amount to avoid excess stock storage.

What are the costs of inventory?

There are three main types of inventory cost:

Ordering costs

These are costs for ordering goods. For example, administrative costs, inspection costs, cost of placing an order with a supplier.¹

To minimize the ordering costs, a company can calculate EOQ (Economic Order Quantity) - an optimal order quantity at the lowest total costs.

$EOQ\mathit{}\mathit{=}\mathit{}\sqrt{\frac{\mathit{2}\mathit{}\mathit{\times }\mathit{}Annual\mathit{}demand\mathit{}in\mathit{}units\mathit{\times }\mathit{}Cost\mathit{}per\mathit{}order}{Annual\mathit{}holding\mathit{}cost\mathit{}per\mathit{}unit}}$

Holding costs (carrying costs)

These are costs associated with inventory unsold, including²:

• Opportunity costs: This is the money that could be invested elsewhere if not used in inventory. For example, if you invest £10,000 in warehousing, you couldn't use it to purchase new office furniture.

• Storage costs: These are costs for storing physical inventory. For example, warehousing, storage rents, utilities, insurance. An increase in inventory comes with a higher storage cost.

• Wages: These are the salaries you pay for employees who work at the warehouse and fulfil the order.

• Depreciation costs: These are costs incurred as the value of your inventory appreciates over time. For example, products become obsolete.

$InventoryHoldingCost=\frac{StorageCosts+Wages+Opportunity\cos ts+Depreciation\cos ts}{TotalValueofAnnualInventory}$

Shortage costs

These are costs that incur when inventory goes out. For example, a loss of sales due to unfulfilled orders and overnight shipping fees to acquire inventory that is not available.

Inventory planning and control in the supply chain

Inventory planning is an important aspect of the supply chain since it controls the level of inventory held. This allows the company to keep up with its production and meet customer needs while safeguarding against the loss of goods or late deliveries by the suppliers.

Planning and controlling inventory is also tied with the company's working capital - the money used to pay for short-term expenses (within a year). If the business spends too much money on holding inventory, it may not have enough capital for other business activities. To balance the working capital, companies must order the right amount of stock at the right time. Thus, the primary objective of inventory control is to minimize inventory costs.

Inventory control charts

An inventory control chart is an efficient tool for managing stock levels and minimizing inventory costs (see Figure 1 below).

Figure 1. Inventory Control Chart, StudySmarter

The components of the inventory control chart:

• The maximum stock level: the largest amount of inventory a business can hold
• Lead time: the time it takes for the inventory to arrive from the moment it is ordered
• Re-order level: the trigger point for ordering a new batch of supplies.
• Re-order quantity: the amount of quantity ordered each time.
• The minimum stock level: the smallest amount of inventory a business wants to keep.
• Buffer stock (safety stock): the surplus of inventory the company wants to hold to safeguard against unexpected events.

What factors influence the level of inventory?

Having the right level of inventory is important as it allows the company to keep up with the production while waiting for new materials to arrive. Reserved inventory also serves as a buffer for unpredictable events such as natural disasters or economic crises.

Here are some factors influencing the level of stock:

• The rate at which the stock is used up: This is also known as the stock turnover rate. Typically, the company needs to hold more stock if the supplies tend to run out quickly.
• Available space in the warehouse: More storage space can hold more inventory.
• Reliability of the supplier: Should the suppliers always deliver goods in time, the firm can hold less inventory in stock.
• The nature of the product: Perishable goods such as meat, dairy, or fresh produce can't be kept in normal inventory conditions for long.
• The lead time of the supplier: Lead time is the number of days between when the order is made and when it is delivered. The shorter the lead time, the smaller the inventory that a firm needs to hold.
• The demand for the product: Higher product demand will require more available stock. For example, a business needs to keep a higher level of inventory during a peak season.

References

1. Wikiaccounting, Ordering Cost: Definition, Formula, Example, and How Does It Work, 2022

2. Shannon Callarman, What Is Inventory Holding Cost? The Price for Ecommerce Storage, 2020