7.2.1 Reasons for holding inventories
There are four reasons for holding inventory:
- To avoid inventory shortages: Frequent shortages of inventory may cause customers to look for alternative suppliers. This will reduce sales and profit.
- To take advantage of quantity discounts: Suppliers often offer quantity discounts. However, any cost savings must be balanced against higher storage costs, increased risk of damage and the greater cost of financing higher inventory levels.
- To protect against price increases: Carrying (holding) inventory is one way of hedging against possible price increases. Firms that supply goods against contracted or quoted prices may buy the required inventories and hold them for future use rather than risk a price increase in the future.
- To avoid uncertainty associated with market fluctuations: When supply and/or demand are irregular and/or seasonal, the buying and storing of inventories above a normal level effectively reduces the uncertainty associated with such market fluctuations.
Inventory Turnover
Inventory turnover, as you know, relates to the time a unit of inventory remains in stock before it is sold. Products that are sold very quickly are considered high inventory turnover items and those sold slowly as low inventory turnover items. As a reminder, the rate of inventory turnover measures the number of times that the average inventory level is turned over or sold in a year. It is expressed as:
Cost of goods sold = inventory turnover
Average inventory
The lower the average inventory held, the higher the rate of turnover. Other benefits of lower inventory levels are cost savings from lower storage costs, and lower insurance and financing costs.
The fundamental decision managers must make is between larger and less frequent inventory orders, or smaller and more frequent orders.
The inventory decision
The two basic decisions to be made on inventory policy, therefore, are how much to order, and when to order.
These two decisions are influenced by the need to keep down the total costs associated with inventory policy. The total cost of inventory policy is the sum of the costs of ordering inventory, and the costs of holding inventory.
The costs of ordering inventory. These are the costs of acquiring an item of inventory each time an order is placed and are expressed as the 'dollar cost per order'.
Ordering costs include all costs of issuing the purchase order; placing the order; following up the order; taking physical delivery; and inspecting the items delivered. They also include costs of the necessary paperwork and record keeping of accounts payable.
The costs of holding inventory . Holding costs, also called carrying costs, are expressed as the cost of holding one item of inventory in stock for one year. They may be expressed as a percentage, for example, the holding cost is 20% of the average unit cost per year; or as a dollar amount, for example, $2.50 per unit per year. Holding costs include:
- The cost of forgoing interest when money is invested in inventory
- Costs incurred when inventory items go 'out of style' (obsolescence)
- Storage or space costs, including heating, lighting, refrigeration and occupancy costs
- Costs associated with storeroom operations, including costs for record keeping and physical stocktaking of inventory
- Insurance costs against fire and reportable theft
- Costs associated with the risks of deterioration and undetected pilferage.
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