Inventory Management is the second important segment of working capital management inventory Management is the second step in the operating cycle wherein cash is converted into various items of the inventory. Inventory has the following
(a) Raw Material
(b) Work in Process
(c) Finished Goods.
The advantages of increased inventories are several. The firm can affect economies of production and purchasing and can fill orders more quickly. In short, the firm is more flexible. The obvious disadvantages are the total cost of holding the inventory, including storage and handling costs, and the required return on capital tied up in inventory. An additional disadvantage is the danger of obsolescence. Because of the benefits, however, the sales manager and production manager are biased toward relatively large inventories. Moreover, the purchasing manager often can achieve quantity discounts with large orders, and there may be a bias here as well. It falls on the financial manager to dampen the temptation for large inventories. This is done by forcing consideration of the cost of funds necessary to carry inventories as well as perhaps the handling and storage costs.
Inventories should be increased as long as the resulting savings exceed the total cost of estimates of holding the added inventory. The balance finally reached depends on the estimates of actual savings, the cost of carrying additional inventory, and the efficiency of inventory control. Obviously, this balance requires coordination of the production, marketing, and finance areas of the firm in keeping with an overall objective. Our purpose is to examine various principles of inventory control by which an appropriate balance might be achieved.
Strategy for Inventory Management
A successful strategy for inventory management has at its core the objective of holding the optimum level of inventory at the lowest cost.
The cost of holding inventory has the following three elements:
(i) Carrying Cost
This is the cost of keeping or maintaining the inventory in a usable condition. This includes the storage costs, i.e. the cost of storing the inventory in rented premises or the opportunity cost of storing in own premises + the wage cost of personnel assigned to storing and securing it + cost of utilities and insurance + cost of financing.
Inventory carrying cost is directly proportional to the level of inventory assuming that the loading of carrying cost is done pro-rata to the space occupied. Thus if the inventory level rises, its carrying cost also rises.
(ii) Ordering Cost
It is the cost associated with placing each individual order for the supply of raw materials, stores, packing materials, etc. If these items are procured in small lots, then the ordering cost per unit of inventory would be more and vice versa.
(iii) Stock-out Cost
It is the cost associated with procuring an inventory item, which has gone out of stock and is needed for immediate supply. This cost includes the reduction of profit and costs accruing due to disruption in the operating cycle.