inventory management chapter 24 Flashcards
inventory
materials and goods held by a business and required to allow for the production of products and their supply to their customer. Operations efficiency can be improved if a business manages inventory well by balancing the holding cost against the cost of running out of essential supplies.
reasons for holding inventory
raw materials and components
work in progress
finished goods
reasons for holding inventory: raw materials and components
These will have been purchased from outside suppliers. They will be held in storage until they are used in the production process These inventories can be sent to the production line quickly. The business can meet increases in demand by increasing the rate of production quickly.
reasons for holding inventory: work in progress
At any one time, the production process will be converting raw materials and components into finished goods. During this process there will be work in progress and for some businesses such as building and construction businesses, this will be the main form of inventories held. The value of work in progress depends s on the length of time needed to complete production and on the method of production. Batch production tends to have high work-in-progress levels.
reasons for holding inventory: finished goods
Having been through the complete production process, goods may then be held in storage until sold and dispatched to the customer. These inventories can be displayed to potential customers and increase the chances of sales. They are also held to cope with sudden unpredicted increases in demand, so that customers can be satisfied without delay. Firms will also stockpile completed goods to meet anticipated increases in demand
inventory management
the process of ordering, storing and using a company’s inventory
problems with ineffective inventory management
There might be insufficient inventories to meet unforeseen changes in demand.
Out-of-date or obsolete inventories might be held if an effective rotation system is not used
Inventory wastage might occur due to mishandling or incorrect storage conditions.
High inventory levels have high storage costs and a high opportunity cost.
Poor management of the supply purchasing function can result in late deliveries, low discounts from suppliers or a delivery too large for the warehouse to cope with.
costs of holding inventory
opportunity cost
storage costs
risk of wastage and obsolescence
costs of holding inventory: opportunity cost
Working capital tied up in goods in storage could be put to other uses. It might be used to pay off loans, buy new equipment or pay suppliers early to gain an early payment discount. The capital could be left in the bank to earn interest. The most favorable alternative use of the capital tied up in inventories is called its opportunity cost. The higher the value of inventories held and the more capital used to finance them, then the greater will be this opportunity cost. During periods of high interest rates, the opportunity cost of inventory holding increases.
costs of holding inventory: storage costs
Inventories have to be held in secure warehouses. They often require special conditions, such as refrigeration. Employees will be needed to guard and transport the goods. Insurance of inventories is recommended in case they are stolen or damaged by fire or flood. If finance has to be borrowed to buy the goods held in storage, then this will incur interest charges.
costs of holding inventory: risk of wastage and obsolescence
If inventories are not used or sold as rapidly as expected, then there is a danger of goods deteriorating or becoming outdated. This will lower the value of such inventories. Goods often become damaged while held in storage or when moved. They can then only be sold for a much lower price.
benefits of holding inventory
reduce risk of lost sales
allows for continuous production
avoids the need for special orders from suppliers
large orders of new supplies reduce costs
(The optimum inventory level will be at the lowest point of total costs on the total inventory cost graph)
benefits of holding inventory: reduce risk of lost sales
If a business cannot supply customers from goods held in storage, then sales could be lost to businesses with higher inventory levels. This is a form of poor customer service. Holding high inventories not only gives customers more choice but reduces the risk of losing sales because no products are available.
benefits of holding inventory: allows for continuous production
If inventories of raw materials and components run out, then production will have to stop. This will leave expensive equipment idle and labour with nothing to do. The costs of lost output and wasted resources could be considerable and can be avoided by holding inventories.
benefits of holding inventory: avoids the need for special orders from suppliers
If a business runs out of inventory, an urgent order may have to be given to a supplier to deliver additional materials. This incurs extra costs because of the administration of the order and possibly also special delivery charges.
benefits of holding inventory: large orders of new supplies reduce costs
To keep inventory levels low, goods and supplies may be ordered in small quantities. The larger the size of each delivery, the higher will be the average level of inventories held. By ordering in large quantities and keeping inventory levels high, a business may gain from bulk discounts while transport costs could be lower since fewer deliveries have to be made.
economic order quantity
the optimum or least cost quantity of stock to reorder taking into account delivery costs and stock holding costs
optimum order size
The purchasing manager must ensure that supplies of the right quality are delivered at the right time and in sufficient quantities to allow continuous production. The temptation might be to order huge quantities to gain economies of scale and to ensure that there is never zero inventory. Ordering and administration costs will be low, as few orders will need to be placed. Continuous production should be ensured and special order costs for out-of-stock materials should be unnecessary. However, this policy also incurs costs.
factors of that influence the magnitude of optimum order size
Inventory-holding costs will be higher as the large orders will have to be stored until needed. Opportunity costs will be high due to more capital being tied up. The danger of goods held in storage becoming obsolete and out-of-date is increased. What, then, is the optimum order size? It will differ for every business and every kind of inventory.
inventory control charts
Inventory control charts or graphs are widely used to monitor a firm’s inventory position. These charts record, over time, the numbers of goods held, inventory deliveries. buffer levels and maximum inventory. They help an inventory manager to determine the appropriate order time and order quantity. They also allow an analysis of what would happen to inventory levels if an unusual event occurred, such as a competitor operating a very successful promotion campaign.
key features of a typical inventory control chart:
buffer inventory
maximum inventory level
reorder quantity
lead time
reorder level
key features of a typical inventory control chart: buffer inventories
The greater the degree of uncertainty about delivery times or production levels, then the higher this buffer level will have to be. Also, the greater the cost involved in shutting production down and restarting, the greater the potential cost savings from holding high buffer levels of inventories.
