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Last updated 7 Aug 2019
Inventory management is a key operational activity for many businesses and also has important implications for working capital and cash flow.
What are Inventories?
Otherwise known as "stock", inventories are the raw materials, work-in-progress and finished goods held by a business to enable production to take place and to meet customer demand. The main categories of inventory are:
Raw materials & components
- Bought from suppliers
- Used in production process
- E.g. parts for assembly or ingredients
Work in progress
- Semi or part-finished production
- E.g. construction projects, part-assembled products
- Completed products ready for sale or distribution
- E.g. products on supermarket shelves; goods in e-commerce warehouses
Why Do Businesses Hold Inventory?
Depending on the nature of the business, there are several reasons why a business will want to hold inventory:
- To enable production to take place
- To satisfy customer demand
- As a precaution against delays from suppliers
- To enable efficient production
- To allow a business to meet seasonal changes in demand
- To provide a buffer between different parts of a production process
Why is Inventory Management and Control Important?
Inventory management & control is a key part of a business operating efficiently:
- The business damage from stock-outs or having the wrong inventory can be significant
- However, it is crucial to manage inventory carefully as it often ties up a significant value of capital (cash) that could be used elsewhere in the business
- These days, inventory management is much easier due to widely available IT systems
What are the Main Influences on the Quantity of Inventory Held by a Business?
How much inventory should a business hold? The answer of course is – it depends. Key factors a business needs to consider are:
- The need to satisfy customer demand
- Failure to have goods available for sale is costly
- Demand may be seasonal or unpredictable
- The need to manage working capital
- Holding inventories ties up the cash of the business in working capital once suppliers have been paid
- There is an opportunity cost associated with inventory holding - that cash might be able to be used for better purposes
- Risk of inventory losing value
- The longer that inventories are held, the greater risk that they cannot be used or sold
What are the Costs to a Business of Holding Inventories?
A decision to hold inventory involves more than just the cost of the inventory itself. The overall cost of inventory needs to take account of:
Cost of storage - more inventories require large storage space and possibly extra employees and equipment to control and handle them
Interest costs - holding inventories means tying up capital (cash) on which the business may be paying interest
Obsolescence risk - the longer inventories are held, the greater is the risk that they will become obsolete (i.e. unusable or not capable of being sold)
Stock out costs - a stock out happens if a business runs out of inventory. This can result in:
- Lost sales & customer goodwill
- Cost of production stoppages or delays
- Extra costs of urgent, replacement orders