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Inventory Management

A-Level, IB, BTEC National
AQA, Edexcel, OCR, IB, Eduqas, WJEC

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

Finished goods

  • 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

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