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Inventory

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Business Studies

The more inventory a company has, the less likely they will have what they need."

- Taiichi Ohno

To understand what Taiichi Ohno meant by this statement, let's examine what inventory is exactly, how it can be managed and discuss why he was concerned by companies holding too much inventory.

Inventory management is the management of goods held by a company.

Inventory is a stock of goods that is recorded under the current asset on the company's balance sheet.

Typically, there are three types of inventory.

1. Raw materials or components: stock purchased from suppliers and are to be used in manufacturing.

Wood and screws to make a table.

2. Work in progress: semi or partially-finished goods.

A table leg made from a piece of wood.

3. Finished goods: finished goods ready for distribution.

A complete table to be sold in a furniture store.

What are the reasons for holding inventory?

Let's take a look at why companies might decide to hold inventory.

Allow more efficient production

The lack of raw materials not only slows down production but also affects other stages of the supply chain. Limited supplies could lead to products not being finished on time, which may result in the cancellation of orders and loss of sales. Keeping stock can prevent this by making sure materials needed are available at all times.

Safeguard against late delivery

Having inventory in stock allows the company to keep the production going while waiting for new materials to arrive. Safety stock can provide a buffer for events such as natural disasters or loss of goods.

Reduce buying costs

Suppliers tend to offer discounts for a large number of goods. By buying in bulk, the company can take advantage of lower prices, which reduces the amount that customers have to pay for the final products. However, the high level of inventory will result in more expensive storage and maintenance.

Meet an unexpected demand

The demand for goods is not consistent but fluctuates wildly over the year. For example, special occasions such as Christmas, Valentine's, and Halloween may ramp up the demand for certain goods. Keeping inventory allows businesses to meet customer needs during the high seasons. The key is to make the right order amount to avoid excess stock storage.

What are the costs of inventory?

There are three main types of inventory cost:

Ordering costs

These are costs for ordering goods. For example, administrative costs, inspection costs, cost of placing an order with a supplier.1

To minimize the ordering costs, a company can calculate EOQ (Economic Order Quantity) - an optimal order quantity at the lowest total costs.

Holding costs (carrying costs)

These are costs associated with inventory unsold, including2:

  • Opportunity costs: This is the money that could be invested elsewhere if not used in inventory. For example, if you invest £10,000 in warehousing, you couldn't use it to purchase new office furniture.

  • Storage costs: These are costs for storing physical inventory. For example, warehousing, storage rents, utilities, insurance. An increase in inventory comes with a higher storage cost.

  • Wages: These are the salaries you pay for employees who work at the warehouse and fulfil the order.

  • Depreciation costs: These are costs incurred as the value of your inventory appreciates over time. For example, products become obsolete.

Shortage costs

These are costs that incur when inventory goes out. For example, a loss of sales due to unfulfilled orders and overnight shipping fees to acquire inventory that is not available.

Inventory planning and control in the supply chain

Inventory planning is an important aspect of the supply chain since it controls the level of inventory held. This allows the company to keep up with its production and meet customer needs while safeguarding against the loss of goods or late deliveries by the suppliers.

Planning and controlling inventory is also tied with the company's working capital - the money used to pay for short-term expenses (within a year). If the business spends too much money on holding inventory, it may not have enough capital for other business activities. To balance the working capital, companies must order the right amount of stock at the right time. Thus, the primary objective of inventory control is to minimize inventory costs.

Inventory control charts

An inventory control chart is an efficient tool for managing stock levels and minimizing inventory costs (see Figure 1 below).

Inventory, Inventory planning and control in the supply chain, Inventory control charts, StudySmarterFigure 1. Inventory Control Chart, StudySmarter

The components of the inventory control chart:

  • The maximum stock level: the largest amount of inventory a business can hold
  • Lead time: the time it takes for the inventory to arrive from the moment it is ordered
  • Re-order level: the trigger point for ordering a new batch of supplies.
  • Re-order quantity: the amount of quantity ordered each time.
  • The minimum stock level: the smallest amount of inventory a business wants to keep.
  • Buffer stock (safety stock): the surplus of inventory the company wants to hold to safeguard against unexpected events.

What factors influence the level of inventory?

Having the right level of inventory is important as it allows the company to keep up with the production while waiting for new materials to arrive. Reserved inventory also serves as a buffer for unpredictable events such as natural disasters or economic crises.

Here are some factors influencing the level of stock:

  • The rate at which the stock is used up: This is also known as the stock turnover rate. Typically, the company needs to hold more stock if the supplies tend to run out quickly.
  • Available space in the warehouse: More storage space can hold more inventory.
  • Reliability of the supplier: Should the suppliers always deliver goods in time, the firm can hold less inventory in stock.
  • The nature of the product: Perishable goods such as meat, dairy, or fresh produce can't be kept in normal inventory conditions for long.
  • The lead time of the supplier: Lead time is the number of days between when the order is made and when it is delivered. The shorter the lead time, the smaller the inventory that a firm needs to hold.
  • The demand for the product: Higher product demand will require more available stock. For example, a business needs to keep a higher level of inventory during a peak season.

Inventory - key takeaways

  • Inventory is the stock of goods held by a company. It is divided into three categories: raw materials, work in progress, and finished goods.
  • The reasons for keeping inventory include ensuring seamless production, reducing buying costs, safeguarding against late deliveries, and meeting unexpected demands.
  • Planning and controlling inventory is crucial to maximizing the cost of holding inventory and ensuring sufficient stock for production.
  • Key components of the inventory control chart include the maximum and minimum stock level, lead time, reorder levels, and safety stock.
  • Factors determining the level of stock include the availability of warehouse space, reliability of the supplier, the nature of the product, lead time, and the demand for the goods.
  • Most common inventory costs include ordering costs, storage costs, and shortage costs.

References

1. Wikiaccounting, Ordering Cost: Definition, Formula, Example, and How Does It Work, 2022

2. Shannon Callarman, What Is Inventory Holding Cost? The Price for Ecommerce Storage, 2020

Inventory

Inventory is the stock of goods held by a company. It is a current asset on the balance sheet as the company plans to sell finished goods within a year. There are three types of inventory: raw materials, work in progress, and finished goods.

Small businesses can employ many techniques to organize their inventory such as adopting ABC stock categorization, using the First In First Out (FIFO) approach, identifying and removing low-turn stock, installing cloud-based stock management software, tracking inventory at all times, and controlling quality.

Inventory can help the business to ensure more efficient production, reduce buying costs, safeguard against late deliveries, and meet unexpected demands.

Final Inventory Quiz

Question

What is inventory?

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Answer

Inventory is the stock of goods by a company.

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Question

What is not a type of inventory?


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Answer

Machine to produce the products

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Question

Why do companies store inventory? 


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Suppliers typically offer discounts to companies who buy their products in bulk. By ordering a larger quantity, the company can benefit from a better buying cost. This transfers to lower prices and helps the company to gain a competitive advantage in the market.

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What happens if the company keeps too much stock?


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Excessive storage costs.

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What is working capital?


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Working capital is the money used to pay for short-term expenses (within a year) such as inventory, short-term debts, and day-to-day operations.

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How does customer demand affect the level of inventory? 


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  • The demand can be unexpected or seasonal

  • Unfulfillment of the demand can cost the company dearly. 

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How inventory can lose value?

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The longer a product stays in inventory, the higher the risk of it not being sold. Also, there’s the risk of perishable inventory which may spoil quickly and require replacement.

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What are some types of inventory costs?


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ordering costs, storage costs, and shortage costs.

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What are the shortage costs?  


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Shortage costs may come from the loss of customers who choose to make their purchases elsewhere, loss of sales for orders not fulfilled, and overnight shipping to acquire inventory not in stock.

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What are ordering costs?

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Answer

Ordering costs are costs for procuring raw materials, which include the cost of purchase and the cost of inbound logistics.

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How to minimize ordering costs?

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To minimize the ordering costs, companies often employ the technique of EOQ (Economic Order Quantity) to place the optimal order that incurs the lowest cost. 

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What are storage costs?

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Storage costs are the costs for storing and maintaining raw materials and goods.

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What is the primary goal of planning and controlling inventory?

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Answer

The primary goal of inventory planning is to minimize inventory costs. 

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Question

What are the components of the inventory control chart?

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Answer

  • The maximum stock level: the largest amount of inventory a business can hold
  • Lead time: the time it takes for the inventory to arrive from the moment it is ordered
  • Re-order level: the trigger point for ordering a new batch of supplies.
  • Re-order quantity: the amount of quantity ordered each time.
  • The minimum stock level: the smallest amount of inventory a business wants to keep.
  • Buffer stock (safety stock): the surplus of inventory the company wants to hold to safeguard against unexpected events.

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Question

Which factors determine the level of inventory in the warehouse?

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Answer

  • The rate at which the stock is used up: the company needs to hold more stock if the supplies tend to run out quickly
  • Available space in the warehouse: More warehouse space would allow for more stock-up
  • Reliability of the supplier: if the suppliers always deliver goods in time, the firm can keep less stock in reserve
  • The nature of the product: perishable goods such as vegetables or fruits can't be held for a long period of time.
  • The lead time of the supplier: the shorter the lead time, the smaller the inventory that a firm needs to hold.
  • The demand for the product: higher demand will require more inventory in reserves

Show question

Question

This diagram is showing 

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Answer

a. Stockroom

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From the diagram below what will you say is happening 

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a. Inventory 

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This formula is used to calculate what?

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Answer

Economic Order Quality is used to celebrate the optimal order quantity

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From the diagram below is used to calculate what?

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Inventory holding costs

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Wha is inventory planning?

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This is the control of the supply chain and the level of inventory held.

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List three factors affecting the level of humanity

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Answer

1. The rate at which stock is used

2. Reliability of the supplier

3. Nature of product

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Question

What is the diagram below called and used for?

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Answer

Inventory control chart is an efficiency tool used for managing stock levels and minimising inventory costs

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Question

There are ...... and ...... storage costs associated  with inventory 

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Answer

Ordering and holding costs

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Question

What is inventory?

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Answer

This is the stock of goods registered as part of a company assets

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what is inventory management?

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Answer

This is how a company manages and handles its inventory

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Question

How many types of inventory do we have?

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three, raw materials, work in progress anf finished goods

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Question

Meeting unexpected inventory is s reason to hold inventory

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Answer

True

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