Concept of Inventory:
What is inventory? Inventory refers to those goods which are held for eventual sale by the business enterprise. In other words, inventories are stocks of the product a firm is manufacturing for sale and components that make up the product. Thus, inventories form a link between the production and sale of the product.
The forms of inventories existing in a manufacturing enterprise can be classified into three categories:
(i) Raw Materials:
These are those goods which have been purchased and stored for future productions. These are the goods which have not yet been committed to production at all.
These are the goods which have been committed to production but the finished goods have not yet been produced. In other words, work-in-progress inventories refer to ‘semi-manufactured products.’
(iii) Finished Goods:
These are the goods after production process is complete. Say, these are final products of the production process ready for sale. In case of a wholesaler or retailer, inventories are generally referred to as ‘merchandise inventory’.
Some firms also maintain a fourth kind of inventory, namely, supplies. Examples of supplies are office and plant cleaning materials, oil, fuel, light bulbs and the like. These items are necessary for production process. In practice, these supplies form a small part of total inventory involving small investment. Therefore, a highly sophisticated technique of inventory management is not needed for these.
The size of above mentioned three types of inventories to be maintained will vary from one business firm to another depending upon the varying nature of their businesses. For example, while a manufacturing firm will have all three types of inventories, a retailer or a wholesaler business, due to its distinct nature of business, will have only finished goods as its inventories. In case of them, there will be, therefore, no inventories of raw materials as well as work-in- progress.
Motives for Holding Inventories:
A simple but meaningful question arises:
Why do firms hold inventories while it is expensive to hold inventories? The reply to this question is the motives behind holding inventories in an enterprise.
Researchers report that there are three major motives behind holding inventories in an enterprise:
1. Transaction Motive
2. Precautionary Motive
3. Speculative Motive
A brief description about each of these motives follows in seriatim:
1. Transaction Motive:
According to this motive, an enterprise maintains inventories to avoid bottlenecks in its production and sales. By maintaining inventories; the business ensures that production is not interrupted for want of raw material, on the one hand, and sales also are not affected on account of non-availability of finished goods, on the other.
2. Precautionary Motive:
Inventories are also held with a motive to have a cushion against unpredicted business. There may be a sudden and unexpected spurt in demand for finished goods at times. Similarly, there may be unforeseen slump in the supply of raw materials at some time. In both the cases, a prudent business would surely like to have some cushion to guard against the risk of such unpredictable changes.
3. Speculative Motive:
An enterprise may also hold inventories to take the advantages of price fluctuations. Suppose, if the prices of raw materials are to increase rather steeply, the enterprise would like to hold more inventories than required at lower prices.
Benefits and Costs of Holding Inventories:
Holding inventories bears certain advantages for the enterprise.
The important advantages but not confined to the following only are as follows:
1. Avoiding Losses of Sales:
By holding inventories, a firm can avoid sales losses on account of non-supply of goods at times demanded by its customers.
2. Reducing Ordering Costs:
Ordering costs, i.e., the costs associated with individual orders such as typing, approving, mailing, etc. can be reduced, to a great extent, if the firm places large orders rather than several small orders.
3. Achieving Efficient Production Run:
Holding sufficient inventories also ensures efficient production run. In other words, supply of sufficient inventories protects against shortage of raw materials that may at times interrupt production operation.
Costs of Holding Inventories:
However, holding inventories is not an unmixed blessing. In other words, it is not that everything is good with holding inventories. It is said that every noble acquisition is attended with risks; he who fears to encounter the one must not expect to obtain the other. This is true of inventories also. There are certain costs also associated with holding inventories. Hence, it is necessary for a firm to take these costs into consideration while planning for inventories.
These are broadly classified into three categories:
1. Material Costs:
These include costs which are associated with placing of orders to purchase raw materials and components. Clerical and administrative salaries, rent for the space occupied, postage, telegrams, bills, stationery, etc. are the examples of ordering costs. The more the orders, the more will be the ordering costs and vice versa.
2. Carrying Costs:
These include costs involved in holding or carrying inventories like insurance charges for covering risks, rent for the floor space occupied, wages to laborers, wastages, obsolescence or deterioration, thefts, pilferages, etc. These also include opportunity costs. This means had the money blocked in inventories been invested elsewhere in the business, it would have earned a certain return. Hence, the loss of such return may be considered as an ‘opportunity cost’.
The above facts underline the need for inventory management, i.e., to decide the optimum volume of inventories in the firm/enterprise during the period.
Objectives of Inventory Management:
There are two main objectives of inventory management:
1. Making Adequate Availability of Inventories:
The main objective of inventory management is to ensure the availability of inventories as per requirements all the times. This is because both shortage and surplus of inventories prove costly to the organization. In case of shortage of availability in inventories, the manufacturing wheel comes to a grinding halt. The consequence is either less production or no production.
The either case results in less sale to less revenue to less profit or more loss. On the other hand, surplus in inventories means lying inventories idle for some time implying cash blocked in inventories. Speaking alternatively, this also means that had the organization invested money blocked in inventories invested elsewhere in the business, it would have earned a certain return to the organization. Not only that, it would have also reduced the carrying cost of inventories and, in turn, increased profits to that extent.
2. Minimising Costs and Investments in Inventories:
Closely related to the above objective is to minimize both costs as well as volume of investment in inventories in the organization. This is achieved mainly by ensuring required volume of inventories in the organization all the times.
This benefits organization mainly in two ways. One, cash is not blocked in idle inventories which can be invested elsewhere to earn some return. Second, it will reduce the carrying costs which, in turn, will increase profits. In lump sum, inventory management, if done properly, can bring down costs and increase the revenue of a firm.