Inventory Management

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Chapter 11

Inventory Management

Inventory: An inventory is a stock or store of goods. Firms stock hundreds or even thousands of items in inventory ranging from small things (eg. pencil, paper clips etc) to large items (eg. machines, trucks etc).

Major reasons for holding inventory:

To understand why firms hold inventories, we need to understand the following functions of inventory. i) To meet anticipated customer demand: A customer can be a person who walks in off the street to buy a new stereo system, a mechanic who requests a tool at a tool crib, or a manufacturing operation. These inventories are called anticipated stocks because they are held to satisfy expected demand. ii) To smooth production requirements: Firms that experience seasonal patterns in demand often build up inventories during pre-season periods to meet overly high requirements during seasonal periods. Companies that process fruits and vegetables deal with this inventory. iii) To decouple operations: Manufacturing firms often use inventories as buffer between successive operations to maintain continuity of production that would otherwise be disrupted by events such as breakdown of equipments, and accidents that cause a portion of the operation to shut down temporarily. iv) To protect against stock outs: Delayed deliveries and unexpected increases in demand increase the risk of shortages. This risk of shortages can be reduced by holding safety stocks. v) To take advantage of order cycles: To minimize purchasing costs, a firm often buys in quantities that exceed immediate requirements. This necessitates storing some or the entire purchased amount for later use. vi) To hedge against price increase:

vii) To permit operations: The production operations take a certain amount of time means that there is some work-in-process inventory. viii) To take advantage of quantity discounts: Suppliers may give discounts on large orders.

Objectives of inventory control:

Inventory management has two main concerns:
i) Customer service: That is, to have the right goods, in sufficient quantities, in the right place, at the right time. ii) Cost of ordering and carrying inventories.

Managers have a number of measures of performance they can use to judge the effectiveness of inventory management. A widely used measure is inventory turnover. Another useful measure is days of inventory on hand.

Inventory turnover: It is the ratio of annual cost of goods sold to average inventory investment.

Days of inventory on hand: It is a number that indicates the expected number of days of sales that can be supplied from existing inventory.

Inventory counting system:

It can be (i) periodic or (ii) perpetual.

Periodic inventory system: A physical count of items in inventory is made at periodic intervals such as monthly or weekly in order to decide how much to order of each item. Example: a retailer periodically checks the selves and stock room to determine the quantity on hand. Then he estimates how much will be demanded prior to the next delivery period.

Perpetual or continual inventory system: System that keeps track of removals from inventory continuously, thus monitoring current level of each item.

Lead time: Time interval between ordering and receiving the order. Point-of-sale: Record items at time of sale.

Inventory costs:

There are three basic costs associated with inventories. They are as follows: i) inventory holding or carrying costs
ii) transaction or ordering costs
iii) shortage costs

(i) Holding costs: It relates to physically having items in storage. Example: costs include interest, insurance, taxes, breakage, heat, light, rent security etc.

(ii) Transaction costs: The cost of ordering and receiving inventory. Example: preparing invoices, shipping costs, inspection costs, moving the goods to temporary storage.

(iii) Shortage cost: Shortage costs result when demand...
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