What is Inventory? Categories, Importance, Cost of Holding Inventory

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What is Inventory?

Inventory is defined as the goods (raw material, work-in-process and finished goods) held by a business with the purpose of production and sale in the future. Inventories of an organisation show its major investment in assets from various manufacturers, wholesalers and retailers. Inventory management is the branch of management that checks and controls the flow of inventory needed and available for the production and distribution of goods.

Inventory management is the process of keeping track of inventory so as to maintain adequate levels and fulfil consumer demand on time. Inventory ties up money and has an impact on performance; therefore, determining the optimum inventory level is critical. Having too much inventory affects working capital and has a negative influence on the company’s liquidity.

On the contrary, having insufficient inventory leads to stock outs and missed sales, resulting in lower profits. It becomes evident that management’s focus should be on keeping inventory levels in the middle, aiming for more customer satisfaction and fewer stock outs while keeping inventory costs as low as possible.

A business can run its operating activities only when an appropriate amount of inventory is maintained. Inventory affects all operating activities like manufacturing, warehousing, sales, etc. The amount of opening and closing inventory should be sufficient enough so that other business activities are not adversely affected. Thus, inventory plays an important role in operations management. Inventory is an asset that is owned by a business and has the express purpose of being sold to a customer.

Every firm relies on inventory to carry out its operations smoothly on a day-to-day basis. It has an impact on several aspects of the supply chain, including manufacturing, warehousing and sales. The amount of inventory accessible to a company should be sufficient to ensure that manufacturing activities happen smoothly. Similarly, excessive investment in inventories should be precluded as excessive investment might result in idle inventories.

Categories of Inventory

As a result, working capital would be blocked. Inventory can be divided into the following categories:

Raw Material

Raw material inventory contains items that are purchased by the firm from others and are converted into finished goods through the manufacturing (production) process. They are an important input on the final product. For example, leather can be the raw materials to make belts and bags; cotton can be the raw materials for a garment manufacturer.

Work-in-Progress (WIP)

It refers to semi-finished goods that are still in the manufacturing process and have not yet reached the ultimate level of completion. For example, after baking, cookies, undergo quality checks. At this stage, cookies are WIP inventory as they are still not packed to be given to end users. The length of a company’s manufacturing process determines how much work it has in progress. The time it takes to convert raw materials into completed items is referred to as the length of the production process. The longer the time gap, the more work-in-progress to the business.

Finished Goods

Finished goods are the final items that are ready to be sold in the market. These goods undergo various stages of production and quality checks. So, for the bakery owner, the final packets of cookies that are sent to the market for selling after undergoing quality checks will be finished goods. Raw materials, semi-finished goods and finished goods are the key categories of inventory that are accounted for in a company’s financial accounts.

There are other types of inventories as well, which are maintained as a precautionary measure or for some other specific purpose. To avoid supply shortages, organisation keeps finished goods on hand. The quantity of finished goods in inventory is determined by the type of the company, the demand for the goods and related factors.

Maintenance, Repairing and Operating (MRO) Supplies

This sort of inventory is mostly relevant for manufacturing industries. MRO items are not accounted as inventory items in books of accounts; however, they play a cardinal role in the day-to-day operations of an organisation. MRO supplies are utilised in maintenance, repair and maintenance of the machines, tools and other equipment used in the production process. Some examples of MRO items are lubricants, coolants, uniforms and gloves, nuts, bolts, screws, etc.

Importance of Inventory

As discussed earlier, inventory is considered to be one of the most important assets of a business. It is essential for every organisation to ensure a smooth running of the production process; thereby, reducing the ordering cost of inventory, avoiding opportunity, loss of sales, optimising the plant capacity and reducing the overall price. Thus, the management of inventory needs to be proactive, accurate and efficient.

Let us understand the importance of inventory in brief:

Managing Lead Time

Lead time refers to a lapse in time between an order placement for the replenishment of inventory and the actual receipt/fulfilment of orders. For example, a customer purchases a new laptop (i.e. order placement) from an online website and the final delivery of the laptop will be made in a week’s time. The period of one week i.e. between order placement and final delivery is called lead time.

Sometimes, suppliers are not able to deliver purchase orders on time due to various reasons, such as adverse climatic or transportation conditions or technological issues. Such adverse conditions can be managed by an organisation through effective inventory management practices. Managing inventory enables theorganisation to maintain an adequate level of inventory customer orders can be fulfilled when there are uncertain delays in product delivery.

Let us consider the above example of laptop. In case the customer does not get his order within a week, he may cancel his order and switch to the other brand or website. In this way, the organisation may lose important customers or can have the risk of losing revenues due to delay in fulfilling customer orders.

Meeting Seasonal Variation

Seasonal products refer to items that attract sharp demand only in their season and no demand outside of their season. For example, the demand for gift items rises before festivals like Diwali and Christmas, but slows down soon after. To manage such demand, inventory teams perform seasonal demand forecasting wherein they identify and manage the peaks and troughs in demand of seasonal products that takes place at a certain times of the year. If seasonal demand is not considered early in the ordering cycle, it can affect the entire supply chain.

Overcoming Contingencies

A business can face difficulties in its supply chain and order management in events like natural disasters, price hikes and many more. To fulfill customer orders in such situations, inventory teams prepares a contingency plan according an adequate level of safety stock is maintained.

These contingency plans have become more relevant in light of the ongoing global pandemic and sudden shifts in consumer behavior. Without adequate safety stock, an organisation does not have buffer against unexpected spikes in consumer demand or unforeseen delays in fulfillment. Safety stock, if maintained properly by warehouses, can eliminate the possibility of stockouts.

Achieving Economies of Scale in Procurement

The term economies of scale means cost reductions that take place when an organisation increases production volume. In the context of procurement, economies of scale refer to buying raw materials in larger lots from suppliers and holding inventory. It is considered to be cheaper for the company than buying frequent small lots. In such cases, the organisation buys in bulk and holds inventories at the plant warehouse.

For example, if the organisation buys raw materials for production for a whole year, it will be more cost-effective as compared to placing orders on a quarterly basis and incurring expenses like travel cost four times a year. However, such economies of scale can be achieved through effective inventory management practices.

Hedging Against Inflation

Rise in the prices of inventory can increase the purchase cost of inventory for an organisation. Such rise can flow through the production line of the organisation. In such a scenario of price fluctuations, an adequate level inventory can help the organisation battle inflation. In other words, buying inventory at lower prices at the present time and selling it in thefuture at higher prices will enable the organisation to use inventory as a hedge against inflation.

Cost of Holding Inventory

Once storage, personnel, opportunity and depreciation costs are estimated, calculating inventory holding costs is quite simple. All costs connected with physically holding the inventory, such as warehousing, storage rent, utilities and insurance, are included in storage costs. Salaries and compensation for warehouse staff who maintain the building, manage and audit inventory, and fill orders account for the majority of employee expenditures. Intangible opportunity costs are the costs of holding dead stock rather than alternative, more profitable products.

Various costs pertaining to inventory are as follows:

Initial Investment Expenses

The costs of carrying inventories are referred to as capital costs. Money spent on goods, interest paid on a purchase, interest lost (as cash transforms into inventory) and the opportunity cost of purchasing inventory are all examples of capital costs. The capital cost usually accounts for the majority of the total carrying cost.

Costs of Storage

Storage costs are the price of keeping inventory safe and organised in a certain location, such as of warehouse. It can be broken down into two categories: fixed and variable costs. The storage space’s rent or mortgage charges are fixed costs, whereas labour costs, material handling costs and utility expenses are variable costs.

Costs of Service

Service expenditures are incurred to safeguard inventory from theft or workplace accidents, maintain compliance with government laws and efficiently manage inventory.

Inventory Risk Costs

Carrying inventory entails a certain level of risk, which is reflected in the cost of inventory. There are a few things that make up this cost component. The first consideration is the possibility of shrinkage, which is defined as any inventory loss that occurs after a product is purchased but before it is sold to a client.

Shrinkage can occur as a result of transit damage, administrative errors or staff theft. The second danger is that the real worth of goods may depreciate while it is being stored for sale. The introduction of new items or models could be one of the reasons for this. Finally, there is a risk of obsolescence, which occurs when things are held past their expiration date.

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