Reasons for holding inventories and its effects.


Formulation of an inventory policy requires an understanding of the role of inventory in an organization. Many firms hold inventories for several reasons some of which are highlighted below:

1. Customer service and stock out.

Inventories provide protection against stock outs to demand variability in the market place. If forecasts of demand are reliable, inventory levels can be maintained with relative accuracy and can be kept fairly accurate.
Stock outs may occur when there are raw material shortages or sole-source supplier with production problem that increase the risk of inadequate supply. Although a stock out may seem to have little effect, normally the lack of a particular product could shut down an assembly line or cause customers to go to competitors.

2. Maximizing returns on investment

Investment in inventories is a major cost, so a major management strategy is to maintain minimum inventories. Because there are many different processes and activities, there is no standard inventory level that applies to all companies. Different investment levels are required for different product lines within the same company. The establishment of inventory levels must be a joint decision of production, marketing and financial management.

Various factors influence the inventory levels of a company. Some of the most significant factors include:

  • Use of the purchased components.
  • Type of products.
  • Distance from suppliers and customers.
  • Warehousing availability.
  • Production cycle time
  • Consignment stocking policies.

Inventory management requires the establishment of procedures, policies, rules and guidance for various inventory situations. Inventory must be carefully analyzed to detect short-term seasonal fluctuations and identify long-term trends as early as possible.

3. Increasing production efficiency.

Efficient utilization of facilities depends on many factors and a steady state in inventory level is an important contribution to minimizing unit costs.

4. Improving management

One benefit of inventories is overall improvement in managerial performance in all areas i.e. financial, marketing, and manufacturing. This improvement can occur in many e.g., marketing will improve sales through better service to customers. More accurate customer service and more accurate pricing of products results in more efficient operations.

5. Economies of scale.

When the firm purchases large quantities of input, there are advantages of price reduction or discount. Handling of large quantity of material cost less than small quantities since this is done only once. Transportation and manufacturing also costs less per unit when large quantities are involved.

6. Balancing supply and demand.

In agriculture, it is usual to have large quantities of produce in one part of the year and very low quantities on others. Users of agricultural produce have therefore to hold large inventories just after harvest to make sure that they satisfy the demand for their product at low supply times. Inventories are held to cater for price fluctuations/ speculations.

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One thought on “Reasons for holding inventories and its effects.”

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