Inventory Management - Financial Management

Inventories serve as a buffer between the various phases in the procurement -productionsales cycle of a manufacturing firm. They uncouple the various phases by giving the firm flexibility with respect to timing the purchase of raw materials, scheduling production facilities and employees, and meeting fluctuating and uncertain demand for the finished product. Inventories also serve similar purposes in the procurement-sales cycle of a wholesaling or retailing firm.

The remainder of this chapter explores the various types of inventories and their functions, along with the different categories of inventory -related costs. It also develops some models and procedures that can be used in efficiently managing a firm’s level of inventory investment. Although financial managers usually do not have primary responsibility for managing a company’s inventories, they are responsible for seeing that funds are invested in a manner consistent with shareholder wealth maximization.

(Normally, production and/or marketing management has primary responsibility for determining the specific quantities of the various types of inventories that the firm holds.) To perform this function, financial managers must have a good working knowledge of inventory control techniques. Like any other asset, the holding of inventories constitutes an investment of funds. Determining the optimal level of inventory investment requires that the benefits and costs, including the opportunity cost of the funds invested, associated with alternative levels be measured and compared. To do this, it is necessary to determine the specific benefits associated with holding the various types of inventories.

Benefits of Holding Inventories

Manufacturing firms generally hold three types of inventories:

  • Raw materials inventories
  • Work-in-process inventories
  • Finished goods inventories

Raw Materials Inventories Raw materials inventory consists of items a business purchases for use in its production process. It may consist of basic materials (for example, iron ore for a steel-making operation), manufactured goods (for example, memory chips for a computer assembly operation), or both. Maintaining adequate raw materials inventories provides a company with advantages in both purchasing and production. Specifically, the purchasing department benefits by being able to buy needed items in large quantities and take advantage of quantity discounts offered by suppliers. In addition, if rising prices, shortages of specific items, or both are forecasted for the future, maintaining a large stock of raw materials ensures that the company will have adequate supplies at reasonable costs.

Knowing that adequate stocks of raw materials will be available when needed permits the production department to meet production schedules and make the most efficient use of its personnel and facilities. Therefore, there are a number of valid reasons why a company’s purchasing and production departments will want to maintain large inventories of raw materials.

Work-in-Process Inventories Work -in -process inventory consists of all items that are presently in the production cycle at some intermediate stage of completion. For example, they may be currently undergoing some type of operation (such as assembly or painting); they may be in transit between operations; or they may be stored somewhere, awaiting the next step in the production cycle.

Work -in -process inventories are a necessary part of modern industrial production systems because they give each operation in the production cycle a certain degree of independence. This, in turn, aids in the efficient scheduling of the various operations and helps minimize costly delays and idle time. For these reasons, a company’s production department will want to maintain reasonable work-in-process inventories. In general, the longer a firm’s production cycle, the larger its work-in-process inventory.

Finished Goods Inventories Finished goods inventory consists of those items that have completed the production cycle and are available for sale.With the exception of large-scale, specialized types of equipment —such as industrial machinery, military armaments, jet airplanes, and nuclear reactors, which are normally contracted for before they are produced— most consumer and industrial products are manufactured and stored in inventory to meet forecasted future sales.

Keeping enough finished goods inventories on hand provides significant benefits for both the marketing and the production departments. From marketing’s perspective, large finished goods inventories enable it to fill orders promptly, minimize lost sales, and avoid shipment delays due to stockouts. From production’s standpoint, maintaining a large finished goods inventory permits items to be manufactured in large production runs, which helps keep unit production costs low by spreading fixed setup expenses over large volumes of output.

Inventory-Related Costs

At the same time that a number of benefits are to be realized from holding inventories, a number of costs also must be considered, including the following:

  • Ordering costs
  • Carrying costs
  • Stockout costs

Ordering Costs Ordering costs represent all the costs of placing and receiving an order. They are stated in dollars per order.When a company is ordering from an external source, these include the costs of preparing the purchase requisition, expediting the order (e.g., longdistance calls and follow-up letters), receiving and inspecting the shipment, and handling payment. Such factors as an item’s price and engineering complexity also affect its ordering costs.When an order is placed for an item that is manufactured internally within a company, ordering costs consist primarily of production setup costs, which are the expenses incurred in getting the plant and equipment ready for a production run.

In practice, the cost per order generally contains both fixed and variable components because a portion of the cost—such as that of receiving and inspecting the order—normally varies with the quantity ordered. However, many simple inventory control models, such as the EOQ model (which is described later in this chapter), treat cost per order as fixed by assuming that these costs are independent of the number of units ordered.

Carrying Costs Carrying costs constitute all the costs of holding items in inventory for a given period of time. They are expressed either in dollars per unit or as a percentage of the inventory value per period. Components of this cost include the following:

  • Storage and handling costs
  • Obsolescence and deterioration costs
  • Insurance
  • Taxes
  • The cost of the funds invested in inventories

Storage and handling costs include the cost of warehouse space. If a company leases warehouse space, this cost is equal to the rent paid. If a company owns the warehouse, this cost is equal to the value of the space in its next-best alternative use (that is, the opportunity cost). These costs also include depreciation on the inventory handling equipment, such as conveyors and forklift trucks, and the wages and salaries paid to warehouse workers and supervisors. Inventories are valuable only if they can be sold. Obsolescence costs represent the decline in inventory value caused by technological or style changes that make the existing product less saleable. Deterioration costs represent the decline in value caused by changes in the physical quality of the inventory, such as spoilage and breakage.

Another element of carrying cost is the cost of insuring the inventory against losses due to theft, fire, and natural disaster. In addition, a company must pay any personal property taxes and business taxes required by local and state governments on the value of its inventories. The cost of funds invested in inventories is measured by the required rate of return on these funds. Because inventory investments are likely to be of “average risk,” the overall weighted cost of capital should be used to measure the cost of these funds. If it is felt that inventories constitute an investment with either an above-average or below-average risk, some adjustment in the weighted cost of capital may be necessary to account for this difference in risk.

Some firms incorrectly use the rate of interest on borrowed funds as a measure of this cost. This tends to understate the true cost because a given amount of lower -cost debt must be balanced with additional higher -cost equity financing. Inventory investment cost constitutes an opportunity cost in that it represents the return a firm forgoes as a result of deciding to invest its limited funds in inventories rather than in some other asset. Therefore, for most inventory decisions, the appropriate opportunity cost is the firm’s weighted cost of capital. The cost of carrying inventories can represent a significant cost of doing business. contains some ranges on annual inventory carrying costs, expressed as a percentage of inventory value. This study found that total annual carrying costs were in the range of 20 to 45 percent for most of the businesses surveyed.

Like ordering costs, inventory carrying costs contain both fixed and variable components. Most carrying costs vary with the inventory level, but a certain portion of them— such as warehouse rent and depreciation on inventory handling equipment—are relatively fixed over the short run.Most of the simple inventory control models, such as the EOQ model, treat the entire carrying cost as variable.

Table Inventory Carrying Costs (as a Percentage

Table Inventory Carrying Costs (as a Percentage

Stockout Costs Stockout costs are incurred whenever a business is unable to fill orders because the demand for an item is greater than the amount currently available in inventory. When a stockout in raw materials occurs, for example, stockout costs include the expenses of placing special orders (back ordering) and expediting incoming orders, in addition to the costs of any resulting production delays. A stockout in work-in-process inventory results in additional costs of rescheduling and speeding production within the plant, and it also may result in lost production costs if work stoppages occur. Finally, a stockout in finished goods inventory may result in the immediate loss of profits if customers decide to purchase the product from a competitor, and in potential long-term losses if customers decide to order from other companies in the future.


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