Inventory

Inventory is the stock of any item or resource used in an organization. This implies that all organizations carry some inventory or stock of goods at any time. Inventories range from items such as stationery to machinery parts or raw materials. Generally, organizations with activities centered on products or manufacturing processes have more inventory and need to develop more controls and systems than organizations where the service/product mix is oriented more to the service end of the service/product continuum. It has been estimated that a typical firm has about 30 percent of its current assets and perhaps as much as 90 percent of its working capital invested in inventory. Apart from the cost of inventory, the use of excessive inventory can lead to other issues such as the disruption of work flow and hiding problems related to product quality and equipment breakdown. To address these issues and therefore help management keep the cost down while still meeting production and customer service requirements, an efficient inventory system is needed.

[Page 935]Based on an efficient inventory system, inventory is expected to serve several functions that in turn can add flexibility to a firm's operations. Among the most important are the following: to meet anticipated customer demand, to smooth production requirements, to de-couple operations, to protect against stock-outs, to take advantage of order cycles, to hedge against price increases, and to take advantage of quantity discounts.

To accommodate the functions of inventory, firms maintain different types of inventories. Inventory can be classified by location and type. Based on the location, inventory can include raw material inventory, work-in-process inventory, maintenance/repair/operating supply (MRO) inventory, and finished-goods inventory. Inventory classification by type provides a method of identifying why inventory is being held and so suggests policies for reducing its level. Inventory types include buffer/safety, cycle, de-coupling, anticipation, and pipeline/movement.

In making any decision that affects the size of different types of inventory, four basic costs need to be taken into account: holding or carrying costs, setup or production change costs, ordering costs, and shortage costs. Holding costs relate to physically having items in storage. They include the costs for storage, handling, insurance, pilferage, spoilage, breakage, obsolescence, depreciation, taxes, and the opportunity cost of capital. Obviously, high holding costs tend to favor low inventory levels and frequent replenishment. Typical annual holding costs range from 20 percent to 40 percent of the value of an item. Holding costs are stated in either of two ways: as a percentage of unit price or as a dollar amount per unit. Setup costs are the costs to prepare a machine or process for manufacturing an order or changing from one product to another. That is, to make each different product, it is necessary to obtain the required materials, arrange specific equipment setups, fill out the required papers, and move out the previous stock of material. Ordering costs refer to the managerial and clerical costs to prepare the purchase or production order. Finally, shortage costs are the costs resulting from stock-out or when demand exceeds the supply of inventory on hand. For instance, lost profits, the effects of lost customers, or late penalties are examples of shortage costs.

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