Some entities are inventory intensive such as manufacturing and retailing concerns, whereas some are not, but in most of the cases, inventory is a vital part of business and progression of business is significantly affected by the fact that how well the inventory is being managed.
What is inventory management? In a nutshell, managing inventory means finding the right balance between the following two factors:
- Maintaining significant inventory so as to avoid any shortages,
- Minimizing costs associated with inventory
To completely understand inventory management, the factors mentioned above are absolutely crucial and the same are elaborated below:
Maintaining significant inventory so as to avoid any shortages
To understand inventory management, it is important to understand the motives of holding inventory. The most important motives of holding inventories are as follows:
- To make sure that production is not interrupted due to shortage of raw materials
- To make sure that no offer for sale is turned down due to shortage of finished goods
An entity must look into the implications of not maintaining significant inventory so as to avoid any shortages. Besides losing opportunities to make sales and earn profits, these shortages have a detrimental effect on the entity’s reputation and goodwill, which might result in loss of valuable customers. Where will these customers go? To the entity’s direct competitors, so the effect of shortages in inventory are severe and for managing inventor properly, this factor and its implications must be kept in mind.
Minimizing costs associated with inventory
As explained above, importance of avoiding inventory shortages is immense, but at the same time, it must be kept in mind that holding inventory is costly. Therefore, an entity should not keep excessive inventory. Costs associated with inventory include:
- Purchase price of inventory
- Ordering Cost (such as cost of delivery/ freight charges, inventory inspection costs in some cases, costs involved in placing orders such as mailing costs, telephone calls etc.)
- Holding cost (such as rent, lighting and costs of other utilities of warehouse, insurance cost, opportunity cost of investment tied up in inventory which could have earned some profits if invested somewhere else, loss due to obsolescence and theft etc.)
As explained above, the greatest challenge of inventory management is finding the right balance between the levels of inventory to be held and costs associated with inventory. Objective is to avoid shortages of inventory while incurring minimum costs associated with inventory. To find this balance, there are different models and theories such as Economic Order Quantity model, Just in Time procurement theory etc. which can help in minimizing costs associated with inventory.