INVENTORY MANAGEMENT – SUMMARY

Introduction
Manufacturing business will hold inventories in 3 forms:
1. Raw materials and progress
The business will purchase raw materials from outside suppliers and kept in storage until
they’re used in production. This allows the business to meet increasing demand from
customers. It is beneficial for the business if it purchases lots of raw materials at once as
economies of scale will be offered.
2. Work in progress
The raw materials are then converted into finished goods. It doesn’t only depend on the
length of time but also depends on the method of production being used. Batch production
has been proven to have high level of work in progress.
3. Finished goods
Finished goods are being kept in the inventories until sold or dispatched to the customers.
The products are also being displayed to potential customers. The benefit of keeping extra
stock of each products is that the business wouldn’t have to experience any delay at times
when there’s a sudden increase in demand from the customers. Firms will also be able to
cope during times where seasonal goods are in high demand such as during Christmas or
Halloween.

Inventory management
Inventories needs to be managed effectively as problems can arise for some firms. These
includes:
-If the products being held in the inventories are outdated, customers wouldn’t want to
purchase it anymore as it’s no longer trendy.
-There might be insufficient inventories to meet unforeseen changes in demands.
-Inventory wastage may occur due to mishandling
-High inventory levels may result to excessive storage cost and more capital being used to
finance it hence, higher opportunity cost.
-Poor management of the supply purchasing may lead to delayed delivery or missing out on
low discounts (economies of scale)

Inventory-holding cost
These includes:
1. Opportunity cost
When there’s high inventory level, the more capital is being used to finance it hence, more
opportunity cost. Opportunity cost is the alternative most favorable use of the capital being
tied up in inventories. During periods of high interest rates, the opportunity cost of
inventory holding rises.
2. Storage cost
Some products need special requirements in the inventories such as temperature needed to
keep the products. As an example, dairy products and meat need to have refrigerator in
order to prevent it from being expired. In addition, employees guard and transport the
goods. Security is also needed in case someone attempts to rob the inventory and that is
why, insurance of inventory is sometimes useful in that case too.
3. Risk of wastage and obsolescence
Sometimes when the sales didn’t spike as much as the business expected, the finished
goods that are being left in the inventories reduce in quality and gets outdated. The price
will then have to be lowered due to its degrading quality in order for customers to purchase
them. However, this will obviously lead to a loss of profit and capital for the business.

Cost of not holding enough inventories

These are the risks for businesses who have very low inventory levels. These costs are often
called as “inventory out” costs:
1. Loss of sales
If the customer demands for products but the business doesn’t have enough stock held in
the inventory and is unable to supply the customers with the product, the customers will
lose interest in the business and look for alternative companies who sells similar items like
that business who has higher inventory levels to stock up their product. This could also lead
to loss of customer loyalty as they are disappointed and probably wouldn’t repurchase
anymore.
2. Idle production resources
If raw materials are short in stock and the business hasn’t ordered more, then the whole
production process needs to be stopped. This would mean leaving expensive equipments
idle (not work) and labour / staff with nothing to do and if the staff’s contracts aren’t flexible
(meaning that the business can’t lay some of them off when they’re not needed), the
business will still have to pay them even though they did nothing that day. The cost of loss
output and wasted resources could be considerable.
3. Special orders may be expensive
Special orders mean the customer demands for one particular product that is not mass
produced therefore, the business needs to contact the supplier to supply certain raw
materials that’ll be bought in small quantities. This would lead the business to have higher
administration and transportation / delivery cost as economies of scale isn’t applicable.
4. Small order quantities
Keeping low level of inventory to prevent wastage may have negative impacts too. This
would mean purchasing raw materials in small quantities and the business would miss out
on economies of scales and have higher delivery cost as much more deliveries have to be
made.

Optimum order size

Purchasing manager had to make sure that supplies are being purchased sufficiently at the
right time and delivered as well. The temptation level is very high for businesses to purchase
high level of stock in order to cope with sudden demands for customers. Buying raw
materials from suppliers has benefits for the business such as economies of scale that would
save capitals for the business.
In contrast, by doing so, the business needs to keep in mind that with doing so, the
inventory level will be high and the capital used to finance the inventories will be higher as
well, leading to higher opportunity cost. The risk of wastage and products going out of date
and decreasing in quality is also higher.
That is why, there should be an optimum order size using the concept of economic order
quantity. Economic order quantity is the optimum level or least cost quantity of stock to re-
order, considering the delivery and stock holding cost.

Controlling inventory levels – a graphical approach

(see TB for graph)
a) Buffer inventories
The minimum inventory level that ensures the production process could still go smoothly
should a delay in delivery occur or should a production rate increase.
b) Maximum inventory level
This may be limited by financial cost or space of holding an even higher inventory. One way
to calculate the maximum inventory level is to add the economic order quantity of each
component to the buffer level for that item.
c) Lead time
It is the gap between ordering new stocks and the delivery time. Sometimes the lead time
could be huge because there might be a delay in delivery or some sort of miscommunication
happening between the business and the suppliers such as wrong supplies are being
ordered hence, the supplier needs to reorder it again. The business could also forget to
schedule for re-ordering hence, longer delivery time it’ll take for supplies to arrive.
d) Re-order stock level
This is the level of stock that will trigger new order of supplies or raw materials to be made
to the suppliers. Nowadays, computers have a record of the stocks being ordered as well as
the delivery time and the re-order quantity as well as the re-order stock level are being
programmed into the computer. That way, automatic reordering from the supplier when
stocks fall to the reorder stock level could take place.

JIT (just-in-time inventory control)

JIT requires that there’s no buffer inventories held and that the items would be delivered to
the customers right away once it’s finished. This way, no excessive stocks are being kept in
the inventories that could risk wastage or out of date. There are requirements in order for
JIT to work properly:
1. Relationship with suppliers must be excellent / need to have reliable suppliers
This means that with reliable suppliers, the supplier would be able to supply the supplies or
raw materials needed at short notice and not have any delay in the delivery time. This will
have a long-term benefit for the business in the future.
2. Flexible and multi-skilled workers who can switch jobs at short notice
By having flexible workers, it means that the worker needs to be able to switch between
using one sort of machine to another sort at short notice and has the ability to deal with the
machine. In cases where demands of a certain product fall, the workers need to stop
producing that item and focus instead on the items that has higher demand. For ex: denim is
not in high demand therefore the workers need to be able to make or switch to other
machineries and produce more short skirts instead as an example.
3. Equipment and machineries need to be flexible
Having flexible equipment is a great benefit to the business since it could switch to creating
other products in s quick second / doesn’t take too long to do so. This wasn’t available in the
past where machineries are only able to make one piece of similar product in batches and
this is not suitable for JIT system because it would mean more stocks being piled up and risk
out of date or quality degrade of the products. Nowadays, a computer controlled one is
available where using a software, it’s able to control how many pieces of the products the
business wish to produce and mostly, they want to produce in small quantities only. This
keeps stock level to minimum.
However, this is not suitable for businesses who are short on capital or businesses who’ve
just opened because the equipment itself is expensive.
4. Accurate demand forecast would make JIT a much more successful policy
If the firm couldn’t forecast the demands right away for future sales then it is dangerous for
them to keep inventory stock level at zero. Therefore, demand forecast needs to be
converted into productions schedules that allow calculation of components for each type of
product and how much they should produce over a certain time period
5. Quality is everyone’s priority
There is no space for the business to make mistakes as they need to get it right in the first
time. If there’s a mistake and the product have a poor quality, it would mean that the
customers would receive their products late.
6. Employee – employer relationship is essential
Industry – related problems could lead to a break in supplies and stop the whole production
process. It is no coincidence that businesses that apply JIT policy in Japan and Europe has
made a no-strike deal with the major trade unions.

Advantages and disadvantages of JIT

Advantages
1. Capital invested in the inventory will lessen, as there is less space needed due to the JIT
system wherein finished products get delivered immediately without it being stored first.
Hence, opportunity cost will be lesser.
2. There will be less chance of the inventories going out-of-date and lesser chance of
wastage as none is being kept for storage.
3. Cost of storage and inventory holding will be lesser therefore, there’ll be more space
released from holding inventories that can be used for a more productive purpose.
4. The flexible system JIT requires means that the business should have a quicker response
to changes in customer’s demand.
5. Since multiskilled workers are required, the workers might also benefit from improved
motivation. This is because when workers are required to have the ability to switch between
one machinery to the other, it is closely related to job enrichment therefore by doing so, the
workers wouldn’t get bored quickly and their motivation rises.

Disadvantages
1. JIT requires lower inventory holding therefore, buying in bulk from suppliers is not
needed, this means the business will miss out on economies of scale that could’ve saved
them a ton of capital (due to discounts being offered)
2. Buying in small quantities means there would be higher delivery cost as products needs to
get delivered each time, one by one.
3. Administration cost would also be high as each small quantity orders needs to get
processed one by one.
4. The business’ reputation depends highly on external factors such as how reliable the
supplier is. If the supplier is not reliable and won’t be able to deliver the supplies on time it
means the business might have to delay their production and the customers wouldn’t
receive their products on time.

JIT evaluation
The JIT policy requires lesser stock holding inventories and there’s no surplus or buffer in JIT.
There is no room to make any mistakes as it would mean delay in delivering products to
customers. However, JIT may not be suitable for every firm as:
1. Small firms may argue that the IT system or equipment is expensive to purchase, and
especially to those who are just beginning to open their business. They don’t have enough
capital yet.
2. There may be limit to the application of JIT if the costs resulting from production being
halted when supplies do not arrive far exceed the costs of holding buffer inventories of key
components.
3. In addition, in the future when there’s a global inflation (prices will rise), holding stocks in
inventories will be more beneficial compared to buying it in smaller quantities. If the
business decides to buy in smaller quantities in the future where inflation has occurred
(meaning the price has somewhat risen compared to today), it’ll be more expensive. But, if
the business holds stock and buys in bulk even though inflation occurs in the future, it would
be cheaper as economic of scale could be offered so the inflation won’t affect it that much.