Benefits and Costs of Carrying Inventories
Pilling of sufficiently large quantities of stock of raw material. work-in process and finished goods in considered desirable to provide flexibility in business operations of a firm. If a firm is assured of regular supply of raw materials at a rate identical with the rate of production, there would be no need to hold inventory of materials at all. In real world, supply of material is uncertain and source of supply of some materials may be seasonal. Procuring material is also time consuming process. Thus to ensure uninterrupted production and to avoid catastrophe of breakdown of whole operation, the firm must carry as inventory of raw materials. Furthermore, purchase of materials in huge quantity will be economical, resulting in substantial savings in the cost of goods sold. A firm with sufficient stock of materials in hand is also relieved of the dangers of breakdowns in the production process. This further minimizes cost of production.
There would also have been no need for a firm to hold finished goods inventory if the firm could sell its finished goods at the same rate at which production was taking place. Since the production runs cannot be synchronized with vagaries of customer’s demand. the firm must stockpile sufficiently large quantities of finished goods so as to avoid risks of losing customers who cannot wait for delivery and hence the opportunity cost of not being able to till and order on a timely basis. Furthermore, firm with big stock of sudden pick up in demand of the firm’s product which would otherwise be lost. Inventories of finished goods are also needed when production schedule must be geared to the supply of materials. Above all, long production runs have been found economical since they reduce the number of times the set-up costs must be incurred Cost of depreciation is also spread over a larger number of units.
The above discussion peters out that it would be advantageous to order at one rate, produce at another and sell at a third rate so that each function is performed as independently as possible and at the optimal level of efficiency.
But carrying inventories is not free from cost. A firm has to incur a host of costs to hold stocks, such as, capital costs, service costs and storage costs. Some of these costs are fixed while others are variable. Cost of capital tied up and inventory service costs such as handing, taxes, insurance, record keeping, obsolescence and spoilage are variable costs which tend to increase in correspondence with rise in the size of inventory holding. As against this, storage costs such as cost of heat and light, janitorial service, ware house, labour, and depreciation are fixed costs in the short run and do not change in response to variation in size of inventory holdings. There are also certain risks cost associated with different kinds of inventory, for example, the risk resulting from price fluctuation and the risk of obsolescence. Besides, the firm has to incur acquisition cost to affect delivery of inventory items to the firm. Such costs include order costs which comprise, costs of preparing and processing requisitions, purchase orders and other kinds of administrative paper work relating to placement of order to supplier will be the same regardless of size of orders. However, larger orders will mean that the firm will have to acquire inventory less frequently and hence reduce its total acquisition costs. The same is true of production runs also.
Thus, if added costs in carrying additional inventory outweigh the benefits of holding the inventory, the firm should drop the idea of stockpiling additional quantities of materials. Conversely, if cost of stock pilling added quantities of materials is less than what they save, inventory holding will be desirable, Thus, the basic problem facing the finance manager in a firm is that of determining the level of inventory that will provide maximum benefits at minimum costs. The decision to determine the optimal level of inventory in a firm therefore, involves balancing of the benefits derived from inventory availability against the costs and risk of carrying the amount of inventory. We shall now delve into the technique of determining the optimal size of inventory.