Inventory Management I: Meaning, Objectives and Costs
Course: Corporate Finance / Operations Management
Lecture: 3 – Inventory Management I
1. Meaning of Inventory and Inventory Management
Inventory refers to all goods and materials that a business holds for future use or sale. It typically includes:
- Raw materials: Inputs yet to be processed in production.
- Work‑in‑process (WIP): Partially completed products still in the production cycle.
- Finished goods: Completed products ready for sale to customers.
Inventory management is the process of planning, ordering, storing, and controlling these items so that the right quantity is available at the right time and at minimum cost. Effective inventory management balances service levels (avoiding stockouts) with cost control.
2. Objectives of Inventory Management
Key objectives of inventory management include:
- Avoid stockouts: Ensure enough inventory is available to meet production requirements and customer demand, preventing production stoppages and lost sales.
- Minimize costs: Keep total inventory‑related costs (ordering, carrying, and stockout costs) as low as possible without harming service levels.
- Ensure uninterrupted production and sales: Maintain a smooth flow of materials into production and finished goods to customers, supporting stable operations and customer satisfaction.
In simple terms, the aim is to hold “enough, but not too much” inventory.
3. Types of Inventory Costs
There are three major categories of inventory‑related costs:
3.1 Ordering costs
Ordering costs are the costs incurred each time an order is placed with a supplier. They usually do not depend on the order size.
- Preparing and processing purchase orders.
- Communication and follow‑up with suppliers.
- Transportation and handling per order.
- Receiving, inspection, and paperwork on delivery.
3.2 Carrying (holding) costs
Carrying costs are the costs of holding or storing inventory over a period of time.
- Warehouse rent, utilities, and staff salaries.
- Insurance and security for stored goods.
- Spoilage, damage, theft, or obsolescence of items.
- Opportunity cost of capital tied up in inventory.
Carrying costs generally increase with the level of average inventory.
3.3 Stockout costs
Stockout costs arise when inventory is insufficient and the firm cannot meet demand.
- Lost sales and profit contribution.
- Emergency purchases at higher prices or rush freight.
- Production stoppages and idle labour or machines.
- Loss of customer goodwill and future business.
Although stockout costs are hard to measure precisely, they are crucial when setting inventory policies.
4. Overview of Inventory Control Techniques
This lecture introduces three important inventory control techniques at a high level. Detailed calculations will be covered in Lecture 4.
4.1 Economic Order Quantity (EOQ)
EOQ is a basic model that determines the order size which minimizes the total of ordering and holding costs. It answers the question: “How many units should we order each time?”
4.2 ABC analysis
ABC analysis is a selective inventory control method that classifies items into three groups based on their value or annual consumption value:
- Category A: High‑value items, usually low in quantity.
- Category B: Moderate value and quantity items.
- Category C: Low‑value items, usually high in quantity.
Management gives the highest attention and tightest control to A items, moderate control to B items, and simple controls to C items.
4.3 Just‑in‑Time (JIT) system
Under a JIT system, materials are delivered “just in time” for production or sale, and inventory levels are kept as low as possible. JIT reduces inventory carrying cost and waste, but it requires very reliable suppliers and accurate demand forecasting.
5. Classroom Discussion: Problems from Excessive Inventory
Discussion prompt for students: What problems can arise when a company holds excessive inventory?
Possible points include:
- Higher carrying costs for storage, insurance, and capital.
- Increased risk of damage, spoilage, theft, or obsolescence.
- Lower return on assets because too much capital is tied up in stock.
- Operational inefficiencies being hidden by “too much” safety stock.
- Less flexibility if market demand or technology changes quickly.
6. Homework – Lecture 3
Task: Identify inventory types in a manufacturing company
- Select a local manufacturing firm (for example, a textile, food processing, or pharmaceutical company).
- List at least three examples each of raw materials, work‑in‑process, and finished goods for that firm.
- In 150–200 words, explain why effective inventory management is important in that specific industry.
Related lecture
In the next lecture, we will calculate Economic Order Quantity (EOQ), determine reorder levels, and apply ABC analysis in detail:
){kind=link}
0 Comments