Managing inventory

34.1 Types of inventory

Manufacturing firms hold three types of inventory. These are:

• raw materials and components: these are the stocks the business has purchased from outside suppliers; they will be held by the firm until it is ready to process them into its finished output
• work in progress: at any given moment, a manufacturing firm will have some items it has started to process but that are incomplete; this may be because they are presently moving through the production process; it may be because the firm stores unfinished goods to give it  some flexibility to meet consumer demands.
• finished goods.

The firm's costs increase if it holds more stock. However, this needs to be set against the opportunity cost of keeping too little stock, such as not being able to meet customer demand. One theory is that a firm should try to keep as little stock as possible at all times (JIT). The firm must keep control of all the different types of stock to ensure that it runs at peak efficiency.

34.2 Influences on the amount of inventory held

A firm can hold too much or too little stock. Both cases will add to costs of the firm. Too much inventory will lead to:

• opportunity costs: holding the firm's wealth in the form of stock
• cash flow problems: holding the firm's wealth will caused problems if they're slow selling
• increased storage costs: as well as the rent, insurance, money in stock
• increased finance costs: if the capital needs to be borrowed, the cost of that capital will be a significant overhead
• increased stock wastage: the more stock is held, the greater the risk of it going out of date.

This does not, however, mean that the business is free to carry very low stocks. Too little inventory may lead to:

• Lost orders
• Worker downtime if essential components have been delayed in arriving from suppliers
• The loss of the firm's reputation and any goodwill it has been able to build up with its customers.

The total cost of inventory to the firm will therefore be a combo of these factors. As the level of inventory grows, the costs of holding that stock will increase, but the costs of being out of stock will increase, but the costs of being out of stock decrease.

For a firm, the optimum level of stock to hold will be where the total costs of holding stock are the lowest.

34.3 Inventory control charts

One way in which a firm analyses its stock situation is by using an inventory control chart. The line graph looks at the level of stock…