September 13, 2005
A Simplified Look at the Pros and Cons of Inventory
I'm selling it sooner or later anyway, aren't I?
I spend so much time working with inventory that I often
forget how confusing it can be to beginners. The most common mistake, and the one I made when I first started
learning about inventory, is that it shouldn't matter how much you have because
you're going to sell it sooner or later anyway. In a sense, this is true. Even if
you turn your inventory over once every 3 years, you are selling all of it and
the inventory helps to prevent stock outs and backorders. However, there are some serious costs to
holding inventory.
Anytime inventory is held, there are holding costs. Holding costs are simply the costs that are
incurred just by holding onto inventory. These costs can come from a variety of sources. Here are just a few common costs associated
with high levels of inventory:
Higher rent from increased need for extra warehouse space to
hold extra inventory.
Higher premiums needed to insure extra inventory.
Potentially, the inventory could spoil, expire, or become
outdated and lose value.
Oppurtunity costs. What else could you have invested the money and warehouse space in had
you not been spending it on inventory?
Remember, companies have a limited amount of assets
available to them. These assets are
aquired from money raised through equity and debt. Excessive inventory is a misuse of these
assets because it essentially an investment in something that is just going to
sit around.
So why hold inventory?
The simple answer is that inventory is held in order to fill
unexpected changes in demand and deliveries from suppliers. If there were never
any changes in demand and if suppliers could constantly deliver supplies in the
quantities needed, then there would be no need for inventories (excluding work
in process inventories and negligible day's end inventories waiting for
outbound shipping).
However, demand does fluctuate, as do lead times from
suppliers. Because demand fluctuates
companies are not sure how much of a certain good to produce on a given
day. Companies can make predictions, but
the fact of the matter is, predictions typically only give a rough estimate of
what will be needed on any particular day. One solution to this problem is to maintain a workforce with a very high
unutilized capacity and to simply not use it most of the time, but to have it
available in the event of a day with high demand. The other solution is to carry inventory.
Inventory is a way or preserving excess capacity. On the days when demand was light, the
workforce overproduced. Their work was
stored as inventory and now if there is a day with very high demand that is
beyond the capacity of the workforce, the inventory is there as a safety net
against backorders.
So why not hold loads and loads of inventory?
Well, don't forget about those damn holding costs.
So why not maintain a workforce with a ton of slack
capacity?
As much as the work staff would enjoy this, you can imagine
this would be very expensive to maintain.
(On a side note, this is essentially what service sectors of
the economy have to do. I remember I
worked as a hotel valet when I was younger and there would be plenty of times
when it would be so dead I wouldn't park a car for hours. But when it got busy, boy would it get
busy. You can't inventory services and
the ramifications of a stock out (in this case that would mean that there is no
one to get your car) are too costly to deal with in many service positions.)
So how much inventory should I hold?
This is subject to a wide variety of conditions. Simply put, you need to evaluate your holding costs, your backorder costs, and your demand. From there, it gets pretty tricky and I unfortunately already named this article "A Simplified Look at the Pros and Cons of Inventory" so as much as I'd like to help you, my hands are tied...what with the tiltle already being up and all. Luckily some of my previous posts deal with some of the mathematics involved in determining some facets of optimized inventory levels.
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Comments
We have over 2000 parts in inventory. Rather than calculcating the EOQ with the formula, which I do not have time to do, I want to use the "rough estimate." What are the factors that go into the material's "actual value per year?
Posted by: Dave S | Jul 6, 2006 1:06:28 PM
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