The main purpose of inventory is to enable an organisation to satisfy the demand for its goods from its customers.
To maximise the possibility of meeting customer demand, an organisation could hold large inventories. However, this approach would be extremely costly and impractical. To operate, warehouses incur the following costs:
- Staff
- Administration
- Security and insurance
- Inventory deterioration/depreciation
- Materials handling equipment
- Obsolescence
- Utilities
Decisions on inventory holding have a number of dimensions that need to be taken into account. These dimensions relate to the cost of ordering (acquisition costs) and the costs of holding stock. Low inventories reduce holding costs but increase acquisitions costs because the organisation must place higher volumes of orders with suppliers who in turn have to manufacture in smaller batch sizes. Conversely, high inventories reduce acquisition costs but increase holding costs. Indeed, inventory is a major investment and as such, it ties up cash which consequently cannot be used for other investments such as replacing machinery and other capital investments. Therefore an organisation must find an effective balance between acquisition costs and holding costs the level of investment to simultaneously meet financial objectives and satisfy customer demand.
The more inventory an organisation holds, the higher the holding costs. Inventory is a major investment and as such, it ties up cash which consequently cannot be used for other investments such as replacing machinery other capital investments. Therefore an organisation must balance the level of investment it makes in inventory with being able to satisfy customer demand effectively.
Below are some of the reasons an organisation holds inventory:
- To reduce customer lead time – finished goods which are “on-the-shelf” can be delivered to a customer quickly
- To reduce the risk of supplier failure – if a supplier is underperforming on its delivery metrics, an organisation may hold additional inventory temporarily until the supplier is replaced or its performance improves
- To support variations in customer demand – Holding inventory can ensure unexpected spikes in customer orders can be fulfilled without longer lead times
- To ensure rapid replenishment of products in high demand – Holding a large inventory of popular products ensures high demand can be met quickly
- To meet seasonal demand – holding inventory before the Christmas period for example, will ensure an organisation can meet the seasonal spike in customer orders
- To achieve discounted pricing – purchasing in larger volumes from suppliers to achieve lower pricing
- To avoid anticipated shortages or price increases – organisations can “hedge” against raw material shortages or price increases by holding sufficient inventory to cover a period until pricing levels drop or supply levels increase
- To avoid long lead times from suppliers – holding inventory ensures components are available for production immediately and avoids waiting for suppliers to deliver
- To counteract lack of flexibility in production and facilitate larger batch sizes
- To take advantage of short-term opportunities in a market
- To insure against demand uncertainty and inaccurate forecasting