What is the “right” level of inventory? This is one of the most important decisions an inventory manager must make. In this video, Steven explains the advantages and disadvantages of maintaining both large and small inventories.
- A fundamental decision for any company is how much inventory to have. There are really strong reasons to hold small inventories and equally strong reasons to hold larger inventories. It's the job of the inventory manager to weigh the advantages and the disadvantages of each choice. The primary reason for holding a smaller amount of inventory is because of the money invested in that inventory. This is driven by the inventory holding cost which is the total cost of keeping inventory before you sell it.
You normally estimate inventory holding cost as an annual percentage, which typically is between five and 20% of the value of the inventory. To calculate this percentage you total all holding costs and divide that by the value of your total inventory. Knowing this percentage value helps you to make decisions about future inventory levels. For example, companies that know they have holding costs of 20% are more likely to plan for much lower inventory levels.
So what makes up inventory holding cost? It's the sum of four different values. First, there is the cost of capital, the amount of money you paid for the materials, parts, or components that make your product, and any interest associated with buying that inventory. You will also have to consider opportunity costs here because if you did not have that inventory, you could've spent that money on something else. Inventory is a good investment only if it will yield your minimum financial return or more.
The second, they're our cost to store the inventory, including space, labor, and insurance. The third cost is transportation of all materials, assemblies, and final products from your suppliers to the final cutomer. In a global business economy, transportation costs can be very high. Lastly, you must consider that the longer you hold inventory, the greater the risk that inventory will be damaged, or lost, or become spoiled or obsolete. While having a smaller inventory has its benefits, there are valid reasons to consider holding higher levels of inventory.
Let's consider some reasons to to this. And like our reasons to hold smaller inventories, these are also related to cost. A stockout is the most important cost to consider because it means you've lost the sale. If your product is not available for sale, your cutomer will buy from your competitor. Even if your cutomer is willing to place a backorder, this is not good cutomer service. And you often have to offer a discount to compensate the cutomer for waiting. Holding more inventory can reduce your transportation costs because you can ship in full truckloads.
And with additional inventory available, you seldom need expensive rush orders. Lastly, suppliers offer quantity discounts which give you a lower price per item if you buy large volumes. So you can see, there are advantages and disadvantages no matter which way you go, smaller inventories or larger inventories. There's no magic formula for calculating the right answer. It very much depends upon your company strategies, your capacity, and your supply chain capabilities.
Your job as an inventory manager is to find the right balance between these advantages and disadvantages for the specific product you're managing.
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