What is Inventory

Inventory is the stock of any item or resource used in an organization. This implies that all organizations carry some inventory or stock of goods at any time. Inventories range from items such as stationery to machinery parts or raw materials. Generally, organizations with activities centered on products or manufacturing processes have more inventory and need to develop more controls and systems than organizations where the service/product mix is oriented more to the service end of the service/product continuum. It has been estimated that a typical firm has about 30 percent of its current assets and perhaps as much as 90 percent of its working capital invested in inventory. Apart from the cost of inventory, the use of excessive inventory can lead to other issues such as the disruption of work flow and hiding problems related to product quality and equipment breakdown. To address these issues and therefore help management keep the cost down while still meeting production and customer service requirements, an efficient inventory system is needed.
Based on an efficient inventory system, inventory is expected to serve several functions that in turn can add flexibility to a firm’s operations. Among the most important are the following: to meet anticipated customer demand, to smooth production requirements, to de-couple operations, to protect against stock-outs, to take advantage of order cycles, to hedge against price increases, and to take advantage of quantity discounts.
To accommodate the functions of inventory, firms maintain different types of inventories. Inventory can be classified by location and type. Based on the location, inventory can include raw material inventory, work-in-process inventory, maintenance/repair/operating supply (MRO) inventory, and finished-goods inventory. Inventory classification by type provides a method of identifying why inventory is being held and so suggests policies for reducing its level. Inventory types include buffer/safety, cycle, de-coupling, anticipation, and pipeline/movement.
In making any decision that affects the size of different types of inventory, four basic costs need to be taken into account: holding or carrying costs, setup or production change costs, ordering costs, and shortage costs. Holding costs relate to physically having items in storage. They include the costs for storage, handling, insurance, pilferage, spoilage, breakage, obsolescence, depreciation, taxes, and the opportunity cost of capital. Obviously, high holding costs tend to favor low inventory levels and frequent replenishment. Typical annual holding costs range from 20 percent to 40 percent of the value of an item. Holding costs are stated in either of two ways: as a percentage of unit price or as a dollar amount per unit. Setup costs are the costs to prepare a machine or process for manufacturing an order or changing from one product to another. That is, to make each different product, it is necessary to obtain the required materials, arrange specific equipment setups, fill out the required papers, and move out the previous stock of material. Ordering costs refer to the managerial and clerical costs to prepare the purchase or production order. Finally, shortage costs are the costs resulting from stock-out or when demand exceeds the supply of inventory on hand. For instance, lost profits, the effects of lost customers, or late penalties are examples of shortage costs.
Having discussed the nature, functions, types, and costs associated with inventory, it is of paramount importance for a firm to know how much inventory to keep in stock or to order. In order to answer this question, it is assumed that demand for an item is either independent of or dependent on the demand for other items. In dependent demand, the need for any one item is the direct result of the need for some other item, usually a higher-level item of which it is part. In independent demand, the demands for various items are unrelated to each other. Dependent demand is a relatively straightforward computational problem. That is, needed quantities of a dependent-demand item are simply computed, based on the number needed in each higher-level item in which it is used. For example, if an automobile company plans on producing 100 cars per day, then obviously it will need 400 wheels and tires (plus spares). The number of wheels and tires needed is dependent on the production levels and it is not derived separately. The demand for cars, on the other hand, is independent and unrelated to the demand for other products. Here firms usually turn to their sales and market research departments and other various internal and external sources. Because independent demand is uncertain, extra units must be carried in inventory.
To determine how many units need to be ordered, and how many extra units should be carried to reduce the risk of stocking out, several classes of models can be used: economic order quantity (EOQ)/economic production quantity (EPQ)/quantity discount, reorder point (ROP), fixed order interval, and single period models. The question of how much to order is determined by using EOQ/EPQ or the quantity discount model. The question of when to order is answered by ROP when the quantity on hand of an item drops to a predetermined amount. Fixed-order-interval is used when orders must be placed at fixed time intervals (weekly, twice a month, etc.). Finally, the single-period model is used to handle ordering of perishables (e.g., fresh fruits, vegetables, seafood, cut flowers) and items that have a limited useful life (e.g., newspapers, magazines).
In short, inventories are a vital part of business. Not only they are necessary for operations, but also they contribute to customer satisfaction. The overall objective of inventory management is therefore to achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds. In doing so, management has two basic functions concerning inventory: to establish a system of keeping track of items in inventory, and to make decisions about how much and when to order. More specifically, to be effective, management must have the following: a system to keep track of the inventory on hand and on order (i.e., inventory counting systems that are periodic and perpetual), a reliable forecast of demand that includes an indication of possible forecast error (i.e., use of point-of sale or POS systems), a knowledge of lead times and lead time variability, reasonable estimates of various inventory costs, and a classification system for inventory items (i.e., use of A-B-C approach that identifies inventory items according to some measures of importance and then allocates control efforts accordingly).