Reasons for organisations to hold inventories
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Identify key Reasons for organisations to hold inventories. What factors may lead an organisation to change the level of inventories that it holds? How could such a decision affect the other elements of working capital?
Providing examples from real companies.
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SAMPLE ANSWER
The key decision in most retail and manufacturing industries is how much inventory they should hold. Inventory is by far the largest assets of the business. Furthermore, inventory levels, once established, becomes an important aspect of the business budgeting system. By definition, inventory is the total merchandise that a business has on hand. Inventory is also defined as itemized record or report of the stock that the company or business holds in hand. It includes a list of goods with their respective estimated worth. Making decision on the required inventory level involves establishing a delicate balance between three categories of costs: holding costs, ordering costs, and shortage costs. A company needs not only to hold but also to control its inventories.
The reason for holding inventory may vary significantly depending on the nature of business. The first basic reason for holding inventory is to meet the unexpected demands. Supply and demand chain comes into play here very significantly. Companies know that consumers expect goods whenever they need them. However, they are uncertain about the levels of future demand in the market at any given time. Thereby, businesses hold inventories in order to meet unexpected demands. Business also needs to smoothen the seasonal demands. Markets demands are directly influenced by different seasonal events. For examples, seasonal events such as Christmas and Easter celebrations directly increase the demands of most products. Retail outlets and other businesses need to keep inventories to meet the rising demands during these seasons (Saxena 2009).
Another significant reason for holding inventories is to take advantage of the discount prices. Usually, businesses get discount from manufacturers and suppliers if they buy in large bulk. Discounts are usually given in order to attract and maintain regular customers. It is very helpful for a business to take advantage of price discount by holding large inventories. However, the business does not need to overstock the inventory because it might lead to other failures by the business. Holding inventories also help businesses hedge against price fluctuations. Prices of goods and services often fluctuate due to the action of various market forces. However, by having good and efficient inventory system, the business is able to control the ever-fluctuating market prices.
Irrespective of the nature of business, a company cannot maintain a fixed level of inventory. Of course, a company needs to change the level of inventory that it holds quite often. Many factors may lead to changes in the inventory level. In most cases, company may experience increment in inventory due to late order deliveries, quality problems, unexpectedly increase in demand, and inaccurately forecasted lead-time. These factors are eh major factors that may make the business to change the level of its inventory. The most common one is unexpected changes in demand for goods and services. Businesses make changes to their holding inventory to match the existing level of demand.
Changes in the level of inventory directly affect other elements of working capital. This is because, in any organization, inventory is an important element of the working capital. Practically, proper management of the working capital depends on how the company manages its inventories. Furthermore, as illustrated by Muckstadt and Sapra (2010), holding inventory implies holding the working capital. Therefore, changes in the level of inventory are directly reflected by changes in the level of working capital. For example, if the company increases its level of holding inventory, then it must reduce the level of working capital and vice versa.
References
SAXENA, R. S. (2009). Inventory Management: Controlling In a Fluctuating Demand Environment. New Delhi, Global India Publications.
MUCKSTADT, J. A., & SAPRA, A. (2010). Principles of Inventory Management: When You are Down to Four, Order More. New York, Springer.
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