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Maintaining inventories involves tying up of the company’s funds and incurrence of storage and handling costs. There are three general motives for holding inventories.

1. Transactional motive:

It emphasizes the need to maintain inventories to facilitate smooth production and sales operations.

2. Precautionary motive:

It necessitates holding of inventories to guard against the risk of unpredictable changes in demand and supply forces and other factors.

3. Speculative motive:

It influences the decision to increase or decrease inventory levels to take advantage of price fluctuations. It is not possible for the company procure raw materials whenever it is needed.

A time lag exists between demands for material and its supply. Also there exists uncertainty in procuring raw materials in time on many occasions. The procurement of materials may be delayed because of such factors as strike, transport disruption or short supply. Therefore, the firm should maintain sufficient stock of raw material at a given time to streamline production. Other factors, which may necessitate purchasing and holding of raw materials are quantity discounts and anticipated price increase. The firm may purchase large quantities of raw materials than14 needed for the desired production and sales levels to obtain quantity discounts of bulk purchasing. At times, the firm would like to accumulate raw materials in anticipation of price rise. Work-in-process inventory builds up because of the production-cycle. Production-cycle is the time span between introduction of raw material in to production and emergence of finished goods at the completion of production-cycle. Till production-cycle completes stock of work-in- process has to be maintained.

Stock of finished goods has to be held because production and sales are not instantaneous. A firm cannot produce immediately when the customer demand goods on a regular basis, their stock has to be maintained. Stock of finished goods has to be maintained for sudden demand from customers. In case the firm’s sales are seasonal in nature, substantial finished goods inventories should be kept to meet the peak demand. The level of finished goods inventories would depend upon the coordination between sales and production as well as on production time.

RISK AND COSTS OF HOLDING INVENTORIES

Managing inventories to increase net income requires effectively managing costs that fall into the following five categories:

1. Purchasing Costs:

The cost of goods acquired from suppliers, including incoming freight or transportation costs. These costs usually make up the largest cost category of inventories

2. Ordering Costs:

The cost of preparing and issuing purchase orders, receiving and inspecting the items included in the orders and matching invoices received, purchase orders and delivery records to make payments. Ordering costs include the coast of obtaining purchase approvals, as well as other special processing costs.

3. Carrying Costs:

These are the costs that arise, while holding inventory. Carrying costs include the opportunity cost of the investment tied up in inventory and the cost associated with storage; such as space rental, insurance, obsolescence and spoilage.

4. Stock out Costs:

These are costs that result when a company runs out of a particular item for which there is customer demand. A company may respond to a stock out by expediting an order from a supplier. Expediting costs of a stock out include the additional ordering costs plus any associated transportation costs. Or the company may lose sales due to the stock out. In this case, the opportunity cost of the stock out includes the lost contribution margin on sales not make due to the items not being in the stock, plus any contribution margin lost on future sales due to customer will caused by the stock out.

5. Capital Costs: Maintaining of inventories results in blocking of the firm’s financial resources. The funds may be arranged from own resources or from outsides. In the former case, there is an opportunity cost of investment while in the later case; the firm has to pay interest to the outsides.

6. Storage and Handling costs: The storage costs include the rental of the godown, insurance charges, etc.

7. Risk of Price Decline: This may be due to increased market supplies, competition or general depression in the market.

8. Risk of Obsolescence: The inventories may become obsolete due to improved technology, changes in requirements, change in customer’s tastes, etc.

9. Risk Deterioration in Quality: The quality of the materials may also deteriorate while the inventories are kept in store.

OBJECTIVE OF INVENTORY MANAGEMENT:

In the context of inventory management the firm is faced with the problem of meeting two conflicting needs.

 To maintain a large size of inventories of raw material and work-in-process for efficient and smooth production and of finished goods for uninterrupted sales operations.

 To maintain a minimum level of investment in inventories to maximize profitability.

The objective of inventory management should be to determine and maintain optimum level of inventory investment. To optimum level of inventory will lie between the two danger points of excessive and inadequate inventories. The firm should always avoid a situation of over investment or under investment in inventories.

The major dangers of over investment are:

a) Unnecessary tie up of the firm’s funds and loss of profit and opportunity costs. b) Excessive carrying costs

c) Risk of liquidity.

The consequences of under investment in inventories are: a) Production hold ups, and

b) Failure to meet delivery commitments.

Thus, efforts should be made to place an order at right time with the right source to acquire the right quantity at the right price and quantity. An effective inventory management should

 Ensure a continuous supply of raw material to facilitate uninterrupted production.  Maintain sufficient stocks of raw materials in periods of short supply and

anticipated price changes.

 Maintain sufficient finished goods inventory for smooth sales operations and efficient customer services.

 Minimize the carrying costs and time, and Control investment in inventories and keep it at an optimum level.

TOOLS & TECHNIQUES OF INVENTORY MANAGEMENT AND