Page 427 -

PRINCIPLES OF INVENTORY MANAGEMENT 407

the company may well lose sales if demand is higher than expected as customers may
not be prepared to wait until new stock arrives in the stores.
A second role of inventory is to help organizations cope with seasonal or cyclical
demand for items. Demand for many products follows such a pattern: sales of toys
increase at Christmas; sales of the latest Xbox from Microsoft will follow a typical
product life cycle; sales of garden products will increase in the Spring; sales of fuel
will increase at holiday time as motorists go on holiday. The companies producing
such products are unlikely to have the production capacity to meet maximum
seasonal demand so they will need to schedule their production over the year in
order to increase stocks of an item during periods of low demand and then, using
this buffer stock, to meet demand when it exceeds production capacity. (We looked
at how to do this in Chapters 2 and 4 where LP was used to determine an optimum
production schedule over time.)
A third role of inventory is to help organizations reduce, or manage, risk. An
organization might anticipate a risk of disruption to its supplies of some item and
may therefore decide to increase its buffer stocks now. For example, a high street
retailer considers that one of its key suppliers may face the prospect of industrial
action from its workforce so it increases its buffer stocks now in anticipation of
such a situation. Alternatively, an organization might anticipate the risk of an
imminent price increase for some product that it buys for its suppliers so increases
buffer stocks now to minimize the future effect of this. An airline, for example,
might anticipate a rise in the global price of aviation fuel, or even fuel shortages,
in the near future because of increased military conflict in the Middle East so
buys buffer stocks of fuel now. Similarly, a manufacturing company might keep
buffer stocks of work-in-progress inventory as part of a multi-stage manufacturing
process.
A fourth important role of inventory is to take advantage of price discounts. A
supplier may be willing to offer a large discount if we purchase in bulk, allowing us
to pass low prices on to customers and increase market share and customer loyalty.

Inventory Costs

There are typically three critical costs involved in inventory management. The first
of these, holding costs, refers to the costs associated with holding or carrying a
given level of inventory. Effectively, the more stock you hold the bigger the holding
cost incurred by the organization. Holding costs are made up of a mixture of other
costs. The cost of financing the inventory is one of these. If the organization has
borrowed the money to buy the stock it is holding then it will incur interest charges.
If the organization uses its own money, there is an opportunity cost involved since,
by definition, the money tied up in stock could have been invested elsewhere to
generate income. So, in both cases there is a cost of capital incurred usually
expressed as a percentage of the amount tied up in the stock cost. Other costs that
contribute to the holding cost include storage costs (perhaps warehouse rent,
heating/refrigeration, security, insurance); depreciation; obsolescence as stock
Calculating inventory becomes out of date; product deterioration; pilferage. Holding costs are normally
costs accurately can be a calculated in one of two ways. The first is to calculate the total holding costs
major task in many
organizations as the incurred by the organization over a given period of time, normally a year, and
component costs may then average these per unit of stock. This would be shown as, for example, E10 per
not be readily visible. unit per year. Alternatively, the holding cost may be shown as a percentage of
the value of the stock item – for example holding cost is 10 per cent of the stock
value.
The second type of cost involved in inventory management is ordering cost.
Ordering costs are those costs involved in actually placing an order for more

Copyright 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.