Why do companies keep inventory?

Introduction

Inventory management is an important practice for corporations. This is because it helps companies define what they can produce, produce it at the right time, and ensure effective distribution to the customers that need it. In this paper, the focus will be on understanding why companies keep inventory, factors that can influence the level of inventory kept, and how such decisions influence capital allocation in the company.

Why companies keep inventory

The main reason why companies keep inventory is to balance the difference between supply and demand. These differences occur due to the fact that:

• Demand is highly variable, and it is difficult to accurately estimate it.
• It is impossible for supply to be exactly planned as per demand because of other considerations that must be taken into place, such as economies of scale in production and purchasing in larger lots (Blanchard, 2010).

As a result, corporations keep inventory in order to build a strong wall (hedge) against declining service levels while also achieving economies of scale.

Factors that influence organizations to change the level of inventory held

The factors that influence an organization’s plan for required inventory emanate from both internal and external factors. Externally, such factors are demand- and supply-related. The supply aspects also include the supply chain (Chopra, 2006). These factors are as follows:

• Demand factors: when the demand for a given product increases, the company is forced to increase its inventory in order to ensure that such demands are effectively met. Without such records, the company may have difficulties monitoring and fulfilling orders. The reverse is also the case with reduced demand.
• Supply factors: as suppliers deliver new raw materials based on the company’s orders, an increase in supply will result in a subsequent increase in inventory. This is because it will ensure that the company does not keep surplus raw materials or incur costs due to poor inventory on the supply side. Additionally, the company utilizes this inventory to compare prices between suppliers and make supply decisions.

impact of inventory on working capital

Working capital is defined as the current assets and current liabilities of a company, and it measures the short-term liquidity of such a company. When a company records negative working capital, the implication is that such a company will not be able to repay its short-term liabilities via available liquid assets in the company.

In order to maintain solvency, a company must fight to maintain a positive working capital while also reducing expenses. The level of inventories in a supply chain does influence the level of other working capital accounts (cash and receivables) (Gupta, 2008; Hugos, 2003; Iocco, 2009). The influence inventories can have on companies depends on the industry they operate in. Take Walmart in the retail industry, for instance. The company operates with minimal credit sales, so an increase in invoice will be offset by minimal receivables, generating quicker cash in the process. On the other hand, in industries that have higher credit sales, such as HP and Dell (typical within the B2B environment), an increase in inventory does have the chance of resulting in a cash crunch and impacting solvency in the process. Thus, the more credit a company keeps, the greater the negative influence of inventory on its working capital (that is to say, the less cash it will have to operate its business).

Conclusion

In conclusion, keeping inventory is necessary in companies because it helps to regulate the level of demand as compared to the level of supply in the company. This reduces waste resulting from either excess production or surplus raw materials. Furthermore, inventories have an impact on working capital in the sense that the more credit inventory a company maintains, the less working capital it has to operate its businesses.

1.      Reference

Blanchard, D. (2010). Supply Chain Management Best Practices. John Wiley & Sonc.

Chopra, P. M. (2006). Supply Chain Management. Pearson.

Gupta, H. (2008). Network Design and Safety Stock Placement For a Multi-Echelon Supply Chain. MIT .

Hugos, M. (2003). Essentials of Supply Chain Management. John Wiley & Sons.

Iocco, J. D. (2009). Multi-Echelon Multi-Product Inventory Strategy in a Steel Company. MIT PhD Thesis.