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Is the cost of holding inventory justified?

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  • Is the cost of holding inventory justified?

    Inventory is an undesirable cost to the organisation at the same time organisations need the inventory to run their production plants and satisfy their ever demanding customers.

    Inventory categories range from raw materials, machinery spares, sub-assemblies, semi-finished and finished goods.

    Different industries, such as retail chain stores, manufacturing plants, mining even the banking sector, hold inventory for different purposes and reasons.

    Some of the reasons for holding inventory are;
    • Speculative purposes
    • Hedge against rising prices or possible shortages
    • Long supplier lead times
    • Uncertainty in supply market
    • "Forced" by suppliers just to benefit from quantity discounts
    • Poor inventory planning and inaccurate sales forecasts
    • Just to fill-up warehouse space
    • Warehouse focused production systems instead of customer oriented systems
    In as much as there are reasons for holding inventory, companies need to be prudent as the costs associated with holding such inventory might outweigh the benefits.

    Successful and competitive organisations are those who continuously work towards reducing their inventory levels. Such inventory management strategies have been used, Just-In Time, Materials Requirements Planning concepts, Vendor Managed Concepts, Consignment Stocks, all these are efforts to minimise holding inventory. The saying in procurement circles "inventory is evil" need to be justified.

    Heavy investment in inventory can expose companies to some of the following risks and deprive them of some of the much needed revenue to finance certain projects without borrowing from the bank due to cash liquidity constraints;
    • Insurance costs
    • Pilferage and theft
    • Obsolescence and redundancy
    • Cash flow distress
    • Security and warehouse facilities
    To achieve the balance, the buyer must have the ability to do a Cost-Benefit Analysis (CBA) on Total Cost of Ownership (TCO) and Total Cost of Acquisition (TCA).

    Economic Order Quantity (EOQ) formula provides the best of options on holding costs and ordering costs.

    "The higher the quantity ordered per order, the less the acquisition cost and the higher the inventory carrying costs." At the same time, "The less the quantity ordered per order, the higher the acquisition cost and the less the inventory carrying costs"

    It is this dilemma that the EOQ addresses.

    EOQ = 2 x annual usage x order cost/unit cost x carrying cost (square root)
    Last edited by andrewh; 08-07-2009, 11:20 AM.