Topic 6.

Inventories

Introduction

Companies have the need to generate inventories to cover market requirements, as

demand is generally unpredictable. Imagine everything involved in producing goods:
production managers have to calculate how much material is required to meet
manufacturing forecast.

Production plan is based on a prediction of the requirements the market will consume,
and despite this prediction being based on market statistics, the company must be
prepared for surges in demand in order not to miss that opportunity for sales growth.

All the above gets more complicated when the company is serving different markets in
different regions, with a range of different products at the same time. Ideally the
company could have a big inventory to make sure they supply the market
independently of sudden changes in demand but remember that inventory is an
investment on working capital paid by the company, and it is only recovered once the
goods are sold. Thus, inventory levels should be kept as low as possible without
missing opportunities to satisfy the market demands; can you imagine now the
complexity of inventories?

6.1 Justification of inventories and types of inventories

 Inventories are units of products a company
accumulates with the purpose of meeting the demand of its market, and whose
existence is derived from the uncertainty of the extent clients will require products, and
the difficulty to forecast demand.

Financially, inventories are a type of working capital recorded in the company's books
as circulating assets. This means that, although the inventory requires the company
spending to produce, acquire, or maintain it, this is not an expense, but an investment
on assets that will be recovered upon selling the merchandise, in most cases with a
return or profit additional to the capital invested on them.

That being said, and inventory being an investment stationed in the company's
warehouse, it becomes very important to plan inventories correctly for their levels to
be as close to potential sales in the short term, thus allowing the company to have a
constant cash flow, obtaining return on investment and reinvesting on inventory to
satisfy the demand of the following period.

The main foundation of inventories is meeting market demand, which translates

mainly into customer service. The higher the product availability, the higher the
efficiency in response time to satisfy client needs, which improves the way the market
perceives the service, which means higher customer loyalty and increased sales.

There are five main inventory types:

Inputs or raw materials

This type of inventory refers to the accumulation of all those materials used in the production process of the finished product, the
commercialization of which is not regularly part of the company operations. They are just consumed for the creation of the product or
the company offers as part of its major business.
Work in progress
This is inventory found in the process of producing the end product or in transition from some intermediate transformation process.
Finished goods
This is the end product ready for commercialization. It may be found on the facility’s production area, in company warehouses, in stra
distribution centers, in loading yards, or displayed in a store.
In transit
This type of inventory is that located in the modes of transportation contracted or operated by the company in some of its sections, wh
the production plant, to one of its warehouses or distribution centers, or to the intermediary or end customer. It may be finished produ
product in progress, raw material, or inputs.
In consignment
This type of inventory is that found in the facilities of a distributor; however, they are still the property of the manufacturer or market
the distributor commercializes the product, they report the sale to the manufacturer, and accounts are reconciled. Generally, the consig
time is limited, and after concluding the term, the distributor is obligated to purchase the merchandise.
6.2 Inventory costs

Inventory-related costs require special attention due to three main reasons:

1. They generally represent a significant percentage of logistics costs.

2. Due to the direct impact of inventories on customer service level, it is necessary
to compare the benefits of increasing the customer service level against
increasing costs of maintaining a higher inventory level.
3. There is an inverse relation between transportation and inventory costs, that is,
as inventory costs decrease, transportation costs increase by covering the
decrease of inventory levels, therefore, it is necessary to reach an equilibrium
point.

The focus on costs related to inventories has led specialists to classify them according
to the process or activity for which they are generated. Coyle (2018) mentions the
following classification:

1. Inventory maintenance cost: These are the costs related to waiting for the
product to be used or commercialized.

a. Capital cost: It is known as opportunity cost. It is defined as the lost

opportunity of investing capital in something other than unused
inventory.
b. Storage room cost: Refers to the management costs associated to the
warehouse, such as rentals, utilities, and salaries, and related with the
space used during the time the inventory is maintained.
c. Inventory service cost: Related to the taxes applied by governments on
inventories and insurance premiums the company incurs to maintain
them.
d. Inventory risk cost: Refers to the risks of irrecoverable damage,
obsolescence risks, or theft risk.
 2. Ordering and preparation costs: These are secondary costs generated
additionally to the cost of products upon ordering or preparing production of
end products.

a. Ordering cost: Costs associated with placing orders comprising the

order preparation process, payment, special information systems, bank
commissions, among others.
b. Preparation cost: Cost associated with the preparation of the
production line to manufacture the article in the assembly line.

3. Expected stock-out cost: Cost related with having insufficient material or

product to continue production or to close a sale with a client. It is calculated as
lost sales cost.

4. Cost of inventory in transit maintenance: Costs incurred when inventories are

in transit, such as storage costs, customs duties, customs brokers fees,
maneuvering, special packaging, among others.

Conclusion

Given the uncertain conditions in market demand, and the need of companies to be
prepared for surges in customer requisitions, inventories are necessary. The
fundamental point of the efforts of a company in managing their inventories lies on
the capacity to operate efficiently and effectively with the minimum inventory level
possible due to the cost it represents for the company.

Even though having inventories generates a series of additional logistics costs,

companies find equilibrium points used to determine the level of inventories they can
maintain so the potential benefits they would have outweigh the costs associated with
them.