The right amount of inventory

- A fundamental decision for any company is how much inventory to have. There are really strong reasons to hold small inventories and equally strong reasons to hold larger inventories. It's the job of the inventory manager to weigh the advantages and the disadvantages of each choice. The primary reason for holding a smaller amount of inventory is because of the money invested in that inventory. This is driven by the inventory holding cost which is the total cost of keeping inventory before you sell it. You normally estimate inventory holding cost as an annual percentage, which typically is between five and 20% of the value of the inventory. To calculate this percentage, you total all holding costs and divide that by the value of your total inventory. Knowing this percentage value helps you to make decisions about future inventory levels. For example, companies that know they have holding costs of 20% are more likely to plan for much lower inventory levels. So what makes up inventory holding cost? It's the sum of four different values. First, there's the cost of capital the amount of money you paid for the materials parts or components that make your product and any interest associated with buying that inventory. You will also have to consider opportunity cost here because if you did not have that inventory you could have spent the money on something else. Inventory is a good investment only if it will yield your minimum financial return or more. Second, there are costs to store the inventory including space, labor, and insurance. The third cost is transportation of all materials, assemblies and final products from your suppliers to the final customer. In a global business economy transportation costs can be very high. Lastly, you must consider that the longer you hold inventory, the greater the risk that inventory will be damaged or lost or become spoiled or obsolete. While having a smaller inventory has its benefits there are valid reasons to consider holding higher levels of inventory. Let's consider some reasons to do this and like our reasons to hold smaller inventories. These are also related to costs. A stockout is the most important cost to consider because it means you lost the sale. If your product is not available for sale your customer will buy from your competitor even if your customer is willing to place a back order. This is not good customer service and you often have to offer a discount to compensate the customer for waiting. Holding more inventory can reduce your transportation costs because you can ship in full truckloads and with additional inventory available you seldom need expensive rush orders. Lastly, suppliers offer quantity discounts which give you a lower price per item if you buy large volumes. So can see there are advantages and disadvantages no matter which way you go. Smaller inventories or larger inventories there is no magic formula for calculating the right answer. It very much depends upon your company's strategies, your capacity, and your supply chain capabilities. Your job as an inventory manager is to find the right balance between these advantages and disadvantages for the specific product you are managing.