FACTORS THAT DETERMINE THE LEVEL OF INVENTORY HELD IN AN ORGANIZATION
Inventory management, or inventory control, is an attempt to balance inventory needs and requirements with the need to minimize costs resulting from obtaining and holding inventory.
The following is a list of reasons for maintaining what would appear to be "excess" inventory.
Meet customers demand.
In order for a retailer to stay in business, it must have the products that the customer wants on hand when the customer wants them. If not, the retailer will have to back-order the product. If the customer can get the good from some other source, he or she may choose to do so rather than electing to allow the original retailer to meet demand later (through back-order). Hence, in many instances, if a good is not in inventory, a sale may be lost forever.
Keep operations running.
A manufacturer must have certain purchased items (raw materials, components, or sub-assemblies) in order to manufacture its product. Running out of only one item can prevent a manufacturer from completing the production of its finished goods. Inventory between successive dependent operations also serves to decouple the dependency of the operations. A machine or work center is often dependent upon the previous operation to provide it with parts to work on. If work ceases at a work center, then all subsequent centers will shut down for lack of work. If a supply of work-in-progress inventory is kept between each work center, then each machine can maintain its operations for a limited time, hopefully until operations resume the original center
Lead-time is the time that elapses between the placing of an order (either a purchase order or a production order issued to the shop or the factory floor) and actually receiving the goods ordered.
If a supplier (an external firm or an internal department or plant) cannot supply the required goods on demand, then the client firm must keep an inventory of the needed goods. The longer the lead time, the larger the quantity of goods the firm must carry in inventory.
A just-in-time (JIT) manufacturing firm, such as Nissan in Smyrna, Tennessee, can maintain extremely low levels of inventory. However, steel mills may have a lead time of up to three months. That means that a firm that uses steel produced at the mill must place orders at least three months in advance of their need. In order to keep their operations running in the meantime, on-hand inventory of three months’ steel requirements would be necessary.
Inventory can also be used as a hedge against price increases and inflation. Salesmen routinely call purchasing agents shortly before a price increase goes into effect. This gives the buyer a chance to purchase material, in excess of current need, at a price that is lower than it would be if the buyer waited until after the price increase occurs.
Often firms are given a price discount when purchasing large quantities of a good. This also frequently results in inventory in excess of what is currently needed to meet demand. However, if the discount is sufficient to offset the extra holding cost incurred as a result of the excess inventory, the decision to buy the large quantity is justified.
Sometimes inventory is used to smooth demand requirements in a market where demand is somewhat erratic. Considering the demand forecasts and production schedules and use of inventory it allows the firm to maintain a steady rate of output by building up inventory in anticipation of an increase in demand. In essence, the use of inventory has allows the firm to move demand requirements to earlier periods, thus smoothing the demand.
A firm would purchase large stock of materials if there is a looming shortage that would take long time before supply gets back to normal. For instance, maize millers would purchase large stock of maize if it is predicted that rains would fail resulting in shortage in supply. To mitigate this, the firms would purchase the available stock to avoid interruptions and high prices during shortages.
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J. Mageto, Moi University, class notes - Materials handling and stores management, January 22, 2012