Inventory management deals with when to order and how much to order. It aims to minimize the total cost of inventories so as to generate high return.
If we hold more than the optimum level of inventory, we are incurring considerable opportunity cost because the funds are tied up in inventories. There are other explicit costs of holding inventory such as storage costs, insurance costs, etc. If we hold too little inventory we might have to place more orders and incur more communication and transportation costs. Then is another category of inventory costs: the stock out of costs. If we are too low inventories we might run out of stock and might not be able to lose sales and customers.
We have some tools to minimize the above mentioned costs. These include:
- Economic order quantity model
- Just-in-time system
Traditionally companies would keep high level of inventories in accordance with the just-in-case system .They would keep high inventories just in case they are faced with high demand. Such risk-averse companies intended to keep ordering costs and stock out costs low. In JIT system on the other hand companies try not to keep inventories in hand and order only when a sales order is received. Such a system is called pull system because inventories are pulled through the system by sales order received.
Written by Obaidullah Jan, ACA, CFA and last revised on