Why Hold Inventory

Formulation of an inventory policy requires an understanding of the role of inventory in manufacturing and marketing. Inventory serves five purposes within the firm: (1 ) it enables the firm to achieve economies of scale; (2) it balances supply and demand; (3) it enables specialization in manufacturing; (4) it provides protection from uncertainties in demand and order cycle; and (5) it acts as a buffer be­tween critical interfaces within the channel of distribution.

Economies of Scale. Inventory is required if a firm is to realize economies of scale in purchasing, transportation, and/or manufacturing- For example, raw materials inventory is necessary if the manufac­turer is to take advantage of the per-unit price reductions associated with volume purchases. Purchased materials have a lower transportation cost per unit if ordered in larger volumes. This lower per-unit cost results because truckload and full railcar shipments receive lower transportation rates than smaller ship­ments of less than truckload (LTL) or less than carload (LCL) quantities.

The reasons for holding finished goods inventory are similar to reasons for holding raw materials in­ventory. Transportation economies are possible with large-volume shipments, but in order to take, advan­tage of these more economical rates, larger quantities of finished goods inventory are required at manufac­turing locations and field warehouse locations, or at customers' locations.

Finished goods inventory also makes it possible to realize manufacturing economies. Plant capacity is greater and per-unit manufacturing costs are lower if a firm schedules long production runs with few line changes. Manufacturing in small quantities leads to short production runs and high changeover costs.

The production of large quantities, however, may require that some of the items be carried in inven­tory for a significant period of time before they can be sold. The production of large quantities may also prevent timely and responsive recovery on items that are stocked out, since large production runs mean that items will be produced less frequently. The cost of maintaining this inventory must be compared to the production saving? Realized. Although frequent production changeovers reduce the quantity of invento­ry that must be carried, and shorten the lead time that is required in the event of a stock out, they require time that could be used for manufacturing a product. When a plant is operating at or near capacity, fre­quent line changes may mean that contribution to profit is lost because there are not enough products to meet demand. In such situations, the cost of lost sales plus the changeover costs must be compared to the increase in inventory carrying costs that would result from longer production runs.