8.2 Fundamentals of Inventory: Definition, Types, Purpose, and Costs

Inventory is any asset that is not currently being used but is intended for some future use. At its core, the term “asset” signifies that inventory holds value. This value can be in the form of raw materials waiting to be transformed, products on a shelf ready for purchase, or goods in transit to a destination. Reflecting on our earlier example, Cisco’s unsold products had to be written off because they no longer held any value. Despite being physical items, their inability to generate future revenue or benefits meant they could no longer be considered valuable assets or inventory.

Consider a retail store: products lining the shelves are inventory. They are assets intended for future use, in this case, to be sold to customers. Though they aren’t being used at the very moment, they hold potential value for both the business (in terms of revenue) and the customer (in terms of utility or satisfaction). Similarly, think of a library. Books sitting on the shelves are inventory for the library. While they are not being read at that exact moment, they are assets intended for future use by patrons. Each book holds value in the knowledge or entertainment it offers, waiting for the right reader to come along and borrow it. In both scenarios, the items are assets with an anticipated future use, embodying the essence of what inventory represents.

8.2.1 Types of Inventory

Inventory, depending on its stage in the operational process, can be categorized into several distinct types. The primary types of inventory include Raw Materials (RM), Work-In-Progress (WIP), Finished Goods (FG), and Maintenance, Repair, and Operations (MRO). Categorizing inventory in this manner provides a structured approach that allows different departments within a business to manage specific segments of the inventory, optimizing costs and ensuring smooth operations, whether in manufacturing or service sectors.

Raw Materials (RM) Raw materials are the foundational components or inputs that a firm uses to produce the items it sells or services it provides. In a manufacturing context, this could be basic elements like metals or textiles. In the service sector, it might refer to base data, software components, or initial research essential for a particular service. The management and control of raw materials typically fall under the purview of the purchasing department in manufacturing or the procurement team in services. They determine how much to acquire and when, ensuring that production or service delivery can proceed without interruptions.

Work-In-Progress (WIP) Work-in-progress inventory consists of items or tasks that are part of the operational process but are not yet complete. In manufacturing, this pertains to products that are underway. In services, it could be a project that’s started but not yet finalized or a software application in the development phase. This type of inventory is primarily overseen by production planning in manufacturing or project management teams in services. They decide on aspects like batch sizes, production schedules, or project milestones.

Finished Goods (FG) Finished goods are the completed products or services ready for consumption or delivery. In manufacturing, this refers to items ready for sale. In the service sector, it could be a completed IT project, a finalized financial report, or a training module ready for delivery. The management of finished goods or completed services is often influenced by the marketing department or client relationship teams. They gauge market demand, client needs, or customer preferences to determine the quantity or scope of offerings.

Maintenance, Repair, and Operations (MRO) MRO inventory includes items essential for the operational process but aren’t directly involved in the creation of the end product or service. This can be spare parts, maintenance supplies, or any items used in the upkeep of operational facilities or tools, whether it’s machinery in manufacturing or software tools in a tech firm. The management of MRO inventory ensures that the production or service delivery process can continue without hitches due to equipment breakdowns or lack of essential supplies.

By understanding the distinct characteristics and needs of each type of inventory, organizations, whether in the manufacturing or service sectors, can allocate responsibilities to specific departments. This ensures that each segment of the inventory is managed effectively, resources are utilized optimally, and the entire operational process is streamlined.

8.2.2 Purpose of Inventory

Inventory serves various purposes in an organization, each addressing specific operational needs and challenges. By understanding the reasons behind holding different types of inventory, businesses can make informed decisions that balance costs with service levels and operational efficiency. Here, we delve into the primary purposes of inventory:

Safety Stock Safety stock is maintained to account for unexpected variations in demand or unforeseen disruptions in supply. It acts as a buffer against uncertainties, ensuring that even if there’s a sudden spike in demand or a delay in replenishment, the business can continue to meet customer requirements without any interruptions. For instance, consider a bakery where the demand for cakes can vary between 80 to 130 cakes per day, with an average demand of 105 cakes. The bakery chooses to make and stock 125 cakes daily to ensure a high level of availability for their customers. The extra 20 cakes (125 – 105) represent the safety stock, ensuring that most customers can purchase a cake even on unexpectedly busy days.

Anticipation Inventory Anticipation inventory is held in expectation of a known future event that will affect either demand or supply. This could be a planned sale, a seasonal demand surge, or an anticipated increase in prices or supply shortages. By holding anticipation inventory, businesses can prepare for these events and ensure they can meet the increased demand or avoid higher costs. A classic example is winterwear stocked up by retailers in anticipation of the cold season.

Cycle Stock Cycle stock is the inventory kept on hand because of the way specific processes are structured. It’s the inventory that rotates as orders of size Q are received and inventory is refilled. If Q is the quantity ordered each cycle, then at the beginning of the order interval, cycle inventory is at its maximum (Q), and at the end, it reaches zero right before the next order is received.

Average cycle inventory is defined as:     Average Cycle Inventory = Q/2

For instance, if a retail company’s average daily demand is 40 units and the plan is to have a delivery of Q=40 every week, the cycle stock would 40/2 or 20 on a weekly basis. Similarly, if a manufacturing policy dictates production in batches of 2,500 units per batch, the average inventory held due to this process would be at least half of that, or 1,250 units. Cycle stock ensures that there’s always enough inventory to meet the demand between replenishments or production cycles.

Understanding the purpose behind each type of inventory allows businesses to optimize their inventory levels, ensuring they have the right amount of stock for each need. This not only helps in meeting customer demand efficiently but also in managing costs and improving overall operational efficiency.

8.2.3 Costs of Inventory

Effectively managing inventory is a delicate task that hinges on understanding the costs associated with it. Ultimately, the best strategy is a balance between the cost of having inventory and the cost of not having inventory.  Clearly, as a firm increases its inventory, the costs of having inventory rise, while the costs of not having enough inventory decrease. Conversely, as inventory levels are reduced, the costs of having stock diminish, but the risks and costs associated with stockouts and missed sales opportunities increase. The challenge for businesses is to find that level of inventory where the sum of these two categories of costs is minimized.

Costs of having inventory can be further classified as Inventory Holding Cost and Ordering/Set-up Cost.  Other costs associated with inventory include Purchasing and Transportation Costs.  Costs associated with not having enough inventory typically are categorized as Shortage costs.

Inventory Holding Costs:

Storage Cost: This pertains to the expenses related to warehousing and ensuring the security of the items. The storage cost is calculated by dividing the total warehousing and security expenses for a specific period (e.g., a year) by the number of items that flow through during that period. For instance, if the total warehousing cost is $400,000 and 600,000 items are sold in a year, the storage cost is $0.67 per item per year.

Capital Cost: Money tied up in inventory that could have been used elsewhere, potentially earning interest or being invested in other business opportunities. Capital costs are determined by multiplying the average inventory value by the firm’s weighted average cost of capital (WACC). If a company’s average inventory value is $1 million and its WACC is 8%, the capital cost would be $80,000.

Obsolescence: As products age or become outdated, they may need to be sold at discounted prices or might not sell at all. This cost encompasses expenses related to end-of-life promotions, retailer buybacks, and the cost of unsold products. The obsolescence cost per product is calculated by dividing the total of these costs by the number of products sold.

Insurance and Taxes: As inventory levels rise, so do the associated insurance premiums. Additionally, in some jurisdictions, businesses may be subject to inventory taxes based on their inventory levels.

Ordering Cost:

The administrative costs associated with placing orders with vendors can vary based on the frequency and size of the orders. Larger, less frequent orders typically require less administrative effort than smaller, more frequent orders. The ordering cost is calculated by dividing the total expenses related to the ordering process (including salaries, software costs, and other related expenses) by the number of orders placed.

Costs of not Having enough Inventory:

Stockouts: When there’s insufficient inventory to meet demand, businesses face the risk of lost sales and potentially losing customers in the long run. Estimating these costs can be challenging, so businesses often rely on thumb rules to gauge the cost of lost sales and the long-term impact of lost customers.

Rush Orders: When stock levels are low, and there’s a sudden demand, businesses might need to expedite deliveries, which come at a premium. The cost associated with these rush orders is determined by dividing the total expedited delivery costs by the number of products sold.

Lost Goodwill: Running out of stock can tarnish a company’s reputation, leading to a loss of customer trust. Quantifying this cost is complex, and businesses often resort to thumb rules or industry benchmarks to estimate it.

All these costs are calculated based on past data and applied to future orders, operating under the implicit assumption that the future will not be significantly different from the past. By understanding and effectively managing these costs, businesses can optimize their inventory levels, ensuring profitability and smooth operations.