A firm’s inventory is an important item of current assets that also forms a key part of working capital. The finance manager should balance the inventories needed for the production schedule, which ultimately suits the interests of its valued customers.

The management of inventories faces the following two basic problems:

  • Management of sufficient-sized inventories for production and distribution
  • Maintaining minimum investment in inventories to guard against unnecessarily locking up capital

Objectives of Inventory Management

The objectives of inventory management are raised in the following points:
(i) Adequate investment in inventories is desirable for smooth production and sales.
(ii) Maintaining the optimal supply of inventory can serve as protection during shortages of raw materials.
(iii) Adequate stock of inventory of finished goods is helpful for smooth sales.
(iv) Purchases of large inventories will benefit from carrying costs.
(v) To avoid fear of wastage and obsolescence. Inventory management is helpful to avoid stock remaining idle for a long time, as well as the effects of bad weather and changes of fashion.
(vi) Useful in emergencies. An adequate inventory offers protection in periods of short supply.

Techniques of Inventory Management

The main inventory management techniques are:

  1. Minimum stock level
  2. Maximum stock level
  3. Re-order stock level
  4. Danger level

1. Minimum Stock Level

This is the minimum quantity of stock to hold at all times. The stock level never goes below this level, ensuring the availability of buffer stock for use during emergencies.

When the stock level falls below the minimum level, this represents a potential danger to the business. Therefore, efforts must be made to expedite the supply.

To calculate the minimum stock level, the formula is:

Minimum stock level = Re-order level – (Normal consumption x Normal re-order period)

The following factors should be considered when fixing the minimum stock level:

  • Nature of items of materials
  • Minimum time required for delivery
  • Rate of consumption of materials
  • Stock-out costs (which includes loss of contribution margin)

2. Maximum Level

The maximum level is the largest quantity of an item of material that should be held at any time. It is the level above which stocks are not allowed to rise. It is calculated as:

Maximum level = (Re-order level + Re-order quantity) – (Minimum consumption x Minimum re-order period)

In the maximum stock level, the factors to be considered are:

  • Maximum requirement of the stock for production at any point in time
  • Storage space available
  • Storage and insurance costs
  • Availability of funds
  • Price advantage from bulk purchases
  • Economic order quantity also affects the maximum level
  • Government import restrictions
  • Likelihood of price fluctuation

3. Danger Level

This level is typically fixed below the minimum level. Emergent purchase actions are initiated if stock falls below the danger level.

4. Re-order Quantity (EOQ)

This refers to the quantity to be purchased in a single purchase order. It is nothing but economic order quantity.

Lead time: This is the period of time between ordering and replenishment.
Usage: It represents the consumption pattern.

Frequently Asked Questions

What are the two basic problems of the management of inventories?

These are management of sufficient-sized inventories for production and distribution and maintaining minimum investment in inventories to guard against unnecessarily locking up capital.

What are the techniques of inventory management?

The main Inventory Management techniques are: minimum stock level, maximum stock level, re-order stock level and danger level.

What is the minimum stock level?

This is the minimum quantity of stock to hold at all times. The stock level never goes below this level, ensuring the availability of buffer stock for use during emergencies.

What is the maximum level?

The maximum level is the largest quantity of an item of material that should be held at any time. It is the level above which stocks are not allowed to rise.

What is the danger level?

This level is typically fixed below the minimum level. Emergent purchase actions are initiated if stock falls below the danger level.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.