Inventories constitute the most significant part of current assets of a large majority of firms situated throughout the world. On an average, inventories are approximately sixty percent of current assets in public limited companies as well as in certain organizations where the inventory management is found to be very poor.
On account of the large size of inventories maintained by the firms, a considerable amount of funds are required to be committed in them and it is, therefore, absolutely imperative to manage the inventories efficiently and effectively in order to avoid unnecessary investments in them. An undertaking neglecting the management of inventories will be jeopardizing its long-run profitability and may fall ultimately. It is possible for a company to reduce its level of inventories to a considerable degree e.g. 10 to 20 percent without any adverse effect on production and sales, by using a simple inventory planning and control techniques.
Inventories are the goods held for eventual sale by the firm. Inventories are thus one of the major elements which help the firm in obtaining the desired level of sales. Inventories can be classified into three categories: 1. Raw materials: These are goods which have not yet been committed to production in a manufacturing firm and they may consist of basic raw materials or finished components; 2. Work in process: This include those materials which have been committed to production process but have not yet been completed and 3. Finished goods: These are completed products awaiting sale. They are the final output of the production process in a manufacturing firm. In case of wholesalers and retailers, they are generally referred to as merchandise inventory.
Need for holding inventory by the firm:
The question of managing the inventories arises only when the company holds inventories and maintaining the inventories involves typing up of the company’s funds due to the shortage and handling costs. If it is expensive to maintain inventories, why do companies hold inventories? There are three general motives for holding the inventories: 1. The transactions motive which emphasizes the need to maintain inventories to facilitate smooth production and sales operations; 2. The precautionary motive which necessitates holding of inventories to guard against the risk of unpredictable changes in demand and supply forces and other factors; 3. The speculative motive which influences the decision to increase or reduce inventory levels in order to take advantage of the price fluctuations
A company should maintain adequate stock of materials for a continuous supply to the factory for an uninterrupted production. It is not possible for a company to procure raw materials whenever it is necessary. A time lag exists between demand for the materials and its supply. Apart from the above, there exists uncertainty in procuring the raw materials in time at many occasions. The procurement of materials may be delayed because of such factors as strike, transport disruption or short supply.
Therefore, the firm should maintain sufficient stock of raw materials at a given time to streamline production and the other factors which may necessitate purchasing and holding of raw materials are found to be the discounts allowed on purchases and the anticipated price increase in the future days. Under such situations, the firm starts purchasing large quantities of raw materials than required for the desired production and sales levels in order to obtain quantity discounts of bulk purchasing and at times, the firm will be in a position to accumulate the raw materials in anticipation of the price rise.
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