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Management accounting: Reasons for holding inventory
Whether a business actually manufactures its goods, simply resells them or provides a service, maintaining optimum inventory levels is a critical aspect of serving customers and remaining viable. Inventory does not only include raw materials; machinery spare parts, work in progress and stocks of finished goods are also types of inventory.
In accounting, there is a cost or value attached to everything, so ordering, purchasing and carriage inwards are some requisition costs to bear. Firms choose to hold adequate levels of inventory as a strategy to minimize order costs and maximize use of storage capacity and space. There are also costs of holding and maintaining inventory, but these costs can be offset by the benefits of holding inventory.
Meeting anticipated demand
It does not matter whether it is a production, retail or even a service-oriented business – there must be adequate supplies of materials/ products to meet expected demand for goods or services. For businesses or departments where the demand is exceptionally high, consistent and there is rapid stock turnover, this is critical to ensuring that they can comfortably meet expected demand and keep customers satisfied.
Guarding against shortages
In times are shortages, adequate inventory is a blessing. Businesses that can efficiently hold stock have a competitive advantage. This is because the production runs/ services of those businesses would not be immediately affected by adverse supply conditions. Therefore, holding inventory ensures continuity in the short-to-medium term.
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Benefitting from bulk discounts
Trade discounts are usually available for bulk purchases. In many cases, the larger the order, the higher the discount is. Businesses seek to hold inventory when the trade discounts make the cost of holding it worthwhile. Apart from reducing the unit cost of each item, ordering costs (carriage inward and import duties for example) are also reduced.
Dealing with variations in usage or demand
A spike in production levels or increased inefficiency in usage of materials can lead to increased demand for items held in inventory. This can arise in cases where a customer requires a special order or where seasonal demand is significantly higher. A related point is that stock can improve a business’ responsiveness to contingencies; holding inventory is a useful tool in contingency planning.
To guard against high inflation/ supply shortages
Efficient inventory holding can also be part of a deliberate strategy by a business in difficult economic times. High inventory levels can be a safeguard against rapid increases in prices in the short term. This strategy prevents the business from having to purchase stock at higher prices in the near future. Supply shortages can be inflationary as well, making this strategy a sensible one – even beyond mere cost considerations.
Work in progress
Recall that inventory includes stocks of unfinished goods or work in progress. Since some products have longer production cycles than others, holding inventory is unavoidable.
Even though there are many good reasons for inventory holding, these are not without constraints. Safety concerns, regulations, storage space, holding costs and budget constraints serve to restrict how much inventory a business should or could hold. Holding too much inventory can be as bad or worse are insufficient inventory levels. However, with proper warehouse management systems, inventory levels can be planned and optimized.