A firm’s functional areas may disagree over inventory. Marketing wants high inventories over a broad range of products to allow quick response to customer demand. Manufacturing wants high inventories to support long production runs and to realize economies of scale through the reduction of per unit fixed costs. Also, lack of inventories may shut down the production line. Finance normally prefers low inventories to increase inventory turns, reduce current assets and increase return on assets. Integrated logistics agrees with finance. High inventory increases inventory carrying costs, packaging costs, and material handling costs. Both finance and integrated logistics recognize the need for some inventory, but the question is: how much?
The arguments for carrying inventories are many. First, inventories allows for economies of scale. Second, it helps balance demand and supply. Third, inventories allows for production specialization. Fourth, inventories protects against uncertainties in demand and in the order cycle, such as transit delays, loss and damage, and schedule delays. Finally, inventory can act as a buffer throughout the distribution channel.
ECONOMIES OF SCALE:
A firm can realize economies of scale in manufacturing, purchasing and transportation by holding inventories. If purchasing buys large amounts, the firms get quantity discounts. In turn, transportation can move larger volumes and get economies of scale through better equipment utilization. Manufacturing can have longer production runs if more material is inventoried, allowing per unit fixed cost reduction.
BALANCING SUPPLY AND DEMAND:
Some firms must accumulate inventory in advance of seasonal demand. A toy manufacturer sees some demand year-round, but 60 percent or more of sales will come in Christmas season. By manufacturing to stock, production can kept level throughout the year. This reduction idle plant capacity and maintains a relatively stable workforce, keeping costs down. If demand is relatively constant but input materials are seasonal, such as in the production of canned fruits, then finished inventories help meet demand when the materials are no longer available.
SPECIALIZATION:
Inventories allow firms with subsidiaries to specialize. Instead of producing a variety of products, each plant can manufacture a product and then ship the finished products directly to customers or to a warehouse for storage. By specializing, each plant can gain economies of scale through long production runs.
PROTECTION FROM UNCERTAINTIES:
A primary reason to hold inventory is to offset uncertainties in demand. If demand increases and raw material stocks out, the production line shuts down until more material is delivered. Likewise, a shortage of work in process means the product cannot be finished. Finally, if customer orders outstrip finished goods supply, the resulting stock outs could lead to lost customers.
Finished products stock outs leave customers a variety of options. The customer can wait, back order, substitute, buy elsewhere this time, or buy elsewhere permanently. The frequency of stock outs and the existence of completion influence the choice. The customer would probably wait or backorder if stock outs are infrequent. Repeated stock outs may cause the customer to substitute or seek another supplier.
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