4.1 Inventory Types and Costs

Inventory management is crucial in supply chains, involving various types like raw materials, work-in-process, and finished goods. Each type serves a specific purpose, from ensuring smooth production to meeting customer demand. Understanding these categories helps businesses optimize their inventory strategies.

Effective inventory management requires balancing costs and benefits. Holding, ordering, and stockout costs all impact a company's bottom line. By calculating these costs and using metrics like inventory turnover and cash conversion cycle, businesses can make informed decisions to improve financial performance and operational efficiency.

Inventory Classification and Cost Analysis

Types of inventory in supply chains

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• Raw materials inventory encompasses components and materials used in production ensuring uninterrupted manufacturing processes (metal sheets, plastic pellets)

• Work-in-process (WIP) inventory consists of partially completed products representing value added during production stages (partially assembled electronics)

• Finished goods inventory comprises completed products ready for sale enabling quick response to customer demand (packaged smartphones)

• Safety stock serves as buffer inventory to handle uncertainties protecting against stockouts and demand fluctuations (extra canned goods in supermarkets)

• Cycle stock represents regular inventory used to meet expected demand replenished in periodic cycles (weekly restocking of dairy products)

• Anticipation inventory built up before peak demand periods helps smooth production and manage seasonal fluctuations (toys before holiday season)

• Pipeline inventory accounts for goods in transit between supply chain locations considering lead times in transportation and order processing (shipping containers on cargo vessels)

Costs of inventory management

• Holding costs include storage space expenses insurance and taxes on inventory depreciation and obsolescence opportunity cost of capital tied up in inventory (warehouse rent, spoilage of perishables)

• Ordering costs encompass administrative expenses for placing orders receiving and inspection costs transportation and handling fees (purchase order processing, quality control checks)

• Stockout costs involve lost sales and potential customers expedited shipping charges for rush orders production downtime due to material shortages damage to company reputation and customer goodwill (rush air freight, negative online reviews)

Calculation of inventory-related costs

• Inventory holding cost calculation

  • Annual holding cost = Average inventory value × Holding cost rate
  • Holding cost rate typically ranges from 20% to 30% of inventory value

• Ordering cost calculation

  • Total annual ordering cost = (Annual demand / Order quantity) × Cost per order
  • Economic Order Quantity (EOQ) formula: $EOQ = \sqrt{\frac{2DS}{H}}$ D: Annual demand S: Ordering cost per order H: Annual holding cost per unit

• Stockout cost calculation

  • Direct stockout cost = Number of lost units × Profit per unit
  • Indirect stockout cost = Estimated long-term impact on sales and reputation (customer churn, brand damage)

Impact of inventory on finances

• Working capital management involves inventory tying up cash that could be used for other purposes efficient inventory management improves cash flow (freeing up capital for investments)

• Profitability analysis considers gross profit margin affected by inventory write-offs and obsolescence operating profit impacted by holding and ordering costs (markdown sales for outdated fashion items)

• Return on Assets (ROA) decreases with excessive inventory by increasing total assets Formula: $ROA = \frac{Net Income}{Total Assets}$

• Inventory turnover ratio measures efficiency of inventory management Formula: $Inventory Turnover = \frac{Cost of Goods Sold}{Average Inventory}$

• Days Sales of Inventory (DSI) indicates how long it takes to sell inventory Formula: $DSI = \frac{365}{Inventory Turnover}$

• Cash Conversion Cycle (CCC) measures time required to convert inventory into cash Formula: $CCC = DSI + Days Sales Outstanding - Days Payables Outstanding$