Inventory management is an important area of concern in working capital management. Corporate financial managers are concerned with whether or not they well have enough inventory to meet demand, and balancing this concern with the carrying costs of inventory (such as the opportunity cost of cash is tied up in investments in inventory, storage (warehousing) costs, the cost of obsolescence, insurance, and shrinkage).
Decisions in inventory management also affect other areas of working capital management. For example, capital budgeting is used to ensure that the firm will have enough cash to cover its raw material or merchandise inventory purchases. The inventory policy the firm chooses will affect how much cash the firm needs to fund its investment in inventory. Similarly, cash requirements may lead to short-term financing needs and the related fnancing decisions. Furthermore, a firm may loosen its credit policy or offer sales discounts if it has too much inventory on hand, or vica versa in order to slow sales.
Two Strategies for Production Planning:
There are two pure strategies used in production planning: the chase strategy and the level production strategy. In practice, a mixed strategy, or some combination of the two, is typically used.
Chase strategy: Also known as seasonal production or demand-matching strategy. This strategy attempts to match production with demand, producing only enough goods to exactly match the demand for goods for the period. This strategy keeps investment in inventory low and reduces inventory carrying costs, but has high smoothing costs.
Level production: A company that uses level production continuously produces a constant amount of goods each period equal to the average demand. For example, an RV company that sells 120,000 RVs a year, most in the summer might produce 10,000 RVs each month in expectation of this demand. It allows for a stable workforce, no overtime, low smoothing costs, but high inventory carrying costs.
Two Strategies for Ordering Inventory or Raw Materials:
Production planning looks at how inventory moves from raw materials, through work-in-process, to finished goods. Inventory management also looks at how the raw materials (or merchandise inventory for a retailer) is ordered in the most efficient way. There are two prominent examples of inventory management strategies: economic order quantity and just-in-time.
Economic order quanity (EOQ): EOQ is the order quanity that minizmizes total inventory holding costs and ordering costs. It is one of the oldest classical production models. Economic order quantity takes into account a fixed cost for placing each order of inventory, and a holding cost for holding inventory in storage. The model allows us to calculate how many units to order inorder to minimize the total costs related with ordering inventory.
Just-in-time: Just-in-time is an inventory strategy that attempts to reduce holding costs by having inventory available only as it becomes needed. It requires much more commitment by management to implement succesfully then simply setting reorder policy based on the economic order quanity. As a result, we also discuss Just-In-Time under Management Tools and Techniques, under Business Strategy.
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