Lecture 1: Introduction to Planning and Controlling Inventory
Hi guys, in this lecture we're just going to look at the introduction to planning and controlling for inventory. So, I want you to just listen and picture yourself as part of this company. It's a retail company that buys and sells goods, so you don’t have to take any notes, just picture yourself as the person responsible for determining or controlling and planning for the inventory that they keep.
Inventory is the product that we buy and hold until we sell it. If you look at this top picture here, that's an empty warehouse. We don't have any inventory on the floor and now picture our first customer coming in with his or her money, and they want to buy a product from us. Now, what's going to happen if we go into the storeroom and we tell them, “Well it's empty, we don’t have anything in stock”? They're going to first be very surprised, how could that happen? And then they're going to run very quickly with their money to the nearest customer, or a competitor of ours, and they might never come back.
So, it's a big risk not having something available when the customers come and ask for it. Then you might say the picture at the bottom is a better scenario where we keep everything in stock, and we keep more than enough of it. So then we will never run into this problem of not being able to serve our customers.
What is the problem with the picture at the bottom? This is a very full and big warehouse, so obviously, it's going to cost us in terms of space or rent. We're going to have a very high cost for rent for the warehouse space. Then there's also risk of a fire breaking out and damaging the stock, or the stock could get old, and since we have so much of it, it could go out of date before we sell it. So we'll have to take out some insurance, so that's another cost. And insurance is usually paid on the value of the stock. So if it's a large quantity like this, the value is going to be high, so the insurance is going to be high.
Then, what about the opportunity costs that are tied up in this inventory? Because we had to buy all of this; we had to pay for all of this inventory, so we had to either borrow money, or we had to use our cash reserves, and that could have been used for something else. So we've got an opportunity cost - that would be the cash price paid for all of this inventory times the interest rate or the cost of capital, whatever we could earn on the money elsewhere, like interest that we could’ve earned at the bank.
So you can see, this picture at the bottom is going to cost us in terms of holding costs or storage costs. We would not want to go overboard in terms of storing inventory. Then you might say these are two extremes, so we need to find some balance somewhere in between. So, we could close to the extreme of holding no inventory; we could order a very small quantity every day. We could place frequent small orders and so that we keep almost no stock, but we at least have something when the customers arrive.
The problem with that is, we're going to place frequent orders, and each time we order something, there's cost involved. So we need to check the inventory, someone needs to inspect it, we need to handle and move the orders that arrive, and we have to process the documentation, issue delivery notes etc. So there are service costs involved, and that is called ordering costs. We need to find a balance between the two extremes. That is where economic order quantity comes in, and you should have dealt with that in your earlier studies.
So, just a quick recap on why do companies keep inventory. The example we mentioned in the previous slide is the transaction motive, so we want enough inventory in order for the business to run smoothly and to service our customers when they come for the inventory, but then there are other reasons as well.
So another reason could be precautions. A precautionary reason - that is when we expect inventory to go out of stock at our suppliers, or we expect it to become scarce or unavailable in future. We might stock up on it in time so that we don't run into problems. Or if there are problems with the lead time; so our suppliers might be running late, or there is a strike somewhere. If we can anticipate that, we can hold precautionary inventory so that we don't run out of stock.
Then a last reason is a speculative reason or speculative motive. And that is if we expect the price of the inventory to increase in future; we can buy more of it now at the lower price, so we basically speculate on the price of the inventory.
These are some of the reasons why we would keep inventory and the cost involved. So we've got the ordering cost if we have small frequent orders. So think of a situation where we buy inventory every single day, then our ordering costs are going to be very high. Or we could have a once-off large order or very infrequent large orders, and that will mean our average inventory will be very high and that will mean our holding costs will be very high.
Then we can use the economic order quantity in order to balance these two. The ordering costs on the one hand and the holding costs on the other hand. So we need to find that spot where the total of ordering and holding costs are as low as possible.
Before we move on, make sure that you revise your economic order quantity calculation. You should have done that in the past, and if you’re uncomfortable with it, please make sure that you can do it and understand it.