This article throws light upon the three types of inventories of a firm. The types are: 1. Inventory of Raw Materials 2. Inventory of Work-in-Process 3. Inventory of Finished Goods.
Inventory Type # 1. Inventory of Raw Materials:
A manufacturing enterprise must stock an adequate amount of raw materials to ensure uninterrupted production.
The following factors influence the level of inventory of raw materials:
(i) Quantum of Anticipated Production:
Amount of raw materials which has to be stocked in a firm is essentially conditioned by the quantum and pattern of goods to be produced. For this purpose, it would be worthwhile to consult production and sales executives for assessing capital requirement for carrying the inventory. Firm anticipating decline in demand would decide to reduce the production level. Accordingly, raw materials inventory requirements would tend to be low.
Contrary to this, rise in demand will necessitate large investments in inventory of raw materials. Further, company engaged in producing a number of goods will have to invest large funds in building up inventory since inventory of raw materials of varied types is required to be carried simultaneously.
(ii) Scope of Business Activity:
For a firm that manufactures products, it would be necessary to carry inventory of direct materials, indirect materials and supplies. But where the firm is carrying on trading activity, inventory will be restricted to finished goods and supplies for the most part.
(iii) Need to Pile Raw Material in Stocks:
Need to pile substantially large stock of materials increases the level of investment in raw material inventory.
In the following circumstances holding huge quantity of stock is found advantageous:
(i) Where acquisition of materials in bulk quantity is economical and the amount of benefits accruing there-from is more than the cost that the firm will incur in carrying additional inventory, handling and storage cost, spoilage and obsolescence it would be expedient to pile stocks.
(ii) Where sources of supply of raw materials and other supplies are not reliable and their availability in desired quantity is uncertain, carrying large amount of inventory would be necessary to assure the flow of production.
(iii) Where a firm deals in seasonal products it will have to stockpile materials during busy season.
(iv) Where a firm is manufacturing products of raw material which is available in particular season, it will be desirable to build large stock of materials so as to enable the firm to carry on production work uninterruptedly throughout the year.
(v) Where requisite materials are available in local market, firm need not carry large amount of materials in inventory. However, if a firm has to depend for its requirements on the market of distant states or has to import materials from abroad, it would be safer to keep comparatively large stocks.
(vi) Where time involved between order and delivery on goods is prolonged, interest of firm is expedient in carrying adequate stocks of materials.
(iv) Business Cycles:
Raw material inventory requirements vary depending on fluctuations in level of economic activity. Where management expects expansionary tendency to set in the ensuing months and prices of materials are very likely to shoot up, it would be in fitness of things to buy the materials in bulk to exploit the forthcoming opportunities. But in the event of depression firm would be hesitant to stockpile.
(v) Management Policy:
Management pursuing hand-to-mouth policy of purchasing materials in view of the existence of healthy market conditions would require less funds to carry inventories of raw materials at any one time. Cost of storage in that case is also reduced and risk of spoilage and obsolescence and losses emanating from oscillations in price structure tend to be minimum.
However, hand-to-mouth policy may not be appreciated by others in view of the inherent disadvantages of the policy. In the first instance, unit prices in the case of small purchases are usually higher than what they would have been in case of purchases in big lots. Ordering costs also increase due to frequent purchases.
This policy is also not helpful to save the firm against dangers of rising prices and labour trouble. In view of these, if management must decide to pursue the policy of buying for stock to hedge the firm against the risk of rising prices and labour trouble and to derive the benefits of acquiring goods at economic prices, larger amount of capital will be required to meet the inventory requirements.
Inventory Type # 2. Inventory of Work-in-Process:
Work-in-process inventory includes all such materials as are in various processes of production. These goods are thus in semi-finished form. A manufacturing enterprise must carry some amount of materials in process to assure uninterrupted flow of production. Until these materials are turned into finished goods and disposed off, funds are tied in them.
In his endeavour to minimise investment in work-in-process inventory, finance manager must consider the following three important factors:
(i) Period of Production Cycle:
Magnitude of investment in work-in-process is essentially dependent upon time lag between feeding raw materials in production process and completing the finished product. Longer the time required for inventories to travel through the various product process, greater would be fund requirements to carry work-in-process inventory and vice-versa.
It is usually observed that length of production period is greater where production process is complex and complicated. By perfecting engineering techniques and thereby eliminating some processes of production or speeding up manufacturing process, inventory requirements for work-in-process can, to some extent, be reduced.
(ii) Operational Efficiency of Firm:
By accelerating efficiency of production engineering and planning, length of production period can be shortened. Consequently, fund requirements to carry investment in work-in-process will decline.
A firm which is engaged in a few processes of production of goods and contracts with others for the other processes, its inventory requirements will be less than what it would have been had the firm engaged in complete production.
Inventory Type # 3. Inventory of Finished Goods:
Since an enterprise has little control over the rate at which its products are sold, sufficient amount of finished goods has always to be carried in stock to meet customers’ demand. Firm carrying on large stock of finished goods can reap benefits of future price boom. But this should not suggest that a large volume of finished goods should be held in store because additional space would be required for the purpose.
In the event if price declines the firm holding large inventories is placed in disadvantageous position. There is also risk of severe loss resulting from change in taste and fashion.
In view of this, finance manager must be very careful while planning fund requirements for finished goods inventory.
He should take into consideration the following factors in determining the finished goods inventory requirements:
(i) Inventory Turnover:
The level of finished goods inventory is a matter of coordination between production and sales. By hastening the speed of finished goods a firm can reduce working capital requirements. Sales can be stimulated by liberalizing credit policy and relaxing credit standards. Consequently, finished goods do not remain in stock for long period of time.
But funds locked in inventories will not be released because it will have to be tied in receivables when goods are sold. There is a possibility of delinquencies in payments and losses from bad debts in case of receivables. Still many firms consider it desirable to convert inventories into receivables through sales and take one step nearer to realising cash in the hope that the potential profits can outweigh the additional collection risk.
(ii) Need to Store Finished Goods:
Firms dealing in seasonal products have to hold sufficiently large stock of finished goods during peak season to meet customers’ demand. For example, woolen concerns stockpile large volume of woolen goods a few months in advance to cope with winter season demand. During lean months inventory requirements would be less.
There are a number of firms who assure constant supply of raw materials on the terms that finished goods manufactured there-from will be delivered to them. Under such situations firms need not carry forward finished goods inventory. Likewise, firms manufacturing goods against advance order do not require large funds to pile stock of finished goods.
(iii) Change in Economic Conditions:
Economic and business conditions have their strong bearing upon the position of investment in finished goods inventory. During expansion period finished goods do not lie in stock for a long period because of high turnover. But in times of recession when demand slackens large amount of goods in stock has to wait for a long period for their disposal.
Accordingly, large amount of funds are locked in inventory. It may be argued in this connection that firms anticipating fall in demand can reduce production and thus avoid holding unnecessarily large volume of finished goods inventory. However, large manufacturing concerns cannot bring about desired changes in level of production so promptly.
(iv) Durability and Style of Product:
Firms dealing in durable products whose style factor is small would carry large inventories because possibility of loss resulting from change in fashion and destruction is very low. Inventories are low in baking concerns because of perish-ability of the end product.
(v) Attitude of Management:
Dynamic management, with the help of advanced techniques of forecasting, estimates precisely the future changes in demand, makes necessary adjustment in production and stock accordingly. Thus, possibility of loss resulting from large amount of goods lying unnecessarily in stock is less.
As against this, conservative management does not bother much in-forecasting demand and considers it safer to carry huge stocks of goods in hand. Obviously, inventory requirements in the former case would be less than in the latter.