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Why are inventory levels important?

Inventory is the amount of stock a firm has of its own products. Managing inventory levels is extremely important for businesses for to maximise efficiency levels. Having either too much or too little inventory can compromise the effectiveness of the business.

Businesses which have excess inventory, for example:

  • Have cash tied up in inventory which could otherwise be used to invest in other areas of the business, such as marketing & promotion or research and development.
  • Are usually required to spend extra funds paying for storage, as well as maintenance of their warehouses to ensure the quality of their products.
  • Risk inventory degradation and lack of demand for their existing inventory. This can be a serious problem for technology firms or businesses which store products that are very cyclical or highly sensitive to consumer tastes.
  • May engage in aggressive discounting in order to clear their excess inventory. This lowers their profit margins and does not bring as much money in.
  • May be required to write-down the value of their inventory as business needs evolve and the net-worth of the firm’s products declines.

Conversely, businesses which have a lack of sufficient inventory face a number of serious problems including:

  • Not being able to satisfy consumer demand. A lack of sufficient inventory may drive consumers to competitor products as they are unable to procure the product they desire.
  • Lower confidence in the business as potential buyers are frustrated that they cannot find the correct item.
  • Overpaying for current inventory. Firms which purchase inventory in very small quantities may spend proportionally more money than firms which purchase large amounts of inventory in bulk.

So what is the right level of inventory?

Generally, business inventories should increase incrementally alongside sales growth. For example, should a business forecast that sales will increase 30% in the following year, inventory levels should increase by a corresponding 30%. Firms can also engage in a number of inventory management methods, including:

  • Back ordering: This involves purchasing inventory, only once an order has been placed for them.
  • Just in time shipping: This involves putting orders through for new stock just before it is needed. This, however, requires highly sophisticated business operations, to ensure that there is no delay in the production.

Conclusion

Managing inventory is tricky and requires a significant amount of experience and expertise.  However, ensuring that the firm keeps an appropriate amount of stock on hand is highly beneficial for profit levels.

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