Material costs

Cost/Management Accounting notes

WHY FIRMS KEEP INVENTORY
Firms hold inventories despite incurring holding costs, which vary with the size of inventory. There are three general kinds of stocks kept by firms due to various reasons:
(i) Buffer inventories
Firms keep these inventories to protect themselves against the uncertainties of demand and supply. To meet these uncertainties, firms normally hold inventories in excess of average or expected demand. They may also keep excess stocks to meet requirements during the time for which lead-time goes beyond normal.
(ii) Anticipation inventory
Firms keep some items of stock in anticipation that future demand for the item will happen. The whole idea underlying anticipation inventory is to smoothen the production process. This is attained by producing for a longer duration for continuous basis rather than operating with excessive overtime in one period leaving the system to be idle or close down for reason of inadequate or no demand.
(iii) Appreciation inventory
Firms hold inventory in anticipation of an increase in price. Some items of inventory such as wines and spirits and jewellery appreciate in value the longer they are kept in the warehouse. However, quantitative models do no take into account the appreciation inventory.
Inventory decisions
Inventory management is important since in most organizations (the merchandising and manufacturing firms), inventory represents the largest single investment. The major types of inventory are raw materials, work in progress and finished goods

Various decisions regarding the inventory are made by the manager in charge of inventory control and management. These decisions include:

 The optimal quantity to order in order to minimize the inventory total costs.

 When to make each order.

 What commodities to stock.

 The amount of safety stock to be kept in anticipation of variation in demand and supply
among others.

The overall objective of inventory control is to maintain stock levels that minimize the total costs. These costs include the holding costs, acquisition or purchase costs, stock out costs and ordering costs.

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