Question

Managers say that holding too much inventory is "evil". Please explain why. Examples and detail please.

Answer 1

Inventory is an asset for any business. Though it is a matter of judgement, which is based on facts and circumstances of each case, varying from business to business, still holding too much inventory is not good for any business.

Inventory is treated like cash due to its liquid nature. So definitely, there is an opportunity cost involved in inventory.

Reasons why holding too much inventory is "evil" -

1. Storage issues - If there is excess Inventory, more storage space will be required to store excess Inventory. It leads to loss in rent income that would have been earned if such space would have been rented. If the storage space is taken on rent, then excess rent has to be expensed.

Example - A company has taken on rent one warehouse to store its inventory . Now to store excess Inventory, it has to rent one more warehouse. It leads to more rent expense.

2. Management issues - Holding excess Inventory leads to more management issues. More labour and time is employed to select appropriate inventory according to requirements of business. The problem increases when inventory is of perishable nature. More efforts are put to evaluate whether inventory would be sold before it gets spoiled, to examine market demand, to examine market trend. Keeping track of inventory becomes cumbersome.

Example - A company engaged in manufacture of tomato sauce purchase excess tomatoes keeping in mind the trend. After few days, it comes to know that demand for chocolate sauce has increased. Now, management of excess tomatoes is a big issue for management . It has to utilise before it gets spoiled.

3. Cash flow issues - Money is blocked when excess Inventory is purchased. If an organization gets discount on purchasing bulk Inventory, it set off the benifit that an organization would have received if it had invested such excess money in any othet asset. If more money is invested in inventory, there is a possibility that an organization faces difficulty in meeting its daily expenses. Then in such situation, it may end up borrowing money from outside and pay interest on it. This automatically set off the benifit that an organization received on purchasing bulk quantity of inventory in the form of discount.

Example- A company purchases 1000 computers for sale. Generally it purchases 700 computers. This leads to excess investment of suppose $30000 in inventory. Now to pay rent of building, it faces cash shortage problem. The company has to borrow money from outside at interest rate of 8%. Now interest cost of 8% has set off the discount benifit of 2%.

4. Demand issues - If there is a sudden or unexpected change in demand in market, the inventory held by company has to be written off obsolete and to be sold as scrap, leading to bigger loss to organization. It will not be able to recover its basic cost of purchasing inventory. Such situation sometimes may lead to closure of business.

Example - There is a trend of woollen overcoat in the market. Company analyses that for next six months at least, the trend would not change. After two months, there is a trend of leather jacket. So Now, the company has to treat the woollen overcoat inventory as obsolete or to sale at very less value as scrap.

Therefore , we can say inventory management is a issue which requires high experience and expertise, so that appropriate prediction could be made for inventory requirement.