Question

1. What, exactly, are “inventories”? What are the three ‘types,’ or areas, of inventories? 2. Why does a firm hold inventories? In theory, why did that hypothetical car company hold 400,000 cars?? Please discuss three reasons. 3. If our sales volume jumped wildly from month to month, why would it be difficult to match production volume with sales volume each month? 4. What will happen to our “400,000 cars, produced but not yet sold” inventory if, in theory, interest rates were to double, from, say, 10% to, say 20%? Why?

Answer 1

1. Inventories are actually the stock on hand that each company holds in anticipation of customer demand down the supply chain.

The three areas of inventory are the raw materials, work in progress and finished goods. Raw materials are the basic components that form the foundation for making the finished goods. WIP constitute the partially finished goods with partial labor and raw material being used to make the intermediate good. The finished good is the final end product stored in demand and distribution centers to be supplied to the trade.

2. Firm hold inventories to keep the goods and stock necessary for forecasted sales and demand. The raw material inventory is held to anticipate the production whereas the finished goods inventory is held to fulfill the customer demand forecast.

Reasons for keeping 400,000 cars:

• To cater to the domestic demand. To be distributed to local car dealers for sales.
• To keep sufficient buffer stock due to spike in car sales during festive seasons.
• To cater to an ever increasing international demand; To enable exports.

3. In reality, if sales volume sky rockets to historic high as compared to production volume, there will be huge stock pressure at the production side. Hence, the prices of the cars will increase. Also, it will be difficult to match the sales volume with the production volume since any increased production will necessitate requirement of additional plant capacity. This will definitely take time to build capacity additions.

Also, for the question on increase in cost of capital from 10% to 20%, the holding cost per unit of finished goods inventory will double. Hence, the inventory cost is set to double for holding the cars on hand.