Question

Everything else held constant, will an increase in the amount of inventory on hand increase or decrease the firm’s profitability? at least 250 words

Answer 1

Inventory in hand is the excess goods that you hold and are unable to sell. This can be due to lack of demand or you have produced too much than what is required. From an accounting perspective when the production exceeds sales, the book profit shown in the income statement is higher as the cost of goods sold is lower. A higher inventory on hand as the same effect as sales revenue in the income statement since it added on the credit side of a typical profit and loss account . Having higher ending inventory can help the business meet unexpected demand which may boost profitability and also reduces the ordering cost due to inventory orders. Also when firms purchase or manufacture in bulk there are discounts and economies of scale which help in reducing the overall input cost. However the profitability ideally reduces in the long run due to increase in the carrying costs of the inventory i.e, warehousing, maintenance and depreciation costs of inventory. Holding too much inventory increases the financing costs and working capital needs as well. The company will have to borrow more to purchase inventory and pay extra costs in financing charges which reduces the profitability of the firm. The liquidity position of the business if also threatened and hence it may end up making losses in the short run. An increase in inventory on hand usually helps those retailers or manufacturers who have seasonal demand. For example, manufacturers who sell trees during the Christmas season. Having enough stock of the trees is vital for the company just before the season so as to not lose out on sales to competition.