why businesses hold inventory

4.1.1 Production Processes – Why Businesses Hold Inventory

1. Definition and Types of Inventory

Inventory is the stock of goods that a business holds at any one time. It is normally classified into three categories.

Type of inventory	Description	Typical location	Real‑world example
Raw materials	Basic inputs that have not yet entered the production process.	Warehouse or storage area before production.	Steel coils stored by an automobile manufacturer.
Work‑in‑progress (WIP)	Goods that are partially completed and are at various stages of the production process.	Production floor or assembly line.	Part‑assembled smartphones on a factory line.
Finished goods	Completed products ready for sale to customers.	Finished‑goods store, distribution centre, or retail outlet.	Boxed cereal ready for supermarket shelves.

2. Reasons for Holding Inventory

Businesses keep inventory for three inter‑related reasons. Each reason is illustrated with a practical example.

1. To meet customer demand
   • Prevent stock‑outs – ensures customers can buy when they want, avoiding lost sales.
     Example: A fashion retailer keeps a small buffer of popular T‑shirts so that a sudden trend does not result in empty shelves.
   • Seasonal demand – build up stock before peak periods (e.g., holidays, back‑to‑school).
     Example: Toy manufacturers produce large batches in July–August to satisfy the Christmas rush.
   • Quick delivery – ready‑made stock shortens order‑fulfilment time, improving satisfaction and competitive edge.
     Example: Amazon’s “Prime” service relies on stocked items in regional fulfilment centres.
2. To reduce costs
   • Economies of scale in purchasing – larger orders attract discounts, lower unit prices and freight costs.
     Example: A supermarket chain orders 10 000 cartons of canned beans at a 12 % discount.
   • Ordering‑cost savings (EOQ model) – fewer, larger orders lower administrative and set‑up costs.
     EOQ formula: $$EOQ = \sqrt{\frac{2DS}{H}}$$ where D = annual demand, S = ordering cost per order, H = holding cost per unit per year.
     Worked example (annual demand 12 000 units, ordering cost £30 per order, holding cost £2 per unit per year): $$EOQ = \sqrt{\frac{2 \times 12\,000 \times 30}{2}} = \sqrt{360\,000}=600\text{ units}$$ The firm should order 600 units each time, giving 20 orders per year and minimising total inventory cost.
   • Smoothing production – inventory acts as a buffer, allowing a steady production rate and avoiding the cost of frequent start‑stop cycles.
     Example: A bakery keeps dough in a refrigerated buffer so that ovens can run continuously rather than being stopped each time a new batch arrives.
3. To manage risk and uncertainty
   • Supply‑chain disruptions – safety stock protects against delays from suppliers, transport strikes or natural disasters.
     Example: A computer maker holds extra printed‑circuit boards in case a supplier’s factory is hit by a flood.
   • Demand fluctuations – buffer stock absorbs unexpected spikes or drops in customer orders.
     Example: A beverage company keeps extra cases of a new flavour during a sudden promotional campaign.
   • Lead‑time variability – when the time between ordering and receipt is uncertain, inventory provides a cushion.
     Example: An electronics retailer orders from overseas where shipping times can vary by ±3 days.

3. Key Concepts

• Safety stock – extra inventory kept to guard against unforeseen demand or supply problems.
• Buffer stock – inventory held at specific points in the production process to smooth flow (often between stages of assembly).
• Holding cost (H) – cost of storing inventory (rent, insurance, security, capital tied up, obsolescence).
• Stock‑out cost – cost incurred when inventory is insufficient (lost sales, loss of goodwill, emergency production or expedited shipping).
• Economies of scale – lower per‑unit cost when buying or producing in larger quantities.
• Ordering cost (S) – cost of placing and receiving an order (administrative work, transport, set‑up).

4. Numerical Example – Safety Stock

Suppose a retailer sells 500 units of a product each month. Lead time from the supplier is 10 days, but it can vary by ±2 days.

Average daily demand:

$$\text{Average daily demand} = \frac{500}{30} \approx 16.7 \text{ units}$$

Maximum possible lead time = 12 days.

Safety stock needed:

$$\text{Safety stock} = (\text{Maximum lead time} - \text{Average lead time}) \times \text{Average daily demand}$$ $$= (12 - 10) \times 16.7 \approx 33 \text{ units}$$

The retailer therefore holds 33 units of safety stock in addition to the normal stock required for the 10‑day lead time.

5. Link to Other Functional Areas

• Finance – Inventory is a major component of working capital. High inventory levels increase the cash conversion cycle and may affect ratios such as the current ratio and inventory turnover. Reducing inventory frees cash for other investments.
• Operations – Production philosophies influence inventory policy:
  • Lean production – aims to eliminate waste, including excess inventory, by streamlining processes.
  • Just‑in‑time (JIT) – seeks to receive materials only when they are needed, keeping inventory as low as possible.
  Understanding why inventory is held helps students evaluate the trade‑off between the cost savings of JIT/lean and the risk of stock‑outs.

6. Comparison – Traditional Inventory Holding vs. Lean/JIT

Aspect	Traditional (high inventory)	Lean / JIT (low inventory)
Primary objective	Guarantee product availability, achieve economies of scale.	Minimise waste, reduce holding costs, improve flexibility.
Typical inventory level	Large safety and buffer stocks.	Very small safety stock; production triggered by actual demand.
Risk exposure	Low risk of stock‑outs, high risk of obsolescence and high capital tie‑up.	Higher risk of stock‑outs, lower risk of obsolescence, lower capital tied up.
Cost focus	Ordering‑cost reduction and bulk‑purchase discounts.	Holding‑cost reduction and process efficiency.

7. Evaluation – Weighing Benefits Against Costs (AO4)

Benefits of Holding Inventory	Costs / Disadvantages
Ensures product availability – avoids lost sales and protects brand reputation. Enables bulk purchasing → lower unit costs (economies of scale). Smooths production flow – reduces set‑up time and avoids costly start‑stop cycles. Provides a buffer against supply‑chain disruptions and demand spikes.	Holding costs (storage, insurance, capital, obsolescence) increase with inventory size. Risk of stock becoming obsolete, especially for fast‑changing products (technology, fashion). Cash tied up in inventory reduces liquidity and may increase financing costs. Excess inventory can hide inefficiencies in the production system.

In practice, managers aim for the point where the marginal benefit of an additional unit (e.g., reduced probability of a stock‑out) equals the marginal holding cost. Tools such as the EOQ model, safety‑stock calculations, regular demand forecasting and periodic inventory reviews help locate this optimal level.

8. Suggested Diagram

Insert a flow diagram showing the movement of inventory through a production system:

• Raw materials → Safety stock (at supplier/warehouse) → Work‑in‑progress → Buffer stock (between production stages) → Finished goods → Distribution/retail.

9. See Also

• Section 4.2 – Cost Classification and Break‑Even Analysis (how inventory holding cost fits into fixed and variable costs).
• Section 5 – Marketing and the Product Life Cycle (impact of product obsolescence on inventory decisions).