Identify key reasons that organizations may need to hold inventories. What factors may lead an organization to change the level of inventories that it holds? How could such a decision affect the other elements of working capital?
Key reason to hold the inventory
One of the major reasons for organization to hold the inventory is to manage and control the increase and decrease of demand and supply within the changing market environment. The growing and demand of product makes the company to hold the inventory in order to increase the price of the product to gain the maximum benefit out of it (Arthur et al. 2010). Apart from that, organization also holds the inventory in order to lower purchase for future. This helps the organization helps to gain the price benefit when the price of raw materials is higher at peak season.
Another major benefit is to take advantages of economies scale which is very much helpful for the organization in the long run. On the other hand, holding inventory creates higher sales during the seasonal products offerings (Berger et al. 2007). For instance, during year 1994, Dell computer faces losses because of demand of products was decline because of the too much of stock push which ultimately results into write off the inventory. Moreover, inventory helps the manufacturing company to reduce the uncertainty and help to availability of products and services in the market e.g. FMCG and grocery items (Campbell and Shiller, 2008). However, most of the organisation or rather industry holds the inventory to increase the price of their products. Some of the major company that holds the inventory to increase the price of the products are cement and oil companies has formed cartels to hold the supplies to create higher price.
Factors lead to change the level of inventory
Changing demand: With the changing market trend and demand keeps the manufacturer to hold the inventory which helps them to manage the variation in demand. Manufacturing organization keeps changing its plan as per the increase in decrease of demand and sales (Dechow, 2008). Holding raw materials helps the company to always be ready to cope with changes in demand in near future. Most of the organizations estimate its demand cost of products and accordingly hold the inventory in order to manage the higher demand of the products (Finger, 2008).
Price: Other major factors that influences the companies to hold their inventory is price. Most of the companies hold their inventory to increase the price fluctuation within the existing market. Some of the major companies who are form cartel to increase the price are oil and gas companies (Hashemi, 2008). Apart from that, some of the manufacturing companies estimate the increase in the price of raw materials lead to change in future makes them purchase more and hold the inventory to reduce their cost of production in near future. Apart from that, it also helps the organization to reduce the cost of transformation which is rising with every year (Khairurizka, 2009).
Availability of products: Form most of the FMCG companies like Wal-Mart, Tesco and Coles holing inventory to cater the rising demand of the products. Company hold or rather store most of inventory to take advantages of product availability in the market incomer to other competitors (Lewellen, 2009). Apart from that, it also helps the companies to gain the seasonal discount and off season price for the consumers which help these retail companies to gain the large customer base.
Inventory decision making affects the working capital
Holding inventory affect the working capital of the company in many ways it affects the short term receivables, cash bank balance and accounts receivables and accounts payables. Working capital management helps the company to smooth running of their operations (Balakrishnan and Sivaramakrishnan, 2008). Holding the inventory may increase the company accounts payables or increase the cost of inventory holding which may lead to difficulty in managing the operations. If the accounts payables is affected due to higher inventory holding cause the company huge shortage of cash for managing their short term obligations (Banker and Chen, 2006).
This will also impact in their working capital cycle of the company which would affect the company cash flow statement. Holding large inventory needs lots of cash spending which may affect the supply chain of the company (Khairurizka, 2009). Short term loan will be required to gain the smooth running of existing operation which will creates huge problem for the company because company has to pay interest on loan. Most of the MNC like Tesco and Asda keep their inventory intact which why their current ratio are poor. For manufacturing the storing of the large inventory or holding inventory is to create the demand of the products for seasonal sales which again helps the company to increase their sales. Working capital cycle is very much affected by the inventory management because it can create imbalance between the trade receivable and trade payables.
Arthur, N., Cheng, M. and Czernkowski, R. (2010) "Cash flow disaggregation and the prediction of future earnings". Accounting & Finance, 50, pp. 1–30.
Berger, P., Ofek, E. and Swary, I. (2007) "Investor valuation of the abandonment option", Journal of Financial Economics, 42, pp. 257–287
Campbell, J. and Shiller, R. (2008) The dividend-price ratio and expectations of future dividends and discount factors. Review of Financial Studies 1, 195–228.
Dechow, P.M. (2008) "Accounting Earning and Cash Flows as Measures of Firm Performance", Journal of Accounting and Economics, 18, pp. 3-42.
Finger, C. A. (2008) "The Ability of Earnings to Predict Future Earnings and Cash Flow", Journal of Accounting Research 32, pp. 210-223.
Hashemi, S. A. (2008) Analyze the relationship between operating cash flows and accruals, operating cash flow forecasting model, according and Auditing Review, 38, 1-24.
Khairurizka, R. (2009) The effect of financial ratios, firm size, and cash flow from operating activities in the interim report to the stock return,) Chinese Business Review, 8(6) , 44-53.
Lewellen, J. (2009) Predicting returns with financial ratios, Journal of Financial Economics, 74, 209-235
Balakrishnan, R. and Sivaramakrishnan, K. (2008) A critical overview of the use of fullcost data for planning and pricing. Journal of Management Accounting Research, 14: 3-31
Banker, R., and Chen, L. (2006) ‘‘Predicting Earnings Using a Model Based on Cost Variability and Cost Stickiness.’’ The Accounting Review 81, 285–307.