The Importance Of Inventory Management

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Inventory is account for a considerable part of total asset, so inventory management plays an important role in business survival. This management include manage inventory level to ensure producing process run smoothly and is not interrupted by material shortage as well as decrease inventory cost such as warehouse rent, administrative cost, salary, order cost, opportunity cost and insurance to minimum level.
On the one hand, If firm set too low inventory level, this will make producing stagnate and cannot fulfil orders when demand increasing. Moreover, firm may not deliver products for customers on time, this could affect firm's reputation and relationship with important customers, firm even compensates for breaking contract commitments.
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This means inventory items are divided into 3 classes base on sale volume in monetary value by calculation annual demand × unit cost. Class A consist of items which have significant effects on total inventory value. Items of class A have large demand, easy to sale out, low unit cost and account for large percentage in sale target as well as customer's satisfaction. Class B include items which low demanded and have smaller effect than class A. Lastly, class C has least effects on inventory value, high value and rarely ordered, so that firm store small amount of class C because of high cost.
Firm usually apply this method bases on Pareto principal, which is called 80/20 rule. This means most of firm realizes that 80 percentages of their revenue come from their top 20 percentage total items which is presented as class A. Hence, firm can set optimal ratio between classes. A typical ratio is 70/20/10 for class A/B/C.
I showed some methods for firm to manage inventory. In order to evaluate efficiency of inventory management, we use days inventory outstanding (DIO) which is number of day firm need to transform total inventory into sales. In terms of theory, the smaller DIO ratio, the larger profit firm
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Besides holding cash for running business, firm also need cash for unexpected events as a precaution or reducing effects of fluctuation around expected cash flow. Because firm cannot ensure that their business operating will run exactly as plan. In terms of precautionary motive, unexpected events are bad events. For example, if account receivable cannot be collected on time, firm need precautionary cash to pay for their operating cost. In addition, with problems with inventory such as thief or fire, firm need cash to buy material immediately to continuously producing process and make orders delivers on time. Therefore, back-up money play important role in stable firm. Usually, risky firm have more motivation to divide cash for precautionary purpose than less risky ones. With this motive in mind, managers usually apply Baumol's approach. According this model, managers can determine optimal cash balance, upper and lower limit which cash balance is allowed to fluctuate. Hence, if cash balance reach to these limit, it will be