Inventory management is entirely a balance between two opposing risks: the risk of holding too much and freezing your money, and the risk of holding too little and losing a sale or halting production. There is no single right number, only a right number for each item.
1 Types of inventory
| Type | Description | Found in |
|---|---|---|
| Raw materials | Inputs not yet entered into production | Manufacturers |
| Work in progress | Started but not finished | Manufacturing and contracting |
| Finished goods | Ready for sale | Manufacturers |
| Goods for resale | Bought and sold as they are | Trading and retail |
| Spares and consumables | To run the business, not to sell | Every sector |
| Goods in transit | Shipped but not yet arrived | Importers |
| Consignment stock | Held by us but owned by another, or the reverse | Distribution and agencies |
Consignment stock: present but not yours
Goods sitting in your warehouse that your supplier owns until they are sold are not your inventory for accounting purposes, however plainly they sit in front of you. They must be separated in the system and in the count. Mixing them with your own inflates your assets and distorts every inventory measure you have.
2 Why hold inventory at all?
- To cover the lead time: the supplier needs weeks, and the customer will not wait.
- To absorb demand variability: demand is not steady, and sales sometimes jump.
- To capture volume discounts: buying in larger quantities lowers the unit price.
- To hedge against price rises or an interruption in supply.
- To keep production stable: a line is not stopped for want of a cheap material.
- For seasonality: produced all year and sold in one season.
3 The cost of holding and the cost of running out
Capital
Cash frozen that could have been working
Storage
Rent, power, labour and insurance
Obsolescence
Expiry or a change of model
Shrinkage
Damage, breakage and theft
Annual holding cost is usually estimated at a significant percentage of the inventory value
A warehouse with average inventory of 4,000,000 riyals:
| Cost element | Rate | Annual amount |
|---|---|---|
| Cost of funding | 8% | 320,000 |
| Storage and handling | 5% | 200,000 |
| Insurance | 1% | 40,000 |
| Obsolescence and damage | 4% | 160,000 |
| Total | 18% | 720,000 |
The reading: cutting average inventory by a quarter saves around 180,000 riyals a year and releases a million riyals in cash. That is a saving requiring no extra sale and no new customer.
Running out has a cost too — but it appears in no report
A lost sale, a customer who went to a competitor and never came back, a production line halted, an expedited shipment at double freight, a late-delivery penalty on a contract. Because the cost of a stock-out is never booked, businesses tend to ignore it and focus on cutting inventory alone — until they fall into the opposite trap.
4 Who owns the inventory decision?
| Function | Its responsibility | Its natural bias |
|---|---|---|
| Sales | Availability for the customer | Always more stock |
| Purchasing | Buying at the best price | Larger quantities for volume discounts |
| Finance | Liquidity and working capital | Always less stock |
| The warehouse | Custody, accuracy and safety | Less movement and clearer order |
| Planning | Balancing all of them | The optimal number per item |
Which is why the inventory decision must not be left to one function: leave it to sales and stock piles up; leave it to finance and it runs out. The answer is a written policy setting a target service level per item category that everyone is held to.
Lesson summary
- Inventory is cash in another form, and it only becomes cash again through a sale.
- Its types differ by sector, and consignment stock is not your inventory for accounting.
- We hold it to cover lead time, demand swings, volume discounts and seasonality.
- Annual holding cost is a significant share of its value and includes funding and obsolescence.
- The cost of a stock-out is real but unbooked, so it gets forgotten in the decision.
- The inventory decision is shared, and is governed by a policy and a target service level.
5 Test your understanding
Three quick questions
Pick the answer you believe is correct and you will see the result immediately.
1. Goods in your warehouse remain the supplier’s property until sold. The correct treatment:
What governs is the transfer of ownership, not possession; including them inflates assets and distorts the measures.
2. A finance director asks for inventory to be cut to the absolute minimum. The risk:
The cost of running out is never booked, which makes it easy to overlook in the trade-off.
3. Average inventory is 4 million and holding cost is 18%. Cutting it by a quarter saves annually:
The saving is one million × 18% = 180,000, and the same amount is freed up as liquidity.