CP

594 CHAPTER 16 Working Capital Management

Inventory

Inventory management techniques are covered in depth in production management

courses. Still, since financial managers have a responsibility both for raising the

capital needed to carry inventory and for the firm’s overall profitability, we need to

cover the financial aspects of inventory management here.

The twin goals of inventory management are (1) to ensure that the inventories

needed to sustain operations are available, but (2) to hold the costs of ordering and

carrying inventories to the lowest possible level. Table 16-3 gives a listing of the

typical costs associated with inventory, divided into three categories: carrying costs,

ordering and receiving costs, and the costs that are incurred if the firm runs short of

inventory.

There is always pressure to reduce inventory as part of firms’ overall cost-

containment strategies, and many corporations are taking drastic steps to control in-

ventory costs. For example, Trane Corporation, which makes air conditioners, adopted

just-in-time inventory procedures. In the past, Trane produced parts on a steady basis,

stored them as inventory, and had them ready whenever the company received an or-

der for a batch of air conditioners. However, the company reached the point where its

inventory covered an area equal to three football fields, and it still sometimes took as

long as 15 days to fill an order. To make matters worse, occasionally some of the neces-

sary components simply could not be located, while in other instances the components

were located but found to have been damaged from long storage.

Then Trane adopted a new inventory policy — it began producing components

only after an order is received, and then sending the parts directly from the machines

TABLE 16-3 Costs Associated with Inventory

Approximate Annual

Cost as a Percentage

of Inventory Value

I.CARRYING COSTS

Cost of capital tied up 12.0%

Storage and handling costs 0.5

Insurance 0.5

Property taxes 1.0

Depreciation and obsolescence 12.0

Total 26.0%

II.ORDERING, SHIPPING, AND RECEIVING COSTS

Cost of placing orders, including production and set-up costs Varies

Shipping and handling costs 2.5%

III.COSTS OF RUNNING SHORT

Loss of sales Varies

Loss of customer goodwill Varies

Disruption of production schedules Varies

Note: These costs vary from firm to firm, from item to item, and also over time. The figures shown are U.S. Depart-

ment of Commerce estimates for an average manufacturing firm.

Working Capital Management 589