Inventory Investment: Definition, Calculations And All You Need To Know

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Inventory management is a critical skill for business managers and a major consideration for investors and economists. It is a term used by economists to explain shifting levels of stock that businesses hold from one year to the next, including work-in-progress and both tangible and intangible stock. 

To understand the implications of inventory management for an individual business, this article defines inventory investment, states the formula for calculating inventory investment, and every other thing you need to know about inventory investment. Carefully read through!

What is Inventory?

According to Netsuite, inventory refers to the tracking of commodities, component components, and raw materials that a corporation consumes or sells. You perform inventory management as a business leader to ensure that you have enough merchandise on hand and to recognize when there is a shortfall. 

The act of counting or listing objects is referred to as “inventory.” Inventory is a current asset in accounting and refers to all merchandise in various stages of manufacturing. Both shops and manufacturers can continue to sell or develop things if they keep stock.

For most businesses, inventory is a substantial asset on the balance sheet; nevertheless, too much inventory can become a practical problem.

What is Inventory Investment?

Wikipedia defines inventory investment as production minus sales. It is a component of a country’s gross domestic product (GDP). 

The change in inventory levels in an economy from one time period to the next is measured by inventory investment. Economists keep a careful eye on these figures since they are frequently linked to the amount of an economy’s gross domestic product. 

Inventory investment is characterized as positive if inventory levels rise over time, while it is labeled as negative if levels fall. Although it is not always precise, this assessment is often a good prediction of an economy’s future trajectory.

In short, inventory investment = production – sales.

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What Does Unplanned Inventory Investment Entail?

Businesses purchase inventory today in order to sell it later. The amount they invest is determined by assumptions about a company’s costs, sales, and growth. If any of those assumptions change, or if the business reality falls short of those expectations, the company’s inventory investment must be adjusted.

As a result of this change, unanticipated inventory investment is made. If growth is better than expected or expenses are lower than expected, businesses can invest more than they intended. Similarly, if revenues are low or expenditures are high, corporations can invest less than intended. Month to month, week to week, and even day to day, these assumptions and plans alter.

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How To Calculate Unplanned Inventory Investment

Businesses purchase inventory now in order to sell it later. The amount they invest is determined by assumptions about a company’s costs, sales, and growth. If any of those assumptions change, or if the business reality falls short of those expectations, the company’s inventory investment must be adjusted.

To calculate unplanned inventory investment, subtract the inventory you need from the inventory you have to determine an unexpected inventory investment for your business. If the unplanned inventory investment, as a result, is larger than zero, the company has more inventory than it requires. 

When this happens, the company has spent money on inventory that could have been spent on marketing, advertising, or hiring new personnel instead. However, because this money is now invested in those extra inventory purchases, it can’t be converted back to cash until either sale grow or the business owner stops buying new inventory at the same rate. This might take anything from days to months to fix, depending on the business and the amount of unplanned inventory investment.

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What Is a Negative Unplanned Inventory?

Negative unplanned inventory occurs when a company’s inventory is insufficient to meet client demands. When this happens, the business’s busiest hours will see empty shelves. 

This can occur as a result of higher-than-expected sales, such as when a certain toy becomes viral during the Christmas season, causing widespread shortages. 

Even if sales predictions are accurate, and inventory shortfall might emerge owing to bad management decisions, such as allocating insufficient capital to inventory. Negative unplanned inventory, in either situation, results in lesser sales than would otherwise occur.

Why Do Businesses Hold Inventories?

Business firms hold different types of inventories such as finished goods, raw materials, and semi-finished (intermediate) goods (called goods-in-process or work-in-progress).

Here are the four major reasons why businesses hold inventories:

1. Intertemporal production smoothing 

Most firms find it easy to sustain a steady level of production even in the face of unsteady demand. Production variation in the face of changing demand is not always warranted. When sales are low, a firm is left with unsold stocks which are put into inventory.

On the other hand, when sales are high, the firm first reduces its inventories. So it produces less than its sales level. In this case, the aim of holding inventories is known as smoothing out the level of production over time.

2. Inventories as productive capital

Inventory holding of raw materials helps avoid temporary suspension of production. Manufacturing firms keep inventories of spare parts to avert the stoppage of work when a machine suddenly breaks down.

The volume of output that a firm can produce depends on the stock of inventories it holds. In this sense, inventories can be seen as a factor of production. This is known as the precautionary motive for holding inventories since inventories protect against uncertainty.

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3. Stock-out avoidance 

Inventory management contributes to a company’s efficiency. To avoid losing possible profits, finished goods inventory is kept. More so, inventories are kept to avoid running out of products during an unexpectedly strong demand time. When demand outstrips supply and there are no inventories, some business is lost to competitors. 

Apart from the loss of present sales and profits, this also results in a loss of goodwill, which is likely to impair future sales and profitability. The desire to avoid stock-outs is a major motivator for textbook publishers to keep inventory.

You may like to read this: CAPITAL GOODS VS CONSUMER GOODS: Differences Explained

4. Linked processes

In production systems with multiple linked processes, stocks serve as a balancing factor rather than just a buffer stock. The next steps of the manufacturing process cannot begin in such businesses unless specified components and spare parts are manufactured. 

When a product, such as a car, is only partially created, its components are counted as part of the inventory of the automobile assembly factory. Some steel, glass, paint, and tyres and tubes, for example, will become obsolete if adequate numbers of automobile chassis are not produced. Thus, chassis inventory can be considered a factor of production because finished automobiles cannot be created without it.

Factors That Affect The Size Of Investment Inventories

A variety of factors influence the extent of inventory investments. The following are a few of them: 

1. Safety Stock Level 

Because of the higher degree of unpredictability connected with production and sales, a company’s investment in inventories is also higher if it keeps a high level of safety stock. When the turnover rate is high, inventory investment is typically minimal. 

2. Costs of Carrying 

If the expenses of keeping goods in stock are minimal, the company will retain larger inventories on hand. Carrying goods comes with its own set of charges. Some of these costs (such as storage, setup, change-over, ordering, spoiling, and obsolescence) are explicitly measured.

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3. Economy in purchase

If the company is anticipated to obtain some benefits in the form of a cash discount for current purchases, the size of the inventory investment is also likely to be bigger due to the larger quantity buy. As a result, every business prefers to keep an adequate supply of raw materials on hand to assure ongoing production. 

4. The possibility of a price increase 

If the price of materials is expected to grow in the near future, the company purchases a larger quantity now. If a price increase is projected in the near future, the raw material investment will increase in order to keep production costs low.

5. Cost and availability of funds

The firm makes a substantial purchase of inventories if the cost of money to invest in them is relatively lower and they are readily available at the time. A well-run business can acquire goods in bulk and store them for future use. 

6. Possibility of a demand increase 

If the company expects increasing demand for its products in the future, it will keep larger stockpiles on hand now. The inventory level is also influenced by management’s inventory policy and attitude.

READ ALSO: Product Service Management: Definition and Examples

7. Production Cycle Length 

If the production cycle is particularly long, the firm must sustain investment in work-in-progress inventories for a longer period of time, resulting in a rise in the size of inventory investment. When the manufacturing process is of a technical nature, it necessitates a significant investment in inventory. 

8. Material Availability

If a certain type of material is only accessible during a specific season, the company must boost its inventory investment to maintain higher stocks throughout that season. When a company sells perishable goods, the amount of money it invests in inventories decreases. The investment in inventories is larger for a company with a larger size and broader market coverage.

FAQs On Inventory Investment

What is the average cost of inventory?

The average cost of inventory is a method for calculating the per-unit cost of goods sold.

What is the benefit of inventory management and accurate inventory?

Companies can save money by using a strong inventory management plan and precise inventory counts since they will only deliver things that customers buy, simplifying their operations.

What is inventory analysis?

Inventory analysis is the study of how product demand changes over time. It assists firms in stocking the appropriate amount of items and forecasting how much customers will want in the future.

What is inventory investment?

Inventory investment is the difference between goods produced (production) and goods sold (sales) in a given year.

What usually causes inventory shortage?

An inventory shortage can occur due to poor management decisions, where not enough capital is allocated to inventory even when sales projections are accurate.

Conclusion 

When attempting to comprehend how inventory is linked to the economy, it is critical to notice just what goes into inventory measurement. Inventory levels should only be monitored at the conclusion of a time period to ensure accuracy, as sales will change inventory levels during that time period and skew the data. 

Furthermore, inventory investment is only significant in terms of its relationship to present output levels. Because prior inventory production isn’t counted, it’s measured by how it changes from one period to the next.

References

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