If all works well, then it is a perfect world. You carry just the right amount of inventory to service your customers at 99% and get away with very minimal working capital. Obviously, your low cash-to-cash cycle should result in larger portion of your Gross Margins go to your Net Margins………..
Excess inventories happen as a matter of fact:
- Forecasting problems – not knowing what the customers need. This may also result in some obsolescence.
- Forecast Bias – Just keeping the forecasts high generally on everything.
- Sudden Demand reduction due to market place volatility or losing a key customer.
- Economies of Scale in production – Higher lot sizes are way too attractive to resist.
Excessive inventory can also be carried as a price Hedge. Steel prices are expected to rise and quantities may even be in short supply. So you buy up and keep more of it.
Life time Buys – Rare earth materials or a supplier that is close to a single source is facing financial difficulties.
Utilities some times carry spare parts inventory for the next 100 years. Perhaps one or two ancient grids use these parts. If we stock out of these parts, the Utility has no choice but to scrap the old grid and build a new one. The opportunity cost may actually outweigh many times over the cost of carrying these parts.
Excess inventory can also result from supplier uncertainty. If supplier does not meet schedule or if the lead time is time varying over a period, you have to carry more inventory to meet the uncertainty in supply.
There is perhaps another reason but really a different version of the price hedge. IF suppliers offer a quantity discount, then that ends up lowering your cost of production with the consequent higher price to pay on the inventory carrying cost.
The punch here is the lowered cost per unit from the discount that applies to your consumption as well. This may result in ordering and carrying a quantity much higher than the dictated EOQ. Now here comes the distinction between items above the COGS line and items below. If a quantity discount is offered, this lowers the COGS and boosts the Gross Margin. You may have to order more than your calculated EOQ to avail the discount.