Inventory management - Inventory holding vs stockout trade-o...

Learning Outcomes

After reading this article, you will be able to explain the trade-offs between inventory holding costs and stockout risks, identify factors influencing optimal inventory levels, and describe approaches for maintaining operational efficiency while minimising the risk of running out of stock—key skills for the ACCA FM exam.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the principles and decision-making processes involved in inventory management. In particular, you should be able to:

• Explain the costs associated with holding inventory
• Explain the impact and costs of stockouts
• Evaluate the trade-off between inventory holding and stockout risks
• Explain the objective of inventory management: balancing liquidity (minimising working capital) with profitability (avoiding lost sales and production stoppages)
• Apply these considerations to recommend appropriate inventory management strategies

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes a stockout?
   1. Excess inventory in storage
   2. The inability to meet demand due to a lack of inventory
   3. Regular review of inventory levels
   4. Reordering inventory when it reaches a minimum level
2. Inventory holding costs typically include which of the following?
   1. Obsolescence and lost contribution from missed sales
   2. Storage, insurance, and capital tied up in stock
   3. Additional production wages only
   4. Early settlement discounts

3. True or false? Increasing inventory levels reduces the chance of stockouts but raises the company's working capital requirements.

4. Briefly explain two potential negative effects of excessive inventory levels and two effects of frequent stockouts.

Introduction

Inventory management is a critical working capital function. It requires a careful balance between keeping enough inventory to satisfy demand and avoiding excessive costs from holding more stock than needed. Businesses must consider both the expenses of storing inventory and the risks associated with running out—known as stockouts. Efficient inventory management seeks to find the optimal point where costs are minimised, and operations are not disrupted.

Key Term: inventory holding cost
The total expenses incurred by maintaining inventory, including storage, insurance, risk of obsolescence, and the opportunity cost of capital tied up in stock.

Key Term: stockout
A situation where inventory is insufficient to meet demand, leading to lost sales, production delays, or dissatisfaction among customers.

Inventory Holding vs Stockout: Finding the Balance

Managing inventory involves weighing the opposite risks of holding too much or too little stock. Each approach carries distinct costs and operational consequences.

Inventory Holding Costs

Keeping high levels of inventory cushions against uncertainties but brings increased expenses.

Examples of inventory holding costs:

• Storage costs: Rental or maintenance of warehouse facilities
• Insurance: Covering potential loss or damage
• Obsolescence and deterioration: Risk that goods lose value before sale or use
• Opportunity cost: Capital invested in stock cannot be used elsewhere in the business

Stockout Costs

Reducing inventory to low levels may lower holding costs but increases the chance of stockouts.

Consequences of stockouts:

• Lost sales: Customers may seek alternatives if products are unavailable
• Production stoppages: In manufacturing, running out of parts can halt the production line
• Emergency purchases: Last-minute orders often come at higher cost or compromised quality
• Reputational damage: Persistent stockouts can erode customer trust and loyalty

The Inventory Management Trade-Off

Balancing the costs of holding inventory against the risks and costs of stockouts is essential for efficient business operations. Carrying more inventory reduces the chance of stockouts but increases costs. Holding too little may save money in the short term but risks much larger costs if stockouts occur frequently.

Key Term: inventory management
The process of planning and controlling inventory levels to meet demand while minimising total associated costs.

Determining Optimal Inventory Levels

The “right” inventory level will vary by business, industry, and the predictability of demand and supply.

Factors influencing optimal inventory:

• Demand volatility: Greater uncertainty requires higher inventory to buffer against unexpected sales spikes
• Lead time variability: Longer or less predictable supplier lead times increase the need for safety stock
• Stockout cost severity: Where the cost of missed sales is high (e.g., medical supplies), higher inventory levels are justified
• Inventory holding cost rate: When storage and capital costs are significant, firms tend toward lower inventory levels to save money

Worked Example 1.1

A retailer estimates the annual cost of holding extra inventory at $8,000, while the average cost from lost sales during stockouts is $15,000 per year. The company considers increasing inventory by $20,000 (with a holding cost rate of 10%).

Should the retailer increase inventory?

Answer:
Increasing inventory would add $2,000 (10% of $20,000) per year to holding costs. If this reduces lost sales from $15,000 to $5,000 per year, the net saving is $8,000 ($10,000 reduction in lost sales minus $2,000 increased holding costs). The increase is financially beneficial.

Worked Example 1.2

A manufacturer reduces safety stock to decrease tied-up capital, saving $4,000 per year. However, this leads to three production stoppages per year, each costing $2,000 in lost output.

What is the net effect of reducing inventory?

Answer:
The $4,000 annual saving is outweighed by $6,000 in stoppage losses ($2,000 × 3 events). The net effect is a $2,000 increase in total cost, indicating the decision to reduce inventory is detrimental.

Strategies for Managing the Trade-Off

• Set reorder points and safety stocks to align with demand and supply variability
• Monitor stockout frequency and associated costs to inform adjustments
• Apply inventory models (such as EOQ) to identify economic order quantities when demand and costs are predictable
• Invest in forecasting and supplier reliability for demand-driven stock management

Exam Warning

When calculating optimal inventory levels or evaluating management decisions, always include both holding costs and the full impact of stockouts—lost sales, emergency procurement, and reputational damage. Omitting any of these costs may result in incomplete analysis leading to the wrong recommendation.

Revision Tip

A simple sensitivity analysis can help you determine how much demand or supply variation your current inventory policies can handle without frequent stockouts.

Summary

Inventory management requires a deliberate balance. Too much inventory increases costs without gaining much benefit; too little saves money only until a disruptive stockout leads to lost sales or halted operations. The best decision is the one with the lowest total expected cost (holding plus stockout costs), taking business-specific priorities into account.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and explain the main costs of holding inventory
• Identify the consequences and costs of stockouts
• Evaluate the trade-off between holding costs and stockout risks
• Recognise the factors affecting optimal inventory levels
• Apply these concepts to recommend effective inventory control strategies

Key Terms and Concepts

• inventory holding cost
• stockout
• inventory management