Financial Management: Core Concepts, Third Edition

13.4 Inventory Management: Carrying Costs and Ordering Costs

Inventory is one of the most important business assets because it generates revenue. It includes the raw materials that go into the making of the company’s products, work-in-progress products, and finished goods. Holding too much inventory for too long is usually not a good thing because of the storage costs, potential spoilage, and obsolescence. So firms must choose the appropriate level of inventories to support their operations. How do they do it? What determines the right inventory size for a business? When is “too many toys” a bad thing for Toys”R”Us, and when is “too few toys” a bad thing?

We can view the appropriate inventory level as a trade-off between the additional costs ...