Riddhi Siddhi Multi Services Guide on Inventories and Cash Balances
So
far Riddhi Siddhi Multi Services
have focused on managing the flow of cash efficiently. We have seen how
efficient float management can improve a firm’s income and its net worth. Now
we turn to the management of the stock of
cash that a firm chooses to keep on hand and ask:
How
much cash does it make sense for a firm to hold?
If that seems more easily said than done, you
may be comforted to know that production managers must make a similar
trade-off. Ask yourself or Riddhi Siddhi Multi Services consultants why they carry inventories of raw
materials, work in progress, and finished goods. They are not obliged to carry
these inventories; for example, they could simply buy materials day by day, as needed.
But then they would pay higher prices for ordering in small lots, and they
would risk production delays if the materials were not delivered on time. That
is why they order more than the firm’s immediate needs. Similarly, the firm
holds inventories of finished goods to avoid the risk of running out of product
and losing a sale because it cannot fill an order.
But
there are costs to holding inventories: money tied up in inventories does not
earn interest; storage and insurance must be paid for; and often there is
spoilage and deterioration.
Production
managers must try to strike a sensible balance between the costs of holding too
little inventory and those of holding too much. In this sense, cash is just
another raw material you need for production. There are costs to keeping an
excessive inventory of cash (the lost interest) and costs to keeping too small
an inventory (the cost of repeated sales of securities).
Recall
that cash management involves a trade-off. If the cash were invested in securities,
it would earn interest. On the other hand, you can’t use securities to pay the
firm’s bills. You would incur heavy transactions costs if you need to sell
those securities at each moment you have to pay a bill,. The art of cash
management is to balance these costs and benefits.
MANAGING INVENTORIES
Let
Riddhi Siddhi Multi Services
take a look at what economists have had to say about managing inventories and then
see whether some of these ideas can help us manage cash balances. Here is a
simple inventory problem.
A
builders’ merchant faces a steady demand for engineering bricks. When the
merchant every so often runs out of inventory, it replenishes the supply by
placing an order for more bricks from the manufacturer.
There
are two costs associated with the merchant’s inventory of bricks. First, there
is the order cost. Each order placed with a supplier
involves a fixed handling expense and delivery charge. The second type of cost
is the carrying cost. This includes the cost of space,
insurance, and losses due to spoilage or theft. The opportunity cost of the
capital tied up in the inventory is also part of the carrying cost.
Just-in-time inventory management also can reduce
costs by allowing suppliers to produce and transport goods on a steadier
schedule. However, just-in-time systems rely heavily on predictability of the
production process. A firm with shaky labor relations, for example, would adopt
a just-in-time system at its peril, for with essentially no inventory on hand;
it would be particularly vulnerable to a strike.
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