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.