Inventory analysis is the examination of inventory to determine the optimum amount to keep on hand. Traditionally, this has been done by balancing the costs of ordering and holding inventory (known as the economic order quantity).
Inventory Analysis technique for determining the optimum level of inventory for a firm, it commonly employs one of the two formulas:
(1) Inventory turnover = Cost of goods sold / average inventory.
(2) Number of day’s sale in inventory = inventory at the end of an accounting period / average daily cost of goods sold.
However, considerably more inventory analysis must be conducted to account for additional factors, including the following:
- Just-in-time ordering. A business may have a just-in-time system, which is designed to minimize the amount of inventory on hand. In this situation, suppliers are likely to be close by and able to deliver small quantities with great frequency. If so, the amount of inventory kept on hand may represent only a few hours of usage.
- Order fulfillment philosophy. If management wants to reduce the turnaround time on orders placed by customers, it may be necessary to store large amounts of finished goods inventory near the shipping area, in every possible product configuration.
- Inventory obsolescence. If a company manufactures goods that are only relevant in the marketplace for a short period of time (such as consumer electronics), it will need to maintain tight control over the amount of inventory kept on hand.
- Cash availability. If an entity has little excess cash, it will have little to invest in inventory, and so is forced to keep inventory levels lower than may be optimal. This could involve accepting stockout conditions, where customers must wait for extended periods before goods are delivered to them.
In short, inventory analysis involves more than the use of a single calculation to determine inventory levels. Instead, a number of factors involving company strategy, production systems, financing, and the requirements of the marketplace must all be examined to arrive at the optimal inventory level.