Q. Just-in-time inventory management?
It considerably improves the short-term liquidity of the business with a maximum financing requirement of $138533 rather than $155640. There is as well a more rapidly improving deficit thereafter with the balance falling to $134986 by the end of June. In the longer term nevertheless there is continued loss of profitability due to lost sales when demand is high.
The main reason for this is the reduced investment in inventory that is tying up cash. Under the original proposal there is excess inventory amounting to the next month's sales which means production is necessary at an earlier stage thereby using up cash resources.
- Interest costs as well as inventory holding costs are saved by reduced inventory levels thereby adding to profit.
- There already seems to be a just-in-time inventory management policy with respect to raw materials and work in progress and such a policy for finished goods would be consistent with this.
There is however a number of problems with just-in-time inventory management in these circumstances
- When demand is higher than expected the supplementary sales are lost as there is insufficient production to accommodate demand above the mean expected level as no inventory is carried. This nevertheless amounts to only $100 per month of sales on average which may be a price worth paying in return for improved liquidity in terms of a reduced cash deficit.
- Additionally to losing contribution there may be a loss of goodwill and reputation if customers cannot be supplied. They may perhaps go elsewhere not just for the current sale but also for future sales if Mr Geep is seen as an unreliable supplier. This outcomes from the fact that customers demand immediate delivery of orders.
- The Just-in-time management of inventory relies upon not just reliable timing and quantities but also reliable quality. The number of defects is able to be planned if it is constant but if they occur irregularly this presents an additional problem.
- If production in each month is to supply demand every month this relies on the fact that demand parallels production within the month. If most of demand is at the beginning of each month this would cause problems without a level of safety stock given that prompt delivery is expected by customers.
A number of compromises among the two positions would be possible
- Inventory could be held adequate to accommodate demand when it was high. This amounts to merely an extra $2000 at selling values thus an extra $1200 at variable cost. This is considerably lower than a whole month's production but would accommodate peak demand.
- Liquidity is very vital initially as the business attempts to become established. Smallest inventory could be held in the early months therefore with perhaps slightly increased inventory once the business and its cash flows become established.