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Why Do Companies Set Maximum Stock Levels to Control Inventory?
Discover why setting a maximum stock level is crucial for effective inventory management. Learn how this strategy helps businesses avoid unnecessary holding costs, reduce the risk of inventory obsolescence, and maintain optimal stock levels for improved profitability and efficiency.
Question
Which of the following best explains why maximum stock levels are set?
A. To guarantee continuous profit growth
B. To eliminate the need for safety stock
C. To avoid unnecessary holding costs and obsolescence
D. To maintain a warehouse always full of goods
Answer
C. To avoid unnecessary holding costs and obsolescence
Explanation
Maximum stock prevents overstocking and waste. Setting a maximum stock level is a strategic control measure designed primarily to prevent the financial burdens associated with overstocking, which include excessive holding costs and the risk of inventory obsolescence.
Avoiding Unnecessary Holding Costs
Holding costs, also known as carrying costs, are the expenses a business incurs for storing unsold inventory. These costs are a significant drain on profitability and can account for 20-30% of the inventory’s total value annually. By setting a maximum stock level, a company establishes an upper limit on the quantity of goods it keeps on hand, thereby capping these expenses. Exceeding this level leads directly to increased financial pressure from various sources.
Key components of inventory holding costs include:
- Capital Costs: The opportunity cost of the money tied up in inventory that could be invested elsewhere.
- Storage Space Costs: Expenses related to the physical warehouse space, such as rent, utilities, and maintenance.
- Inventory Service Costs: Includes insurance to protect against loss, as well as taxes and the cost of inventory management software.
- Inventory Risk Costs: The financial losses that occur when inventory becomes obsolete, shrinks, is damaged, or expires.
Preventing Inventory Obsolescence
Inventory obsolescence occurs when products become unsellable or unusable, resulting in a total loss of their value. This can happen for several reasons, such as the end of a product’s lifecycle, shifts in market demand, technological advancements, or inaccurate demand forecasting. Setting a maximum stock level is a critical defense against this risk. By limiting the volume of inventory, a company reduces its exposure to having large quantities of stock that could become outdated before they can be sold. This practice forces a more disciplined approach to procurement and ensures that inventory levels are kept in line with current, predictable demand, minimizing the chance of being left with worthless goods.
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