13 Inventory Management

8/2/2019 13 Inventory Management

1/14

Financial Management Unit 13

Sikkim Manipal University 204

Unit 13 Inventory Management

Structure

13.1 Introduction

13.2 Costs associated with inventories are

13.3 Inventory management Techniques

13.3.1 Determination of Stock Levels

13.3.2 Pricing of inventories

13.4 Summary

Terminal Questions

Answer to SAQs and TQs

13.1 Introduction

Inventories are the most significant part of current aspects of most of the firms in India. Since

they constitute an important element of total current assets held by a firm the need to manage

inventories efficiently and effectively for ensuring optimal investment in inventory cannot be

ignored. Any lapse on the part of management of a firm in managing inventories may cause the

failure of the firm. The major objectives of inventory management are:

a. Maximum satisfaction to customer.

b. Minimum investment in inventory.

c. Achieving low cost plant operation.

These objectives conflict each other. Therefore, a scientific approach is required to arrive at an

optimal solution for earning maximum profit on investment in inventories.

Decisions on inventories involve many departments:

a. Raw material policies are decided by purchasing and production departments

b. Production department plays an important role in work in process inventory, policy and

c. Finished goods inventory policy is shaped by production and marketing departments.

But the decisions of these departments have financial implications. Therefore, as an executive

entrusted with the responsibility of managing finance of the company, the financial manager of the

firm has to ensure that monitoring and controlling inventories of the firm are executed in a

scientific manner for attaining the goal of wealth maximization of the firm.


2/14



Learning Objectives:

After studying this unit, you should be able to understand the following.

1. Explain the meaning of inventory management.

2. State the objectives of inventory management.

3. Bring out the importance of inventory management.

4. State the purpose of inventory.

5. Discuss the techniques of inventory control.

Role of inventory in working Capital:

Inventories constitute an important component of a firms working capital. The following features

of inventory highlight the significance of inventory in working capital management.

1. Characteristics of inventory as current assets.

Current assets are those assets which are expected to be realized in cash or sold or consumed

during the normal operating cycle of the business. Various forms of inventory in any

manufacturing unit are:

a. Raw materials to be converted into finished goods through the process of production.

b. Work in process inventories are semi finished products in the process of being converted

into finished good.

c. Finished goods inventories are completely manufactured products that can be sold

immediately.The first two are inventories concerned with production and the third is meant for smooth

performance of marketing function of the firm.

Nature of business influences the levels of inventory that a firm has to maintain in these three

kinds. A manufacturing unit will have to maintain high levels of inventory in all the three forms. A

retail firm will be maintaining very high level of finished goods inventory only.

The three kinds of inventories listed above are direct inventories. There is an another form of

indirect inventories. These indirect inventories are those item which are necessary for

manufacturing but do not become part of the finished goods. They are lubricants, grease, oil,

petrol, office material maintenance material etc.

The Inventories are held for the following reasons.

1. Smooth production: to ensure smooth production as per the requirements of marketing

department, inventories are procured and sold.


3/14



2. To achieve Competitive edge: Most of the retail and industrial organizations carry inventory

to ensure prompt delivery to customers. No firm likes to lose customers on account of the

item being out of stock.

3. To reap the benefits of buying in large volume . Sometimes buying in large volumes may givethe firm quantity discounts. This quantity discounts may be substantial that the firm will take

benefit of it.

4. Hedge against uncertain lead times: Lead time is the time required to procure fresh supplies

of inventory. Uncertainty due to supplier taking more than the normal lead time will affect the

production schedule and the execution of the orders of customers as per the orders received

from customers. To avoid all these problems arising from uncertainty in procurement of fresh

supplies of inventories, the firms maintain higher levels of inventories for certain items of

inventory.

2. Level of liquidity: Inventories are meant for consumption or sale. Both excess and shortage

of inventory affect of the firms.Profitability .

Though inventories are called current assets, in calculating absolute liquidity of a firm inventories

are excluded because it may have slow moving or dormant items of inventory which cannot be

easily disposed of. Therefore level and composition of inventory significantly influence the

quantum of working capital and hence profitability of the firm.

3. Liquidity Lags: Inventories have three types of lags.

a. Creation lag: Raw materials are purchased on credit and consumed to produce

finished goods. There is always a lag in payment to suppliers from whom rawmaterials are procured. This is called spontaneous finance. The amount of

spontaneous finance that a firm is capable of enjoying influences the quantum of

working capital of a firm.

b. Storage lag: The goods manufactured or held for sale cannot be converted into

cash immediately. Before dispatching the goods to customers on sale, there is

always a time lag. During this time lag goods are stored in warehouse. Many

expenses of storage will be recurring in nature and cannot be avoided. The level

of expenditure that a firm incurs on this account is influenced by the inventory

levels of the firm. This influences the working capital management of a firm.

c. Sale Lag: Firms sell their products on credit. There is some time lag between sale

of finished goods and collection of dues from customers. Firms which are

aggressive in capturing markets for their products maintain high levels of inventory

and allow its customers liberal credit period. This will increase its investment in


4/14



receivables. This increase in investment in receivables will have its effect on

working capital of the firm.

Purpose of inventory:The purpose of holding inventory is achieving efficiency through cost reduction and increased

sales volume. The following are the purpose of holding inventories.

1. Sales : Customers place orders for goods only when they need it. But when customers

approach the firm with orders the firms must have adequate inventory of finished goods to

execute it. This is possible only when firms maintain ready stock of finished goods in

anticipation of orders from customers. If a firm suffers from complaints from customers of

constantly the product being out of stock, customers may migrate to other producers. It

will affect the firms customers base, customer loyalty and market share.

2. To avail quantity discounts: Suppliers give discounts for bulk purchases. Such

discounts decrease the cost per unit of inventory purchased. Such cost reduction

increase firms profits. Firms may go in for orders of large quantity to avail themselves of

the benefit of quantity discounts.

3. Reducing ordering Costs and time

Every time a firm places an order it incurs cost of procuring it. It also involves a lead time

in procurement. In some cases the uncertainty in supply due to certain administrative

problems of the supplier of the product will affect the production schedules of the

organization. Therefore, firms maintain higher levels of inventory to avoid the risks oflengthening the lead time in procurement. Therefore, to save on time and costs firms may

place orders for large quantities.

4. Reduce risk of production stoppages

Manufacturing firms require a lot of raw materials and spares and tools for production and

maintenance of machines. Non availability of any vital item can stop the production

process. Production stoppage has serious consequences. Loss of customers on account

of the failure to execute their orders will affect the firms profitability. To avoid such

situations, firms maintain inventories as hedge against production stoppages.

Therefore, it can be concluded that the motives for holding inventories are

1. Transaction motive: for making available inventories to facilitate smooth

production and sales.

2. Precautionary motive: For guarding against the risk of unexpected changes in

demand and supply.


5/14



3. Speculative motive: To take benefit out of the changes in prices firms increase

or decrease the inventory levels.

13.2 Costs associated with inventories are:

1. Material costs: These are the costs of purchasing the goods and related costs such as

transportation and handling costs associated with it.

2. Ordering Cost: The expenses incurred to place orders with suppliers and replenish

the inventory of raw material are called ordering costs. They include costs of the

following.

a. Requisitioning

b. Purchase ordering or set-up

c. Transportation

d. Receiving, inspecting and receiving at the ware house. These costs increase

in proportion to the number of orders placed. Firms maintaining large inventory

levels, place a few orders and incur less ordering costs.

3. Carrying Costs: costs incurred for maintaining the inventory in ware house are called

carrying costs. They include interest on capital locked up in inventory, storage,

insurance, taxes, obsolescence, deterioration spoilage, salaries of ware house staff

and expenses on maintenance of ware house building. The greater the inventory held

the higher the carrying costs.

4. Shortage costs or stock out costs: These are the costs associated with either a delay

in meeting the demand or inability to meet the demand at all due to shortage of stock.These costs include.

a. Loss of profit on account sales lost caused by the stock out.

b. Loss of future sales customers migrate to other dealers.

c. Loss of customer goodwill and

d. Extra costs associated with urgent replenishment purchases.

Measurement of shortage cost attributable to the firms failure to meet customers demand is

difficult because it is intangible in nature and it affects the operation of the firm now and in future.

Self Assessment Questions 1

1. Lead time is the time required to _______________.

2. Both excess and shortage of inventory affect the firms ____________.

3. Precautionary motive of holding inventory is for guarding against the risk of

_____________________ and supply.

4. Costs incurred for maintaining the inventory in warehouse are called ______.


6/14



13.3 Inventory management Techniques

There are many techniques of management of inventory. Some of them are:

Economic Order Quantity:

EOQ refers to the optimal order size that will result in the lowest ordering and carrying costs for

an item of inventory based on its expected usage.

EOQ model answers the following key quantum of inventory management.

a. What should be the quantity ordered for each replenishment of stock?

b. How many orders are to be paced in a year to ensure effective inventory Management?

EOQ is defined as the order quantity that minimizes the total cost associated with inventory

management.

It is based on the following assumptions:

1. Constant or uniform demand. The demand or usage is even throughout the period.

2. Known demand or usage: Demand or usage for a given period is known i.e deterministic.

3. Constant Unit price: Per unit price of material does not change and is constant irrespective of

the order size.

4. Constant Carrying Costs

The cost of carrying is a fixed percentage of the average value of inventory.

5. Constant ordering cost

Cost per order is constant whatever be the size of the order.

6. Inventories can be replenished immediately as the stock level reaches exactly equal to zero.

Consequently there is no shortage of inventory.

7.

Carrying Costs

Ordering Costs

Cost

Total Cost

Q

x


7/14



Economic order Quantity

2DK

Kc

D = Annual usage or demand

Qx = Economic order Quantity

K = ordering cost per order

kc = pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum.

Example:

Annual consumption of raw materials is 40,000 units. Cost per unit Rs 16

Carrying cost is 15% per annum.

Cost of placing an order = Rs 480

Solution:

2 x 40000 x 480

16 x 0.15

Example:

A company has gathered the following information:

Annual demand 30,000 units

Ordering cost per order = Rs 20 (Fixed)

Carrying cost = Rs 10 per unit per annum

Purchase cost per unit i.e price per unit = Rs 32 per unit

Determine EOQ, total number of orders in a year and the time gap between two orders.

Solution:

2DK 2 x 30000 x 20

Kc 10

= 346 units

K = Rs.20

Kc = Rs.10

D = 30000The total number of orders in a year = 30,000

346

= 87 orders

Qx

=

EOQ = = 4000 units

Qx

= =


8/14



Time gap between two orders = 365 = 4 days

87

1. ABC System: the inventory of an industrial firm generally comprises of thousands of items

with diverse prices, large lead time and procurement problems. It is not possible to exercisethe same degree of control over all these items. Items of high value require maximum

attention while items of low value do not require same degree of control. The firm has to be

selective in its approach to control its investment in various items of inventory. Such an

approach is known as selective inventory control. ABC system belongs to selective inventory

control.

ABC analysis classifies all the inventory items in an organization into three categories.

A: Items are of high value but small in number. A items require strict control.

B: Items of moderate value and size which require reasonable attention of the

management..

C: Items represent relatively small value items and require simple control.

Since this method concentrates attention on the basis of the relative importance of various

items of inventory it is also known as control by importance and exception. As the items

are classified in order of their relative importance in terms of value, it is also known as

proportional value Analysis.

Advantages of ABC analysis:

2. It ensures closer controls on costly elements in which firms greater part of resources are

invested.3. By maintaining stocks at optimum level it reduces the clerical costs of inventory control.

4. Facilitates inventory control and control over usage of materials, leading to effective cost

control.

Limitations:

1. A never ending problem in inventory management is adequately handling thousands of low

value of c items. ABC analysis fails to answer this problem.

2. If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose of ABC

approach.


9/14



13.3.1 Determination of Stock Levels

Most of the industries are subject to seasonal fluctuations and sales during different months of the

year are usually different. If, however, production during every month is geared to sales demand

of the month, facilities have to installed to cater to for the production required to meet the

maximum demand. During the slack season, a large portion of the installed facilities will remain

idle with consequent uneconomic production cost. To remove this disadvantage, attempt has to

be made to obtain a stabilized production programme throughout the year. During the slack

season, there will be accumulation of finished products which will be gradually cleared as sales

progressively increase. Depending upon various factors of production, storing and cost, a normal

capacity will be determined. To meet the pressure of sales during the peak season, however,

higher capacity may have to be sued for temporary periods. Similarly, during the slack season, to

avoid loss due to excessive accumulation, capacity usage may have to be scaled down.

Accordingly, there will be a maximum capacity and minimum capacity, only consumption of raw

material will accordingly vary depending upon the capacity usage.

Again, the delivery period or lead ti me for procuring the materials may fluctuate. Accordingly,

there will be maximum and minimum delivery period and the average of these two is taken as the

normal delivery period.

Maximum Level:

Maximum level is that level above which stock of inventory should never rise. Maximum level is

fixed after taking in to account the following factors:

1. Requirement and availability of capital2. Availability of storage space and cost of storing.

3. Keeping the quality of inventory intact

4. Price fluctuations

5. Risk of obsolescence, and

6. Restrictions, if any, imposed by the government.

Maximum Level = Ordering level (MRC x MDP) + standard ordering quantity.

Where, MRC = minimum rate of consumptionMDP= minimum lead time.

Minimum Level:

Minimum level is that level below which stock of inventory should not normally fall.

Minimum level = OL (NRC x NLT)


10/14



Where,

OL = ordering level

NRC = Normal rate of consumption

NLT = Normal Lead Time.Ordering Level:

Ordering level is that level at which action for replenishment of inventory is initiated.

OL = MRC X MLT

Where,

MRC = Maximum rate of consumption

MLT = Maximum lead time.

3. Average stock level

Average stock level can be computed in two ways

1. minimum level + maximum level

2

2. Minimum level + 1 /2 of re-order quantity.

Average stock level indicates the average investment in that item of inventory. It in of quite

relevant from the point of view of working capital management.

Managerial significance of fixation of Inventory level :1. It ensure the smooth productions of the finished goods by making available the raw material

of right quality in right quantity at the right time.

2. It optimizes the investment in inventories. In this process, management can avoid both

overstocking and shortage of each and every essential and vital item of inventory.

3. It can help the management in identifying the dormant and slow moving items of inventory.

This brings about better co-ordination between materials management and production

management on the one hand and between stores manager and marketing manager on the

other.

Re order Point:

When to order is another aspect of inventory management. This is answered by re order

point. The re order point is that inventory level at which an order should be placed to replenish

the inventory.


11/14



To arrive at the re order point under certainty the two key required details are:

1. Lead time

2. Average usage

lead time refers to the average time required to replenish the inventory after placing ordersfor inventory

Re order point = lead time x Average usage

Under certainty, re order point refers to that inventory level which will meet the consumption

needs during the lead time.

Safety Stock: Since it is difficult to predict in advance usage and lead time accurately, provision

is made for handling the uncertainty in consumption due to changes in usage rate and lead time.

The firm maintains a safety stock to manage the stock out arising out of this uncertainty.

When safety stock is maintained, (When Variation is only in usage rate)

Re order point = lead time x Average usage + Safety stock

Safety stock = [(maximum usage rate) (Average usage rate)] x lead time.

Or

Safety stock when the variation in both lead time and usage rate are to be incorporated.

Safety stock = (Maximum possible usage) (Normal usage)

Maximum possible usage = Maximum daily usage x Maximum lead time

Normal usage = Average daily usage x Average lead time

Example: A manufacturing company has an expected usage of 50,000 units of certain product

during the next year. Re cost of processing an order is Rs 20 and the carrying cost per unit per

annum is Rs 0.50. Lead time for an order is five days and the company will keep a reserve of two

days usage. Calculate 1. EOQ 2. Re order point. Assume 250 days in a year

Solution:

2DK 2 x 50000 x 20

Kc 0.50

= 2000 units

Re order point

Daily usage = 50000 = 200 units

250

Safety stock = 2 x 200 400 units.

EOQ = =


12/14



Re order point (lead time x Average usage) + safety stock

(5 x 200) + 400 = 1,400 units

13.3.2 Pricing of inventoriesThere are different ways of pricing inventories used in production. If the items in inventory are

homogenous (identical except for in significant differences) it is not necessary to use specific

identification method. The convenient price is using a cost flow assumption referred to as a flow

assumption.

When flow assumption is used it means that the firm makes an assumption as to the sequence in

which units are released from the stores to the production department.

The flow assumptions selected by a company need not correspond to the actual physical

movement of raw materials. When units of raw material are identical, it does not matter which

units are issued from the stores to the production department.

The method selected should match the costs with the revenue to ensure that the profits are

uncertain in a manner that reflects the conditions actually prevalent.

1. First in, first out (FIFO): It assumes that the raw materials (goods) received first are used first.

The same sequence is followed in pricing the material requisitions.

2. LIFO (last in, first out): The consignment last received is first used and if this is not sufficient

for the requisitions received from production department then the use is made from the

immediate previous consignment and so on. The requisitions are priced accordingly. This

method is considered to be suitable under inflationary conditions. Under this method the costof production reflects the current market trend. The closing inventory of raw material will be

valued on a conservative basis under the inflationary conditions.

3. Weighted average: Material issues are priced, at the weighted average cost of materials in

stock. This method considers various consignments in stock along with their units prices for

pricing the material issues from stores.

4. other methods are:

a. Replacement price method: This method prices the issues at the value at which it can be

procured from the market.

b. Standard price method: under this method the materials are priced at standard price.

Standard price is decided based on market conditions and efficiency parameters. The

difference between the purchase price and the standard price is analyzed through variance

analysis.


13/14




1. ABC system belongs to ______.

2. ______________ are of high value but small in number.

3. ABC system is known as _____________ because the items are classified in order of theirrelative importance in terms of value.

4. _________ is defined as the order quantity that minimizes the total cost of inventory

management.

13.4 Summary

Inventories form part of current assets of firm. Objectives of inventory management are.

a. Maximum customer satisfaction

b. Optimum investment in inventory and

c. Operation of the plant at the least cost structure. Inventories could be grouped into direct

inventories are raw materials, work-in- process inventories and finished goods inventory.

Indirect inventories are those items which are necessary for production process but do not

become part of the finished goods. There are many reasons attributable to holding of

inventory by the managements.

Terminal Questions

1. Examine the reasons for holding inventories by a firm.

2. Discuss the techniques of inventory control.

3. Discuss the relevance and factors that influence the determination of stock level.

4. Explain the various cost of inventory decision.

Answer for Self Assessment Questions


1. Obtain fresh supplies of inventory

2. Profitability

3. Unexpected changes in demand, supply

4. Carrying costs


1. Selective inventory control.

2. A items

3. Proportional value analysis


14/14



4. EOQ.

Answer for Terminal Questions

1. Refer to unit 13.1

2. Refer to 13.33. Refer to 13.3.3

4. Refer to 13.2

13 Inventory Management

Documents

Transcript of 13 Inventory Management