Amity Global Business School MUMBAI

Sem II

MODULE X
MEANING AND NATURE OF INVENTORY The dictionary meaning of inventory is stock of goods, or a list of goods. The work Inventory is understood differently by various authors, in accounting language it may mean stock of finished goods only. In a manufacturing concerns, it may include raw materials, work in process and stores, etc. a. Raw Material: The quantity of raw materials required will be determined by the rate of consumption and the time required for replenishing the supplies. The factors like the availability of raw materials and government regulations, etc. too affect the stock of raw materials. b. Work-in-Progress: The work-in-progress is that stage of stocks which are in between raw materials and finished goods. The greater the time taken in manufacturing, the more will be the amount of work in progress. c. Consumables: These materials do not directly enter production but they act as catalyst, etc. There can be instances where these materials may account for much value than the raw materials. The fuel oil may form a substantial part of cost. d. Finished Goods: These are the goods which are ready for the consumers. The stock of finished goods provides a buffer between production and market. The purpose of maintaining inventory is to ensure proper supply of goods to consumers. In some concerns the production is undertaken on order basis, in these concerns there will not be a need for finished goods. The need for finished goods inventory will be more when production is undertaken in general without waiting for specific orders. e. Spares: Spares also form a part of inventory. Some industries like transport will require more spares than the other concerns. The costly spare parts like engines, maintenance spares etc. are not discarded after use, rather they are kept in ready position for further use. All decision about spares are based on the financial cost of inventory on such spares and the costs that may arise due to their non-availability.

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

PURPOSE / BENEFITS OF HOLDING INVENTORIES Although holding inventories involves blocking of a firms funds and the cost of storage and handling, every business enterprise has to maintain a certain level of inventories to facilitate uninterrupted production and smooth running of business. There are three main purpose or motives of holding inventories. i. The Transaction Motive which facilitates continuous production and timely execution of sales orders. ii. The Precaution Motive which necessitates the holding of inventories for meeting the unpredictable changes in demand and supplies of materials. iii. The Speculative Motive which induces to keep inventories for taking advantage of price fluctuations, saving in re-ordering cost and quantity discount, etc. RISK AND COSTS OF HOLDING INVENTORIES The various costs and risks involved in holding inventories are as below: i. Capital Costs: Maintaining of inventories results in blocking of the firms financial resources. The funds may be arranged from own resources or from outsides. In the former case, there is an opportunity cost of investment while in the later case, the firm has to pay interest to the outsides. ii. Storage and Handling costs: The storage costs include the rental of the godown, insurance charges, etc. iii. Risk of Price Decline: This may be due to increased market supplies, competition or general depression in the market. iv. Risk of Obsolescence: The inventories may become obsolete due to improved technology, changes in requirements, change in customers tastes, etc. v. Risk Deterioration in Quality: The quality of the materials may also deteriorate while the inventories are kept in store.

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT AND CONTROL The following are the important tools and technique of inventory management and control. 1. Determination of stock levels. 2. Determination of safety stocks. 3. Selecting a proper system of ordering for inventory. 4. Determination of economic order quantity. 5. A.B.C. Analysis. 6. V.E.D. Analysis. 7. Inventory turnover ratios. 8. Aging schedule of inventories 9. Classification and codification of inventories 10. Preparation of inventory reports.

1. Determination of stock levels: Carrying of too much and too little of inventories is detrimental to the firm. If the inventory level is too little, the firm will face frequent stock-outs involving heavy ordering cost and if the inventory level is too high it will be unnecessary tie-up of capital. Therefore, an affective inventory management requires that a firm should maintain an optimum level of inventory where inventory costs are the minimum and at the same time there is no stock-out which may result in lost of sale or stoppage of production. Various stock levels are discussed as such. a. Minimum Level: This represents the quality which must be maintained in hand at all times. If stocks are less than the minimum level then the work will stop due to shortage of materials. Following factors are taken into account while fixing minimum stock level: Lead Time: The time taken in processing the order and then executing it is known as lead time. It is essential to maintain some inventory during the period. Rate of Consumption: It is the average consumption of material in the factory. Nature of Material: If a material is required only against special orders of the customer than minimum stock will not be required for such materials. Minimum stock level can be calculated with the help of following formula: Minimum stock level = Re-ordering level (Normal consumption) Normal Re-order period)

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Amity Global Business School MUMBAI

Sem II

b. Re-ordering Level: Re-ordering level or ordering level is fixed between minimum level and maximum level. Re-ordering level is fixed with the following formula: Re-ordering Level = Maximum Consumption Maximum Re-order period. c. Maximum Level: It is the quantity of material beyond which a firm should not exceed its stocks. If the quantity exceeds maximum level limit then it will be overstocking. A firm should avoid overstocking because it will result in high material costs. Overstocking will mean blocking of more working capital, more space for storing the materials, more wastage of materials and more chances of losses from obsolescene. Maximum Stock Level = Re-ordering Level + Re-ordering Quantity (Minimum Consumption Minimum Re-ordering period). d. Danger Level: It is the level beyond which materials should not fall in any case. If danger level arises then immediate steps should be taken to replenish the stocks even if more cost is incurred in arranging the materials. If materials are not arranged immediately there is a possibility of stoppage of work. Danger level is determined with the following formula: Danger Level = Average Consumption Maximum re-order period for emergency purchases. e. Average Stocks Level: The average stock level is calculated as such: Average Stock Level = Minimum Stock Level + of re-order quantity. 2. Determination of Safety Stocks Safety stock is a buffer to meet some unanticipated increase in usage. The usage of inventory cannot be perfectly forecasted. It fluctuates over a period of time. The demand for materials may fluctuate and delivery of inventory may also be delayed and in such a situation the firm can face a problem of stock-out. The stock-out can prove costly by affecting the smooth working of the concern. In order to protect against the stock out arising out of usage fluctuations, firms usually maintain some margin of safety or safety stocks. The basic problem is to determine the level of

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

quantity of safety stocks. Two costs are involved in the determination of this stock i.e. opportunity cost of stock-outs and the carrying costs. The stock outs of raw materials cause production distruption resulting into higher cost of production. Similarly, the stock-out of finished goods result into the failure of the firm in competition as the firm cannot provide customer service. If a firm maintain low level of safety frequent stock-outs will occur resulting into the large opportunity costs. On the other hand, the larger quantity of safety stocks involve higher carrying costs.

3. Ordering systems of Inventory The basic problem of inventory is to decide the re-order point. This point indicates when an order should be placed. The re-order point is determined with the help of these things: (a) average consumption rate, (b) duration of lead time, (c) economic order quantity, when the inventory is depleted to lead time consumption, the order should be placed. There are three prevalent system of ordering and a concern can choose any one of these: a. Fixed order quantity system generally known as economic order quantity (EOQ) system; b. Fixed period order system or periodic re-ordering system or periodic review system; c. Single order and schedule part delivery system. 4. Economic Order Quantity (EOQ) Economic order quantity is the size of the lot to be purchased which is economically viable. This is the quantity of materials which can be purchased at minimum costs. Generally, economic order quantity is the point at which inventory carrying costs are equal to order costs. In determining economic order quantity it is assumed that cost of managing inventory is made up solely of two parts i.e., ordering costs and carrying costs. Ordering costs: These are the costs which are associated with the purchasing or ordering of materials. These costs include: Costs of staff posted for ordering of goods. A purchase order is processed and then placed with suppliers. The labour spent on this process is included in ordering costs. Expenses incurred on transportation of goods purchased.

1.

2.

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Amity Global Business School MUMBAI 3. Inspection costs of incoming materials. 4. Cost of stationery, typing, postage, telephone charges, etc.

Sem II

These costs are also known as buying costs and will arise only when some purchases are made. When materials are manufactured in the concern then these costs will be known as set-up costs. These costs will include costs of setting up machinery for manufacturing materials, time taken up in setting, cost of tools, etc. The ordering costs are totalled up for the year and then divided by the number of orders placed each year. B. Carrying Costs: These are the costs of holding the inventories. These costs will not be incurred if inventories are not carried. These costs include: 1. The cost of capital invested in inventories. An interest will be paid on the amount of capital locked-up in inventories. 2. Cost of storage which could have been used for other purpose. 3. The lost of materials due to deterioration and obsolescence. The materials may deteriorate with passage of time. The loss of absolescence arises when the materials in stock are not usable because of change in process or product. 4. Insurance cost. 5. Cost of spoilage in handling of materials. 6. The longer the materials kept in stocks, the costlier it becomes by 20 percent every year. The ordering and carrying costs have a reverse relationship. The ordering cost goes up with the increase in number of orders placed. On with the increase in number of units, purchased and stored. It can be shown in the diagram shown. 7. The ordering and carrying costs of materials being high, an effort should be made to minimise these costs. The quantity to be ordered should be large so that economy may be made in transport costs and discounts may also be earned. On the other hand, storing facilities, capital to be locked up, insurance costs should also be taken into account.

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

Assumptions of EOQ: While calculating EOQ the following assumptions are made. 1. The supply of goods is satisfactory. The goods can be purchased whenever these are needed. 2. The quantity to be purchased by the concern is certain. 3. The prices of goods are stable. It results in stabilising carrying costs. 4. When above-mentioned conditions are satisfied, economic order quantity can be calculated with the help of the following formula:

Where

A = Annual consumption in rupees. S = Cost of placing an order. I = Inventory carrying costs of one unit.

EOQ and Quality Discount: Customer is offered some discount for bulk purchase or if the size of a single order is large. Thus, the price per unit of an item may decrease for buying larger quantities. The quantity discount affect inventory cost in three ways: i. As the price per unit is reduced, the total price for the lot is reduced. ii. The lot size is increased, the number of offers is reduced and as a result the total ordering cost is reduced. iii. The average inventory holding increase and as a result the storage cost will increase. Thus, to decide whether to avail the quantity discount or not, first of all EOQ is determined and then its total cost without quantity discount and with quantity discount is determined. In case, the total cost is less due to quantity discount the offer is accepted, other wise it is rejected. The following example illustrates the point.

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

i.

ii.

Illustration 4. Economic Enterprises require 90,000 units of a certain item annually. The cost per unit is Rs.3, the cost per purchase order Rs. 300 and the inventory carrying cost Rs. 6 per unit per year. What is the Economics Order Quantity? What Should the firm do if the suppliers offer discount as below:
Order 4500-5999 6000 and above Discount 2% 3%

Solution. (i) EOQ

2AS I

Where, A = Annual Usage in units = 90,000 S = Cost of placing an order = Rs. 300 I = Inventory carrying costs of one unit. = Rs. 6 2 90,000 300 EOQ 90,000 3,000 units 6 As the supplier offers discount on order quantity, we shall calculate the total cost of 3000 units, 4500 units and 6000 units as below:

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

Order Size

Average Inventory

Annual requirements (units)

No. of orders (3 divided 1)

Price per unit

Cost of purchase (3) X (5) Rs.

Carrying cost at Rs. 6 per unit (Rs.)

Total ordering cost at Rs. 300 per order (Rs.)

Total Cost (6 + 7 + 8) (Rs.)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

3,000 45,00 6,000

1,500 2,250 3,000

90,000 90,000 90,000

30 20 15

3.00 2.94 2.91

2,70,000 2,64,600 2,61,900

9,000 13,500 18,000

9,000 6,000 4,500

2,88,000 2,48,100 2,48,400

Since the total cost at order of 4500 units is the lowest, the firm should place order for 4500 units and obtain 2% discount.

5. A-B.C Analysis The materials are divided into a number of categories for adopting a selective approach for material control. Under A-B-C analysis, the materials are divided into three categories viz, A, B and C. Past experience has shown that almost 10 percent of the items contribute to 70 percent of value of consumption and this category is called A Category. About 20 percent of the items contribute about 20 percent of value of consumption and this is known as category B materials. Category C covers about 70 percent of items of materials which contribute only 10 percent of value of consumption. There may be some variation in different organisations and an adjustment can be made in these percentages.

6. VED Analysis The VED analysis is used generally for spare parts. Spare parts are classified as Vital (V), Essential (E) and Desirable (D). The vital spares are a must for running the concern smoothly and these must be stored adequately. The non-availability of vital spare will cause havoc in the concern. The E type of spares are also necessary but their stocks may be kept at low figures. The stocking of D type of spares may be avoided at times. If the lead time of these spares is less, then stocking of these spares can be avoided. The

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

classification of spares under three categories is an important decision. The classification of spares should be left to the technical staff because they know the need urgency and use of these spares. 7. Inventory Turnover Ratios Inventory turnover ratios are calculated to indicate whether inventories have been used efficiently or not. The purpose is to ensure the blocking of only required minimum funds in inventory. The inventory turnover ratio also known as stock velocity is normally calculated as sales/average inventory or cost of goods sold/average inventory cost. Inventory conversion period may also be calculated to find the average time taken for clearing the stocks. Symbolically,
Inventory Turnover Ratio Cost of Good Sold Average Inventory at Cost Net Sales (Average ) Inventory

8. Aging Schedule of Inventories Classification of inventories according to the period (age) of their holdings also helps in identifying show moving inventories thereby helping in effective control and management of inventories. The following table shown aging of inventories of a firm. 9. Classification and Codification of Inventories The inventories of a manufacturing concern may consist of raw materials, work in process, finished goods, spares, consumable stocks, etc. All these categories may have their sub-divisions. The raw materials used may be of 3-4 types, finished goods may also be of more than one type, spares may be of a number of types and so on. For a proper recording and control of inventory, a proper classification of various types of items is essential. The inventories should first be classified and then code numbers should be assigned for their identification. The identification of short names are useful for inventory management not only for large concerns but also for small concerns. Lack of proper

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

classification may also lead to reduction in production. Generally, material are classified according to their nature such as construction materials, consumable stocks, spares, lubricants, etc. The coding class of materials is assigned two digits and then two or three digits are assigned to the category of materials in that class. The third distinction is needed for the quality of goods and decimals are used to note this factor. 10.Inventory Reports From effective control, the management should be kept informed with the latest stock position of different items. This is usually done by preparing periodical inventory reports. These reports should contain all information necessary for managerial action. On the basis of these reports management takes corrective action wherever necessary. The more frequently these reports are prepared the less will be the chances of lapse in the administration of inventories. JUST IN TIME (JIT) INVENTORY CONTROL SYSTEM The term JIT refers to a management tool that helps to produce only the needed quantities at the needed time. According to the official terminology of C.I.M.A., JIT is a technique for the organisation of workflows, to allow rapid, high quality, flexible production whilst minimizing manufacturing work and stock level. There are broadly two aspects of JIT (i) just in time production, and (ii) just in time purchasing. Just in time inventory control system involves the purchase of materials in such a way that delivery of purchased material is assured just before their use or demand. The philospohy of JIT control system implies that the firm should maintain a minimum (zero level) of inventory and rely on suppliers to provide materials just in time to meet the requirements. The traditional inventory control system, on the other hand, requires maintaining a healthy level of safety stock to provide protection against uncertainties of production and supplies.

Santosh Pathak

Amity Global Business School MUMBAI

Sem II

1. 2. 3. 4. 5. 6.

Objective of JIt The ultimate goal of JIT is to reduce wastage and enhance productivity. The important objectives of JIT include: Minimum / zero inventory and its associated costs. Elimination of non-value added activities and all wastes. Minimum batch / lot size. Zero breakdowns and continuous flow of production. Ensure timely delivery schedules both inside and outside the firm. Manufacturing the right product at right time. Features of JIT It emphasises that firms following traditions inventory control system overestimate ordering cost and underestimate carrying costs associated with holding of inventories. It advocates maintaining good relations with suppliers so as to enable purchase of right quantity of material at right time. It involves frequent production / order runs because of smaller batch/lot sizes. It requires reduction in set up time as well as processing time. Purchase of produce in response to need rather than as per the plans and forecasts.

a.

b. c. d. e.

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