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Inventory Management

Inventories are the current assets of the firm and require substantial investments. Inventory represent the second largest asset category for manufacturing firms next only to plant and equipment. The proportion of inventories to total assets generally varies between 15 30%. Investment in inventories is the least liquid of all current assets. The money gets blocked for longer duration. Hence the importance of inventory management. Like other financial decisions, inventory decisions( how much each item of inventory to carry ) involves a trade off between risk and return.

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Carrying too low inventory : Carrying too high inventory :

Each of the above alternatives have their own risk, return implications. The goal of inventory management is to establish an optimum level of inventory for each item after considering all costs associated with inventory and after reconciling the interests of purchase, production, marketing and finance department. Inventory of each item should me maintained at optimum level so as to ensure smooth production and distribution without involving too much drain on financial resources.

The fundamental objective of keeping inventories is to decouple or uncouple the successive stages in the production and distribution of the firm. Types of inventory and their purpose: i. Raw material inventory : which is held for use in production. This type of inventory is held to ensure that production process is not interrupted for shortage of raw material. Its purpose is to uncouple the production function and purchase function. It gives the firm flexibility and independence in purchase function as well as production function. The quantity of raw material to be kept depends on the speed of use and time required to obtain the fresh deliveries and uncertainty in the supply of raw material.


Work in process : means raw material which is in various stages of production. It refers to partly finished goods. The quantity of work in progress depends on the length of production cycle. If the cycle is lengthy this inventory will be large. The purpose of this inventory is to uncouple the various stages in the production process, so that failures or machine stoppages at one stage does not affect production at other stages.

Finished goods inventory : these are the goods awaiting for sale to the customers. These are either being produced and processed in the firm (manufacturing firm) or purchased by the firm in its present form (trading or distribution firm). This inventory is maintained to uncouple production and distribution function. Sales can take place even if there is stoppage in the production function. Production schedules can also be drawn independently of sales activity. It provides flexibility in both the functions.

Types of inventory depends on nature of business: Manufacturing firms have all the three types of inventories. Trading concerns have only finished goods inventory. Service concerns and E. commerce firms may carry no inventory at all. The same item may be an asset for one firm and inventory item for another firm. Examples securities, furniture, computers etc. The same item could be raw material inventory for one firm and finished goods inventory for the other. Example steel.

Inventory management seeks to maximize the wealth of shareholders by keeping inventory at levels which minimizes the cost of procuring and maintaining inventory. Costs associated with holding inventory : 1. Carrying costs : two main costs a) Cost of storage : rent, insurance, pilferage, handling, obsolescence etc. b) Cost of financing : cost of funds invested in inventory. 2. Ordering (procurement) cost : it includes the cost of acquiring inventories. Costs associated with inviting quotations, selecting the sources of supply, preparation of purchase order, expediting purchase, transportation, receiving and placement. 3. Shortage costs : when inventories are short to meet the demands of production or customers.

Techniques of inventory management :

To ensure the efficient management of inventory, the finance manager has to answer following questions: 1. Are all items of inventory equally important. 2. What should be the size of each order. 3. At what level the order should be placed. ABC Analysis : this technique of inventory management answers the first question. It is a method of selective control. This technique helps in allocating managerial efforts in proportion to the importance of various items in the inventory.

E.O.Q. MODEL : This provides an answer to the second question of order size. EOQ is that order size which minimizes the total costs (ordering + carrying) associated with inventory.

EOQ is that order size where : ordering cost = carrying cost Ordering cost varies inversely with order size. Ordering cost tends to be fixed per order. Total annual ordering cost is equal to cost per order multiplied by the number of orders in a year. If each order size is big, there will be less number of orders annually and total ordering cost will be less. If order size is small, there will be more orders annually, leading to higher ordering cost.
Carrying cost : it varies directly with the level of inventory.

Total annual carrying cost is equal to average inventory level multiplied by annual carrying cost per unit. The carrying cost and ordering costs are opposite forces and they collectively determine the optimum level of inventory in any firm. RE-ORDER LEVEL : It is the level of inventory at which the fresh order is placed. It depends on 1. Length of time between the placement of order and receipt of supply, and 2. Rate of usage of item. R = M + tU where R = Re-order level M = minimum or safety level of inventory. t = delivery time U = Usage rate.

JUST IN TIME inventory control : this system originally developed by Taichi Okno of Japan simply implies that a firm should maintain a minimal level of inventory and rely on the supplier to provide the inventory support. This is in contrast to traditional inventory management system which call for maintaining adequate safety stock to provide a reasonable protection against uncertainties of consumption and supply. This system may be referred to as Just-in-case. Essence of JIT : Job of maintaining inventory rests with the supplier. Supplies should be delivered just in time for them to be used in the production process. Requirement : it requires that supplier should be fully informed about production plans and requirement of

business in advance and that there should be no transportation problem. Supplier may try to recoup added cost of maintaining inventory by charging higher prices. Philosophy : basic philosophy is eliminating waste and striving for excellence. This system was first developed at Toyota Motor company in Japan. It seeks to achieve aq zero level of inventory. Unlike conventional system, where inventory is treated as an asset, JIT system views inventory as root of all evils. In traditional organizations a high level of inventory is held to cover up the problem areas related to quality, vendor delivery, machine breakdown etc. the JIT approach is opposite. The inventory level is lowered to expose real organizational problems and attempts are made to solve the problems at their point of occurrence.

Elements of inventory monitoring and control program : 1. Inventory planning -- inventory required to support the production and marketing should be built into the firms planning process. Vigorous efforts to expedite the completion of unfinished job to get them into saleable condition. Continuous efforts to shorten production cycle. Production schedules should be strictly adhered to. Special pricing to dispose off surplus, slow moving and obsolete items. Maximize the use of standard parts and components which are easily available. Evening out seasonal fluctuation in production & sales.

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Methods of pricing inventories used in production : FIFO, LIFO, Weighted average price etc. Methods of inventory taking : Periodic stock taking. Perpetual inventory system. Maintenance of inventory levels : Maximum level Minimum level Re-order level Average stock level Re-order quantity or EOQ.

Other Factors : In real world the level of inventory is influenced by some additional considerations. These are :
1. 2. Anticipated scarcity : more inventory to protect against the scarcity or non availability in future. Expected price changes : if a price change is expected inventory carried may be adjusted accordingly. If price rise expected, then more inventory can be carried. Risk of obsolescence : if inventory item is likely to become obsolete fast, its stock should be kept at minimum. Government restrictions : through policies of commercial banks government may impose restrictions on the level of certain inventories. Marketing considerations : more competition -- large inventory may have to be carried.