Net working capital is the difference between current assets and current liabilities.

Inventory is a major
item of current assets. The term inventory refers to the stocks of the product of a firm is offering for
sale and the components that make up the product inventory is stores of goods and stocks. This
includes raw materials, work-in-process and finished goods. Raw materials consist of those units or
input which are used to manufactured goods that require further processing to become finished goods.
Inventory may be defined as “Stock of goods that is held for future use”. Since inventories constitute
about 50% to 60% of current assets, the management of inventories is crucial to successful working
capital management.

The question of managing inventories arises only when the company holds inventories. Maintaining
inventories involves tying up of the company's funds and incurrence of storage and handling costs.
Inventory management, like the management of other current assets, should be related to the overall
objective of the firm.

There are three general motives for holding inventories-

i. Transactions motive emphasizes the need to maintain inventories to facilitate smooth

production and sales operations.
ii. Precautionary motive necessitates holding of Inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors.
iii. Speculative motive influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.

Objectives of Inventory Management

In the context of the inventory management, there lies the problem of meeting two conflicting needs-

• To maintain a large size of inventory for efficient and smooth production and sales
operations.
• To maintain a minimum investment in inventories to maximize profitability.

The aim of inventory management, thus, should be to avoid excessive and inadequate levels of
inventories and to maintain sufficient inventory (optimum Inventory) for the smooth production and
sales operations.

An effective inventory management should-

✓ Ensure a continuous supply of raw materials to facilitate uninterrupted production,

✓ Maintain sufficient stocks of raw materials in periods of short supply and anticipate price
changes,
✓ Maintain sufficient finished goods inventory for smooth sales operation and efficient customer
service,
✓ Minimize the carrying cost and time,
✓ Control investment in inventories and keep it at an optimum level.

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The basic responsibility of the financial manager is to make sure the firm’s cash flows are managed
efficiently. Efficient management of inventory ultimately results in maximization of the owner's wealth.

The objective of inventory management consists of two counter balancing parts-

• To minimize investments in inventory, and

• To meet demand for the product by efficiently organizing the production and sales operations.

These two conflicting objectives of inventory management can also be expressed in terms of cost and
benefit associated with inventory.

Elements of Inventory Management

Inventory management consists of two elements namely Inventory Planning and Inventory Control.

1) Inventory Planning
It is important for financial management to determine the correct amount of working capital to
invest in inventory at any one time. Inventory planning not only includes investments of working
capital in inventories of all types at one point of time; but it also includes the amount and types of
inventories to be maintained for the smooth production of a manufacturing enterprise.

Therefore, inventory planning covers the fixation of the following policies.

a) Inventory turnover policy,

b) Finished goods policy,
c) Purchase and procurement policy,
d) Inventory accounting policy.

a) Inventory Turnover Policy: Inventory turnover, or the inventory turnover ratio, is the number of
times a business sells and replaces it stock of goods during a given period. It considers the cost
of goods sold, relative its average inventory for a year or in any a set period of time. A high
inventory turnover generally means that goods are sold faster and a low turnover rate indicates
weak sales and excess inventories, which may be challenging for a business. In a short,
Inventory turnover is the average number of times in a year that a business sells and replaces
its inventory.

b) Finished Goods Policy: Finish goods inventory is the total stock/amount of stock available for
customers to purchase that can be fulfilled.

c) Purchase And Procurement Policy: The main objective of purchasing and procuring raw
materials, supplies, spares etc. is to ensure continuity of their supplies and at the same time to
reduce the ultimate costs of finished goods. For ensuring this, there are a number of
parameters viz., right price, right quantity, right quality, right time, right source, right terms and
conditions etc.

d) Inventory Accounting Policy: Proper inventory accounting i.e., store keeping and recording of
inventories and also for right pricing of them is a precondition of efficient inventory
management. Material costing is very significant in terms of valuation of the cost of materials
consumed by the production department.

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There are two costs associated with the merchant's inventory

First, The Order Cost that each order placed with a supplier involves a fixed handling expense and
delivery charge. Second, The Carrying Cost that includes the cost of space, insurance, and losses due to
spoilage or theft. The opportunity cost of the capital tied up in the inventory is also part of the carrying
cost.

As the firm increases its order size, the number of orders falls and therefore the order costs decline.
However, an increase in order size also increases the average amount in inventory, so that the carrying
cost of inventory rises. The trick is to strike a balance between these two costs.

Determination of various Inventory Costs

Total Inventory Cost (TIC) = Total Carrying Costs + Total ordering costs

= (Carrying cost per unit) x (Average units in inventory) + (Cost per order) x (Number of orders)

= (CxPP) x (Q/2) + (O) + (T/Q)

The variables in the equation are defined as follow-

C = Carrying costs as a percent of the purchase price of each inventory item

PP = Purchase price, or cost, per unit

Q = Number of units purchased with each order

T = Total demand, or number of units sold, per period

O = Fixed costs per order

Optimum Level of Inventory Order

Order Size Orders per Average Order Costs Carrying Costs Total Costs
Year Inventory $90 per Order $0.05 per unit
1000000 1 500000 90 25000 25090
500000 2 250000 180 12500 12680
200000 5 100000 450 5000 5450
100000 10 50000 900 2500 3400
60000 16.7 30000 1503 1500 3003
50000 20 25000 1800 1250 3050
20000 50 10000 4500 500 5000
10000 100 5000 9000 250 9250

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 Determination of Optimum Order Size:

Techniques of Inventory Control

Economic Ordering Quantity (EOQ)

Economic Ordering Quantity (EOQ) is the quantity fixed at the point where the total cost of ordering and
the cost of carrying the inventory will be the minimum. If the quantity of purchases is increased, the cost
of ordering decreases while the cost of carrying increases. If the quantity of purchases is decreased, the
cost of ordering increases while the cost of carrying decreases. But in this case, the total of both the
costs should be kept at minimum.

𝟐(𝑶)(𝑻)
𝑬𝑶𝑸 = √ 𝑾𝒉𝒆𝒓𝒆 𝑶 = 𝑭𝒊𝒙𝒆𝒅 𝒐𝒓𝒅𝒆𝒓 𝒄𝒐𝒔𝒕 𝒑𝒆𝒓 𝒐𝒓𝒅𝒆𝒓
(𝑪)(𝑷𝑷)

Investment in Inventories and Analysis thereof

A decision to determine or change the level of inventory is an investment decision. The analysis should,
therefore, involve an evaluation of the profitability of investment in inventory. The goal of the inventory
policy should be maximization of the firm's value.

The inventory policy will maximize the firm's value at a point at which marginal (incremental) return
from the investment in inventory equals the marginal (incremental) cost of funds used to finance the
investment in inventory.

Incremental Analysis

The investment in inventory should be analyzed involving the following four steps-

1. Estimation of operating profit

2. Estimation in investment in inventory
3. Estimation of the rate of return on investment in inventory
4. Comparison of the rate of return on investment with the cost of funds.

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The incremental analysis should be used to compute the values of operating profit, investment in
inventory, rate of return and cost of funds. A change in the inventory policy is desirable if the
incremental rate of return exceeds the required rate of return.

Techniques of Inventory Control

Fixing Levels (Quantity Control)

1. Maximum Stock Level: The maximum stock level is that quantity above which stocks should not
normally be allowed to exceed. The following factors are taken into consideration while fixing
the maximum stock level-
i. Average rate of consumption of material
ii. Lead time
iii. Re-order level
iv. Maximum requirement of materials for production at any time
v. Storage space available cost of storage and insurance
vi. Financial consideration such as price fluctuations, availability of capital, discounts due
to seasonal and bulk purchases etc.
vii. Keeping qualities e.g., risk of deterioration, obsolescence, evaporation, depletion and
natural waste etc.
viii. Any restrictions imposed by local or national authority in regard to materials i.e.,
purchasing from small scale industries and public sector undertakings, price preference
clauses, import policy, explosion in case of explosive materials, risk of fire etc.
ix. Economic ordering quantity is also considered.

Formula of Maximum Level

Maximum Level = Re-order level - (minimum consumption) x (minimum lead times) +
Reordering quantity

2. Minimum Stock Level: The minimum stock level is that quantity below which stocks should not
normally be allowed to fall. If stocks go below this level, there will be danger of stoppage of
production due to shortage of supplies. The following factors are taken into account while fixing
the minimum stock level-
i. Average rate of consumption of material.
ii. Average lead time. The shorter the lead time, the lower is the minimum level.
iii. Re-order level.
iv. Nature of the item.
v. Stock out cost.

Formula of Minimum Level

Minimum Level = Re-order level - (Average usage x Average lead time)

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 3. Re-order Level: This is the point fixed between the maximum and minimum stock levels and at
this time, it is essential to initiate purchase action for fresh supplies of the material. The
following factors are taken into account while fixing the re-order level-
i. Maximum usage of materials
ii. Maximum lead time
iii. Maximum stock level
iv. Minimum stock level

Re-ordering Quantity (How much to purchase) is also called Economic Ordering Quantity.

Formula of Re-order Level

Re-order level = Maximum usage x Maximum lead time or Minimum level +
Consumption during lead time

4. Danger Level: This is the level below the minimum stock level. When the stock reaches this
level, immediate action is needed for replenishment of stock. As the normal lead time is not
available, regular purchase procedure cannot be adopted resulting in higher purchase cost.

Hence, this level is useful for taking corrective action only. If this is fixed below the re- order level and
above the minimum level, it will be possible to take preventive action.

Techniques of Inventory Control

ABC Analysis for Value of Items Consumed

ABC Analysis for Inventory Control: ABC analysis is a method of material control according to value. The
basic principle is that high value items are more closely controlled than the low value items. The
materials are grouped according to the value and frequency of replenishment during a period.

A Class items: Less percentage of the total items but having higher values.

B Class items: More percentage of the total items but having medium values.

C Class items: High percentage of the total items but having low values.

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 ABC Analysis
Item Units % of Total Cum % Unit Price Total Cost % of Total Cum %
1 10000 10 15 30.40 304000 38.00 70
2 5000 5 51.20 256000 32.00
3 16000 16 45 5.50 88000 11.00 90
4 14000 14 5.14 72000 9.00
5 30000 40 1,70 51000 6.38
6 15000 15 100 1.50 22500 2.81 100
7 10000 10 0.65 65000 0.81
Total 100000 800000

The general procedure for classifying A, B or C items is as follows-

a) Ascertain the cost and consumption of each material over a given period of time
b) Multiply unit cost by estimated usage to obtain net value
c) List out all the items with quantity and value
d) Arrange them in descending order in value i.e., ranking according to value
e) Ascertain the monetary limits for A, B or C classification
f) Accumulate value and add up number of items of A items
g) Calculate percentage on total inventory in value and in number
h) Similar action for B and C class items.

Advantages of ABC Analysis

a) To minimize purchasing cost and carrying cost i.e., holding cost

b) Closer and stricter control on these items which represent a high portion of total stock value
c) Ensuring availability of supplies at all times
d) Clerical costs can be reduced
e) Inventory is maintained at optimum level and thereby investment in Inventory can be regulated
and will be minimum
f) Equal attention to A, B and C items is not desirable as it is expensive
g) It’s based on the concept of Selective Inventory Management and helps in maintaining high
stock-turnover ratio.

Problem 1: The following inventory data have been established for the Thompson Company-
1. Orders must be placed in multiples of 100 units
2. Annual sales are 338,000 units
3. The purchase price per unit is $6
4. Carrying cost is 20 percent of the price of goods
5. Fixed order cost is $48
6. Three days are required for delivery
a) What is the EOQ?
b) How many orders should Thompson place each year?
c) Calculate the total cost of ordering and carrying inventories if the order quantity is-
a. 4,000 units
b. 4,800 units
c. 6,000 units
d) What is the total cost if the order quantity is the EOQ?

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Solution:

Problem 2: Ray Smith thinks that inventories might be too high as a result of the manager's tendency
to order in large quantities. Smith has decided to examine the situation for one key product - fly rods,
which cost $320 each to purchase and prepare for sale. Annual sales of the product are 2,500 units
(rods), and the annual carrying cost is 10% of inventory value. The company has been buying 500 rods
per order and placing another order when the stock on hand falls to 100 rods. Each time SSP orders, it
incurs a cost equal to $64. Sales are uniform throughout the year.

a) Smith believes that the EOQ model should be used to help determine the optimal inventory
situation for this product. What is the EOQ formula, and what are the key assumptions
underlying this model?
b) What is the formula for total inventory costs?
c) What is the EOQ for the fly rods? What will be the total inventory costs for this product if the
EOQ is produced?
d) What is SSP's added cost if it orders 500 rods rather than the EOQ quantity? What if it orders
750 rods each time?