Advanced Financial Management 20MBAFM306

Module -4 Inventory Management 7 hours

Inventory Management: Determinations of inventory control levels: ordering, reordering,

danger level. EOQ model. Pricing of raw material. Monitoring and control of inventories,
ABC Analysis. (Theory and problems)

Introduction
Inventories constitute the most significant part of current assets of the business concern. It is
also essential for smooth running of the business activities. A proper planning of purchasing of
raw material, handling, storing and recording is to be considered as a part of inventory
management. Inventory management means, management of raw materials and related items.
Inventory management considers what to purchase, how to purchase, how much to purchase,
from where to purchase, where to store and when to use for production etc.

Meaning

The dictionary meaning of the inventory is stock of goods or a list of goods. In accounting
language, inventory means stock of finished goods. In a manufacturing point of view, inventory
includes, raw material, work in process, stores, etc.

Kinds of Inventories

Inventories can be classified into five major categories.

A. Raw Material: It is basic and important part of inventories. These are goods which
have not yet been committed to production in a manufacturing business concern.
B. Work in Progress: These include those materials which have been committed to
production process but have not yet been completed.
C. Consumables: These are the materials which are needed to smooth running of the
manufacturing process.
D. Finished Goods: These are the final output of the production process of the
business concern. It is ready for consumers.
E. Spares: It is also a part of inventories, which includes small spares and parts.

Objectives of Inventory Management

Inventory occupy 30–80% of the total current assets of the business concern. It is also very
essential part not only in the field of Financial Management but also it is closely associated
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with production management. Hence, in any working capital decision regarding the
inventories, it will affect both financial and production function of the concern. Hence, efficient
management of inventories is an essential part of any kind of manufacturing process concern.

The major objectives of the inventory management are as follows:

• To efficient and smooth production process.
• To maintain optimum inventory to maximize the profitability.
• To meet the seasonal demand of the products.
• To avoid price increase in future.
• To ensure the level and site of inventories required.
• To plan when to purchase and where to purchase
• To avoid both over stock and under stock of inventory

Techniques of Inventory Management

Inventory management consists of effective control and administration of inventories.

Inventory control refers to a system which ensures supply of required quantity and quality of
inventories at the required time and at the same time prevent unnecessary investment in
inventories. It needs the following important techniques. Inventory management techniques
may be classified into various types:
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Determinations of inventory control levels

Order quantity of inventories can be determined with the help of the following techniques:

Stock Level

Stock level is the level of stock which is maintained by the business concern at all times.
Therefore, the business concern must maintain optimum level of stock to smooth running of
the business process. Different level of stock can be determined based on the volume of the
stock. Stock level refers to the amount of goods or raw materials that should be maintained by
businesses to continue their activities and avoid any situations like understocking or
overstocking. Every organization should always keep an optimum amount of inventory to
ensure the regular operation of its production activities.

Inventory acts as a bridge between production and sales of business and ensures a regular
supply of finished goods to customers. Raw materials, work-in-progress, finished goods and
various consumables like fuel and stationery are three important types of inventories that every
firm needs to maintain.

Inventory managers should properly control the inventory and determine the optimum size to
be always kept within the organization. Managers should consider various factors like storage
space of firm, the frequency with which inventory is sold or used, risk of inventory getting
outdated before it is used, insurance cost on inventory, etc. for deciding the right amount of
stock.

Minimum Level

The business concern must maintain minimum level of stock at all times. If the stocks are less
than the minimum level, then the work will stop due to shortage of material.

This represents the quantity that must be maintained in hand at all times. If stocks are less than
the minimum level, then the work will stop due to a shortage of materials.

The minimum level shows the lowest figure of inventory balance, which must be maintained
in hand at all times so that there is no stoppage of production due to non-availability inventory.
This level is possible to maintain a fixed level after taking into consideration the rate of
consumption and the time required to acquire sufficient material to avoid dislocation of
production.
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The following factors should be considered while fixing the minimum level of various stocks.

Re-order level: - The product of maximum consumption of inventory item and its maximum
delivery period.

Average rate of consumption: - Average rate of consumption for each inventory items.

Maximum consumption and maximum delivery period: - in respect of each item to determine
its re-order level.

Average re-order Period: - to each item. This period can be calculated by averaging minimum
and maximum period.

Re-order Level

Re-ordering level is fixed between minimum level and maximum level. Re-order level is the
level when the business concern makes fresh order at this level.

Re-order level=maximum consumption × maximum Re-order period.

When the quantity of materials reaches a certain level then fresh order is sent to procure
materials again. The order is sent before the materials reach the minimum stock level.

The reordering level is fixed between the minimum level and maximum level. The rate of
consumption, the number of days required to replenish the stocks, and the maximum quantity
of materials required on any day are taken into consideration while fixing the reordering level.

Following factors are considered white maintain this re-order level.

Maximum consumption

Maximum Re-order period

Minimum level

Maximum Level

It is the maximum limit of the quantity of inventories, the business concern must maintain. If
the quantity exceeds maximum level limit then it will be overstocking.
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Maximum level = Re-order level + Re-order quantity – (Minimum consumption ×

Minimum delivery period)

It is the quantity of material beyond which a firm should not exceed its stocks. If the quantity
exceeds the maximum level limit then it will be termed as overstocking. A firm avoids
overstocking because it will result in high material costs. Overstocking will lead to the
requirement of more capital, more space for storing the materials, and more charges of losses
from obsolescence.

This level of stock indicates the maximum figure of inventory quantity held in stock at any
time. The quantity of stock should not exceed the level.

The following factors should be considered while fixing the maximum level of various stocks.

Re-order level: - The product of maximum consumption of inventory item and its maximum
delivery period.

Minimum Consumption: - Minimum Consumption and minimum delivery period for each
stock should be known.

Adequacy of working capital: - It should know to maintain maximum level of inventory.

Storage space: - It should be stored properly in stores.

Additional storage cost: - Cost required for additional storage should be considered. Additional
insurance cost should be considered.

Regular supply: - In case of importance materials due to their irregular supply, the maximum
level should be high.

Danger Level

It is the level below the minimum level. It leads to stoppage of the production process. Danger
level=Average consumption × Maximum re-order period for emergency purchase

Average Stock Level

It is calculated such as, Average stock level= Minimum stock level + ½ of re-order quantity
maximum level. It is the level of an average of minimum level and Maximum level. It means
the average level is maintained in states.
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Lead Time

Lead time is the time normally taken in receiving delivery after placing orders with suppliers.
The time taken in processing the order and then executing it is known as lead time.

Safety Stock

Safety stock implies extra inventories that can be drawn down when actual lead time and/ or
usage rates are greater than expected. Safety stocks are determined by opportunity cost and
carrying cost of inventories. If the business concerns maintain low level of safety stock, it will
lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying
costs.

Economic Order Quantity (EOQ)

EOQ refers to the level of inventory at which the total cost of inventory comprising ordering
cost and carrying cost. Determining an optimum level involves two types of cost such as
ordering cost and carrying cost. The EOQ is that inventory level that minimizes the total of
ordering of carrying cost.
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TECHNIQUES BASED ON THE CLASSIFICATION OF INVENTORIES

A-B-C analysis

It is the inventory management techniques that divide inventory into three categories based on
the value and volume of the inventories; 10% of the inventory’s item contributes to 70% of
value of consumption and this category is known as A category. About 20% of the inventory
item contributes about 20% of value of consumption and this category is called category B and
70% of inventory item contributes only 10% of value of consumption and this category is called
C category
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Aging Schedule of Inventories

Inventories are classified according to the period of their holding and also this method helps
to identify the movement of the inventories. Hence, it is also called as, FNSD analysis— where,
F = Fast moving inventories N = Normal moving inventories S = Slow moving inventories D
= Dead moving inventories

This analysis is mainly calculated for the purpose of taking disposal decision of the inventories.

VED Analysis

This technique is ideally suited for spare parts in the inventory management like ABC analysis.
Inventories are classified into three categories on the basis of usage of the inventories. V =
Vital item of inventories E = Essential item of inventories D = Desirable item of inventories

HML Analysis

Under this analysis, inventories are classified into three categories on the basis of the value of
the inventories. H = High value of inventories M = Medium value of inventories L = Low value
of inventories

Valuation of Inventories

Inventories are valued at different methods depending upon the situation and nature of
manufacturing process. Some of the major methods of inventory valuation are mentioned as
follows: 1. First in First Out Method (FIFO)

2. Last in First Out Method (LIFO)

3. Highest in First Out Method (HIFO)

4. Nearest in First Out Method (NIFO)

5. Average Price Method

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ABC analysis

ABC analysis is an approach for classifying inventory items based on the items’ consumption
values. Consumption value is the total value of an item consumed over a specified time period,
for example a year. The approach is based on the Pareto principle to help manage what matters
and is applied in this context:

• A items are goods where annual consumption value is the highest. Applying the
Pareto principle (also referred to as the 80/20 rule where 80 percent of the output is
determined by 20 percent of the input), they comprise a relatively small number of
items but have a relatively high consumption value. So it’s logical that analysis and
control of this class is relatively intense, since there is the greatest potential to reduce
costs or losses.

• B items are interclass items. Their consumption values are lower than A items but
higher than C items. A key point of having this interclass group is to watch items
close to A item and C item classes that would alter their stock management policies
if they drift closer to class A or class C. Stock management is itself a cost. So there
needs to be a balance between controls to protect the asset class and the value at risk
of loss, or the cost of analysis and the potential value returned by reducing class
costs. So, the scope of this class and the inventory management policies are
determined by the estimated cost-benefit of class cost reduction, and loss control
systems and processes.

• C items have the lowest consumption value. This class has a relatively high
proportion of the total number of lines but with relatively low consumption values.
Logically, it’s not usually cost-effective to deploy tight inventory controls, as the
value at risk of significant loss is relatively low and the cost of analysis would
typically yield relatively low returns.

Since businesses are not all the same, the thresholds that define the upper and lower limits of
each class are not definable. Nor will they necessarily be fixed over time or across all locations.
A business may have different risk appetites between different locations. For example, a
location in a high-crime area may have a higher proportion of A items or, where a facility is
less secure, more items may be classed as A. The management accountant should carry out risk
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and stock management cost-benefit analyses by location to deliver the optimal

overall cost-benefit balance and to set the ABC ranges.

ABC Analysis Benefits

A long list of benefits can result from applying ABC analysis to inventory management,
including:

▪ Increased Inventory Optimization: The analysis identifies the products that are in
demand. A company can then use its precious warehouse space to adequately stock
those goods and maintain lower stock levels for Class B or C items.

▪ Improved Inventory Forecasting: Monitoring and collecting data about products that
have high customer demand can increase the accuracy of sales forecasting. Managers
can use this information to set inventory levels and prices to increase overall revenue
for the company.

▪ Better Pricing: A surge in sales for a specific item implies demand is increasing and a
price increase may be reasonable, which improves profitability.

▪ Informed Supplier Negotiations: Since companies earn 70% to 80% of their revenue
on Class A items, it makes sense to negotiate better terms with suppliers for those items.
If the supplier will not agree to lower costs, try negotiating post-purchase services,
down payment reductions, free shipping or other cost savings.

▪ Strategic Resource Allocation: ABC analysis is a way to continuously evaluate

resource allocation to ensure that Class A items align with customer demand. When
demand lowers, reclassify the item to make better use of personnel, time and space for
the new Class A products.

▪ Better Customer Service: Service levels depend on many factors, like quantity sold,
item cost and profit margins. Once you determine the most profitable items, offer higher
service levels for those items.

▪ Better Product Life Cycle Management: Insights into where a product is in its life
cycle (launch, growth, maturity or decline) are critical for forecasting demand and
stocking inventory levels appropriately.

▪ Control Over High-Cost Items: Class A inventory is closely tied to a company’s

success. Prioritize monitoring demand and maintaining healthy stock levels, so there’s
always enough of the key products on hand.
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▪ Sensible Stock Turnover Rate: Maintain the stock turnover rate at appropriate
levels through methodical inventory control and data capture.

▪ Reduced Storage Expenses: By carrying the correct proportion of stock based on A,

B or C classes, you can reduce the inventory carrying costs that come with holding
excess inventory.

▪ Simplified Supply Chain Management: Use an ABC analysis of inventory data to

determine if it’s time to consolidate suppliers or shift to a single source to reduce
carrying costs and simplify operations.

ABC Analysis Limitations

ABC analysis, despite all its benefits for inventory maintenance and management, is not a one-
size-fits-all inventory management solution. Every organization has specific customer demand
patterns, classifications, systems and other issues that affect the usefulness of an ABC analysis.

The disadvantages of ABC analysis stem from two issues: an emphasis on the dollar value of
inventory and the significant amount of time and discipline it takes to apply the method. Here
are a few more challenges:

▪ Parameter Instability: ABC analysis often results in managers assigning up to 50%

of items to a new category every quarter or year. Often, companies are not aware of the
changes until there is a problem with demand, and the need to reassess may take up
valuable time and jeopardize customer satisfaction.

▪ Limited Pattern Consideration: The standard ABC method will not account for
factors like new product introductions or product seasonality. For example, a new
product may have low sales volume because it has no buying history. ABC analysis has
a somewhat static perspective on demand and will generate inventory inefficiencies
whenever demand is shifting or unclear.

▪ Low Information Extraction: ABC class information may not provide all the
statistical data or detail needed to make informed, strategic management decisions.

▪ High Resource Consumption: Giving disproportionate weight to trivial issues is

known as bike shedding, which can be an unfortunate consequence of ABC analysis.
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Since ABC analysis is easy to grasp, staff may inject their opinions or request their
own variants making ABC analysis a resource-consuming process rather than a time-
saving tool.

▪ Value Blindness: ABC analysis ascribes product importance based on revenue or

frequency of use, but some items may not hold to this paradigm. For example, a retail
display item may rarely sell but may attract a lot of customers (who will buy other
products) based on its novelty. In aerospace, a specific part for a plane may not be used
often and have little market value, but it may be a fundamental safety function.

▪ System Incompatibility: ABC inventory analysis conflicts with traditional costing

systems and is out of compliance with generally accepted accounting principles
(GAAP) requirements. If you must run multiple costing systems, labor costs will rise
alongside inefficiency.

▪ Undersupply or Oversupply Issues: One ABC analysis disadvantage is it looks at

dollar-based values, rather than the volume that cycles through inventory, so there is a
risk of running out of Class B or C items. The opposite can occur, too. You may have
excess low-class items that accumulate in inventory if you reorder them without regular
reviews.

▪ Loss Risk: Just because B and C items do not have as high a value as Class A products
does not mean they no value. One of the limitations of ABC analysis is that excess
stocks are always in jeopardy of obsolescence or damage. Therefore, the inventory that
habitually goes uncounted or unmonitored may be subject to theft.

▪ Mandatory Standardization: The ABC method is only successful if every item is

subject to the standardization of materials, which includes how they are named, stored,
and consistently rated and monitored.

▪ Arbitrary Categorization: Without preset boundaries or agreed-upon standards for

each category, classifying goods depends on the manager's professional judgment. So
this can be a relatively subjective process.

▪ Business Limitations: ABC analysis is not useful for companies that have an equable
annual consumption value of inventory items by type. For instance, a company that
sells the same version of an item like candy, nails or socks, may not be able to sort stock
based on the Pareto Principle.
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▪ High Resource Consumption: Companies with a significant number of

inventory items will have to hire additional staff or buy special equipment to control
inventory using ABC categorization.