Chapter 4

INVENTORY MANAGEMENT
Q1. Inventory Management
Inventory management refers to the process of ordering, storing, using, and selling a
company's inventory. This includes the management of raw materials, work in
progress, and finished products, as well as warehousing and processing of such items.
It 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.

Q2. Meaning of Inventory

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.

Q3. Objectives of Inventory Management

The major objectives of the inventory management are as follows:
 To ensure an 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.

Q4. Inventory Types

For a manufacturer, inventory is normally classified into one of three categories. The
first category is raw material. This is whatever the firm uses as a starting point in its
production process. Raw materials might be something as basic as iron ore for a steel
manufacturer or something as sophisticated as disk drives for a computer
manufacturer.
The second type of inventory is work-in-progress, which is just what the name
suggests- unfinished product. How big this portion of the inventory is depended in
large part on the length of the production process.
Finally, a very important distinction between finished goods and other types of
inventories is that the demand for an inventory item that becomes a part of another
item is usually termed derived or dependent demand because the firm's need for
these inventory types depends on its need for finished items.
Q5. Inventory Costs
There are two basic types of costs are associated with current assets in general and
with inventory in particular. The first of these is carrying costs. Here, carrying costs
represent all of the direct and opportunity costs of keeping inventory on hand. These
include:
1. Storage and tracking costs.
2. Insurance and taxes,
3. Losses due to obsolescence, deterioration, or theft.
4. The opportunity cost of capital on the invested amount.
The sum of these costs can be substantial, ranging roughly from 20 to 40 percent of
inventory value per year.
The other type of cost associated with inventory is shortage costs. Shortage costs are
costs associated with having inadequate inventory on hand. The two components of
shortage costs are restocking costs and costs related to safety reserves. Depending on
the firm's business, restocking or order costs are either the costs of placing an order
with suppliers or the costs of setting up a production run. The costs related to safety
reserves are opportunity losses such as lost sales and loss of customer goodwill that
result from inadequate inventory.
Q6. Inventory Management Techniques
As we described earlier, the goal of inventory management is usually framed as cost
minimization. Three techniques are discussed in this section, ranging from the
relatively simple to the very complex.
 The ABC Approach
The ABC approach is a simple approach to inventory management in which the basic
idea is to divide the inventory into three (or more) groups. The underlying rationale is
that a small portion of inventory in terms of quantity might represent a large portion in
terms of inventory value. For example, this situation would exist for a manufacturer
that uses some relatively expensive, high-tech components and some relatively
inexpensive basic materials in producing its products. ABC analysis is an inventory
categorization method that consists in dividing items into three categories (A, B, C):
A being the most valuable items, and C being the least valuable ones. This method
aims to draw managers' attention to the like the critical few (A-items), not to the trivial
many (C-items).
The ABC approach states that a company should rate items from A to C, basing its
ratings on the following rules:
 A-items are goods which annual consumption value is the highest; the top 70-
80% of the annual consumption value of the company typically accounts for
only 10-20% of total inventory items.
 B-items are the interclass items, with a medium consumption value; those 15-
25% of annual consumption value typically accounts for 30% of total inventory
items.
 C-items are, on the contrary, items with the lowest consumption value; the lower
5% of the annual consumption value typically accounts for 50% of total
inventory items.

 Economic Order Quantity (EOQ)

EOQ refers to the level of inventory at which the total cost of inventory comprising
ordering cost and carrying cost. The EOQ is that inventory level that minimizes the
total of ordering of carrying cost. EOQ solve the order quantity problem. All of these
are called order quantity problems.
 Buying in large quantity: - Smooth production/ Sale operation
- Lower ordering or set-up costs
- Higher Carrying Costs
 Buying in Small quantity: - Reducing average inventory level
- Reduce in the carrying costs
- Increased ordering costs
- Increased probability of stock out

 Costs of holding inventory in EOQ model:

Excluding the cost of merchandise, the costs associated with inventory fall into two
basic categories in EOQ model:
a) Ordering or Acquisition or Set-up Costs: The cost of acquisition and inbound
logistics form part of the ordering cost of procuring inventory. These include: Time
spent finding suppliers and expediting orders, Clerical costs of preparing purchase
orders, Transportation costs, Receipt of inwards goods, unloading, inspection and
transfer.
b) Carrying Costs: Inventory carrying costs typically include the physical cost of
storage such as building and facility maintenance related costs. These costs can
include: Financing expenses, the cost of storage space and warehousing Security,
which may include securing restricted or hazardous materials, Insurance against theft,
loss or damage, Opportunity cost capital tied up in inventory that could be spent
elsewhere, Deterioration, theft, spoilage, or obsolescence.
These two are an important element of the optimum level of inventory decisions.
EOQ can be calculated with the help of the mathematical formula:
2 AB
EOQ=√ C

Where,
A=Annual usage of inventories (units)
B=Buying cost per order
C=Carrying cost per unit
Assumptions:
The EOQ model, as the technique to determine the economic order quantity, illustrated
by us, is based on three restrictive assumptions:
a. The firm knows with certainty the annual usage (consumption) of a particular item
of inventory
b. The rate at which the firm uses inventory is steady over time
c. The orders placed to replenish inventory stocks are received at exactly that point in
time when inventories reach zero.

Q8. Extensions To the EOQ Model

We consider two extensions: safety stocks and reordering points.
1. Safety Stocks: A safety stock is the minimum level of inventory that a firm keeps
on hand. Inventories are reordered whenever the level of the inventory falls to the
safety stock level. Notice that adding a safety stock simply means that the firm does
not run its inventory all the way down to zero. Other than this, the situation here is
identical to that described in our earlier discussion of the EOQ.
2. Reorder Points: To allow for the delivery time, a firm will place orders before
inventories reach a critical level. The reorder points are the times at which the firm
will actually place its inventory orders. The reorder points simply occur some fixed
number of days (or weeks or months) before inventories are projected to reach zero,
one of the reasons that a firm will keep a safety stock is to allow for uncertain delivery
times.
The result is a generalized EOQ model in which the firm orders in advance of
anticipated needs and also keeps a safety stock of inventory.
Alternatives to holding inventory
 Long-term private contract with the producers of raw materials
 Purchase a contract for future delivery
 Replacing processes, prone to break-down with others that are more reliable
(WIP)
 Offer longer terms of credit of sale or lower prices as an alternative to immediate
availability (finished goods).
 Another option could be to go for the Just in Time (JIT) inventory system.

Q9. Just in Time (JIT) Inventory System

 Also known as the Toyota Production System, JIT is a common inventory
management technique designed to increase efficiency, cut costs and decrease
waste by receiving goods only as they are needed.
 JIT was originally formed in Japan as a response to the country's limited natural
resources, leaving little room for wastage.
 Demand-based-system based on flexible production, small lot sizes and high-
quality output
 Goods are produced and delivered only as they are needed
 A better alternative to traditional production planning system
 Here goods are produced only as needed. Work in process buffer stocks is
minimized.
 Reduction of inventory. Set up cost for processes must be small.
 Small lot size can be economically produced in response to demand.
 Workers are flexible- able to change their work station from one process to
another in response to demand
 Workers must perform their own quality control as there are few en-route quality
control inspections and goods move directly from one production process to
another.
 Since there are no buffer stocks and there is no inventory from which to draw if
the delivered goods are defective, output must be of very high quality.
 Buyers frequently must work with their suppliers to assure that the output from
supplier's manufacturing processes fits as perfectly as possible with the
producer's manufacturing processes.
 Workers must be highly skilled and flexible and machinery must be capable of
high- quality output while being cheap and quick to set up. So, JIT system
substitutes workers education costs and capital costs for inventory costs.
Q10. Difference between Traditional inventory system and JIT
Traditional Method JIT
Quality Quality has cost Quality is free Do things right
first time. It leads to good
quality an also lowers cost.
TQC and total employee
involvement.
Workers Engineers are experts Workers Workers are experts. Managers
Managers- execute their orders and engineers are facilitators
Engineers
Relationship
Errors Errors are to be eliminated by Stepping stones to success.
inspection One must learn from them.
They are not to be repeated.
Closer to the concept of zero
defects.
Inventories Always in stock to keep Inventories hide out
production process continuous. inefficiencies. Low inventories
(does not necessarily mean
zero inventory).
Lot size Mass production. Large lot Small lot sizes, preferably one.
production It means do a little bit of
everything every day. Study
set up times and reduce them.
Modify some equipment.
Queue Queue at work production Against queue formation.
station led to better machine Small lot sizes and low
utilization. inventories result in small or
no queues
Automation Substitute labor Preferred or consistency in
quality
Cost Reduction High machine utilization, High Accelerated flow of products
Tools rate of production, labor to reduction in lead times.
reduction
Lead Times Increase in delivery decreases delivery lead time
Flexibility There is flexibility to the cost of Flexibility by reducing all lead
excess capacity, general purpose times
accumulation of equipment
inventories, and overheads