Inventory Management

BY Priti Singh

Topics
Meaning of inventory management Types of inventories Need for inventory Cost of holding inventories Characteristics of inventory situations Selective inventory control Inventory Control Models Control devices Inventory management & valuation

MEANING OF INVENTORY MANAGEMENT

Inventory management is concerned with keeping enough product on hand to avoid running out while at the same time maintaining a small enough inventory balance to allow for a reasonable return on investment. Excessive level of inventory, results in large inventory carrying cost.

Need of INVENTORY MGT :An efficient system of inventory management will determine (a) what to purchase (b)how much to purchase (c)from where to purchase (d) where to store

Objects of inventory Mgmt.

To Ensure Continuous Supply Of Raw Material, Spares And Finished Goods. To Avoid Both Overstocking And Under stocking Of Inventory. To Maintain Investments In Inventories At Optimum Level. To Keep Material Cost under Control. To Eliminate Duplication In Ordering Or Replenishing Stocks. To Minimize Losses Through Wastage And Damages . To Facilitates Finishing Of Data.

TYPES OF INVENTORIES
(a) RAW MATERIAL:
A inventory of raw materials allows separation of production scheduling from arrival of basic inputs to the production process. (b) WORK-IN-PROGRESS: An inventory of partially completed units allows the separation of different phases of the production process.

(c) FINISHED GOODS:

An inventory of finished goods allows separation of production from selling.

(d) CASH & MARKETABLE SECURITIES:

Cash & marketable securities can be thought of as an inventory of liquidity that allows separation of collection from disbursement.

Need for Inventories

Transaction motive: The transaction motive for holding inventory is to satisfy the expected level of activities of the firm.

Precautionary motive: The precautionary motive is to provide a cushion in case the actual level of activity is different than anticipated.

Speculative motive:

The speculative motive is to purchase larger quantity of materials than normal in anticipation of making abnormal profits.

COST OF INVENTORIES
The determination of inventory cost is essentially an income measurement problem. Relevant inventory costs which change with the level of inventory are listed below: Ordering cost: Every time an order is placed for stock replenishment, certain cost are involved. This cost of ordering includes: - Paper work costs, typing & dispatching. - order inspection cost, checking & handling.

a)

b) Carrying costs or cost of holding inventories

Carrying costs constitute all the cost of holding items in inventory for a given period of time. This cost involves: Capital Cost -Storage & handling costs. -obsolescence & deterioration costs. -Insurance. -Taxes. -The cost of funds invested in inventory.

c) Stock out costs:

Stock out costs are incurred whenever a business is unable to fill orders because the demand for an item is greater than the amount currently available in inventory. This cost involves: -Expenses of placing special orders. -Expediting income orders. -Cost of production delays.

CHARACTERISTICS OF INVENTORY SITUATIONS

1) Lead time: Obtaining inventory usually requires a time lag from the initiation of the process until the inventory starts to arrive. This lead times may be few min.or months. 2) Sources & level of risk: Where there are substantial uncertainties & where the costs of stockout are important . Strategies for addressing risk must be formulated.

3) Static versus dynamic problems: In static inventory problems, the goods have a one-period life; there can be no carryover of goods from one period to next. In dynamic inventory problems, the goods have value beyond the initial period; they do not lose their value completely overtime.

Selective Inventory Control

I. Explosion process:
In many manufacturing organization, production requirements are based directly on the sales forecast. For each of its products, the company prepares a bill of material needed for various products.

II.

Past-usage methods:
The other method used for determining the production requirements relies on the past usage, rather than on the sales forecast . If a certain item was used at the rate of 100 units per month during the past year or during some other period is likely to be used at the same rate in future.

III. Value-volume Analysis: This analysis is used to determine which inventory accounts should be controlled by the explosion method & which should be controlled by past usage method. In valuevolume analysis the no. of each item used in the past year is multiplied by its unit to find the annual activity for the item.

A-B-C Classification (Always Better Control)

In this technique materials are analyzed according to their value so that costly and more valuable materials are given greater attention and care. They are classified acc. to their high, medium, and low, which are known as A, B and C items respectively. 1. A-items : - Costly items - Constitute not more than 10% of the total items, but these consume about 70% of the total budget of inventory. - Require proper storage and handling - Overstocking is avoided. 2. B-items : - Neither costly nor cheap. - Constitute 20% of the total items and consume about 20% of the total inventory budget. - Need moderate control.
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3. C-items : - cheaper - constitute 70% of the total items and consume about 10% of total inventory budget on them. - do not need any control and are given least attention.

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V-E-D Classification (Vital, Essential and Desirable)

V-Vital : items without which the activities will come to halt. eg: adrenaline injection, steroid preparations .

E-Essential : items which are likely to coz disruption of the normal activity. eg: life supporting items such as transfusion fluids. D-Desirable : in the absence of which the hospital work does not get hampered. eg: aspirin, other analgesics, vitamins, enzymes.

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H-M-L Classification (High, Medium, Low)

It is based on the unit value (in rupees) of items. The items should be listed in decreasing order of unit value and management may fix limits for deciding the three categories.

F-S-N Classification (Fast, Slow and Non moving)

It takes into account the distribution and handling patterns of items from stores. Used when obsolescence is to be controlled. May be a change in technology or an item is no longer in use. At such time information must ne given to managers so that they can act on it.
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S-D-E Classification
Its based on lead time analysis and availability.
S- Scarce : longer lead- time (imported). D- Difficult : long lead -time (indigenous). E-Easy : reasonable lead- time.

S-O-S Classification
Items which are seasonal in nature and hence require special purchasing and stocking categories.

G-O-L-F Classification
It stands for Government, Ordinary, Local, Foreign.

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X-Y-Z Classification
It is based on value of inventory stored. If the values are high, special efforts should be made to reduce them. It is done once in a year.

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Lead times, Stockouts, Safety stocks

Maximum quantity : upper limit of inventory in the stores. Minimum quantity : lower limit of the inventory in the stores. Standard order : it is the difference between maximum and minimum
quantities.

Reorder point : it is the time to initiate a purchase order. If it is not done,

inventory may exhaust and even the reserve stock will be utilized before the arrival of new items.

Stock holding : it is the buffer stock that should be available to avoid

break down of production schedule.
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It is the time lapse between placement of an order and receipt of items including their approval by Q.C dept. It may be calculated on the basis of past experience. Reasons for the lead time may be explained as internal-external-internal.
Raising of purchase requisition. Inquiries. Tenders. Scrutiny and approval. Placement of orders to suppliers.

LEAD TIME

Internal

Lead time

Suppliers makes goods ready. Transportation and clearing. Receiving of goods at stores. Taking the stock. Inspection for quantity and quality. Ready for issue to production.

External

Internal
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STOCK-OUTS
Means running out of stocks which leads to back orders. Limits of the stock outs should not be more than 2%.

CAUSES FOR STOCK-OUTS 1] INTERNAL

- Faulty planning.

2] EXTERNAL
- Labour problems

- Poor control
- Improper records - Shortage of funds - Poor follow-up - Strikes etc.

- Poor selection of transportation

- Change in market situations and demand - Floods, Strikes and Fire etc.

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IV. A-B-C ANALYSIS:

The materials are divided into three categories viz, A ,B &C

CATEGORY-A:
Under this almost 10% of the items contribute to 70% of value of consumption.

CATEGORY-B:
Under this category 20% of the items contribute about 20% of value of consumption.

CATEGORY-C:
Under this category about 70% of items of material contribute only 10% of value of consumption.

V. HML Classification: The HML (high, medium, low) classification is similar to ABC classification, but in this case instead of the assumption value of the item, the unit value of the item is considered.

VI. XYZ Classification: The XYZ classification has the value of inventory stored as the basis of differentiation. X items are those whose inventory value are high while Z items are those whose value are low.

VII. VED ANALYSIS: The VED analysis is used generally for spare parts. The requirements and urgency of spare parts is different from that of materials. spare parts are classified as vital (V), essential (E) ,desirable (D).
VITAL SPARE PARTS:

These are must for running the concern smoothly.

ESSENTIAL SPARE PARTS:

Necessary but stock kept at low figures.

DESIRABLE SPARE PARTS:

May be avoided at times

VIII. FSN Analysis:

Movement analysis forms the basis for FSN (fast moving, slow moving, non-moving) classification & the items are classified according to their assumption pattern. IX. SDF & GOLF Analysis: The SDF (scarce, difficult, easy to obtain) classification & the GOLF (government, ordinary, local, foreign sources) are the systems where analysis is done on the basis of general availability & the source of suppliers.

Economic Order Quantity (EOQ) Models

EOQ
optimal order quantity that will minimize total inventory costs

Basic EOQ model

Assumptions of Basic EOQ Model

1. 2. 3. 4. Demand is known with certainty and is constant over time No shortages are allowed Lead time for the receipt of orders is constant Order quantity is received all at once

Inventory Order Cycle

Order quantity, Q Inventory Level

Demand rate

Reorder point, R

Lead time Order Order placed receipt

Lead time Order Order placed receipt

Time

EOQ Cost Model

Co - cost of placing order Cc - annual per-unit carrying cost D - annual demand Q - order quantity CoD Q CcQ 2 CcQ 2

Annual ordering cost =

Annual carrying cost = Total cost = CoD + Q

EOQ Cost Model (cont.)

Annual cost ($) Slope = 0 Minimum total cost Carrying Cost = CcQ 2

Total Cost

Ordering Cost =

CoD Q

Optimal order Qopt

Order Quantity, Q

INVENTORY CONTROL MODELS

1) EOQ MODELS: Economic order quantity is the size of the lot to be purchased which is economically viable. EOQ IS MADE UP OF TWO PARTS

ordering costs: requisitioning, order placing, transportation, receiving, inspecting and storing, administration
carrying costs: warehousing, handling, clerical and staff, insurance, depreciation and obsolescence ordering and carrying costs trade-off:

EOQ =

2AO c

2. Just-In- Time Inventory Management System:

A key part of just-in-time techniques is the replacement of production in large batches with a continous flow of smaller quantities. It is based on the idea that all required inventory items should be supplied to the production process at exactly the right time & in right quantity.

CONTROL DEVICES
i) Control Account:
The control is maintained in the general ledger by accounting. All material purchases are charged against the account & all issuances are credited to it.

ii)

Physical Counting:
Physical counting of stock on hand for tax & cost accounting functions & as a means of verifying the balance showed on perpetual inventory records & in the control account.

iii) Visual Review:

A highly subjective method of determining when to reorder is a visual reviews of stock in inventory. For ex: in the old time general store, the owner would inspect his inventory & determine what should be ordered.

iv) Two-bin system:

The two-bin system divides each item of inventory into two groups. In first, sufficient supply is kept to meet current demand, In second, additional items are available to meet the demand during load time.

v) Minimum- maximum system:

The minimum-maximum system is frequently used in connection with mannual inventory control systems. The min quantity is established in the same way as any reorder point.

vi) Periodic order system: Under this system, the stock levels for all inventory accounts
are reviewed at established intervals, & orders are placed to bring all accounts up to their max level.

INVENTORY MANAGEMENT & VALUATION

A) Average cost method:

For determining the valuation of inventories, consistency from year to year is of prime importance & for this average cost method is appropriate. In this method, weighted average prices are taken with price of each type of material in stock are taken together.

B) First-in-First-out Method:
Under FIFO method, Items received first are assumed to be used first & therefore prices charged are those paid for early purchase. care has to be taken to ensure that each quantity is issued at the correct price.

C) Base Stock Method:

Under this method, the base quantity is carried forward at the cost of the original stock. If a quantity of goods larger than the base stock is owned at the end of any period, the excess will be carried at its identified cost or at the cost determined under FIFO method.

D) Last-In, First-Out Method:

Under LIFO it is assumed that the stock sold or consumed in any period are those most recently acquired or made. The result at the LIFO method is to charge current revenues with amount approximating current replacement cost.