Inventory Management

Abhishek Sinha
Concept Diary Topics
Role of inventory in working capital management Cost of funds tied up with inventory
Liquidity lags Cost of running out of goods
Creation lag
Economic order quantity (EOQ)
Storage lag
Inflation and EOQ
Sale lag
Modified EOQ to include varying unit prices
The purpose of inventories

Types of inventory Reorder point subsystem

Costs associated with inventory Safety stock

Material costs Stock cost and carrying cost

Ordering costs The ABC system of inventory management
Carrying costs  
Role of inventory in working
capital management
Current Asset:

• Generally has a life of one year

• However there are exceptions
• Loose Tools
• Wine Casks
• Piano
• Assumption to make inventories have a life of one year
Level of Liquidity
• Inventories are viewed as a source of near cash.
• However least liquid of all the assets.
• Most firms hold some slow-moving items
• that may not be sold for a long time.
• With economic slowdowns or changes in the market for goods (business risk),
• the prospects for sale of entire product lines may be diminished.
• In these cases, the liquidity aspects of inventories
• become highly important to the manager of working capital.
• At a minimum, the analyst must recognize that
• inventories are the least liquid of current assets.
• For firms with highly uncertain operating environments, the analyst must discount the
liquidity value of inventories significantly.
Liquidity Lags
• Creation Lag:
• In most cases, inventories are purchased on credit, creating an account payable.
• When the raw materials are processed in the factory, the cash to pay production expenses is transferred at
future times, perhaps a week, month, or more.
• Labor is paid on payday.
• The utility that provided the electricity for manufacturing is paid after it submits its bill.
• Or for goods purchased for resale, the firm may have 30 or more days to hold the goods before payment is due.
Whether manufactured or purchased, the firm will hold inventories for a certain time period before payment is
made.
• This liquidity lag offers a benefit to the firm.
Liquidity Lags
• Storage Lag:
• Once goods are available for resale, they will not be immediately converted into cash.
• First, the item must be sold.
• Even when sales are moving briskly, a firm will hold inventory as a back-up.
• Thus, the firm will usually pay suppliers, workers, and overhead expenses before the goods are actually sold.
• This lag represents a cost to the firm.
Reducing Risk of Production Shortages:
• Manufacturing firms frequently produce goods with hundreds or even
thousands of components.
• If any of these are missing, the entire production operation can be halted,
with consequent heavy expenses.
• To avoid starting a production run and then discovering the shortage
of a vital raw material or other component,
• the firm can maintain larger than needed inventories.
COSTS ASSOCITAED
WITH INVENTORY
Raw Materials Inventory:
• This consists of basic materials that have not yet been committed to
production in a manufacturing firm.
• The purpose of maintaining raw material inventory is to uncouple the
production function from the purchasing function
• so that delays in shipment of raw materials do not cause production delays.
Stores and Spares
• This category includes those products which are accessories to the
main products produced for the purpose of sale.
• Examples of stores and spares items are bolts, nuts, clamps, screws, etc.
• These spare parts are usually bought from outside or sometimes they
are manufactured in the company also.
Work-in-Process Inventory
• This category includes those materials that have been committed to
the production process but have not been completed.
• The more complex and lengthy the production process, the larger will be the
investment in work-in-process inventory.
Finished Goods Inventory
These are completed products awaiting sale.
The purpose of a finished goods inventory is to uncouple the
productions and sales functions so that it no longer
COSTS ASSOCIATED WITH
INVENTORIES
• Material Costs: costs of purchasing the goods including
transportation and handling costs.
• Ordering Costs:
• The ordering costs refer to the costs associated with
• the preparation of purchase requisition by the user department,
• preparation of purchase order and follow-up measures taken by the purchase
department,
• transportation of materials ordered for, inspection and handling at the
warehouse for storing.
Carrying Costs
• These are the expenses of storing goods.
• Once the goods have been accepted, they become part of the firm’s
inventories.
• These costs include insurance, rent/depreciation of warehouse,
salaries of storekeeper, his assistants and security personnel,
financing cost of money locked-up in inventories, obsolescence,
spoilage and taxes
Cost of Funds Tied up with Inventory
• Whenever a firm commits its resources to inventory,
• it is using funds that otherwise might have been available for other purposes.
• The firm has lost the use of funds for other profit making purposes. This is its
opportunity cost.
• Whatever the source of funds,
• inventory has a cost in terms of financial resources.

Excess inventory represents unnecessary cost.

Cost of Running out of Goods:
• These are costs associated with the inability to provide materials to
the production department and/or inability to provide finished goods
to the marketing department as the requisite inventories are not
available.
• In other words, the requisite items have run out of stock for want of
timely replenishment.
• These costs have both quantitative and qualitative dimensions.
INVENTORY MANAGEMENT
TECHNIQUES
Economic Order Quantity
• The economic order quantity (EOQ)
• refers to the optimal order size
• that will result in the lowest total of order and carrying costs for an item of
inventory
• given its expected usage, carrying costs and ordering cost.
• By calculating an economic order quantity,
• the firm attempts to determine the order size that will minimize the total
inventory costs.
Components of EOQ
•  Total inventory cost = Ordering cost + Carrying cost
Total ordering costs = Number of orders *Cost per order
= U/Q*F
• Where U = Annual usage, Q = Quantity ordered
F = Fixed cost per order

• Where Q = Quantity ordered, P = Purchase price per unit.

C = Carrying cost as %
Cost Behaviour and Deriving EOQ
• 
• (2UF)/PC
• The order quantity Q becomes EOQ when the total
ordering costs at Q is equal to the total carrying costs.
Using the notation, it amounts to stating:

• Or
• *P*C
• 2UF/(PC)
• 0r
• (2UF)/PC
• Where
U = Annual usage,
Q = Quantity ordered
F = Fixed cost per orde
P = Purchase price per unit.
C = Carrying cost as %
Illustration
•• Suppose a firm expects a total demand for its product over the planning period to be 10,000 units, while the
 ordering cost per order is Rs.100 and the carrying cost per unit is Rs.2. Substituting these values,

• = 1000 units
• Hence , inventory cost is minimised by ordering 1000 units
EOQ Assumptions
1. Constant or uniform demand
2. Constant unit price
3. Constant carrying costs
4. Constant ordering costs
5. Instantaneous delivery
Illustration 2
•• Arvee Industries desires an annual output of 25,000 units. The set-up cost for each production run is Rs.80.
 The cost of carrying inventory per unit per annum is Rs.4. The optimum production quantity per production
run (E)

• =1000 units
Modified EOQ to include Varying Unit Prices

• Bulk purchase discount is offered when the size of the order is at least equal to some minimum
quantity specified by the supplier.
• The question may arise whether Q*, EOQ calculated on the basis of a price without discount will
still remain valid even after reckoning with the discount.
• While no general answer can be given to such a question we can certainly say that a general
approach using the EOQ framework will prove useful in decision-making – whether to avail
oneself of the discount offered and if so what should be the optimal size of the order.
Modified EOQ to include Varying Unit
Prices
• The procedure for such an approach is outlined below:
• The first step under the general approach is to calculate Q*,
EOQ without considering the discount.
• Let us suppose Q¢ is the minimum order-size stipulated by the
supplier for utilizing discount.
• After calculating Q* the same will be compared to Q¢.
Modified EOQ to include Varying Unit
Prices
• Only three possibilities can arise out of the comparison.
• In case Q* is greater than or equal to Q¢,
• then Q* will remain valid even in the changed situation caused by the
quantity discount offered.
• This is so because the company can avail itself of the benefit of
quantity discount with an order-size of Q*
• as it is at least equal to Q¢, the minimum stipulated order size for
utilizing discount.
Modified EOQ to include Varying Unit
Prices
• Only in the case of Q* being less than Q¢
• the need for the calculation of an optimal order size arises as the
company cannot avail itself of the discount with the order size of Q*.
• An incremental analysis can be carried out
• to consider the financial consequences of availing oneself of discount
by increasing the order-size to Q¢.
• A decision to increase the order-size is warranted only
• when the incremental benefits exceed the incremental costs arising
out of the increased order-size.
Incremental Benefits
• The incremental benefits will have two components:
• First, the total amount of discount available on the amount of
material is to be used.
• If we assume Rs. D of discount per unit of material, then the total
discount on the annual usage of material of U units amounts to:
• Annual usage of materials in units x Discount per unit of material =
Rs.UD
Incremental Benefits
•  • Secondly, with an increase in order-size from Q* to Q¢, the
number of orders will be reduced.
• As the ordering cost is assumed to be Rs.F per order irrespective of
the order size, there will be a reduction in the total ordering cost.
• Thus, the reduction in ordering cost.
= (The difference between the number of orders with sizes of Q* and
Q¢) x (the cost per order of Rs. F)
- )* F)
Total incremental Benefits

Thus, the total incremental benefits will

be the sum of the above two expressions
and is given by
Total incremental benefits = Rs. UD +
Rs. {U/Q* – U/Q¢}x F
 Incremental Carrying Cost
• With an increase in the order-size:
• there is likely to be an increase in the average value of inventory
• even after reckoning with the discount per unit of material of Rs.D which will
go to reduce the price per unit for the valuation of inventory.
• The increase in the average value of inventory will result in higher incidence
of carrying cost, assumed to be C percent of the average value of inventory.

• Incremental Carrying Cost = (Q¢(P -D)C)/2 – (Q ¢ P C)/2 )

NET INCREMENTAL BENEFIT
Rs. UD + Rs. {U/Q* – U/Q¢}x F –
(Q¢(P -D)C)/2 – (Q ¢ P C)/2 )

If the net incremental benefits are positive, then the optimal order quantity becomes Q¢. Otherwise Q* will
continue to remain valid even in a situation of bulk purchase discount.
Illustration U = 40,000 units

• The annual usage of a raw material is F = Rs.200 per

40,000 units for the Hy Fly Co., Ltd.
The price of the raw material is Rs.50 order
per unit. The ordering cost is Rs.200
per order and the carrying cost 20
percent of the average value of P = Rs.50 per unit
inventory. The supplier has recently
introduced a discount of 4 percent on
the price of material for orders of D = Rs.2 per unit
1,500 units and above. What was the
company’s E.O.Q. prior to the
C = 0.20
introduction of discount? Should the
company opt for availing the
discount? What would be the optimal
order size if the company opts to
avail for itself the discount offered?
Solution
• 
• E.O.Q. without discount

• = 1,265 units
• For utilizing discount the minimum order size Q¢ = 1,500 units. As Q* is less than Q¢, we have to calculate the
incremental benefits and incremental costs.
• Total amount of discount available with an order size of 1,500 units.
• = U x D = 40,000 units x Rs.2 per unit.
• = Rs.80,000 (1)
• Savings due to reduction in ordering costs
• {U/Q* – U/Q¢}x F
• {40000/1250 – 40000/1500}x 200
• 1000 (2)
Solution
• Incremental carrying cost

• Q¢(P -D)C)/2 – (Q ¢ P C)/2 )

• (1500*48*0.2)/2– (1265*50*0.2)/2 ) = Rs. 875 …………….. (3)

• Net incremental benefits (= 1 + 2 – 3)

• = Rs.80,000 + Rs.1,000 – Rs.875 = Rs.80,125
Reorder Point Subsystem
•The two factors that determine the appropriate order point are
• the procurement or delivery time stock which is the inventory needed during the lead time (i.e., the difference between the order date
and
• the receipt of the inventory ordered) and the safety stock which is the minimum level of inventory that is held as a protection against
shortages.
•Reorder Point = Normal consumption during lead time + Safety Stock.
•Reorder level = Average daily usage rate x lead time in days.

•From the above formula it can be easily deduced that an order for replenishment of materials be made when
the level of inventory is just adequate to meet the needs of production during lead time.
•If the average daily usage rate of a material is 50 units and the lead time is seven days, then
•Reorder level = Average daily usage rate x Lead time in days
• = 50 units x 7 days
• = 350 units
 Safety Stockouts (2) Probability Expected Expected Carrying Total Cost
Stock (1) (3) Stockout Stockout Cost Cost (7)
(4) = (2 x 3) (5) (6)
8,000 units 0 0 0 0 Rs. 24,000 Rs. 24,000
4,800 units 3,200 units 0.0625 200 units Rs. 2,000 Rs. 14,400 Rs. 16,400
2,000 units 6,000 units 0.0625 375 units Rs. 7,250 Rs. 6,000 Rs. 13,250
  2,800 units 0.1250 350 units      
      725 units      
1,600 units 6,400 units 0.0625 400 units Rs. 8,500 Rs. 4,800 Rs. 13,300
  3,200 units 0.1250 400 units      
  400 units 0.1250 50 units      
      850 units      
0 8,000 units 0.0625 500 units Rs.14,500 0 Rs. 14,500
  4,800 units 0.1250 600 units      
  2,000 units 0.1250 250 units      
  1,600 units 0.0625 100 units      
      1,450 units      
 If the safety stock of the firm is 8,000 units, there is no chance of
the firm being out of stock. The probability of stock-out is,
therefore zero

Safety
Stock If the safety stock of the firm is 4,800 units, there is 0.0625 chance
that the firm will be short of inventory.

If the safety stock of the firm is 2,000 units, there is stock-out of

6,000 units with a probability of 0.0625 and 2,800 units with a
probability of 0.125 based on the possible usage of 16,000 units
with probability of 0.0625 and 12,800 with a probability of 0.125
stock-out and the probability of occurrence of stock-out at other
levels are calculated in the same way.
 ABC System
• A firm using the ABC system segregates its inventory into three groups – A, B and
C.
• The A items are those in which it has the largest rupee investment. These are the most
costly or the slowest turning items of inventory.
• The B group consists of the items accounting for the next largest investment. This group
consists approximately 20 percent of the items accounting for about 20 percent of the
firm’s rupee investment.
• The C group typically consists of a large number of items accounting for a small rupee
investment. C group consists of approximately 70 percent of all the items of inventory but
accounts for only about 10 percent of the firm’s rupee investment. Items such as screws,
nails, and washers would be in this group.
ABC System of Inventory Management
• Dividing its inventory into A, B, and C items allows the firm to determine the level and types of inventory
control procedures needed.
• Control of the A items should be most intensive due to the high rupee investments involved,
• while the B and C items would be subject to correspondingly less sophisticated control procedures.