Financial Management -

Inventory
What is inventory
Inventory refers to the collection of goods, materials, or products that a business
holds in stock with the intention of using them in production, selling them to
customers, or otherwise facilitating its operations.
Inventory can consist of raw materials, work-in-progress items, and finished goods.
It is an essential part of many businesses across various industries, enabling them
to meet customer demand, support production processes, and ensure smooth
operations.
As an accounting term, inventory is a current asset and refers to all stock in the
various production stages. By keeping stock, both retailers and manufacturers can
continue to sell or build items. Inventory is a major asset on the balance sheet for
most companies, however, too much inventory can become a practical liability.
• Understanding purchasing trends and the rates at which items sell
determines how often companies need to restock inventory and
which items are prioritized for re-purchase.
• Having this information on hand can improve customer relations, cash
flow and profitability while also decreasing the amount of money lost
to wasted inventory, stock outs and re-stocking delays.
1. Raw Materials:
Raw materials are the materials a company uses to create and finish
products. When the product is completed, the raw materials are typically
unrecognizable from their original form, such as oil used to create
shampoo.

2. Components:
Components are like raw materials in that they are the materials a
company uses to create and finish products, except that they remain
recognizable when the product is completed, such as a screw.
3. Work In Progress (WIP):
WIP inventory refers to items in production and includes raw materials
or components, labor, overhead and even packing materials.
4. Finished Goods:
Finished goods are items that are ready to sell.
5. Maintenance, Repair and Operations (MRO) Goods:
MRO is inventory — often in the form of supplies — that supports
making a product or the maintenance of a business.
6. Packing and Packaging Materials:
There are three types of packing materials. Primary packing protects the product
and makes it usable. Secondary packing is the packaging of the finished good and
can include labels or SKU information. Tertiary packing is bulk packaging for
transport.
7. Safety Stock and Anticipation Stock:
Safety stock is the extra inventory a company buys and stores to cover unexpected
events. Safety stock has carrying costs, but it supports customer satisfaction.
Similarly, anticipation stock comprises of raw materials or finished items that a
business purchases based on sales and production trends. If a raw material’s price is
rising or peak sales time is approaching, a business may purchase safety stock.
8. Decoupling Inventory:
Decoupling inventory is the term used for extra items or WIP kept at
each production line station to prevent work stoppages. Whereas all
companies may have safety stock, decoupling inventory is useful if parts
of the line work at different speeds and only applies to companies that
manufacture goods.
9. Cycle Inventory:
Companies order cycle inventory in lots to get the right amount of stock
for the lowest storage cost.
10. Service Inventory:
Service inventory is a management accounting concept that refers to
how much service a business can provide in a given period. A hotel with
10 rooms, for example, has a service inventory of 70 one-night stays in
each week.
11. Transit Inventory:
Also known as pipeline inventory, transit inventory is stock that’s
moving between the manufacturer, warehouses and distribution
centers. Transit inventory may take weeks to move between facilities.
12. Theoretical Inventory:
Also called book inventory, theoretical inventory is the least amount of
stock a company needs to complete a process without waiting.
Theoretical inventory is used mostly in production and the food industry.
It’s measured using the actual versus theoretical formula.

13. Excess Inventory:

• Raw Materials/Components: A company that makes T-shirts has components that include fabric, thread, dyes and
print designs.
• Finished Goods: A jewelry manufacturer makes charm necklaces. Staff attaches a necklace to a preprinted card and
slips it into cellophane envelopes to create a finished good ready for sale. The cost of goods sold (COGS) of the
finished good includes both its packaging and the labor exerted to make the item.
• Work In Progress: A cell phone consists of a case, a printed circuit board, and components. The process of assembling
the pieces at a dedicated workstation is WIP.
• MRO Goods: Maintenance, repair and operating supplies for a condominium community include copy paper, folders,
printer toner, gloves, glass cleaner and brooms for sweeping up the grounds.
• Packing Materials: At a seed company, the primary packing material is the sealed bag that contains, for example, flax
seeds. Placing the flax seed bags into a box for transportation and storage is the secondary packing. Tertiary packing
is the shrink wrap required to ship pallets of product cases.
• Safety Stock: A veterinarian in an isolated community stocks up on disinfectant and dog and cat treats to meet
customer demand in case the highway floods during spring thaw and delays delivery trucks.
• Anticipated/Smoothing Inventory: An event planner buys discounted spools of ribbon and floral tablecloths in
anticipation of the June wedding season.
• Decoupled Inventory: In a bakery, the decorators keep a store of sugar roses with which to adorn wedding cakes – so
even when the ornament team’s supply of frosting mix is late, the decorators can keep working. Because the flowers
are part of the cake’s design, if the baker ran out of them, they couldn’t deliver a finished cake
• Cycle Inventory: As a restaurant uses its last 500 paper napkins, the new refill order
arrives. The napkins fit easily in the dedicated storage space.
• Service Inventory: A café is open for 12 hours per day, with 10 tables at which diners
spend an average of one hour eating a meal. Its service inventory, therefore, is 120
meals per day.
• Theoretical Inventory Cost: A restaurant aims to spend 30% of its budget on food
but discovers the actual spend is 34%. The “theoretical inventory” is the 4% of food
that was lost or wasted.
• Book Inventory: The theoretical inventory of stock in the inventory record or system,
which may differ from the actual inventory when you perform a count.
• Transit Inventory: An art store orders and pays for 40 tins of a popular pencil set.
The tins are en route from the supplier and, therefore, in transit.
• Excess Inventory: A shampoo company produces 50,000 special shampoo bottles
that are branded for the summer Olympics, but it only sells 45,000 and the Olympics
are over — no one wants to buy them, so they’re forced to discount or discard them.
Motives of Holding Inventory
• Transaction Motive
• Precautionary Motive
• Speculative Motive
Inventory Best Practices
• Carry Safety Stock:
Also known as buffer stock, these products help keep companies from running out of materials or high-
demand items. Once companies deplete their calculated supply, safety stock serves as a backup should
the level of demand increase unexpectedly.
• Invest in a Cloud-based Inventory Management Program:
Cloud-based inventory management systems let companies know in real-time where every product and
SKU are located globally. This data helps an organization be more responsive, up-to-date, and flexible.
• Start a Cycle Count Program:
Cycle counting benefits extend well past the warehouse by keeping stock reconciled and customers
happy while also saving businesses time and money.
• Use Batch/Lot Tracking:
Record information associated with each batch or lot of a product. While some businesses log precise
details, such as expiration dates that provide information about their products’ sellable dates,
companies that do not have perishable goods use batch/lot tracking to understand their products’
landing costs or shelf lives.
What Is Inventory Turnover?
• Inventory turnover is the number of times a company sells or uses an
item in a specific timeframe, which can reveal whether a company has
too much inventory on hand. To determine inventory turnover, use
the following equations:
• Average inventory = (Beginning Inventory + Ending Inventory) / 2
• Inventory turnover = Sales + Average Inventory
The main costs associated with inventory
include:
1. Carrying Costs (Holding Costs):
• Storage Costs: Expenses related to storing inventory, including rent, utilities,
and insurance for warehouse or storage space.
• Interest Costs: The opportunity cost of tying up capital in inventory instead of
investing it elsewhere.
• Obsolescence Costs: The value of inventory that becomes obsolete or
outdated and cannot be sold.
• Risk and Insurance Costs: The cost of insuring inventory against damage,
theft, or other risks.
2. Ordering Costs:
• Procurement Costs: Expenses related to the process of ordering and acquiring
inventory, including administrative costs, paperwork, and communication.
• Setup Costs: Costs incurred when preparing a production process for a new
batch of products.
3. Shortage Costs (Stockout Costs):
• Backorder Costs: Costs associated with processing backorders or managing
unfulfilled orders due to stockouts.
• Lost Sales: Revenue lost when customers cannot purchase products due to
insufficient inventory.
• 4. Quality Control Costs:
• Inspection Costs: Expenses related to inspecting and ensuring the
quality of incoming materials or finished goods.
• 5. Deterioration and Spoilage Costs:
• Perishable Goods: Costs associated with goods that have a limited
shelf life and can spoil or deteriorate if not sold in time.
6. Opportunity Costs:The potential benefits or profits that could have
been realized if the capital tied up in inventory were invested
elsewhere.
7. Administrative Costs:
• Costs associated with managing and monitoring inventory levels, including record-
keeping, data entry, and reporting.
8. Taxes and Depreciation:
• Some jurisdictions may impose taxes on inventory, and inventory may also
depreciate in value over time.
9. Transportation Costs:
• Costs associated with transporting inventory from suppliers to warehouses or
distribution centers.
10. Waste and Shrinkage Costs:
• Costs due to theft, damage, or waste of inventory.
Inventory Decisions
• Order Quantity Decision: How much to order?
• Reorder Point Determination: When to place the order?
• Safety Stock Policy: How much safety stock should be kept?
• Lead Time Management: Decisions related to reducing lead time can
impact inventory levels and order frequency.
• Technology and Systems: Choosing and implementing inventory
management software, automation, and tracking technologies (like
RFID) can enhance accuracy and efficiency.
Lead Time Management:
• Lead time in inventory management refers to the amount of time it
takes for an order of inventory to be fulfilled, from the moment the
order is placed to the moment the inventory arrives and is available
for use or sale.
• It is a critical factor in inventory planning and decision-making
because it directly affects the timing of replenishment orders and the
level of safety stock required to prevent stockouts.
Lead time includes several components, and understanding
each of them is important for effective inventory management:
• Supplier Lead Time: This is the time it takes for a supplier to process an
order, prepare the goods, and ship them to the buyer. Supplier lead time
can vary significantly depending on factors such as the supplier's location,
production processes, and shipping methods.
• Order Processing Time: This is the time it takes for the buyer to process
and place an order with the supplier. It includes tasks such as order
creation, approval, and communication with the supplier.
• Manufacturing or Production Lead Time: For companies that
manufacture their own products, this is the time it takes to produce the
goods after an order is received. It includes tasks such as production
planning, manufacturing, and quality control.
• Shipping or Transportation Time: This is the time it takes for the
goods to be transported from the supplier's location to the buyer's
location. It can vary based on shipping methods, distance, and
transportation modes.
• Customs Clearance and Documentation: If international shipments
are involved, time spent on customs clearance, documentation, and
import/export processes adds to the lead time.
• Transit Time: This is the time the goods spend in transit, moving from
the supplier to the buyer. It is influenced by factors like distance,
transportation mode, and any potential delays.
Stock levels
• Lead time is the difference between the point when the need for materials
has emerged and actual receiving the materials.
• Lead time= Requisition time + Procurement time
• Reorder point is a specific level at which the stock needs to replenished.
• ROL= Maximum rate of usage * Maximum lead time
• Safety stock indicates the minimum level of stock that should always be
maintained in stock so that there is no risk of stoppage of production and to
prevent out of stock situation.
• It is also known as buffer stock or reserve stock or minimum stock
• Safety stock= Order point- ( Avg. usage rate* Avg. lead time)
• Maximum level= Reorder level + Reorder Qty. – (Minimum
Consumption* Minimum reorder period)
• Avg. stock level= (Max stock level + Minimum stock level )/2
Stock levels
Just-in-time (JIT)
• Just-in-time (JIT) inventory and just-in-time manufacturing have been
buzzwords in the world of supply chain for some time now, and quite a
few businesses have adopted this approach.
• With growing competition and increasing pressure to boost profitability,
many businesses have adopted this strategy to boost their bottom line —
which can be problematic when supply chains come to a screeching halt.
• JIT is a form of inventory management that requires working closely with
suppliers so that raw materials arrive as production is scheduled to
begin, but no sooner. The goal is to have the minimum amount of
inventory on hand to meet demand.
Advantages of JIT Inventory Management
• Waste Reduction: The JIT inventory management model eliminates over
ordering and excess of all kinds.
• Improved Efficiency: JIT eliminates the costs that come with extra raw
materials, unneeded inventory and product storage.
• Greater Productivity: JIT enhances productivity by reducing the time and
resources involved in manufacturing processes.
• Smoother Production Flow: JIT can eliminate bottlenecks and delays across
the entire production process.
• Reduce Working Capital: The low inventory levels that come with JIT limit
the amount of working capital needed.
Just in time
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Amazon Inventory system
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