CHAPTER-1
INTRODUCTION
(i) BACKGROUND OF THE STUDY
(ii) RESEARCH METHODOLOGY
(iii) REVIEW OF LITERETURE
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UNIT-I
BACKGROUND OF THE STUDY
An Overview
Focus of the Study
Statement of the Problem
Importance of the Study
Objectives of the Study
Limitation of the Study
Major Hypothesis
Organization of the Study Estelar
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UNIT–I
BACKGROUND OF THE STUDY
1.1 An Overview
Nepal is among the poorest and least developed countries in the world with a
population of 28 million people, 86% of whom live in rural areas, 46 % are
unemployed and nearly 24.7% live below poverty line (CIA, 2010).1 Agriculture
is the mainstay of the economy, providing a livelihood for about 80% of the
population and accounting for 40% of GDP. Industrial activity mainly involves
the processing of agricultural products especially, jute, sugarcane, tobacco
and grain. Nepal has considerable scope for exploiting its potential in
hydropower and tourism. Nepal's gross domestic product (GDP) for 2008 was
estimated at over US$12 billion (adjusted to Nominal GDP), making it the
115th-largest economy in the world. In the total GDP of Nepal agriculture
accounts for about 40%, services comprise 39% and industry 21%. Agriculture
employs 76% of the workforce, services, 18% and manufacturing/craft-based
industry 6%. Agricultural products include tea, rice, corn, wheat, sugarcane,
root crops, milk, and water buffalo meat, mostly grown in the Terai region
bordering India.2
Nepal is situated in the northern hemisphere of the world. It is Located in
southern Asia and is couched between the two Asian giants, China to the
north and India to the south. It is a landlocked as well as mountainous country
which lies on the southern flank of Himalaya. Nepal occupies only .03%
and.3% of the total land area of world and Asia respectively. It extends from
26”22’ north to 30”27’ north latitude in the northern hemisphere and from
80’04’ east to 88’12 east longitudes in the eastern hemisphere. The altitude
ranges from 70 meters to 8848 meters. The country stretches from east to
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west with mean length of 885 Km and widens from north to south with mean
breadth of 193 Km and its shape is roughly rectangular. The total area of the
country is 1,47,181 sq.km.3
Geographically the country is divided into three east-west ecological zones:
The northern range- Mountains, the mid range- Hills and southern range-
Terai. In the northern range the Himalayas form an unbroken mountain which
contains 8 peaks higher than 8000 meters including Mt. Everest on the border
with China. The middle range is captured by gorgeous mountains, high peaks,
hills, valleys and lakes. The Kathmandu valley (kingdom of Nepal) lies in this
region. The southern range with almost 16 km. to 32 km. north south consist
of dense forest areas, national parks, wildlife reserves and conservation areas.
According to the population census of 2001, the annual growth rate of
population was 2.25 percent and the total population of the country has
reached about 26.6 millions in 2011 of which the proportion of male and
female are 48.56 and 51.44 percent respectively. The annual growth rate of
population according to latest population census 2011 is 1.4 percent. There is
an increasing trend of population and its concentration is increasing in urban
areas.4
Nepal is a rich country which has innumerous natural resources but the
people of Nepal are still poor. Nepal’s poor economy is reflected by its
estimated per capita GDP income of $ 323.40 as against that of USA
$43967.80. The preliminary estimate of per capita GDP at current prices
stands at NRs. 34732 (US $ 473) for the year 2008-09 and the economic
growth of the country measured by GDP is 5.56 percent for the year 2007-08.5
Nearly two fifth of the populations live below the poverty line as per the
Nepal living standards survey 2003-04 and the ginni coefficient, which
indicates the inequality between poor and rich, is 41.4. In a research report
published by CEDA (a research center under TU of Nepal) in which economy,
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education, health and so on were taken as the basis of research study Nepal
was ranked 130th among the 139 countries and it was at 125th position in the
last year.6
Among the 207 countries, having population more than 30,000, Nepal
ranks in the bottom ten economically in the category of low income
economies, i.e. having GNI $ 755 or less. In the recent time, population
growth rate (i.e. 2.3%) has outpaced economic growth rate (i.e. GDP
growth rate 2.0%) resulting either in decline in real per capita income or
slow in real income growth: despite rise in monetary income due to higher
inflation rate. Low GDP, low per capita income, high inflation rate have
resulted in low disposable income and low saving and consequently low
investment.7 The real Gross Domestic Product (GDP) is estimated to grow
only by 3.5 percent in the current fiscal year (2008-09) against the targeted
5.5 percent. According to revised estimate, GDP in the previous fiscal year
grew by 4.0 percent.8
At present, the country is divided into five north-south administrative
development zones. The country is further divided into 75 administrative
districts. Moreover, the districts are further divided into smaller units
called Village Development Committees (VDCs- total 3915) and
Municipalities (total-58). The VDCs are rural areas, where as Municipalities
are urban areas of the country.9 It has used a series of five-year plans in an
attempt to make progress in economic development. It completed its tenth
economic development plan in 2007 and eleventh three years interim plan
is also going to be completed. Foreign aid accounts for more than half of
the development budget. Government priorities over the years have been
the development of agriculture, industry, transportation and
communication facilities.10
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1.2 Focus of the Study
Nepal is one of the least developing countries in the world which is still in its
crawling stage of industrialization. The sound economic development of any
nation depends upon the higher rate of growth on production activities in the
different sectors of the country’s economy. About six decades ago, when the
country was under the Rana rule for more than hundred years, no significant
initiatives were taken to improve the economic condition of the country.
There were few Rana rulers who had shown interest in establishing industries
and public utilities companies in the country, thus economic development in
Nepal, in real sense, started only after the Rana regime. In the late period of
Rana regime some positive attempts were made by them, as a result “Udyog
Parishad” got its existence in1935 A. D.
The general process of industrialization started in Nepal in 1936 A.D. after the
establishment of the council of industry and enactment of Nepal company act.
To create some belief in people Ranas started to establish some
manufacturing industries, especially, Biratnagar Jute Mill (1936 A.D.), Morang
Electricity Supply Company (1942 A.D.) Nepal Plywood and Bobbin Company
Ltd. (1943 A.D.), Juddha Match Factory. (1943 A.D.), Morang Sugar Mill and
Cotton Mill and Raghupati Jute Mill (1946 A.D.) were established. During the
same period a commercial bank (Nepal Bank Limited) was also established in
1937A.D.11
In Nepal in the mid 1950s, it was observed that the public enterprises were
essential. Though Nepal is a country with mixed economy, at that time it was
hard for any individual or private group to start the business providing basic
goods and services to the people. Therefore, the state took the initiatives; and
starting in the 1930s, a number of Public Enterprises (PEs) were established by
the government with an aim of building an industrial and manufacturing base.
About 62 PEs in all were established, close to half in the industrial sector and
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rest in the trading, service, public utility and financial sectors. PEs in the
industrial sector include cement factories, brick factories, sugar mills, textile
mills, jute products factories, tool factories, foundries, and industrial chemical
and fertilizer factories.
1.3 Statement of the Problem
The productivity of any manufacturing organization depends on the
availability of raw materials and other component parts in the proper
quantity, quality, price range, and time. Proper control over inventories
provides the management with flexibility in making purchases systematically
rather than buying strictly according to the production schedule and hand to
mouth supplies. Efficient management aims at increasing the level of
inventories as long as the resulting economies and benefits exceed the total
cost of holding such inventories. Proper control over inventories improves the
productivity and profitability of the enterprises. It also helps in achieving
higher return on investment by minimizing locked up working capital and also
improving the cash flow and liquidity position.12
Inventory management is a very important component of corporate finance
because it directly affects the liquidity and profitability of a company. The
corporate finance literature has traditionally focused on the study of long
term financial decisions. Researchers have particularly offered studies
analyzing investments, capital structure, dividends or company valuation,
among other topics. But the investment that firms make in short-term assets,
and the resources used with maturities of under one year, represent the main
share of items on a firm's balance sheet (Pedro and Pedro, 2007).13 A firm is
required to maintain a balance between liquidity and profitability while
conducting its day to day operations. Liquidity is a precondition to ensure that
firms are able to meet its short-term obligations and its continued flow can be
guaranteed from a profitable venture (Kesseven, 2006).14
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Inventory management must meet two conflicting needs, viz., (i) maintenance
of an inventory of sufficient size and diversity for efficient operations and
(ii) maintenance of a financially favorable inventory. The basic objective of
inventory management is to optimize the size of inventory in a firm so that the
smooth performance of production and sales functions may be possible at
minimum cost.
Managing assets of all kinds is basically an inventory problem. The same
method of analysis applies to cash and fixed assets as to inventories
themselves because in borrowing money, in buying raw materials for
production or in purchasing plant and equipment it would be cheaper to buy
more than enough to meet immediate needs.15
Inventory constitutes most significant part of current assets therefore; most
companies are very much concerned with their inventory policies. The size of
inventories varies from industry to industry depending upon the nature and
size of activities performed by them. For a typical manufacturing company
inventories will often exceed 15 percent of assets and for a retailer inventories
could represent more than 25 percent of assets.16
The cost of buy and carry inventories is about 15 percent for the many firms
and storage, insurance, pilferage and obsolescence amount to another 10 to
15 percent. Thus holding Rs. 100 of inventory for a year has a cost in the range
of Rs. 25 to Rs. 30. With these high costs holding excessive inventories literally
can ruin a company. On the other hand inventory shortages can lead to lost
sales to production interruptions and customer ill will, so shortages can be just
as harmful as excesses.17
Both excessive and inadequate inventories are not desirable. The excessive
level of inventories consumes funds of the firm which cannot be used for any
other purpose and thus it involves an opportunity cost. Excessive inventory
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holding also increases inventory holding costs like insurance cost, storage
cost, recording and inspection cost and handling cost. It also increases the
possibility of inventories being deteriorate & obsolescence and excessive
inventories carried for a long may not be sold in full value. All these factors
increase the inventory costs and these costs will impair the firm’s profitability.
On the other, if a firm maintains inadequate level of inventories then the firm
has to face number of problems like production interruption or failure to meet
delivery commitment in time and time to time placement of order. All these
issues related with inadequate holding of inventories will also increase
inventory costs, which in turn hurt the profitability of the firm. Therefore, a
firm should maintained sufficient level of inventoried i.e. neither too high nor
too low to maximize the overall profitability of the firm.
Inventory management is a vital function to help insure the success of
manufacturing and distribution companies. The effectiveness of inventory
management is directly measurable by how successful a company is in
providing high levels of customer service, low inventory investment, maximum
throughput and low costs. Certainly, an area where management should apply
a philosophy of aggressive improvement is inventory management.
The ratio of inventories to total assets computed for selected non finance
enterprises in Nepal have been observed on an average 22 percent. On the
basis of this ratio it is clear that Nepalese enterprises are tying considerable
sum of money in the inventories. The most neglected aspect of Nepalese
enterprises is inventory management perhaps the weakest aspect of the
management. There is no utilization of any scientific method in decision
making and in managing inventories. The tools and techniques for controlling
inventory have not been applied in Nepalese manufacturing industries for
controlling their physical and financial dimension. Cement industries which fall
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under manufacturing industries have large size of inventories for their
uninterrupted production and sales.
Due to the lack of research study in the field of inventory management of
Nepalese manufacturing industries most of the Nepalese manufacturing
industries are blocking huge amount in the inventories. Therefore, this study
focused in the inventory management aspect of the Nepalese cement
industries and their impact on overall profitability of the industries. Attempt
has also been made in this study to examine whether the investment in
inventory of the selected cement companies is justified in term of profitability
and the trends in inventory investment is in relation to the current assets
investment of the company. The study also focuses on whether an efficient
use of inventory investment has been made by the companies with reference
to production.
1.4 Importance of the Study
A truly effective inventory management system will minimize the complexities
involved in planning, executing and controlling a supply chain network which
is critical to business success. The opportunities available by improving a
company’s inventory management can significantly improve bottom line
business performance. From a financial perspective, inventory management is
no small matter. Oftentimes, inventory is the largest asset item on a
manufacturers’ balance sheet. As a result, there is a lot of management
emphasis on keeping inventories down so they do not consume too much
cash. The objectives of inventory reduction and minimization are more easily
accomplished with modern inventory management processes that are
working effectively.
Every enterprise has to reconcile the conflicting objectives of liquidity and
profitability in the inventory management to obtain a higher return on
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investment and to maximize the value of the company in the market. At the
enterprise level, inventory holding assumes greater importance as inventories
constitute a large proportion of the total assets of many concerns. It requires
a substantial investment of capital besides involving costs of storage and
handling as well as risk of damage, loss and obsolescence. In order to
minimize costs and also to ensure that the capital is not unnecessarily locked
up, inventories must be efficiently managed. Errors in inventory management
can not be easily rectified, as it is the least liquid among all the current assets.
The major problem of inventory control is to maximize profitability by
balancing investment cost of materials against what is required to sustain
smooth operations.
Inventory management which is an integral part of material management is
one of the important functions of manufacturing industry. Without an
effective and efficient management of inventory no organization can achieve
their goals. Inventory management helps to maximize profit of the firm. A
slight change on the cost of materials will bring about a great change in the
companies profitability. Therefore, a manufacturing company should maintain
adequate stock of raw materials to meet their production activities. Because
of limited resources industries in developing countries are still using
traditional techniques in inventory management and control. Inventory
management is concerned with keeping inventories on hand to avoid running
out while at the same time a small enough inventories to allow a reasonable
return on investment. Therefore inventory management involves planning of
the optimal level of inventory and control of inventory costs. It involves both
physical and financial dimension of inventories. These dimensions are
interrelated and cannot be looked in isolation. Proper inventory management
is essential for the financial health of the firm.
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In Nepal public enterprises are accepted to build the infrastructure to
produce and supply important consumer goods in complement and
supplement to the private sector and to operate as a model for efficiency.
They are also expected to generate revenue and contribution to the national
treasury in order to carry out these exceptions successfully. Public
enterprises, in the context of developing country must be efficient in
utilization of their resources. The growing number of corporation in Nepal is
facing problem of inventory management. Due to the lack of proper
inventory policies, there are many corporations where large amount of
capital has been blocked up and very little measures have been taken to
manage the inventory decisions. Most of the Nepalese manufacturing
companies are the victim of poor inventory management. Cement industries
are also not free from this obstacle.
The study focuses on the problems faced by the cement industries in the area
of inventory management. It can be hoped that cement industries would be
satisfied by eliminating the obstacles to be faced in the future. Cement
industries spend huge amount of their investment on inventories, but there is
lack of proper inventory management system. Inventory management is wide
subject but no one paid serious attention in this field in Nepal. Many modern
techniques to manage inventories have been realized in the western world,
but in Nepal many manufacturing corporations are still facing the problem of
managing physical & financial dimensions of inventories. The present research
will be the first of its kind in the Nepalese context in general and in
manufacturing sector in particular. Although lots of empirical studies have
been conducted in the western world to correlate inventory management and
profitability, this will be the pioneer in the Nepalese context. Therefore, this
study is justified for identifying the inventory management problems of the
cement industries of Nepal.
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1.5 Objectives of the Study
The main objective of this study is to find the present position of the inventory
management and its impact on the profitability of the cement industries in
Nepal. The specific objectives of the study are as follows:
(i) To evaluate the existing inventory management system of the cement
industries in Nepal.
(ii) To identify the problems facing by the cement industries at the time of
inventory management and control.
(iii) To obtain an optimum inventory management system for the cement
industries in Nepal.
(iv) To examine the inventory management practice and its impact on
profitability of the cement industries in Nepal.
(v) To provide logical suggestions based on the findings of the study.
1.6 Limitation of the Study
(i) The study will be carried out with a range of latest nine fiscal years data
starting from 2001-02 to 2009-10.
(ii) The figure available in the published financial statements will be
assumed to be correct.
(iii) The required information for the study, if not found through the
published documents will be ascertained by the interview and
questionnaires with the concerned personnel. The conclusion drawn
from such sources of information may imply tentative in nature.
(iv) The study will be limited to the area of inventory management and its
impact on profitability and has not covered other areas of cement
industries.
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1.7 Major Hypothesis
In the light of the objective the following null and alternate hypothesis have
been developed for this study
Null hypothesis, H0:µ1= µ2; there is no significance impact of inventory
management on profitability of the cement industries in Nepal.
Alternate hypothesis, H1: µ1≠µ2 there is significant impact of inventory
management on profitability of the cement industries in Nepal.
1.8 Organization of the Study
The study has broadly been divided into 6 chapters.
Chapter 1. Introduction
An introduction to the thesis along with methodology and literature review is
given in Chapter One.
This chapter includes three sub headings.
Unit- I Background of the study
It includes background of the study, statement of the problem, significance of
the study, objective of the study, limitations of the study, research hypothesis
and organization of the study.
Unit-II Research methodology
This chapter explains the research methodology employed to conduct the
study and tool and techniques used in analysis of data. This chapter includes
research design, sources of data, population and sampling and method of data
analysis.
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Unit-III Review of literature
It includes fundamental concepts and components of inventory management
and review of previous research work in the same field.
Chapter 2. Development of cement industries in Nepal
It includes background of cement, origin of cement industries and cement
industries of Nepal.
Chapter 3. Contribution of cement industries in Nepal
This chapter includes contribution of the cement industries in Nepal.
Chapter 4. Presentation and Analysis of data
This chapter analyzes the data and interprets the result so obtained.
Chapter 5. Problems and Suggestion
Problems faced by the Nepalese cement industries and recommendations for
the solutions of those problems have been provided in this chapter.
Recommendations are also made for future research.
Chapter 6. Summary and Findings
The last chapter has provided for summary and conclusions drawn from the
study so that, the complete picture of the study can be understood in short
form. Este
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Reference
1. The world Factbook; Nepal. Retrieved April 26, 2010, From
https://www.cia.gov/library/publications/the-world-factbook/geos/np.html.
2. http://en.wikipedia.org/wiki/Nepal.
3. Central bureau of statistics, Nepal in Figures 2009 - Ramshah Path Kathmandu,
Nepal.
4. Ibid P.2
5. Microsoft Encarta Premium 2009.
6. Economic report published by CEDA Sept. 9, 2010.
7. Daniels and et. al., 2004.
8. International Monetary Fund (World Economic Outlook), 2010 as quotated in
the Economic survey- fiscal year 2009/10 AD Vol.1, Government of Nepal,
Ministry of Finance.
9. Central Bureau of Statistics, Nepal in Figures 2009 - Ramshah Path Kathmandu,
Nepal.
10. http://en.wikipedia.org/wiki/Econom.
11. Corporation Coordination Council, Profile of Public Enterprises in Nepal (HMG
of Nepal, Kathmandu, June, 1978)
12. Hal Mather, How to Really Manage Inventories, McGraw Hill Book Company,
New York, p. 26, 1984.
13. As quoted by Negi, Pushpa; Sankpal, Shilpa; Chakraborty, Anindita; Mathur,
Garima in their article “Manufacturing Industry Profitability Investigations”
Publication: Abhigyan, April, 1, 2010.
14. Ibid.
15. J. Fred Weston and Thomas E. Copeland, Managerial Finance, The Dryden
Press, 1991, P. 815.
16. Stephen A Ross, Randolph W Westerfield and Bradford D Jordon,
Fundamentals of Corporate Finance. The McGraw-Hill Publishing Ltd., New
Delhi, 2007, P.704.
17. Weston, Besley-Brigham, Essentials of Managerial Finance, 11ed. The Dryden
Press Harcourt Brace College Publisher, 1996.
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UNIT-II
RESEARCH METHODOLOGY
Research Design
Population and Sample
Sources of Data
Data Analysis Tools
Financial Tools
Statistical Tools Estelar
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UNIT-II
RESEARCH METHODOLOGY
We need appropriate research methodology to achieve the objective of the
study. Research methodology refers to the various sequential steps to be
followed by the researcher in studying a problem with certain objectives in
view. The study on inventory management of cement industries in Nepal
concentrates in the issues of managing inventory systematically. The following
steps are followed in this study.
2.1 Research Design
Research design is the plan, structure and strategy of investigation conceived
so as to obtain answer to research questions and to control variance.1 The
research design includes specification of the method of the purposed study
and detailed plan for carrying out the study with various empirical data for the
analysis of the problem. Research design is the plan, structure and strategy of
investigation conceived so as to obtain answer to research question and to
control variances.2 The research design of this study basically follows
inventory management and its effect on profitability. In other words, this
research is designed so as to find out the effect of inventory management in
the profitability of the cement industries in Nepal. This study will mainly
concentrate on the study of the inventory management and its impact on
profitability of the cement industries in Nepal. For this purpose various
analytical and descriptive approaches are used.
2.2 Population and Sample
According to the record of the department of industry the number of cement
industries which were granted permission to operate before 2011 was about
50 of which only 28 cement industries came into existence in different fiscal
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years. Among them about 10 are not in operation due to various reasons thus,
at present about 18 cement industries are in operation in Nepal.3
Since this study has been directed towards assessing the impact of inventory
management in the profitability of the cement industry during the period last
nine consecutive years viz. 2001-02 to 2009-10, therefore all cement
industries which are in operation could not provide scope for their study
because most of the cement industries which are in operation are just few
years old and they have absence of data for the last nine years. Therefore, two
public cement industries are selected for the purpose of study.
1. Hetauda Cement Industry Ltd
2. Udayapur Cement Industry Ltd.
2.3 Sources of Data
Although this study is basically conducted on secondary data, primary
sources have also been used in some issues. The financial statements
published by these industries, Auditor General’s reports, Quarterly Economic
Bulletin published by the Nepal Rastra Bank, The Economic Survey published
by ministry of finance, statistical pocket book, Nepal in figure, census of
manufacturing establishment and other related publication of Central
Bureau of statistics, publication National Planning Commission and news
paper, booklets, journals articles relating to the study have been used as
secondary sources of data. For obtaining the information about certain
aspects of the inventory management questionnaires were given to the
concerned personnel of the selected industries and the chief executive of
the sample industries were consulted to get more information and their
personal views. In addition, certain websites were visited to collect the
relevant information.
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2.4 Data Analysis Tools
After collecting the information from the various sources they were edited,
classified, tabulated and analyzed as per requirement of the study. To analyze
the data financial and statistical tools have been used. Among them ratio and
trend analysis under financial tools and mean, standard deviation, coefficient
of variation, correlation and regression analysis etc. under statistical tools are
commonly used throughout the study.
A. Financial tools
1. Ratio analysis
A ratio is defined as “indicated quotient of two mathematical expression” and
as “the relationship between two or more things.”4 A ratio is simply a number
expressed in term of another number and it expressed the quantitative
relationship between any two variables.5 The following financial ratios have
been used in the study.
(a) Inventory Turnover Ratio
Inventory turnover ratio indicates the efficiency of the firm in producing and
selling its product. The general measure of assessing the utilization of
inventory investment is to compute the inventory turnover ratio.6 “Turnover”
is a term that originated many years ago with the old Yankee peddler who
would load up his wagon with goods, then go off his route to peddle his
wares. The merchandise was his working capital because it was what he
actually sold or turnover to produce his profits whereas his turnover was the
number of trips he took each year.7 Inventory turnover indicates the number
of times the average inventory is turnover during the year.8 The following
ratios are calculated under :-
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(i) Inventory to sales ratio: It is calculated by dividing the cost of goods sold
by the average inventory:
Inventory turnover ratio = Cost of goods soldAverage inventory
Some compilers of financial ratios (Dun & Bradstreet) use ratio of sales to
inventory to represent inventory turnover. It is calculated as
Inventory turnover ratio = Sales
Average inventory
Higher inventory turnover ratio indicates the better management of
inventories by the firm.
Average inventory value is calculated by summing the monthly figures
during the year and dividing by twelve. If monthly data are not available,
we can add the beginning and ending figures of inventory and divide by
two.9
(ii) Raw material turnover: This ratio is calculated to examine the efficiency
of the firm in converting its raw materials into work in process and work
in process into finished goods. The formula is:
Raw material turnover = Raw material consumed
Average raw material inventory
The increase in this ratio indicates efficiency in utilizing the raw material,
remaining other things same.
(b) Percentage of investment in the inventory
It indicates the percentage of fund tied up in the inventory. The following
ratios are calculated under it.
(i) Inventory to Total Assets Ratio: It measures the relationship between
inventory and total assets. This ratio is calculated to find out the
percentage of total assets occupied by the inventory.10 The formula is:
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Inventory to total assets = Inventory
Total assets × 100
The increase in this ratio denotes the liberal inventory policy followed by
the firm.
(ii) Inventory to fixed assets ratio: The percentage of inventory in relation to
fixed assets is determined in this ratio.
Inventory to fixed assets ratio = Inventory
Total fixed assets × 100
(iii) Inventory to Current Assets Ratio: This ratio shows what percentage of
current assets is in the form of inventories.11 A higher the ratio of
inventory to current assets would indicate a large volume of inventory
and it would also indicate poor liquidity position of the firm. It is
calculated as:
Inventory to current assets = Inventories
Current assets
(c) Inventory to profit ratio
This ratio tells how much inventories are needed to generate one unit of
profit. It is calculated as:
Inventory to profit = Material Consumed
Gross Profit
or Inventory Net profit
2. Days of Inventory Holdings (DIH) or Average Age of Inventory (AAI)
Inventory holding in relation to sales is determined by calculating days of
inventory holding. It indicates time duration of inventory holding and
represents the average time taken from the purchase of raw material to the
ultimate sales of finished product.12 When the number of days in a year is
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divided by inventory turnover we obtain days of inventor holdings. It is also
called inventory conversion period. It is calculated as:
Days of inventory holdings = 360
Inventory turnover
Smaller the DIH higher the efficiency in managing inventory and vice versa.
3. Gross margin return on inventory (GMROI)
Gross margin return on inventory is considered the best single measure of
inventory management effectiveness because it includes gross margin
component as well as an inventory movement component. GMROI analysis
provides three important benefits.
(i) It shows how inventory buying and pricing procedures be combined with
inventory management procedures to affect profitability.
(ii) It shows how products with a relatively low gross margin and high
turnover can be just as profitable as those with higher margins and lower
turnovers.
(iii) It demonstrates that as gross margins decrease, inventory turnover must
increase otherwise profitability will suffer.
Gross Margin Return on Inventory (GMROI) is a "turn and earn" metric that
measures inventory performance based on both margin and inventory
turnover. In essence, GMROI answers the question, "For every rupee carried
in inventory, how much is earned in gross profit?" In the calculation of GMROI
two terms are incorporated in the formula i.e. earns term and turn term. The
earn term, gross profit/sales, is simply the gross profit margin percentage on
sales. The turn term, sales/average Inventory at cost same as inventory
turnover, which is the cost of goods sold, divided by average Inventory at cost.
Therefore, the GMROI formula can be simplified to address the impact of
these two terms in a single formula
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GMROI = GPM% × ITO
1-GM%
or GMROI = Gross Margin
Inventory
B. Statistical Tools
Besides the financial tools, various statistical tools have also been used to
conduct this study.
1. Arithmetic Mean or Average (X )
An average is the value, which represents a group of values. It depicts the
characteristic of the whole group. Generally the average value lies somewhere
in between the two extremes, i.e. the largest and the smallest items. Average
of a given set of observation is their sum divided by the number of
observations. In general, if X1, X2 ………… Xn are the given 'n' observations then
their arithmetic mean, usually denoted by X is given by,
X =
XN
Where,
X = Sum of Observation
N = No. of observation
2. Standard Deviation (σ)
Karl Pearson first introduced the concept of standard deviation in 1983.
Standard deviation is the positive square root of the arithmetic average of the
squares of all the deviations measured from the arithmetic average of the
series. The standard deviation measures the absolute dispersion of a
distribution. The greater the amount of dispersion the greater the standard
deviation, i.e. greater will be the magnitude of the deviation of the values
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from their mean. A small standard deviation means a high degree of
uniformity of the observation as well as homogeneity of a series. Standard
Deviation (S.D.) is denoted by a Greek letter ''Sigma) and is calculated as
follows:
S.D. () = (X –
X)2
N
Where,
N = Number of items in the series.
X = Mean
X = Variable
3. Coefficient of Variation (C.V.)
It is the measurement of the relative dispersion developed by Karl Pearson. It
is used to compare the variability of two or more series. The coefficient of
variation is the relative measure of dispersion, comparable across distribution
which is defined as the ratio of the standard deviation to mean expressed in
percent.13 The series with higher coefficient of variation is said to be more
variable. On the contrary, the series with less coefficient of variation is said to
be more consistent. It is denoted by CV and is obtained by dividing the
standard deviation by arithmetic mean. Thus,
Coefficient of Variation (C.V.) = S.D. × 100
Mean
or × 100
X
Where,
= Standard deviation
X = Mean
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4. Coefficient of Correlation (r)
The correlation analysis is the technique used to measure the closeness of the
relationship between the variables. It helps us in determining the degree of
relationship between two or more variables. It describes not only the
magnitude of correlation but also its direction. The coefficient of correlation is
a number, which indicates to what extent two variables are related with each
other and to what extent variations in one leads to variations in the other.
The value of coefficient of correlation always lies between ±1. A value -1
indicates a perfect negative relationship between the variables and a value of
+1 indicates a perfect positive relationship. A value of zero indicates that there
is no relation between the variables. Thus, in this study, the degree of
relationship between inventory and other relevant financial indicators is
measured by the correlation coefficient. The correlation
r = Cov (XY)xy
r = (X –
X) (Y –
Y)
(N – 1) xy
Where,
x, y are the standard deviation of the distribution of X and Y values
respectively.
Cov. (XY) = Covariance of XY value
= (X –
X) (Y –
Y)
N – 1
Under this study, the correlations between the following variables are
analyzed:
1. Annual inventory and annual sales
2. Annual profit and annual inventory.
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Reference
1. Kerlinger, F. N. (1986). Foundations of behavioral research (3rd ed.). New York: Holt, Rimehart and Winston.
2. Kothari, 1991:24 1 C. R. Kothari, Quantitative Techniques, Vikash Publishing House Pvt. Ltd. 1991: p. 24.
3. Department of industry, Government of Nepal.
4. Webster’s New Collegiate Dictionary, 8th Ed. Springfield, Mass: G & C, Merriam, 1975, P. 958.
5. C. R. Kothari, Quantitative Techniques, Vikash Publishing House Pvt. Ltd., 1994 P. 487.
6. M. Chapman Frindlay III and Edward E. Williams An Integrated Analysis for Managerial Finance New Jersey: Printice Hall Inc., 1970, p. 75.
7. Weston, Besley & Brigham. Essential of Managerial Finance. The Dryden Press Harcourt Brace Collage Publisher, 11th. Ed. P. 96.
8. M. Chapman Findlay III and Edward E. Williams, An Integrated Analysis of Managerial Finance, opt. cit., P. 75.
9. Ibid, P. 97.
10. Ibid.
11. T. V. S. Ramamohan Rao, Econometric Analysis of Managerial decision, New Delhi: Oxford and IBH Publishing Company, 1978, P. 101.
12. Lawrence J. Gitman, Principle of Managerial Finance, New York: Harper and Row Publishers, 1989, P. 156.
13. Levin & Rubin, 1994, P. 114.
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UNIT-III
REVIEW OF LITERATURE
Meaning of Inventory
Types of Inventory
Need to Hold Inventory
Inventory Management
Need and Importance of Inventory Management
Relationship Management and Material Management
Objective of Inventory Management
Economic Order Quantity
Re-order Point/Re-order Level
Safety Stock
Reducing Safety Stock
Goods in Transit
Methods of Inventory Control
Inventory Valuation
Inventory Management and Profitability
Computers and Inventory
Resume of Earlier Studies on Inventory Management
Studies Conducted in Aboard
Studies Conducted in India
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UNIT-III
REVIEW OF LITERATURE
3.1 Meaning of Inventory
The term “inventaire” or detail list of goods date back to 1415 A. D. The word
inventory is as old as the human civilization. Pacioli published his dynamic
work in Venice in 1494 A.D. but hundred years before in Florence, inventories
were used for opening and closing books.1 These were known as “inventaire”
and included all assets and liabilities.’2 Adam Smith’s conception of stock in
trade as a part of what he so aptly describes as “circulating capital”3 covers
substantially the same variety of materials as we now include in the inventory.
The control and maintenance of inventory is a problem common to all
organizations in any sector of economy. The problems of inventory do not
confine only to the profit-making institutions because the same type of
problems are encountered by social and profit-making institutions.
Inventories are common to all type of organizations and they indeed relevant
to the family units. Inventory problems have been encountered even by the
society but until the half of the nineteenth century analytical techniques for
study and management of inventory were not developed.4 Inventory is the
investment in materials, labor and finished goods from procurement through
processing until use or distribution to the customer.
The word inventory can be used to mean several different meanings, for
example, the term inventory refers to the stock of raw materials and supplies,
good finished and in process of manufacture, merchandise on hand or in
transit etc on hand at the end of accounting period. In connecting with
financial statements and accounting records the reference may be the
aggregate value representing the stock of goods owned by an enterprise at a
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particular time. As a verb the term embraces the act or process of counting,
weighing, listing and pricing the stock items. The word is also used to mean
itemized list showing unit price extensions and totals. It also refers detailed
lists of property that often accompanies a bill of sale or lease of finished
premises.5
In financial parlance, inventory is defined as the sum of the value of raw
materials, fuels and lubricants, spare parts, maintenance consumables, semi-
processed materials and finished goods stocks at any given point of time. The
operational definition of the inventory would be: the amount of raw
materials, fuel and lubricants, spare parts and semi- processed materials to be
stocked for the smooth running of the business. Since these resources are idle
when kept in the store, inventory is defined as an idle resource of any kind
having economic value.6
In this study inventory refers stocks of raw materials, finished goods, semi-
finished goods and other miscellaneous spare parts and supplies. The term
“Inventory” is used to designate that the aggregate of those items of tangible
personal property which (i) are held for the sale in the ordinary course of
business (ii) are in the process of production for sale or (iii) are to be currently
consumed in the production of goods or services to be available for sale. The
dictionary meaning of inventory is stock of goods.7
Inventories are expandable physical articles held for resale, for use in
manufacturing of product or for consumption in carrying on business
activities.8 An inventory refers to the movable articles of business which are
eventually expected to go into the flow of trade.9
For the non-manufacturing institutions the items of inventory are different,
for example books are inventories for library, cash is inventory for a bank,
specialists are inventories for the consulting organization but it is stock of
finished and semi finished goods and raw material for the trading and
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manufacturing organization. The inventory is of such great consequences to
the manufacturer that it shows of in the most of the financial statement i.e.
balance sheet and profit and loss account.10
Inventory is the stock on hand at a particular time of raw materials, goods in
process of manufacture, finished products, merchandise purchase for resale
and the like tangible assets which can be seen, measured and counted.11
There can be no unanimity on the items, which would be included in an
inventory, an itemized list for wide variations exist in the process of
production or non- production firm. Inventories can be defined and classified
in many different ways according to their function, importance and type of
company in which they exist.
Generally inventories in a manufacturing company can be divided into the
following categories based on their state or condition: raw materials, work-in-
process, finished goods, service parts and factory supplies. These categories
can be further subdivided or expanded into additional classifications, such as
purchase parts, component parts, replacement parts, maintenance inventory,
shop worn inventory packaging and shipping materials, miscellaneous
operating supplies etc. The exact definition of inventory in these categories
varies from company to company. The category name is normally self
explanatory. Inventory free one stage in the production and distribution
process from the other, permitting each to operate more economically. A
business house holds inventory because the alternatives are costlier or less
profitable.12
3.1.1 Types of Inventory
Inventories are the stock of product, a company is manufacturing for sale and
components that make up product. Manufacturing firms generally hold four
types of inventories.13
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(i) Raw materials
The inventories purchased from suppliers which ultimately will be
transformed into finished goods are called raw materials. In other words, raw
material consists of items that a firm purchases for use in its production
process. It may consist of basic materials and/ or manufactured goods.
Maintaining adequate raw materials inventories provides a firm with
advantage in both purchasing production. In manufacturing company raw
materials involves those inputs or components which are converted into final
product through manufacturing process. In the context of cement industries
raw materials are limestone, clay, coal, gypsum, iron ore, iron oxide, silica and
packaging bags.
(ii) Work- in- process (WIP)
Goods partially worked on but not fully completed are called work in process.
These categories include those materials that have been committed to the
production process but not been completed. “Goods in process include items
as components and sub assembles that are not yet ready to be sold.14 These
inventories may be in transit between operations or they may be currently
undergoing some type of operations, waiting for the next step in the
production process.
(iii) Finished goods
Inventories that have completed the production process and are ready for sale
are called finished goods. In other words, finished goods inventories are those
completely manufactured products that are ready for sale and to use. Stock of
raw materials and work in process facilitate production while stock of finished
goods require for smooth marketing operations, thus finished goods serve as a
link between production and consumption of goods.
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(iv) Stores and spare parts
The inventories of this type play supporting role to operate organization in the
day to day affairs. Every organization must keep the stock of supplies for
effective and efficient operation. Stock of this type includes stationeries, spare
parts for maintenance and operation of machinery, soap, brooms, well, fuel,
light bulbs etc. these materials aren’t directly used in production process but
they are necessary for supporting materials for production process.
3.1.2 Need to Hold Inventory
The question of managing inventories arises when the company purchase and
hold inventories. Maintaining inventories involve tying up of companies fund
and incurrence of storage and handling cost. Every firm knows this reality of
the inventory holding even though they hold inventories. There are three
general motives for holding inventories.15 K. Arrow has attributed to the
inventory the three motives for holding cash are referred to in Keynesian
analysis of demand for money. Arrow analysis established that a business
house will hold the stock of goods for one or more of the following reasons.16
(i) Transactions motive
The transactions motive for holding inventory is to satisfy the expected level
of activities of the firm. This motive emphasizes the need to maintain
inventories to facilitate smooth production and sales operations.
(ii) Precautionary motive
This motive necessitates holding of inventories to guard against the risk of
unpredictable change in demand and supply forces and other factors. The
precautionary motive is to provide cushion in case the actual level of activity is
different than anticipated.17
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(iii) Speculative motive
This motive influences the decision to increase or reduce inventory levels to
take advantages of price fluctuations. The speculative motive for holding
inventory might entice a firm to purchase a large quantity of materials then
normal in anticipation of making abnormal profits.
In addition, there may be contractual reason for holding some inventories.
Occasionally it may be necessary to carry a certain level of inventory to meet a
contractual agreement. Some manufacturers require dealers to maintain a
specified level of inventory in order to be the sole representative in a
particular territory.18
3.2 Inventory Management
Inventory management is one of the aspects of production management and
it is an integral part of material management. Inventory is the investment in
materials, labor and finished goods from procurement through processing
until use or distribution to the customer. Inventory management, then is the
establishment of policies and standards of performance to control these
investment as to amount (units and rupees). Proper management of inventory
requires understanding of the following major factors involved:19
(i) Value of inventory items
(ii) Volume of inventory items
(iii) Length of time a unit remains in inventory and
(iv) Costs of carrying inventory.
Inventory is as old as man himself but inventory management is a product of
industrialization. The modern concept of inventory management was
developed by several authors during 1915-1922, especially by R. C. Davis, E. F.
Clark, H. S. Owen and R. S. Wilson. The need for systematic and scientific
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approach to the problem of inventory management is felt much more keenly
by an industrial undertaking, particularly a large one operating on small profit
margin after the great economic depression of 1930.20 A lot of work has been
done in the western countries on inventory management yet there does not
seem to exist, commonly accepted terminology in this respect. In past
attempts have been made to define and to use such term as:
(i) Inventory control-Simon, Herbert A., Charles C. Holt “The control of
inventory and production rate”- A survey operation research voI.2 No.3
Aug 1954, P. 289.
(ii) Inventory problem- Dvoretzky A.J… J. Kiefer and J. Wolfwitz-“The
inventory problem” Econometrica Vol.20, No. 2 April 1952, P. 187.
(iii) Inventory process-Ackoff, Russell L. “The development of operation
research as a science”-Operation research vol. 4 no. 3 June 1956, P. 271.
(iv) Inventory theory-Star, Martin and David W. Miller “Inventory control
theory and practices” Prentice-Hall, Englewood cliffs, N.J. 1962 P. 3.
(v) Inventory management-Joseph Buchan and Ernest Konigsberg, “Scientific
inventory management” Prentice-Hall India Pvt. Ltd., New Delhi, 1976
p. 2 and James W. Prichard and Robert H. Eagle, “Modern inventory
management” John Wiley and Sons, Inc., New York,1965 P. 2.
(vi) Inventory system-Naddor Eliezer “inventory system” John Wiley and
Sons, Inc, New York, 1966 P. 3.
“Inventory management can be defined as the sum of total of those activities
necessary for the acquisition, storage, sales, disposal or use of materials.21 In
general, inventory management comprises the planning for minimum quantity
of inventory i.e. management aspect of inventory and implementing and
carrying out of policies which have been established by the management i.e.
controlling aspect of inventory. Therefore, inventory management involves
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the development and administration of policies as well as systems and
procedures by which they are implemented. The inventory management
comprises two phases of inventory i.e. inventory management and inventory
control. The first phase of inventory management consist of –
determination of optimum inventory level and procedures for their review
and adjustment
determination of the degree of control that is required for the best result
planning, designing of inventory control system.
planning of inventory control organization.
The first phase of inventory management is concerned with inventory
planning and the second phase of inventory is concerned with the day to day
planning required to meet production requirement which is described as
inventory control.22
The inventory management is a part of materials management that ensures
the provision of required quantity of inventories for the required quality at the
required time with minimum amount of capital.23
Inventory management is concerned with planning, directing and controlling
the kind, amount, location, moment and timing of various flows of
commodities use in and produced by business organization.24
Inventory management is defined as a planned effort that is aimed at
supporting a given production program with the right quantity of materials
having the required quality and made available as and when needed ensuring
at the same time that the investment is kept at the minimum possible level
and economics of shortage and ordering cost are secured in the raw material
phase of inventory management. With reference to working process phase
the inventory management will involve organized effort at attaining economy
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of cost by processing economic batch quantities and tracking down as well as
correction tendencies for semi processed items moving out of the production
flow accumulating as in process inventories. The finished good phase of
inventory is concerned with action to keep adequate production inventories
at the required outlets to meet the market needs promptly and yet avoid
build up of imbalance such as excess stocks in certain outlets and shortage in
other areas.25
In the context of financial management the efficient and effective
management of inventories possess a challenging problem. Inventory
constitute the largest component of working capital in the manufacturing
organization, thus to a large extent, the success and failure of business
depends upon the inventory management of the concerned organization. The
proper management and control of inventory not only solve the acute
problem of liquidity but also increase annual profit and causes substantial
reduction in the working capital of a firm.26
Management is primarily about specifying the size and placement of stocked
goods. Inventory management is required at different locations within a
facility or within multiple locations of a supply network to protect the regular
and planned course of production against the random disturbance of running
out of materials or goods. The scope of inventory management also concerns
the fine lines between replenishment lead time, carrying costs of inventory,
asset management, inventory forecasting, inventory valuation, inventory
visibility, future inventory price forecasting, physical inventory, available
physical space for inventory, quality management, replenishment, returns and
defective goods and demand forecasting. Balancing these competing
requirements leads to optimal inventory levels, which is an on-going process
as the business needs shift and react to the wider environment.
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In general inventory management involves the development and
administration of policies as well as system and procedures by which they are
implemented. Inventory management techniques are covered in depth in the
production management course, but it is responsibility of the financial
managers to analyze the costs of inventory and to estimate the effect of
inventory costs on overall profitability of the firm. Proper inventory
management requires close coordination among the sales, purchasing,
production, and finance departments.
The sales and marketing are the first places to change in demand. The
changes must be worked into the company’s purchasing and manufacturing
schedules, and the financial manager must arrange any financing that will
be needed to support the inventory build-up. Lack of coordination among
departments, poor sales forecasts or both can lead to disaster.27 Thus
inventory management broadly comprises developing, implementing, and
receiving inventory policies relating to procurement, storage, use, sale and
disposal of inventories to get the requisite service level while keeping the
investment in inventories with in the financial constraint set by the top
level management.
3.2.1 Need and Importance of Inventory Management
Inventories are major asset and represent a sizeable investment in the
business that sell or manufacture products. In extraction manufacture,
wholesale/retail, import/export and other fields inventory constitutes one of
the largest controllable assets of the business. Therefore, in order to maximize
the overall profitability inventory must be managed efficiently. An improper
control over the maintenance of inventory can spell disaster. It is evidently
recognized by John V. Scott and associates Ltd. that the tough economic times
in which we live many companies are facing the probability of bankruptcy or
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at least are earning unsatisfactory return on investment. One of the major
causes of these situations is lack of proper inventory control.28
Inventory management is an important part of a business because inventories
are usually the largest expense incurred from business operations. Most
companies use an inventory management system that helps to track and
maintain the inventory requirement of the business. Most systems used by
companies are linked to the management or accounting information system
for increasing the effectiveness of their operations.
Inventory, by nature is circulating assets and exhaust frequently because of
consumption and sale. Inventories in any organization are of pivotal role. If
the organization does not pay attention on the management of inventories
the organization’s efficiency and profitability are severely affected. Buffa
observe that Inventories serve the vital function of developing the various
operation in sequence beginning with raw materials extending through all the
manufacturing operations and into finished goods storage and continuing to
ware house and retail stores.29
Inventory helps in smooth and efficient running of business.
Inventory provides service to the customer immediately or at a short
notice.
If there is absence of inventory, the organization may have to pay high
price because of price-wise purchasing. If inventories are maintained there
is a chance of getting price discount on bulk purchasing.
Inventory also acts as buffer stock when raw materials are received late
which may force to reject many orders.
Inventory also reduces product costs because there is an additional
advantage of batch production and smoothen production run.
Inventory helps in maintaining the economy by absorbing some of the
fluctuations when the demand for an item fluctuates.
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3.2.2 Relationship of Inventory Management with Material
Management
Theoretically distinction is also drawn between material management and
inventory management. A few writers pointed out material management
covers several disciplines including value analysis, inventory control,
purchasing, standardization and codification, storages and transportation etc.
The more emphasis on material management on quantity and quality of
material needed in manufacturing process with an eye on economy on
material related work. In inventory management, on the other hand the
emphasis is on application of techniques of inventory control without
sacrificing the quality of the material purchased.30 A simpler definition of
material management could be the line of responsibility which begins with the
selection of suppliers and ends when the material is delivered to its point of
use.31
The chartered institute of purchasing and Supply defines material
management as the total to all those tasks, functions, activities and routines
which concern the transfer of external material and service into the
organization and the administration of the same until they are consumed or
used in the process of production, operation or sales.32
Material management is a body of knowledge which helps the manager to
improve the productivity of the capital by reducing material costs, preventing
large amount of capital being locked up for long periods and improving the
capital turn over ratio.33
The techniques of material management were evolved and developed during
and after the World War II. Material management covers a much wider field
and deals with all aspects of material supply and utilizations as well as it
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concerns with the entire range of functions which effects the flow,
conservation, utilization, quality and cost of material.
The general electric company USA a pioneer in the field of material
management have grouped the following functions under the heading of
material management and these comes under the unified control of material
manager.34
(i) Material planning and programming
(ii) Purchasing
(iii) Store keeping
(iv) Inventory control
(v) Receiving and warehousing
(vi) Value analysis and standardization
(vii) Predesigned value analysis
(viii) Production control
(ix) Transportation
(x) Material handling
(xi) Disposal of scrap and surplus
The essence of material management is the coordination of various material
functions namely production and inventory control, purchasing, material
handling etc. are extensively involved with one another. They cannot operate
efficiently without some form of coordination- and closer the coordination;
the more effective the total operation.35 The objective of material
management is to have the correct quantity and right quality of material on
hand at the time required, with a minimum of investment on them. For this
purpose arriving at right balancing point in inventory investment like
investment in any other capital assets is the first and foremost problem of
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material management. Thus inventory management is an integral part of
material management.
3.2.3 Objective of Inventory Management
Through the efficient management of inventory of the wealth of owners will
be maximized. To reduce the requirement of cash in business, inventory
turnover should be maximized and management should save itself from loss
of production and sales, arising from its being out of stock. It means
management should maximize stock turnover so that investment in inventory
could be minimized on the other hand, it should keep adequate inventory to
operate the production and sales activities efficiently. Therefore the main
objective of inventory management is to maintain inventory at appropriate
level so that it is neither excessive nor short of requirement. In the context of
inventory management financial manager has to try to achieve two conflicting
objectives.
(i) To keep inventory at sufficiently high level to perform production and
sales activities smoothly.
(ii) To minimize investment in inventory at minimum level to maximize
profitability.
Both in adequate and excessive quantities of inventory are undesirable for
business. These mutually conflicting objectives of inventory management can
be explained is from of costs associated with inventory and profits accruing
from it low quantum of inventory reduces costs and high level of inventory
saves business from being out of stock and helps in running production &
sales activities smoothly. Manufacturing firms generally carry sufficient
inventories to meet scheduled production as well as to meet needs during late
deliveries by suppliers. Holding inventories more than necessary is as much
costly as the danger of under stocking. While over stocking is costly in term of
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fixed and variable cost of carrying inventory, under stocking frequently
troubles the production flow and causes a loss of revenues and higher
production and transportation costs.
For any manufacturing company there is a level that is optimal in term of total
costs of maintaining inventory. The optimal level is a function of cost of
maintaining and scale of operation. Therefore, it should be stressed that
potential for significant cost reduction or profit improvement exists through
proper inventory management. The level that minimizes the total costs
without affecting the flow of inventory for production and sales is an optimal
level of inventory. Thus, the objective of inventory management is primarily to
control the inventory maintenance cost that particularly consist of i) cost of
ordering ii) cost of carrying inventory iii)cost of running short.
3.3 Economic Order Quantity
Inventory models for calculating optimal order quantities and reorder points
have been in existence long before the arrival of the computer. When the
first Model T Fords were rolling off the assembly line, manufacturers were
already reaping the financial benefits of inventory management by
determining the most cost effective answers to the questions of when? and
how much?36 Economic order quantity (EOQ) is that size of the order which
gives maximum economy in purchasing any material and ultimately
contributes towards maintaining the materials at the optimum level and at
the minimum cost.
The economic order quantity is the amount of inventory to be ordered at one
time for purposes of minimizing annual inventory cost.37 It is one of the oldest
classical production scheduling models. The framework used to determine this
order quantity is also known as Wilson EOQ Model or Wilson Formula.38 The
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model was developed by F. W. Harris in 191339 but R. H. Wilson, a consultant
who applied it extensively, is given credit for his early in-depth analysis of it.
The quantity to order at a given time must be determined by balancing two
factors: (1) the cost of possessing or carrying materials and (2) the cost of
acquiring or ordering materials. Purchasing larger quantities may decrease the
unit cost of acquisition, but this saving may not be more than offset by the
cost of carrying materials in stock for a longer period of time. To determine
the economical order size, implication of both carrying and ordering cost
should be studied.40
3.3.1 Carrying Costs
Also called holding cost, carrying cost is the cost associated with having
inventory on hand. It is primarily made up of the costs associated with the
inventory investment and storage cost. In the EOQ formula, carrying cost is
represented as the annual cost per average on hand inventory unit. In other
words costs incurred for maintaining a given level of inventory is called
carrying costs. They include opportunity cost of the fund invested on
inventories, property tax and insurance, storage cost, handling cost,
deterioration and shrinkage of stocks and obsolescence of stocks. Carrying
costs vary with inventory size i.e. carrying costs decrease with increase in
inventory size and vice versa.41
3.3.2 Ordering Costs
The term ordering costs is used in case of raw material or supplies. It is also
known as purchase cost or set up cost, this is the sum of the fixed costs that
are incurred each time an item is ordered. These costs are not associated with
the quantity ordered but primarily with physical activities required to process
the order. For purchased items, these would include the cost to enter the
purchase order and/or requisition, any approval steps, the cost to process the
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receipt, incoming inspection, invoice processing and vendor payment, and in
some cases a portion of the inbound freight may also be included in order
cost. It is important to understand that these are costs associated with the
frequency of the orders and not the quantities ordered.42
The nature of these two types of inventory costs is quite contradictory.
Ordering costs increase with number of orders and decrease if few orders are
placed or maintained large inventory levels. On the other hand carrying costs
increase as the volume of inventory holding increases and vice versa.
Therefore, the optimum size of inventory to be ordered each time can be
determined by balancing these two types of costs which is commonly known
as Economic Order Quantity. In other words it is that size of inventory at
which annual costs of ordering and holding are the minimum.
EOQ only applies where the demand for a product is constant over the year
and that each new order is delivered in full when the inventory reaches zero.
Under Economic order Quantity analysis, we want to determine the optimal
number of units of the product to order so that we minimize the total cost
associated with the purchase, delivery and storage of the product. The
required parameters to the solution are the total demand for the year, the
purchase cost for each item, the fixed cost to place the order and the storage
cost for each item per year. The underlying assumptions of EOQ analysis are
as under:43
the ordering cost is constant.
the rate of demand is constant.
the lead time is fixed.
the purchase price of the item is constant i.e. no discount is available.
the replenishment is made instantaneously; the whole batch is delivered
at once.
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EOQ is the quantity to order, so that ordering cost + carrying cost finds its
minimum. Thus,
Q = order quantity
Q * = optimal order quantity
A = annual demand quantity of the product
P = purchase cost per unit
O = fixed cost per order (not per unit, in addition to unit cost)
C = annual holding cost per unit, also known as carrying cost or storage cost
and generally given in percent of purchase price.
The Total Cost function
The single-item EOQ formula finds the minimum point of the following cost
function:44
Total Cost = purchase cost + ordering cost + holding cost
Purchase cost: This is the variable cost of goods therefore it is purchase
unit price × annual requirement or P×A.
Ordering cost: This is the cost of placing orders i.e. each order has a fixed.
cost O and we need to order A/Q times per year. Therefore it is O × AQ .
Holding cost: The average quantity in stock
Q
2 multiplied by carrying
cost per unit is inventory holding cost. So this cost is C × Q2 . Thus the total
cost function of inventory is as under:
Total inventory cost (TIC) = P × A + AQ × O +
Q2 × C
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Q is independent of P; it is a function of only A, O, C .Therefore, to determine
the minimum point of the total cost curve, we have to set the ordering cost
equal to the holding cost:
Q2 × C =
AQ × O
Solving for Q gives (the optimal order quantity):
Q2 = 2AO
c
Q = 2AO
c
Several extensions can be made to the EOQ model, including backordering
costs and multiple items. Additionally, the economic order interval can also be
determined from the EOQ.45 The following approaches can be used in
determining EOQ.46
The long analytical approach or Trial and Errors Approach
Formula Approach and
Graphic Approach
(i) Trial and error approach
If annual requirements are known and steady usage of inventory is assumed
an analytical approach of inventory cost analysis can be used to determine the
EOQ. While determining the EOQ by trail and error technique, the following
steps are to be taken;
Determining the total costs for each lot size chosen.
Selecting the ordering quantity which minimizes total costs.
Example:
Annual demand = 1200 unit
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Price per unit = Re. 10
Carrying Cost = 10% of average inventory value
Cost per order = Rs. 50
Now, applying the techniques, optimum economic quantity can be
determined for no. of orders 1,2,4,6 and 8 in this way.
Table No. 3.1
Calculation of EOQ by using Tabular Method
(1) No of Order (N) = AQ 1 2 4 6 8
(2) Order Size (Q)= AN 1200 600 300 200 150
(3) Average Inventory = Q2 600 300 150 100 75
(4) Total Carrying Cost = C × Q2 600 300 150 100 75
(5) Total Ordering Cost AQ × O 50 100 200 300 400
(6) Total Cost = 4 + 5 650 400 350 400 475
The multiple order plan i.e. 4 times ordering in a year minimize the total costs
in comparison of other plan, thus purchasing 300 units at once is the most
economical inventory size in this example
(ii) Formula approach
The formula method is an important technique to calculate economic order
quantity. The economy order quantity can, using a short-cut method, be
calculated by the Following equation
EOQ = 2AO
C
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Where,
A = Annual usages of inventory (units)
O = Ordering cost per order
C = Carrying cost per order
(iii) Graphic approach
The economic order quantity can also be found out graphically. In the figure,
costs-carrying, ordering and total- are plotted on Vertical axis and horizontal
axis is used to represent the order size. We note that total carrying cost
increases as the order size increases, because, on an average, a large
inventory level will be maintained and ordering costs decline with increase in
order size because large orders size means less mumbers of orders. The
behaviour of total cost line is noticeable since it is a sum of two types of costs,
which behave differently with order size. The total costs decline in the first
instance, but they start rising when decrease in average ordering cost is more
than offset by the increase in carrying cost.47 Therefore, the Eoconomic Order
Quantity (Range) occures at the point Q where the total cost is minimum.
Figure 1 : Showing Order size & Costs through Graphic Approach
TC
CC
OC Costs
Q Order size (unit)
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3.4 Re-order Point/Re-order Level
The EOQ technique determines the size of an order to acquire inventory so as
to minimize the carrying costs as well as the otdering cost. In other words the
EOQ provides an answer to the question how much inventory should be
ordered in one lot? Another important question is when should the order to
procure inventory be placed? The re-order point is stated in terms of the level
of inventory at which an order should be placed for replenishing the current
stock of inventory. In other words as its name suggests, this determines the
amount of inventory at which the stores/purchase department should order
new stocks of raw materials to replenish supplies to the optimum quantity.
Under the Constant daily usages of inventory and fixed lead-time we should
know Lead time, Average Usage and EOQ to determine the Re-order Point.
Under such situation Re-order Point is simply that inventory level which is
needed to meet the requirement of inventory during the lead time. Thus it is
calculated as
Re-order point = Lead time × Averages usages
The term lead-time refers to the time normally taken in reciving the delivery
after placing orders with the suppliers. It covers the time span form the point
when the decision to place the orders for the procurement of inventory is
made to the actual receipt of the inventory by the firm. The average usages
means the quantity of inventory-consumed daily. To illustrate, Suppose
demand for inventory is known with certain but that it takes 5 days before an
order is received. The EOQ of the firm is 200 units resulting in orders being
placed every 10 days. If the usages were steady the firm now would need to
orders 5 day before it run out of stock or at 100 units of stock on hand. Thus,
the re-order point is 100 units when the new order is received 5 days later the
firm will just have exhausted its existing stock.
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3.4.1 Safety Stock
The economic order quantity and reorder point as explained aboved are based
on the assumptions of certainty conditions. It is difficult to predict usage and
lead time accurately because in the real world situations a descrepancy
between assumed (expected) and actual usage rate of inventory is likely to
occur. Similarly, the receipt of inventory from the suppliers may be delayed
due to strikes, floods, transportation and other reasons beyond the expected
lead time. Thus, the firm would come across situations in which the actual
usage of inventory is higher than the anticipated and /or the delivery of
inventory from the supplier is delayed.
The effect of increase usage and/or slower delivery would be shortage of
inventory which in turn creates a problem of stock-out and that can prove to
be costly for the firm. Therefore, the firm should keep a sufficient safety
margin by having additional inventory to guard against stock-out situations.
Such stocks are called safety stock and defined as the minimum additional
inventory to serve as a safety margin or buffer to meet an unanticipated
increase in usage and/or late receipt of incomming inventories.
Safety stock also called buffer stock is a term used by logisticians to describe a
level of extra stock that is maintained to mitigate risk of stock-outs (shortfall
in raw material or finished goods) due to uncertainties in supply and demand.
Adequate safety stock levels permit business operations to proceed according
to their plans. Safety stock is held when there is uncertainty in the demand
level or lead time for the product; it serves as an insurance against stock-
outs.48 Under the situation of uncertainty in the usage and/or lead time the
reorder point will be determined as follows :-
Re-order point = Lead time × Average Usage + Safety stock.
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Keeping safety stocks involves two type of conflicting costs.49 They are as
under:
(i) Stock-out cost
The cost associated with the shortage of inventory is called stock out costs.
Infact, it involves the loss of profit which the firm could have earned from
increased sales if there was no shortage and the damage to the relationship
with the customer due to the shortage of inventories.
(ii) the oppournity cost of the additional inventories
The cost associated with the maintenance of safety stock is called carrying
cost. If a firm maintain additional inventories in execess of normal usage
additional carrying cost are involved.
The nature of these two types of cost are counterbalancing. The larger the
safety stock the larger the carrying cost and vise-virsa. Conversly, the larger
the safety stock the smaller the stock outcost. Therefore, the job of financial
manager is to determine the appropriate level of safety stock on the basis of
a trade-off between these two types of conflicting costs.
3.4.2 Reducing Safety Stock
Safety stock is used as a buffer to protect organizations from stock-outs
caused by inaccurate planning or poor schedule adherence by suppliers. As
such, its cost (in both material and management) is often seen as a drain on
financial resources which results in reduction initiatives. In addition, time
sensitive goods such as food, drink, and other perishable items could spoil and
go to waste if held as safety stock for too long. Various methods exist to
reduce safety stock; these include better use of technology, increased
collaboration with suppliers, and more accurate forecasting. An Enterprise
Resource Planning System (ERP System) can also help an organization reduce
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its level of safety stock. Most ERP systems provide a type of Production
Planning module. An ERP module such as this can help a company develop
highly accurate and dynamic sales forecasts and sales and operations plans. By
creating more accurate and dynamic forecasts, a company reduces their
chance of producing insufficient inventory for a given period and, thus, should
be able to reduce the amount of safety stock which they require.50
3.4.3 Goods in Transit
Sometimes the previous order/orders may not be received before the
placement of new order in such situation goods in transit will exist. In other
words if a new order must be placed before the previous is received, a good in
transit inventory will build up. Goods in transit are goods that have been
ordered but have not been recived. A good in transit inventory will exist if the
normal delivery leads than the time between orders.51 Under a situation of
goods in transit re-order point is calculated as follows:
Re-Order Point = Lead Time × Average Usages – Goods in Transit
3.5 Methods of Inventory Control
The most important objective of inventory control is to determine and
maintain an optimum level of investment in the inventory. Most companies
have now successfully installed one or the other system of inventory planning
and control. The inventory control methods range from very simple to highly
sophisticated mathematical inventory models.
The following are the primary stock control methods that are often used by
companies in their production operations. All these methods are well
established and have been used in production industry for quite a long period
of time.
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(i) Min-Max system
Under this method of inventory control the cost accountant as an in charge of
the inventory control, establishes two levels (the minimum and maximum
level) of stock. Maximum level represents EOQ and safety stock and minimum
level represents reorder point. When the items or materials, reach the
minimum level, the order to replenish the stock is placed. The maximum level
is the level that the stock quantity should not exceed, because it will put a
considerable strain on the finances of the company and will also create
problems such as storage, wastage and insurance. Therefore, under this
method inventory level should fall within these two limits.
(ii) Order cycling system
This system is based upon a review timetable. According to this system, a
review of the entire inventory is done at regular interval. After the review is
done, the cost accountant views stock items with low quantities that will not
last up to the next review interval. The purchase order for such a stock item is
placed immediately. The order cycling system is not exactly foolproof and one
requires a rather experienced cost accountant to efficiently conduct it.
(iii) Perpetual inventory system
It is a system of record maintained by the controlling department which
reflects the physical movement of stocks and their current balance. Thus, this
is a method of ascertaining balance of inventories after every receipt and
issue of materials. This essential feature of this method is continuous
recording of stock for physical checking and to ensure the accuracy of the
inventory system. It is based on record so it requires lot of recording and
expenses. The perpetual inventory system is intended as an aid to inventory
control because the balance of stock ledger should tally with the balance
ascertained by physical checking.52
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(v) Just-in-time system
As the name implies it refers to receiving inventories Justas they are needed.
It is a disciplined approach to improve manufacturing quality, flexibility and
productivity through the elimination of the waste. The management of
inventory has become very sophisticated in the recent years. In certain
industries the production process leads itself to just- in- time inventory
control. This system requires efficient purchasing, very reliable suppliers and
efficient handling system. The most important thing that has made this system
possible is the advent of instant information through sophisticated computer
system.
(vi) ABC analysis
Under this method inventories are segregated into different categories
specially, into three classes or inventory items are classified into 3 categories;
A, B and C. In this analysis, the classification of existing inventory is based on
annual consumption and the annual value of the items. Hence we obtain the
quantity of inventory items consumed during the year and multiply it by unit
cost to obtain annual usage cost. The items are then arranged in the
descending order of such annual usage cost. The logic of segregating inventory
items into sections is that section A consists of limited number of items that
are very expensive. Section B has items that are not expensive and the
number of units that is to be ordered is also not very large. The section C
consists of numerous items that have a low monetary value. The logic behind
such segregation is that maximum attention should be paid to those items
whose value is highest, items with least value would be under simple control
and items under category ‘B’ should get reasonable attention of the
management. The firm should be selective in its approach to control
investment in various types of inventories thus; this method is also called
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selective inventory control. It emphasizes on important items and also known
as control by importance and exception.53
3.6 Inventory Valuation
Valuation of inventory is the determination of the cost assigned to raw
materials inventory, work-in-process, finished goods, and any other inventory
item. Inventory valuation is determined according to the basis by which a firm
assumes inventory units are sold. An inventory valuation allows a company to
provide a monetary value for items that make up their inventories. Inventories
are usually the largest current asset of a business and proper measurement of
them is necessary to assure accurate financial statements. If inventory is not
properly measured expenses and revenues cannot be properly matched and a
company could make poor business decisions. Various methods of valuation
of the inventory are as follows.
(i) Specific identification method
Under this method each unit in inventory be identified with the particular
time it was purchased and they are distinguished by modes, colures, size and
price. Each item’s value is fixed on the basis of their purchase price and
records are created separately. This method is suitable for low volume high
cost items.
(ii) Standard cost method
Under the Standard costing method approach, both inventory and the cost of
goods sold are based on the standard fixed cost assigned to the items within
the item manager at the time of reporting.
(iii) First-in first-out (FIFO) method
Under FIFO, the cost of goods sold is based upon the cost of material bought
earliest in the period, while the cost of inventory is based upon the cost of
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material bought later in the year. This results in inventory being valued close
to current replacement cost. During periods of inflation, the use of FIFO will
result in the lowest estimate of cost of goods sold among the three
approaches, and the highest net income.
(iv) Last-in first-out (LIFO) method
Under LIFO method the cost of goods sold is based upon the cost of material
bought towards the end of the period, resulting in costs that closely
approximate current costs. The inventory, however, is valued on the basis of
the cost of materials bought earlier in the year. During periods of inflation, the
use of LIFO will result in the highest estimate of cost of goods sold among the
three approaches.
(v) Weighted average cost method
Under the weighted average approach, both inventory and the cost of goods
sold are based upon the average cost of all units currently in stock at the time
of reporting. When inventory turns over rapidly this approach will more
closely resemble FIFO than LIFO.
(vi) Average method
Under the average approach, both inventory and the cost of goods sold are
based upon the average cost of all units received in stock.
3.7 Inventory Management and Profitability
The main cause of bankruptcy in most businesses today is not lack of sales,
not overpaid executives, and it's not overstaffed operations too. It is
mismanagement of assets. In inventory based manufacturing companies, the
most important assets is inventory therefore, for the sound financial health
and profitability of such companies there must be an excellent inventory
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system.54 To maximize profit through an excellent inventory system a firm
should be effective in the following aspects of inventory management.
(i) Inventory, the lifeblood of a company
The inventory in a company is cash and the stockroom is the community bank,
from which a lot can be learned. It is remarkable that a company with several
million rupees in inventory - more than a community bank would ever have in
cash. Proper handling of inventory and dealing with customers are essential in
this regard. Therefore the attitude of all employees must be changed to view
inventory as the lifeblood of the company and their livelihood.
(ii) Information systems
Obviously, to get a good handle on how to manage inventory, one must have
correct up-to-date information. Properly managing inventory requires a
system that will produce enough timely information to make informed
management decisions. The primary objective of any system is to provide
predictable results. If certain benchmarks or standards are set to help manage
a business, the system should capture the data consistently and measure
those standards correctly.
(iii) Key performance indicators
Once a good information system is set- up and running, a determination
should be made of which key performance indicators need to be calculated.
The key performance indicators are data that consistently measured and
properly monitored the management of inventory. For inventory, the primary
indicators deal with inventory turnover and customer service levels.
Maintaining the best possible customer service and maintaining the optimum
levels of inventory should be the goal of any inventory system. A delicate
balance between the two must be maintained to achieve maximum
profitability.
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(iv) Inventory turnover
Inventory turnover is a measurement of inventory use. It expresses how many
times per year the stock inventory is used. It is calculated by dividing annual
cost of sales by average inventory. Inventory turnover rates should be
measured, ideally, at least on a monthly basis. Some businesses may choose
to use the end of month inventory as the denominator, and that is acceptable.
It is very critical, however, to be consistent in the calculation for each period.
Otherwise, correct trends cannot be identified. Exactly how many times
should inventory turn? It depends on what industry is being served and what
the profit margins are. The lower the profit margins are, the higher the
inventory turns should be, and vice versa.
(v) Customer service level
Since good customer service is the other part of the formula, it too needs to
be measured and monitored regularly, preferably on a weekly basis. However,
measuring customer service is not as easy as measuring inventory turns.
3.8 Computers and Inventory
In today's business environment, even many smaller businesses have come to
rely on computerized inventory management systems. Certainly, there are
plenty of small retail outlets, manufacturers, and other businesses that still
rely on manual means of inventory tracking. Indeed, for some businesses-such
as convenience stores, shoe stores, or nurseries-the purchase of an electronic
inventory tracking system might constitute a wasteful use of financial
resources. But for firms operating in industries that feature high volume
turnover of raw materials and/or finished pro-ducts, computerized tracking
systems have emerged as a key component of business strategies aimed at
increasing productivity and maintaining competitiveness.
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Moreover, the recent development of powerful computer programs capable
of addressing a wide variety of record-keeping needs-including inventory
management-in one integrated system have also contributed to the growing
popularity of electronic inventory control options. Telecommunications
technologies as a critical organizational asset that can help a company realize
important competitive gains in the area of inventory management. Companies
that make good use of this technology are far better equipped to succeed
than those who rely on outdated or unwieldy methods of inventory control.55
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3.9 Resume of Earlier Studies on Inventory Management
A review of previous studies on inventory management is essential to
understand the nature and importance of inventory management and also to
identify the areas already investigated so that new areas hitherto unexplored
may be studied in depth. Therefore, the purpose of this section is to present
the findings of study in the field of inventory management done by the
researcher in the past.
3.9.1 Studies Conducted in Aboard
Chun-Tao Chang in her study56 tried to assess the effect of an inventory level
dependent demand rate to maximize the profit instead of minimizing the cost
in an inventory system. For this purpose she developed certain assumptions
and non-linear equation for holding costs. The conclusion of her study was “In
the inventory system that possesses an inventory–level dependent demand
rate, a higher level of inventory causes not only inventory and deterioration
costs but also higher purchasing costs due to demand increase. Consequently,
costs minimizing efforts through lower level of inventory will defeat the
potential profit likely to be earned from the increased demand. Therefore, in
an inventory system with stock dependent demand we must try to maximize
the profit not to minimize the costs”.
McGouldrick in his study57 attempted to explore the evidence of interest rates
and other measures of credit conditions on inventory investment. But his
findings were disappointing. In his study, the durable manufacturing inventory
equation had a negative interest rate coefficient but the coefficient was not
statistically significant. His inventory equation for the distribution sector
showed a positive interest rate coefficient. Lovell in his study58 reported
incorrect signs of interest rate coefficients in his regression explaining deflated
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durable and non durable manufacturing inventory levels. His other study with
Paul Darling59 again reported positive signs of interest rate coefficients.
Michael C. Knapp and Carol A. Knapp in their study60 for inventory in a retail
environment reported positive effect of inventory management on gross
profit of the drug store. Lieberman in his study61 also included the opportunity
cost of inventories as a key explanatory variable along with sales. He
examined the size and significance of the theoretically important cost of
capital effect on inventory investment by utilizing firm specific cost of capital
measures in a pooled cross-section econometric analysis of inventory
behavior. The study hypothesized that desired inventories are a function of
sales and the opportunity cost of holding inventories. In his study he used a
firm specific cost of capital measures instead of market interest rate and two
firms were used as samples for the econometric analysis. His findings were as
under:
The desired inventories are a function of sales and opportunity cost of
holding inventories as his calculation strongly supported this proposition
with the theoretically correct signs.
Similarly, his study suggested that the significant cost of capital effects
may be attributed to the use of a theoretically more appropriate cost of
capital measures.
The estimated inventory equations for textile firms confirmed the
behaviour expected for the firms that produce output for stock. However,
the role performed by the inflation rate was uncertain or contrary to
theory.
A speculative behaviour of the firm to earn speculative profit by increasing
inventories in an anticipation of an increase inflation rate was also
reflected in the study.
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Irvine in his study62 tried to found out whether or not retail inventory levels
depends significantly on the costs associated with inventory holdings. In his
study, he estimated time series equations explaining the monthly inventory
levels held by the total retail sector and the non durable and durable sectors.
In his study he observed that the expected future sales are the major
determinant of retail inventory levels. In the total retail and non durable
equations the estimated coefficients on these measures were statistically
different from that of theory. Beside the study also noticed that the estimated
coefficient on the capital cost measures was not negatively signed but also
they were statistically significant. In this connection target inventories of
durable goods were noticed as being much more sensitive to variation in
financial inventory carrying costs then were the inventories of non durable
goods.
Akhtar in his study63 indicated that fluctuations in carrying costs have very
significant effects on inventory investments. He included the expected price
inflation and capacity utilization as variables in his model. He hypothesized
that the unobservable desired level of inventories is determined by expected
sales, carrying cost and cyclical considerations along with other factors.
Akhtar’s findings on inventory carrying cost were in sharp contrast to most of
the earlier evidence on this subject.
Apart form the above studies; it is worthwhile to mention some other studies
on inventories though they deal more with the use of the acceleration
principle in inventory equations. Inventory modeling has been an area of
intensive inquiry in operations management and operations research. Some
classical texts describing the variables that are widely used in classical
inventory models are Silver et al. (1998) and Cachon and Terwiesch (2005).64
At the same time, only a few recent papers in operations management
analyze inventories at the firm level empirically and try to reconcile inventory
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behavior observed in practice with the behavior predicted by the models.
Most of these papers analyze the link between inventory management and
financial performance.
Gaur et al. (2005)65 examined firm-level inventory behavior among retailing
companies. They propose a model explaining differences in inventory turns
across companies and create an adjusted measure of inventory turns that is
better suited to gauge the operational metrics of retailers. Gaur et al. (2005)
also found that inventory turnover for retailing firms is positively associated
with both capital intensity and sales surprise, and are negatively associated
with gross margins. Gaur and Kesavan (2006)66 extend this work by studying
effects of firm size and sales growth on inventories.
Gaur et al. (1999)67 demonstrated that the financial excellence of retailing
companies comes from various operational strategies that may involve low or
high product margins and low or high inventory turns in different retailing
segments.
Rajagopalan and Malhotra (2001)68 study trends in inventory levels at US firms
over time to test the widely held belief that inventory management has
improved due to the introduction of just-in-time (JIT) practices and
information technology (IT) system implementations. Using a large sample of
firms from the US Census Bureau that included both private and public
companies, they found that material and work in process inventories
decreased in most of the two-digit Standard Industrial Classification (SIC)
industries from 1961 to 1994. Furthermore, in some segments there were
greater improvements in the post-1980 period when JIT practices were
adopted.
Continuing this line of work, Chen et al.69 (2005, 2007) found decreasing
trends for relative inventories (inventory as days of sales), in both the
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manufacturing and the wholesaling sectors for the period 1981-2003. They
also found somewhat mixed evidence in the retailing sectors, with a
downward trend starting only in 1995. Using an event study approach, they
showed that firms with abnormally high inventories have abnormally poor
long-term stock returns was weak in cross-section for all sectors.
Lai (2005)70 provided empirical evidence that (i) markets cannot differentiate
between good and bad inventory, (ii) markets punish firms when they can tell
that inventory decisions are bad and (iii) inventory levels do not statistically
explain firm value.
Lieberman et al. (1999)71 studied the dynamics of inventory levels for
automotive suppliers in North America. They combined a survey and
secondary plant-level data to show that inventory levels are affected by both
technological and managerial factors in a manner consistent with classical
inventory theory. Namely, they show that inventory levels at selected plants
increase with setup costs, item costs per unit and production lead times and
those inventories are lower for plants in which the workforce engages in
making process improvements.
Ramey and West (1999)72 economists have proposed models based on stock-
adjustment and Production-smoothing to link inventory with production, sales
and GDP so as to show the two main stylized facts about inventory behavior:
(i) that aggregate economy-level inventory dynamics have a pro-cyclical
nature and
(ii) that there is a persistent relationship between sales, production and
inventory in the form of production smoothing.
The most relevant among these is the work of Thomas and Zhang (2002)73
which analyzed various ways in which changes in balance sheet items impact
stock returns. Interestingly, they found that the negative relationship between
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accruals and future abnormal returns is mainly due to inventory changes. They
proposed three explanations for this phenomenon that are related to the
mispricing of accruals but they could not found statistical support for them in
the data. They states that it was not enough to look at balance sheet items
and accounting identities alone operational understanding of such issues in
the context of expected versus unexpected demand shifts was required.
3.9.2 Studies Conducted in India
In addition to the above studies there are also studies on inventory
management which deals exclusively in the context of Indian industries. The
major findings of their studies are reviewed briefly here:
Inter-firm Comparison in the Indian Cement Industry was a research work
conducted by Chakraborthy and Malla Reddy in the year 1976.74 The main
purpose of this study was to show the position of each firm's in relation to the
other firms within the industry. The profitability ratios, proprietary ratios,
liquidity ratios and other miscellaneous group ratios were calculated and
compared with the selected cement companies in India.
Iyengar (1980)75 in his research work entitled, “An Empirical Study on
Inventory Management Practices in Indian Industry” mainly dealt with the
responsibility of company management for better inventory management.
The study highlighted the fact that the inventory management in India
warrants a higher degree of sophistications in approach and further
sharpening of the tools and techniques, rather than a sense of resignation and
disillusionment. The study concluded that, in the crucial areas of forecasting
materials requirements, classification and codification, standardization and
establishment of operating norms of inventories, a large ground still remained
to be explored, in most of the organizations.
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In the article “Inventory Management in Iron and Steel” Harbans Lal Verma,
(1989)76 evaluated the practices and performance in inventory management
in Iron and Steel Industry in India. The study was divided into two sections, in
the first section, an attempt has been made to analyze the size, composition,
circulation and the growth of the inventory in the selected units during the
period under study and in the second section inventory control techniques
adopted in the selected units. The study concluded with the findings that
almost all the selected units during the period of investigation have had
overstocking with serious repercussions on liquidity and profitability of the
company.
Nirjhar Sarkar (1993)77 on his article titled “Fluctuation in Inventory and Its
Impact on Profitability” concluded that the profit and loss statement drawn
under the conventional method of accounting were apt and err in reflecting
the actual production department on the ground that fluctuating inventory
levels always tend to create or liquidate the hidden profits as the case may be.
The statement, therefore, should be such that the periodic production
performance could be disclosed in financial terms. The author felt that the
principle of inventory valuation at cost or market value whichever is lower
may be considered as the main issue.
Man Steven (1994)78 conducted a research on “A Comparative Study on
inventory of Indian Airlines Limited and Air India Corporation Limited”. In the
study, he analyzed the size of inventory by progressive growth percentage. He
measured the overall effectiveness of inventory policies by calculating the
turnover of inventory. He also evaluated the relationship between inventory
to current assets, inventory to total assets, inventory to working capital, and
inventory to capital employed. He concluded the study by saying that the
concept of optimum inventory is never followed in both the study units. He
also found out that the effort of these two companies to optimize the size of
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inventory do not lay full emphasis on the absolute reduction of inventory
volume itself. He also suggested that some ratio tests which provide good
insight into the extent of over-stocking or under-stocking shall be frequently
applied to determine the value of inventory.
Omprakash Kajipet and Krishnama Chary (1997)79 did an extensive research on
“Inventory Management in Selected Paper Mills of Andhra Pradesh-Some
Reflections.” The research work broadly covered the various aspects of
inventory management in the context of paper mills in Andhra Pradesh, such
as size and level of investment in inventories, justification and the extent of
use of such investment techniques used in the control and management of
inventory and the implications for future expansion and growth of paper mills
in Andhra Pradesh.
The major findings of the study are that the amount of investment in
inventory is relatively larger in the study units with lower inventory turnover.
The study also noticed the absence of effective inventory control and
management in the study area. It concludes with a categorical statement that
there is a wide scope for further improvement in the area of inventory
management so that the paper mills can expand and growth in future.
Bhatia (1984)80 carried out a study on inventory management in textile mill in
Delhi, Punjab and Rajasthan by selecting six textile mills out of seven. The
period of investigation was 1980-84. The basic objectives of his research was
to present a picture of how the textile mills studied, managed their
inventories and what their attitudes are to this aspect of management. The
other objectives of his study were:
To find out weather or not the inventory in the mills is excessive in terms
of working capital locked and in term of days’ sales consumption. If
inventory in the mills is excessive, what are the factors responsible for
high inventory and which component/s need immediate attention.
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What is the impact of inventory on profit of the mills and on industrial
sickness?
What are the inventory control methods that may be adopted for
improving the effectiveness of inventory management in the mills?
To assist the managers to make better decisions
In his studies he has used some financial and statistical tools like ratio analysis,
mean and standard deviation, tests and correlation, time series analysis and
so on.
His findings were as under:
(i) The analysis of total inventory in term of sales showed that the inventory
in case of mills studied were unjustifiably high and inventory kept by
them deviates significantly from the norms of textile mill. It is found in
some cases that the position is progressively worsening and in some
cases the rate of growth in inventories exceeds the rate of growth in
sales.
(ii) The inventory components analysis established that Store and spare
inventory is properly controlled.
(iii) The analysis of inventory data in textile mill studied showed that
inventory in days’ sales is significantly related to profit and loss. As
inventory in days’ sales increase profit decrease or loss increase and vice
versa.
(iv) The position of inventory executive in the hierarchy of the organizational
structure directly reflects on the consciousness of the management to
control inventory. In some case inventory executable occupy lower-
middle position. This proves that due importance has not been accorded
to this vital function. There is a very strong case for inventory
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management function to be evaluated to a much higher status with close
and continuing association with the top management.
(v) It has been found that all inventory control activities are not the
responsibility of the person looking after the inventory, means there was
lack of proper coordination among various function of inventory control.
Munish (1986)81 carried out a study on inventory management in the selected
companies in India. In his study 216 large manufacturing and processing
enterprises (130 private and 86 public) companies were sent questionnaires
by mail to collect information in the various aspect of inventory management.
The response of questionnaires was not good. Only 50 responses were
received (39 private 11 public). In his study different aspect of inventory
management like selective inventory control, inventory requirement
forecasting, material requirement, lead time analysis, inventory control
system, evaluation for the performance and application of computers in
controlling inventory have been examined.
The main objective of his study was to evaluate the present state of affairs in
the area of inventory management in large manufacturing and processing
companies with a view to provide a set of guideline for improvement. For this
purpose he fixed norms of inventory management on the basis of published
data available and information collected through questionnaires and personal
interviews. He framed two levels of propositions in his study.
(i) Basic Proposition-Scientific inventory management (SIM) influences
positively the level of inventory to achieve and maintain satisfactory
inventory level (SIL).
(ii) Other proposition-Scientific inventory management helps to achieve and
maintain satisfactory profitability rate (SPR).
(iii) A satisfactory inventory level is defined in term of inventory/sales,
inventory/total assets, inventory/current assets ratios and satisfactory
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profitability rate (SPR) is defined in terms of gross profit by sales and
EBIT/total assets.
(iv) In his study the following other aspects of inventory management were
also analyzed.
Availability of information required of inventory control for
scientific control over inventory.
Selective inventory control techniques for better control over them
Lead time analysis for reduction of inventory level.
Forecasting material requirement for better material planning.
Application of theoretical models for development of inventory
control system.
Evaluation of inventory control system.
The findings of his study were as follows
Regarding the first proposition
Scientific inventory management influence to satisfactory inventory level.
The coefficient of correlation indicated high degree of positive association
between SIM and achieving and maintaining SIL. 2 value was more than
tabulated value at 0.05 significant level. The conclusion was that SIM
helped positively to achieve and maintain SIL.
Regarding the second proposition
Scientific inventory management (SIM) helps to achieve and maintain
satisfactory profitability rate (SPR) was not supported statistically. In his
calculation 2 was less than tabulated value at 0.05 significant levels. But
in both cases the percentage of enterprises achieving and maintaining SPR
was higher in that group where SIM was followed. Coefficient of
association also indicated low positive association. He also noted that
there are other factors like reputation of the products, amount of
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competition, government policies (regarding the pricing of its products)
etc affecting the profitability.
From the above the impact of inventory management on the profitability of
the firm has been a controversial subject. Some studies indicated a significant
effect of inventory management on the profitability of the firm while other
did not. Similarly, some studies reported the effect of the opportunity cost of
fund invested in the inventory holding while others reported abnormally high
inventories have abnormally poor long-term stock returns or overall
profitability. In order to validate the inventory behavior predicted by the
models in the Nepalese context, so far, no studies have been conducted,
therefore this study try to explore the impact of inventory behaviour in the
overall profitability of the cement industries of Nepal.
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