CHAPTER-1

INTRODUCTION

(i) BACKGROUND OF THE STUDY

(ii) RESEARCH METHODOLOGY

(iii) REVIEW OF LITERETURE

Estelar

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

1

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

Estelar

2

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,

Estelar

3

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

Estelar

4

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

Estelar

5

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

Estelar

6

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

Estelar

7

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

Estelar

8

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

Estelar

9

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.

Estelar

10

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.

Estelar

11

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.

Estelar

12

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.

Estelar

13

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

lar

14

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.

Estelar

13

UNIT-II

RESEARCH METHODOLOGY

Research Design

Population and Sample

Sources of Data

Data Analysis Tools

Financial Tools

Statistical Tools Estelar

14

Estelar

15

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

Estelar

16

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.

Estelar

17

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 :-

Estelar

18

(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:

Estelar

19

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

Estelar

20

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

Estelar

21

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

Estelar

22

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

Estelar

23

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.

Estelar

24

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.

Estelar

23

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

Estelar

24

Estelar

25

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

Estelar

26

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

Estelar

27

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

Estelar

28

(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.

Estelar

29

(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

Estelar

30

(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

Estelar

31

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

Estelar

32

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

Estelar

33

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.

Estelar

34

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

Estelar

35

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.

Estelar

36

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

Estelar

37

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

Estelar

38

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

Estelar

39

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

Estelar

40

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

Estelar

41

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.

Estelar

42

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

Estelar

43

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

Estelar

44

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

Estelar

45

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)

Estelar

46

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.

Estelar

47

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.

Estelar

48

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

Estelar

49

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.

Estelar

50

(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

Estelar

51

(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

Estelar

52

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

Estelar

53

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

Estelar

54

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.

Estelar

55

(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.

Estelar

56

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

Estelar

57

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

Estelar

58

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.

Estelar

59

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

Estelar

60

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

Estelar

61

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

Estelar

62

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.

Estelar

63

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

Estelar

64

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.

Estelar

65

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

Estelar

66

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

Estelar

67

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

Estelar

68

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.

Estelar

69

Reference

1. C. Paul Jannis, Carl H. Poedtke, Donald R. Ziegler – Managing and Accounting for Inventories. Ronald Press Publication, New York, (Pg-22).

2. Paragalow Edward – origin and evaluation of double entry book keeping. American Institute of Accountants, New York, 1938. (Pg-27).

3. Adam Smith- Wealth of Nation, Book –II, Chapter-I.

4. Principle of Inventory and Materials Management- Richard J. Tersine- pg-5.

5. Ibid.

6. P. Gopalakrishan M. Sundaresan. Material Management, an Integrated Appproach. PHI Learning Pvt. Ltd.

7. Committee on Accounting Procedures, Restatement and Revision of Accounting Research Bulletin No-43, American Institute of Accountants, New York June, 1953, P. 27.

8. H.A. Black, J. E. Champion and G.U. Miller, Accounting in Business Decision-Theory Method and Use, Prentice-Hall Inc, New Jersey, 1967, P. 52.

9. James H. Greene, Production and Inventory Control System and Decision, Richard D. Irwin, Inc Home Wood Illinois 1974, revised edition, P. 203.

10. Ibid.

11. L.R. Howard, “Working Capital- Its Management and Control”, Mac Donald and Evans Ltd., London, 1971, P. 92.

12. Joseph Buchan and Ernest Kornigsberg, “Scientific Inventory Management” Prentice Hall of India Pvt. Ltd., 1970, P. 282.

13. Vijaya Saradhi P. Sisthla, “Working Capital Management in Public Enterprise” International Centre for Public Enterprise in Developing Countries. Yugoslavia. (ICPE monograph No. 51, 1982, P. 51).

14. Hampton J. John, Financial Decision Making Prentice Hall of India Pvt. Ltd., New Delhi, 1998, p. 241.

15. Starr, Martin and David W. Miller, op. cit., p. 15.

16. Arrow Kenneth J., “Study in the Mathematical Theory of Inventory and Production, Stanford University Press, Stanford, California, 1958, chapter 1.

17. V. K. Bhalla, Financial Management and Policy, Anmol publication Pvt. Ltd. 1998, P. 382.

18. Ibid.

Estelar

70

19. Henry De Vos and Donald L Thiry, “Management Services: Manufacturing Management,” Journal of Accounting, May, 1967.

20. R. S. Chadda, Inventory Management in India, Allied Publishers, New Delhi, 1971, P. 2.

21. Bhatia Jawaharlal “Inventory management in Textile Mill in Delhi, Panjab, Rajasthan” Unpublished Ph. D. Thesis Submitted in Delhi University, 1986.

22. Harold T. Amrine, John Ritchy and Oliver S. Hulley, “Manufacturing Organization and Management, Prentice, Englewood, 1966, P. 216, 219.

23. B.K. Bhar, “Cost Accounting Method and Problems”, Academic Publisher Calcutta, 1976, P. 31.

24. Bethel as quoted by B.K. Mishra, “Theory and Practice of Inventory Management”, Akashdeep Publishing House, New Delhi 1989, P. 8.

25. V.E. Ramamorthy, “Working Capital Management”, Institute of Financial Management and Research, Madras, 2nd revised edition, 1977, P. 150.

26. L.R. Howard, “Working Capital- Its Management and Control”, Mac Donald and Evans Ltd., London, 1971, P. 92.

27. E. F. Brigham, L. C. Gapenski, M. C. Ehrhardt, “Financial Management Theory and Practice”, Harcourt Publisher International Company, 2001, P. 809.

28. “John V. Scott and Associates Limited in their Articles”, Inventory Control or bust Cost and Management, Sept/Oct, 1981, P. 26.

29. E. S. Buffa, Modern Production/Operation Management (1983), 7th Edition, Newyork : Wiley.

30. Bhatia Jawaharlal “Inventory Management in Textile Mill in Delhi, Panjab, Rajasthan” Unpublished Ph. D. Thesis Submitted in Delhi University, 1986.

31. Dean Ammer, Harvard Business Review (1969).

32. R. J. Karter and P. Price, “Integrated Material Management”, The M and E Hand Book Seris U. K. 1993. P. 23.

33. P. R. Gokarn, Edited by M.V. Pylee ‘Essentials of Material Management. Somniya Publications Pvt. Ltd., Bombay, 1970, P. 1.

34. P.R. Gokarn, Edited by M.V. Pylee, op. cit., P. 3.

A. N. Khosla, “A Seminar Paper on Material Management” Aug., 1962.

35. Optimizing Economic Order Quantity, Dave Piasecki, Journal of Economic Perspectives, Winter 2010, V 24, N 1.

Estelar

71

36. Hax, AC and Candea, D. (1984), Production and Operations Management, Prentice-Hall, Englewood Cliffs, NJ, pp. 135, http://catalogue.nla.gov.au/Record/772207

37. Wilson, R. H. "A Scientific Routine for Stock Control" Harvard Business Review, 13, 116-128 (1934).

38. Harris, F.W. "How Many Parts To Make At Once" Factory, The Magazine of Management, 10(2), 135-136, 152. 1913.

39. Ramamoorthy, op., cit., P. 157.

40. I. M. Pandey, Financial Management. Vikash Publishing House Pvt. Ltd., P. 882.

41. Optimizing Economic Order Quantity, Dave Piasecki, op. cit., P. 3.

42. Purchasing and Inventory Control, K.S. Menon. Wheeler Publishing.

43. Inventory Management by Gopalakrishnan. Prentice Hall of India Pvt. Ltd.

44. Inventory Management, Martin K. Starr and Miller. Prentice Hall of India Pvt. Ltd.

45. I. M. Pandey, Financial Management. op. cit., P. 883.

46. James C. Van Horne, Financial Management and Policy, Prentice Hall of India Pvt. Ltd., New Delhi, 1999, P. 478.

47. Monk, Ellen and Bret Wagner. Concepts in Enterprise Resource Planning. 3rd Edition. Boston: Course Technology Cengage Learning, 2009.

48. Bolten, S.E., Managerial Finance, (Boston), Houghton Mifflin Co., 1976, P. 437.

49. Rooney, C., & Bangert, C. (2009, April). Developing the Right Approach to Requirements Planning Under ERP. Adhesives Age, 44(4), 49.

50. Weston J. Fred, Scott Basely & Brigham Eugene F. Essentials of Managerial Finance, The Dryden Press Harcourt publisher 1996, P. 434.

51. The Chartered Institute of Management Accountant, London.

52. Richmond, Herbert J., Effective Inventory Management- Fact or Fiction? Financial Executive, March, 1969, P. 74.

53. Carl J. "Skeet" Haag, Maximizing Profitability through Inventory Management.

54. Production and Inventory Management Journal, Godwin Udo.

55. Chun-Tao Chang, Inventory Models with stock dependent demand and nonlinear holding costs for deteriorating items. Asia Pacific Journal of Operational Research Vol. 21, No. 4 (2004), World Scientific Publishing Co. & Operational Society of Singapore.

Estelar

72

56. P. P. McGouldric, The Impact of Credit Cost and Availability on Inventory Investment, in Inventory Fluctuation and Economic Stabilization, Part II Washington Joint Economic Committee, 87th Congress, 1961.

57. M. C. Lovell, Determinants of Inventory Behaviour, in Model of Income Behaviour. Edward F. Denison Lawrence R. Klein, eds. New York, 1964.

58. Paul G. Darling and M. C. Lovell, Factors Influencing Investing in Inventories, in The Bookings Quarterly Econometric Models of the U. S., J. S. Dusenberry et. Al., eds., Chicago., 1965.

59. Michael C. Knapp and Carol A. Knapp, Perry Drug Stores, Inc.: Accounting and Control Issues for Inventory in Retail Environment. Issues in Accounting Education Vol. 15, No. 2, May, 2000.

60. Charles Lieberman, Inventory Demand and Cost of Capital Effects, The Review of Economics and Statistics, Aug., 1980, P. 348.

61. F. Owen Ervin, Jr., Retail Inventory Investment and the Cost Capital, The American Economic Review, Sept., 1981, P. 633.

62. M.A. Akhtar, Effect of interest rates and inflation on aggregate inventory investment in the United State, The American Economic Review, June, 1983, P. 328.

63. Cachon G. and C. Terwiesch. 2005. Matching Supply with Demand: An Introduction to Operations Management. Second edition, The McGraw-Hill Companies.

64. Gaur V., M. Fisher and A. Raman. 2005. An Econometric Analysis of Inventory Turnover Performance in Retail Services. Management Science, Vol. 51, 181-194.

65. Gaur, V., S. Kesavan. 2006. The Effects of Firm Size and Sales Growth Rate on Inventory Turnover Performance in the U.S. Retail Sector. Forthcoming in N. Agrawal and S. Smith (editors). Retail Supply Chain Management, Kluwer Publishers.

66. Gaur V., M. Fisher and A. Raman. 1999. What Explains Superior Retail Performance? Working paper, New York University.

67. Rajagopalan S. and A. Malhotra. 2001. Have US Manufacturing Inventories Really Decreased? An Empirical Study. Manufacturing and Service Operations Management, Vol. 3, 14-24.

68. Chen H., Frank M., and O. Wu. 2007. US Retail and Wholesale Inventory Performance from 1981 to 2003. Forthcoming, Manufacturing and Service Operations Management.

Estelar

73

69. Lai R. 2005. Inventory and the Stock Market. Working paper, Harvard University.

70. Lieberman M. B., S. Helper and L. Demeester. 1999. The Empirical Determinants of Inventory.

71. Levels in High-Volume Manufacturing. Production and Operations Management, Vol. 8, 44-55.

72. Ramey V. and K. West. 1999. Inventories. Chapter 13 in the Handbook of Macroeconomics, Vol. 1, Elsevier Science.

73. Thomas J. and H. Zhang. 2002. Inventory Changes and Future Returns. Review of Accounting Studies, Vol. 7, 162-187.

74. Chakraborthy. S.K. and Malla Reddy. K, Inter-firm Comparison in the Indian Cement Industry', Topics in Accounting and Finance, Oxford University Press, New Delhi, pp. 277-308, 1976.

75. Iyengar. A.V.K., An Empirical Study on Inventory Management Practices in Indian Industry', Inventory Management, VORA Publisher's Private Limited, Bombay, pp. 46-67, 1980.

76. Verma, Harbans Lal, Inventory Management in Iron and Steel Industry in India, VORA Publisher’s Pvt. Ltd., p. 51, 1989.

77. Nirjhar Sarkar, Fluctuation in Inventory and its Impact on Profitability', The Chartered Accountant, Vol. 54, No. 5, August, pp. 83-87, 1993.

78. Man Steven, “A comparative study on inventory of Indian Airlines Ltd. and Air India Corporation Ltd.” Topic in Accounting and Finance, Oxford University Press, New Delhi, p. 203, 1994.

79. Omprakash Kajipet and Krishnama Chary, P., Inventory Management in Selected Paper Mills of Andra Pradesh-some Reflections’, Research Bulletin, Vol. XIV, July, 1997, p. 47 – 57.

80. Inventory Management in Textile Mills in Delhi, Punjab and Rajasthan, A PhD dissertation submitted to Delhi University by Jawaharlal Bhatia in 1984.

81. Inventory Management in India, A Study of Selected Companies- PhD dissertation submitted to the Delhi University by Munish in 1986.

Estelar

74

Estelar