MANAGEMENT OF INVENTORY

Meaning of inventry managementThe term inventory management is used to designate the aggregate of those items of tangible assets which are :-

1. Held for sale in the ordinary course of business. 2. in the process of production for such sales or,3. to be currently consumed in the production of goods and

services to be available for sales.

Thus inventory means and includes any one or all of the following :-4. Finished goods,5. Work in progress,6. Material and supplies.The above may be considered to be operational definition….!!!!!!!

In financial parlance, inventory is defined as the sum of the

value of raw materials and supplies, including spares semi

processed materials or work in progress and finished goods. The

nature of inventory is largely dependent upon the type of

operations carried upon. For instance in the case of

manufacturing concern in inventory will generally comprise all

the groups mentioned above while in the case of trading concern,

it will simply be represented by stock in trade or finished goods.

Definition of inventory management…!!!!

1. On an average it accounts for a lion’s share of a firms investment in

working capital.

2. The risk factor in holding inventory is generally higher than that of

holding other items of current assets.

3. Though holding of more and more inventory may be desirable from

the point of view of functional managers, it adversely affects

profitability.

4. It involves many type of costs associated with it viz., acquisition cost,

carrying cost, short cost etc.

5. It is the only item of current assets which has direct influence on

price and the income of the firm.

6. It involves almost all the functional areas of management, viz.,

purchasing, production, marketing, and finance.

Inventory : some special features…!!!!!

1) Ensure that materials are available for use in production and production

services as and when required.

2) Ensure that finished goods are available for delivery to customers to fulfill

orders.

3) Minimize investment in inventories.

4) Protect inventory against deterioration, obsolescence, and unauthorized use.

A good management policy should balance the requirements of two opposing and

conflicting demands viz.,

i. To maintain a large quantity for smooth operations and efficient customer

services.

ii. To maintain only a minimum possible inventories because of inventory

holding cost and opportunity cost of funds invested in inventory.

Objectives of inventory anagement….!!!!

A good inventory policy should provide a proper check against losses through pilferage and other means.

It should empower management to dispose of non-moving goods and obsolete items in time.

It should have adequate scope for motivation and proper performance evaluation of persons concerned.

It should eliminate duplication in ordering or in replenishing of inventories.

It should ensure optimum utilization of available storage space without resorting to excess inventory holdings.

It should ensure adequate and effective physical and accounting control over inventories.

It should conform to the recommendation of the Tondon committee related to the inventory norms.

Ingredients of good inventory policy….!!!!!!!

The levels various of inventory may be compared from time to time between firms belonging to the same industry or within the same firm. This comparison may be made for a particular accounting year or over a period of time. The logic behind this is that comparison is fundamental in establishing standards for ascertaining efficient inventory management or otherwise. The following turn over ratios may be used:

1. Material turn over : average material etc. in stores/average daily consumption.

2. Work in progress turn over : average work in progress/ average factory cost of production

3. Finished goods turn over : average finished goods in stores/ average cost of production.

The above 3 ratios are used to determine respectively whether materials & stores are over purchased, production control is defective and finished goods are slow moving.

Traditional approch to inventory management…!!!!

The following problems areas comprise the heart of inventory control and any scientific approach to inventory management should take care of them :

1. The classification problem2. The order quantity problem 3. The order point problem4. Safety stocks

The various techniques that are available for solving the above types of problems are discussed in the succeeding slides.

Scientific inventory management techniques

In any effective control system all items in the inventory are treated in the same manner under the same control techniques. Many firms find it useful to divide materials, parts, supplies and finished goods into sub classification for purpose of inventory control. The classification is made on the basis of annual consumption value of inventories. This technique of inventory classification and control is often called as the ABC analysis or proportional parts value analysis.

Objectives of ABC analysis : the main objective of this analysis is to develop policy guide lines for selective control, that is after the analysis the following policy guide lines can be established in respect of each of the classified categories of inventories.

ABC analysis is no doubt a very useful technique but it should be used with caution because it classifies various items on the basis of their value and not their relative importance.

The classification problem : ABC analysis

This represents the most favorable quantity to be ordered at the reorder point. In purchasing materials for consumption or procuring finished goods for sale, one of the most important problem to be faced is how much to buy at a time. If large quantities are bought, the cost of carrying the inventory is high. On the other hand, if purchases are made frequently in small quantity cost relating to ordering etc. will be high. Therefore the quantity to be ordered at a given time must be determined by taking into account 2 factors i.e. the acquisition cost and the cost of possessing materials.

Buying in large quantities may decrease the unit of acquisition but this saving may be more than offset but the cost of carrying materials in stock for a longer period of time. Therefore the EOQ is a problem of balancing the two conflicting kind of cost that is cost of carrying and cost of not carrying. The EOQ is taken at a level where the cost of carrying approx equals the cost of not carrying. At this point the total cost is also minimum.

Economic order quantity (EOQ)

Apart from the economic order quantity another important point to be decided is the re-order point i.e. when to place the order for replenishment of inventories. It may be defined as that level of inventory when a new order should be placed with the suppliers for replenishment. It is needless to maintain that the order side should be equivalent to the economic order quantity. Re-order point is fixed by taking into consideration :

1. The average daily consumption/ usage

2. Lead time i.e. time necessary to obtain deliveries from the date of order

3. The minimum or safety stock level

The following formula may be used :

4. Re-order point = (average usage of inventory * lead time)

5. Re-order point = (average usage of inventory * lead time) + safety stock.

Re-order point

This is also known as buffer or minimum stock. It may be defined as minimum additional inventory to serve as a safety margin or buffer or cushion to meet an unexpected increase in usage/ demand or unexpected delay in the supply of inventory or both. The safety stock varies from situation to situation. But in general it increases with :

1. Stock out cost(in terms of lost sales and good will)

2. Uncertainty of demand forecast

3. Probability of delay in receiving the deliveries

But holding an additional quantity in terms of safety stock involves an additional cost of carrying. Therefore viewed from cost considerations the optimum level of safety stock is the result of a trade of between stock out cost and carrying cost. These two type of carrying costs are in-fact conflicting with each other. Conversely with more and more safety stock level, stock out cost can be reduced or avoided but it involves a carrying cost of additional inventory in the form of safety stock.

Safety stock

Moderate inflation may be ignored. But the higher the rate if inflation the more important it is to consider this factor in inventory management.

If the rate of inflation tends to be relatively constant, the expected annual rate of inflation is to be deducted from the carrying cost percentage to determine economic order quantity. The reason for deducting the inflation rate from the carrying cost rate is that inflation causes the value of inventory to rise thus of setting somewhat the effects of depreciation and other carrying cost factors.

When the rate of inflation is deducted from the cost of carrying percentage, the EOQ ant hence the average inventory goes up. But with an increase in the rate of inflation, the interest rate also tends to increase and this increases the carrying cost.

An increase in carrying cost, other factors remaining constant is associated with an decrease in EOQ and hence in the average inventory, and vice versa.

Effects of inflation on inventory management