theory inv
TRANSCRIPT
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Introduction: 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 stock at any given
point of time. The operational definition of inventory would be the amount ofraw materials, fuel and lubricants, spare parts and semi-processed material to be
stocked for the smooth running of the plant. Since these resources are idle when
kept in stores, inventory is defined as an idle resource of any kind having an
economic value.
Inventories are maintained basically for the operational smoothness, which they
can affect by uncoupling successive stages of production, whereas the monetary
value of inventory serves as a guide to indicate the size of the investment made to
achieve this operational convenience. The materials management department is
expected to provide this operational convenience with a minimum possible
investment in inventories. The objectives of inventory, operational and financial,
needless to say, are conflicting. The materials department is accused of both
stockouts as well as large investment in inventories. The solution lies in
exercising a selective inventory control and application of inventory control
techniques.
Inventory terminology:
Inventory or stock is referred to in a variety of ways:
A Stock-keeping unit (SKU) is a separately identifiable class of item, which is
complete in the sense that a customer in that form can utilize it.
Manufacturing, wholesale and retail inventory depends on the type of firm
holding the inventory. These could be held in different forms for the same
material. For example, wholesale in bulk form, and retail in packaged form.
During manufacturing, input inventory is raw material; an inventory in-between
processing stage is referred to as work-in-process; and after the completion of
manufacturing is called as finished goods inventory.
Transit or in-transit or pipeline inventory is inventory that either waiting or in
the process of transportation. The speed of transportation and the point of time
of ownership transfer of pipeline inventory determines the time of holding, and
hence the cost of holding this inventory.
Seasonal stock refers to the material, which is purchased or manufactured in
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anticipation of seasonal demand.
Promotional stock is the additional stock kept ready for the increase in demand
due to market promotions of products.
Speculative stock is the additional stock purchased as a hedge against the
possibility of future increase in price of the material.
Dead stock is unused and / or obsolete stock, which cannot be sold.
In order to understand the concept of inventory terms are used for managing
inventory at a logistical facility, let us first view the definitions:
Inventory level is the actual inventory quantity held at a logistical facility at a
particular point of time.
Cycle inventory or base stock refers to the inventory quantity held in stock due to
the replenishment time required in the ordering process.
Replenishment time or lead-time is the time elapsed between order placement
and order receipt for an inventory item. In case inventory is to be replenished bymanufacturing, this is the time elapsed between the work order issue for
manufacturing and the completion of manufacturing.
Safety stock or buffer stock inventory is the inventory held due the differences in
demand and supply rate of material at each stage in-between supplier, purchase,
manufacture, distribution, and customer to avoid stock outs at each stage.
Average inventory is the calculated average of the inventory quantity held at alogistical facility over a period of time.
Reorder point is the pre-decided inventory level, which is reached by a falling
inventory level during utilization of inventory, at which point an order is placed
for replenishing the inventory in order to avoid a stock out.
Order quantity is the inventory quantity, which is ordered for replenishing
depleting inventory.
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Functions of Inventory
the necessity of holding inventory is due to the following functions of inventory
Specialization:
A firm can either produce all the required variety products at a plant at one
location, or, produce different products at separate plant locations. Locating
separately will enable the firm to select the location of each different product
manufacturing plant based on the particular requirements of that product, thus
achieving specialization efficiencies like geographical facilities and economies of
scale. This specialization approach creates inventory at diverse locations. Also,
pipeline inventories are created due to transport linkages required betweendifferent manufacturing plants and with distribution warehouses.
Balancing supply and demand:
Demand depends upon the requirements of customers relating to time and
quantity of products, and is not in the control of the producer. Supply, on the
other hand is under the producers control, but has to be economized and also
paced with the time and quantity requirements of customer demand. In order to
ensure that customers are not dissatisfied when they demand the required
quantity of products, it is necessary to have adequate inventory of productsavailable at all times. This is the balancing inventory required due to the different
rates of manufacturing and consumption. In case of seasonal products when
production has to take place for a longer period of time in advance of the season,
production throughout the year ensures lower investments in production
capacities while increasing inventory. An example is the production of rainwear
throughout the year for the sales which will occur only during the rainy season.
Another example of balancing is seasonal production during raw material
availability and year-round consumption, which also requires inventory. Theexample of this is seasonal availability of mango fruit and year-round
consumption of mango based products.
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Economies of scale:
Economies of scale are obtained by holding large inventories a) While
purchasing, ordering in large quantities provides cost economies and discounts;
(b) transportation economies are obtained by transporting in larger quantities;and, (c) during manufacturing, producing in economic batch quantities lower
costs.
Overcoming uncertainity :
Safety stock of inventory is required to overcome uncertainty of customer
demand on the one hand; and, purchasing, receiving, manufacturing, and order
processing delays on the other. Either of these may result in shortages of
products at the time of customer requirements if adequate safety stock ofmaterial is not provided for. If such material stock outs are not frequent
occurrences, the customer may look elsewhere leading to a last order at the very
least, or a lost customer. This uncertainty results in buffer stocks being created
between (a) supplier and purchasing, (b) purchasing and production, (c)
production and marketing, (d) marketing and distribution, (e) distribution and
intermediary, (f) intermediary and customer, in order to avoid stock outs.
Classification of Inventories :
(1) Production inventories
they represent raw materials, parts and components that are used in the process
of production. Production inventories include
Standard industrial items purchased from outside (also called bought outs)
Non-standard items (purchased items)
Special items manufactured in the factory itself (also called works made parts or
piece parts.
(2) MRO inventories
They refer to the maintenance; repairs and operation supplies, which are
consumed during process of, manufacture but do not become a part of the
product.
(3)In-process inventories
They represent items in the semi-finished condition (i.e. items in the partially
completed stage)
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(4)Goods-In-TransitThey represent such materials, which have been paid for but have not yet
been received by the stores.
Risks of Holding Inventory :The holding of inventory creates the following risks for a firm
The investments committed to a particular inventory combination are not
available for alternative uses for the benefit of the firm. The risks in these case
is due to the interest cost incurred on this inventory until the investment is
recovered, as also the opportunity cost of profit which might have been made
in alternative investment
The inventory may be pilfered or lost
The inventory may become absolute and/ or useless
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Determination of inventory is another risk for holding inventory:
Inventory Cost
In operating an inventory system manager should consider only those coststhat vary directly with the operating doctrine in deciding when and how much
to recorder; cost independent of the operating doctrine are irrelevant.
Basically, there are five types of relevant costs.
Cost of the item.
Cost of procuring the item.
Cost of carrying the item in inventory.
Cost associated with being out of stock when units are demanded but areunavailable (stock outs).
Cost associated with data gathering and control procedures for the inventory
system.
Often these five costs are combined in one way or another, but lets discuss
them separately before we consider combinations.
(1)Cost of Item
The cost, or value, of the item is usually its purchase price: the amount paid to
the supplier for the item. In some instances, however, transportation,receiving, or inspection costs, for example, may be included as part of the cost
of the item. If the cost of the item per unit is constant for all quantities
ordered, the total cost of items purchased during the planning horizon is
irrelevant to the operating doctrine. If the unit cost varies with the quantity
ordered, a price reduction called a quantity discount, this cost is relevant.
If the facility manufactures the item, the cost of the item is its direct
manufacturing cost. Again, constant unit cost mean total costs are irrelevant.
(2) Procurement Costs
Procurement costs are the placing a purchase order or the setup costs if the
item is manufactured at the facility. These costs vary directly with each
purchase order placed. Procurement costs include costs of postage, telephone
calls to the vendor, labor costs in purchasing and accounting, receiving costs,
computer time for record keeping, and purchase order supplies.
(3) Carrying Costs
Carrying or holding casts are the costs of maintaining the inventory
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warehouse and protecting the inventoried items. Typical costs are insurance,
security, warehouse rental, heat, lights taxes, and losses due to pilferage
spoilage, or breakage. The cost of typing up capital inventory is also
considered a carrying cost.
(4) Stockout Cost
Stock out cost, associated with demand when stocks have been, takes the
form of lost sales or backorder costs. When sales are lost because of
stockouts, the firm loses both the profit margin on unmade sale and its
customers good will. If customers take their business elsewhere, future profit
margins may also be lost. When customers agree to come back after
inventories have been replenished, they make backorders. Backorder costs
include loss of good will and money paid to reorder goods and notifycustomers when goods arrive. As the next example shows, stockouts can and
do occur in the service industries.
(5) Cost of operating the information processing system
Whether by hand or by computer, someone must update records as stock
levels change, for system in which inventory levels are not recorded daily, the
cost is primarily incurred in obtaining accurate physical counts of inventories.
Frequently, these operating costs are more fixed than variable over a wide
quantity range. Therefore since fixed costs are not relevant to the operatingdoctrine, we will not consider them further.
(6) Cost tradeoffs
Our objective in the inventory control is to find the minimum cost operating
doctrine over some planning horizon; these costs can be expressed in a
general cost equation:
Total
Annual = cost of the items + procurement costs + carrying Costs + stock outcost
Relevant cycle stocks lost sales
Cost Buffer stocks Backorders
Fundamental approaches to managing Inventory:
Traditional Inventory management has been deciding how much to order?
And when to order? But challenges of today require inventory managers to
find answer to the question where to stock the material as this greatly
influences customer satisfaction level. High level of inventory indicates higher
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customer satisfaction level, but cost of high inventory is obviously high. Hence
the modern challenge is high customer satisfaction at minimum inventory
Reactive Approaches:
Fixed Order Quantity Approach: Q modelThe above approach also called Q model signifies that the order quantity can
be fixed at a level depending on demand, value and inventory related costs. A
stock level called Re Order Level [ROL] is fixed, which triggers ordering. Re
Order Level is the lead-time consumption or product of lead-time and demand
rate during lead-time. When we follow this approach order quantity is fixed
by calculating EOQ and ROL is fixed by calculating lead-time consumption.
Inventory cycles can be conceptualized by looking at the figure given below
and drawn in the class.
Constant monitoring is the main disadvantage of this model:
Salient Features of the above approach : Widely used technique
Requires constant monitoring of stock levels
Suitable for high value and critical items
Limited by the assumptions made cost of in transit inventory, volume
transportation rates, use of private carriage, etc
Economic Order quantity
The order quantity depends upon the cost of the inventory items, the rate and
nature of demand (whether constant or fluctuating), the replenishment time,
and the inventory carrying costs and ordering costs for the inventory items.
The EOQ can be calculated with the help of a mathematical formula.
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Following assumptions are implied in the calculation:
Constant or uniform demand- although the EOQ model assumes constant
demand, demand may vary from day to day. If demand is not known in
advance- the model must be modified through the inclusion of safe stock.
Constant unit price- the EOQ model assumes that the purchase price per unit
of material will remain unaltered irrespective of the order offered by the
suppliers to include variable costs resulting from quantity discounts, the total
costs in the EOQ model could be redefined.
Constant carrying costs- unit carrying costs may very substantially as the size
of the inventory rises, perhaps decreasing because of economies of scale orstorage efficiency or increasing as storage space runs out and new
warehouses have to be rented.
Constant ordering cost- this assumption is generally valid. However any
violation in this respect can be accommodated by modifying the EOQ model in
a manner similar to the one used for variable unit price.
Instantaneous delivery- if delivery is not instantaneous, which is generally the
case; the original EOQ model must be modified through the inclusion of a safe
stock.
Independent orders- if multiple orders result in cost saving by reducing paper
work and the transportation cost, the original EOQ model must be further
modified. While this modification is somewhat complicated, special EOQ
models have been developed to deal with it.
These assumptions have been pointed out to illustrate the limitations of the
basic EOQ model and the ways in which it can be easily modified tocompensate for them.
Fixed Order Interval Approach: P model
The time between two successive orders [order interval], T is fixed and the
maximum stock that can be stored, S is also fixed as pre-requisites for this
approach. The inventory level is not monitored as in Q model continuously
but checked in intervals of T fixed as a policy decision. On the fixed day as per
T the stock is checked and the difference between current stock level and
maximum sock S is calculated. This difference is the order quantity, which
will be ordered immediately. The order quantity arrives after the lead-time.
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Next inventory check will be only after the interval T.
Salient Features of the above approach
Widely used technique
Does not require constant monitoring of stock levels
Suitable for lower value and non critical items
Min-Max Approach a modification to EOQ model
When we follow EOQ model, an order is released when ROL is reached. Here
the assumption is stock depletion is at a specific rate D during replenishment
cycle. In reality when stock depletes in larger increments we may suddenly
find that we are suddenly way below ROL. Min-Max Approach suggests that
the actual order quantity should be the sum of EOQ and the difference
between ROL and actual stock on hand at the time ROL occurs.
Just In Time
The time-based approach to inventory management came into focus when
Toyota Motors Company came out with the concept of kanban in 1950. This
lead to the dramatic reduction in WIP quantities tying the inventory closely to
the demand from subsequent process or internal customer. Kanban is
conceptually a two-bin system, a signal being raised to warrant
replenishment.
JIT approach became a modern production system seeking to implant conceptof stockless production. JIT embraced a variety of manufacturing concepts like
reduced lot sizes, quick switch over [SMED], load leveling [response to tact
time], group technology, statistical process control [control charts],
preventive maintenance and quality circles.
QR, CR, AR, response-based techniques
Quick responseInformation regarding retail sales is communicated by the retailer to the
manufacturer via Electronic data Interface (EDI). The Manufacturer then
decides upon the most effective and efficient replenishment response. The
manufacturer then communicates the replenishment shipment schedule to
the retailer to facilitate receipt. Thus, quick response is achieved by speedier
technology-enabled information exchange.
Continuous replenishment strategy
Also known as vendor managed inventory. This approach eliminates the need
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for placing an order. Retail sales information is directly passed to the supplier,
who takes the responsibility of replenishing the right variety of inventory at
right time with advance shipping notification to the retailer
Automatic or profile Replenishment or ARAR enables the supplier to anticipate the customers requirement in advance
to make replenishment. The responsibility for inventory management is
placed squarely on the supplier. There should be information flow between
customer & supplier that makes inventory visibility possible. While this takes
away the inventory management from the customer and gives it to the
supplier, supplier gets the benefit of inventory visibility and more effective
management to reduce total costs.
Planning approaches
Fair Share Allocation
Inventory planners decide to allocate an amount of inventory to a ware house
based on the past consumption pattern of that particular facility from the
available inventory volume at the source.
In the above example, in the plant warehouse the inventory is 600 units. If we
decide to keep aside 100 units and allocate the balance, the allocation is donekeeping the daily use performance pattern of the distribution centers. The
methodology as given below.
Let A be the amount of inventory available for allocation.
Let I be the inventory in distribution center.
Let D be the daily demand,
Then a common days supply, DS, for distribution center inventories is,
A + I
DS = --------------
D
500 + 50+100+75
DS = --------------------------
10+50+15
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9.67days.
Now amount of inventory allocated to distribution center 1 is
[9.67 50/10]/10 = 4.67X10 = 46.7 units, say 47 units.
Similarly we can find allocations for distribution centers 2 & 3. We get 383 &
70 units. Fair share allocation method doesnt take into account performance
cycle times, EOQ & safety stock considerations.
Requirements Planning Approach
Requirements planning approach include materials or manufacturing
requirement PlanNng or MRP, and DISTRIBUTION REQUIREMENTS PLANING
or DRP. MRP controls inventory management from purchasing to Completionof manufacturing with delivery of finished goods to Plant Warehouse. DRP
then takes over the inventory for distribution to the customers. MRP starts
with MASTER PRODUCTION PLANNING (MPS) which details what, how much
and when to manufacture based on forecasts and/or customer orders. On the
basis of this end-product schedule, MRP prepares a schedule of raw Materials,
Components and Sub-assemblies requirements to meet the MPS. DRP, on the
other hand, starts with Customer Requirements for the end-product at
diverse Geographical locations.
MRP DRP
Guiding factor Guided by production schedules
Guided by customer demandControl of the firm Under control of the firm
Not under control of the firm
Demand situation Operates in dependant demand situation Operates in
independent demand situation
Area of operation and coordination Coordinates scheduling and integration of
materials into finished goods Coordinates demand between outlets and
supply sources Stage of functioning Controls inventory until manufacturing
and assembly is complete. Controls and coordinates inventory after
manufacturing and assembly of finished goods and DRP. MRP plans the
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procurement of raw materials as per their requirements, right from the first
stage till the final assembly.
After the goods have been manufactured, DRP plans the distribution of
finished goods from the plant warehouse to the wholesalers and retailers till
it reaches the customer.The integrated model seeks to combine these two areas. Taking into
consideration the requirements of both MRP and DRP, it provides integrated
planning.
Adaptive Logic Approach
Certain situations may warrant the use of a reactive inventory approach;
while others may find the planning approach to be appropriate. In actual
practice one night find a system wherein different conditions exist atdifference locations and times requiring the use of both the reactive and
panning approaches under different conditions. For example, during the
product lifecycle, it is necessary to push the products through the distribution
channels during the introductory and growth phases, while allowing
customers to pull the inventories through the increased distribution channels
during the saturation/maturity phases.
Techniques Of Inventory Management:
ABC ANALYSIS
ABC analysis underlines a very important principle Vital few: trivial many.Statistics reveal that just a handful of items account for bulk of the annual
expenditure on materials. These few items, called A items, therefore, hold the
key to business. The other items, known as B and C items, are numerous in
number but their contribution is less significant. ABC analysis thus tends to
segregate all items into three categories: A, B, and C on the basis of their
annual usage. The categorization so made enables one to pay the right amount
of attention as merited by the items.
A-items: it is usually found the hardly 5-10% of the total items account for 70-75% of the total money spent on the materials. These items require detailed
and rigid control and need to be stocked in smaller quantities. These items
should be procured frequently, the quantity per occasion being small.
B-items: these items are generally 10-15% of the total items and represent
10-15% of the total expenditure on the materials. These are intermediate
items. The control on these items need not be as detailed and as rigid as
applied to C items.
C-items: these items are generally 70-80% of the total items and represent 5-
10% of the total expenditure on the materials. The procurement policy of
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these items is exactly the reverse of A items. C items should be procured
infrequently and in sufficient quantities. This enables the buyers to avail price
discounts and reduce work load of the concerned departments.
Policies of Control for A, B and c Categories.Any sound stock control system should ensure that the each item gets the
right amount of attention at the right time. ABC analysis makes this possible
with considerably less efforts due to its selective approach there are number
of ways in which ABC classification can be made use of:
Degree of Control
Some one at the senior level should be made responsible for regular
reviewing of these items. Up-to-date and accurate records should be maintainfor these items. B items should be brought under normal control made
possible by goods record keeping and periodic attention. Little control is
required for C items.
Ordering Procedure
A items should be subject to frequent review to reduce unwarranted
stockouts and possibilities of overstocking. A reasonable good analysis for
order points is required for B items butthe stocks may be reviewed less
frequently. No such computations are necessary for C items. These shouldbe bought in bulk.
Staggering of delivery schedules
Staggering of delivery schedules is one of the best strategies to reduce the
inventory investment and ensure un-interrupted inflow of materials.
Staggered deliveries tend to reduce cost of order writing but increase the cost
of inspection and receiving. Annual contract with scheduled deliveries are
desirable for A and B class of items. C class of items, however, should bepurchased in bulk on single-order-basis.
Stock records
Details records of goods ordered, received, issued and goods on hand should
be maintained for A category of items. No such detailed records are
necessary for C items. Any routine method that ensures goods and accurate
records is enough for B category of items.
Priority treatment: VIP treatment may be accorded to A items in all activities
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uch a processing of purchases orders, receiving, inspection movement on the
shop floor, etc., with an object to reduce lead time and average inventory. No
such treatment is necessary for B items. No priority is assigned to C items.
Safety StockAll items of consumption are equally important from production point of
view. Safety stock should be less for A items. The possibility of stockouts can
considerably be cut down by closer forecasting, frequent reviewing and more
progressing. C items, on the contrary, should have sufficient safety stock to
eliminate progressing and to reduce the probability of stockouts. A moderate
policy is required for B items, safety stock being neither too high nor too
low.
Value Analysis
To secure maximum benefits, it is essential to select those items for value
analysis which offer the highest scope for cost reduction. The usage
classification is a useful step in this direction. Only A and B items are
selected for detailed value analysis and the former is given priority over the
latter. C items should not be value analysed.
HML ANALYSIS:H-M-L analysis is similar to ABC analysis except for the difference that instead
of usage value, price criterion is used. The items under this analysis are
classified into three groups that are called high, medium and low. To
classify, the items are listed in the descending order of their unit price. The
management for deciding three categories then fixes the cut-off-lines. For
example, the management may decide that all items of unit price above Rs.
1000/-will of H category, those with unit price between Rs. 100/- to
Rs.1000/- will be of M category and those having unit price below Rs. 100/-will be of L category.
HML analysis helps to -
Assess storage and security requirements
To keep control over consumption at the departmental head level
Determine the frequency of stock verification
To evolve buying policies to control purchase
To delegate authorities to different buyers to make petty cash purchase
VED ANALYSIS:
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V stands for vital, E for essential, D for desirable. This classification is
usually applied for spare parts to be stocked for maintenance of machines and
equipments based on the criticality of the spare parts. The stocking policy is
based on the criticality of the items. The vital spare parts are known as capital
or insurance spares. The inventory policy is to keep at least one number of thevital spare irrespective of the long lead-time required for procurement.
Essential spare parts are those whose non-availability may not adversely
affect production. Such spare parts may be available from many sources
within the country and the procurement lead time many not be long. Hence, a
low inventory of essential spare parts is held. The desirable spare parts are
those, which, if not available, can be manufactured by the maintenance
department or may be procured from local suppliers and hence no stock is
held usually.
S-D-E ANALYSIS:
S-D-E analysis is based on the problems of procurement namely:
Non-availability
Scarcity
Longer lead time
Geographical location of suppliers, and
Reliability of suppliers, etc.S-D-E analysis classifies the items into three groups called scarce, difficult
and easy. The information so developed is then used to decide purchasing
strategies.
Scare classification comprise of items, which are in short supply, imported
or canalized through government agencies. Such items are best to procure
limited number of times a year in lieu of effort and expenditure involved in
the procedure for import.
Difficult classification includes those items, which are available indigenouslybut are not easy to procure. Also items, which come from long distance and
for which reliable sources do not exist, fall into this category. Even the items,
which are difficult to manufacture and only one or two manufacturers are
available belong to this group. Suppliers of such items require several weeks
of advance notice.
Easy classification covers those items, which are readily available. Items
produced to commercial standards, items where supply exceeds demand and
others, which are locally available, fall into this group.
The purchase department employs S-D-E analysis
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To decide on the method of buying
To fix responsibility of buyers
GOLF ANALYSIS:
This stands for Government, Open Market, Local or Foreign source of supply.For many items, imports are canalized through Government agencies such as
state trading corporation, minerals and metals trading corporation, Indian
drugs and pharmaceutical etc.
For such items the buying firms cannot apply any inventory control
techniques and hence to accept the quota allocated by the government. Open
market category is those who form bulk of suppliers and procurement is
rather easy. L category includes those local suppliers from whom items can
be purchased off-the-shelf on cash purchase basis. F category indicatesforeign suppliers since an elaborate import procedure is involved, it is better
to buy imported items in bigger lots usually covering the annual
requirements.
S-OS ANALYSIS
S-OS analysis is based on seasonality of the items and it classifies the items
into two groups S (seasonal) and OS (off seasonal). The analysis identifies
items which are:
Seasonal and are available only for a limited period. For example agricultureproduce like raw mangoes, raw materials for cigarette and paper industries,
etc. are available for a limited time and therefore such items procured to last
the full year.
Seasonal but are available throughout the year. Their prices, however, are
lower during the harvest time. The quantity of such items requires to be fixed
after comparing the cost savings due to lower prices if purchased during
season against higher cost of carrying inventories if purchased throughout the
year.Non-seasonal items whose quantity is decided on different considerations.
M-N-G ANALYSIS;
M-N-G analysis based on stock turn over rate and it classifies the items into M
(moving items), N (non-moving items) and G (ghost items).
M (moving items) is those items, which are consumed from time to time. N
(non-moving items) are those items, which are not consumed in the last one
year. G (ghost items) is those items that had nil balance, both in the beginning
and at the end of the last financial year and there were no transactions
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(receipt or issues) during the year.
Analysis mainly helps to identify non-existing items for which the store keeps
bin-cards or waste computer memory or waste computer stationary while
preparing stores ledger. Stores department even might have even ear-marked
space for these non-existent items.All pending/ open purchase orders (if any) of such items should be canceled.
F-S-N ANALYSIS;
F-S-N analysis is based on the consumption figures of the items. The items
under this analysis are classified into three groups: F (fast moving), S (slow
moving) and N (non-moving).
To conduct the analysis, the last date of receipt or the last date of issuewhichever is later is taken into account and the period, usually in terms of
number of months, that has elapsed since the last movement is recorded.
Such an analysis helps to identify:
Active items which require to be reviewed regularly
Surplus items whose stocks are higher than their rate of consumption; and
Non-moving items which are not being consumed
X-Y-Z ANALYSIS;
X-Y-Z analysis is based on value of the stocks on hand (i.e. inventoryinvestment). Items whose inventory value are high are called as X items while
those inventory value are low are called Z items. And Y items are those which
have moderate inventory stocks.
Usually X-Y-Z analysis is used in conjunction with either ABC analysis or HML
analysis.
XYZ analysis helps to identify a few items, which account for large amount of
money in stock and take steps for their liquidation/retention.
XYZ when combined with FSN analysis helps to classify non-moving itemsinto XN, YN, and ZN group and thereby identify a handful of non-moving
items, which account for bulk of non-moving stock. These can be studied
individually in details to take decision on their disposal or retention.
PECULIRITIES IN INDIA
All the well-known inventory control techniques have a basic assumption:
free availability of materials as and when required in any quantity. This is
however not true of Indian conditions. We operate in a sellers market for
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most of the materials. There is a perpetual scarcity of key raw materials and
the prices fluctuate widely. However, the techniques should not be discarded
but used judiciously as a broad guideline, keeping in mind their limitations.
The Indian industry tends to stress a lot on production and machine
utilization-this focus of attention in the context of scarcity of materials leadsto hoarding of stocks. The inflation that prevails in the country prompts
hoarding
In view of the shortage of foreign exchange, strict import procedures are
enforced. The time taken for import clearance is high and the inventory of
imported materials is therefore usually very high.
In its initial stage of industrial development, the country relied solely on
foreign collaboration. Machinery and spare parts ware readily imported. The
lack of technological knowledge made the country rely on the collaboratorsfor the estimation of the requirements of spare parts. This stock of spares is
abnormally high. It is extremely evident that these spares are useless and
should be written off; however, for financial reasons they continue to exist on
inventory records.
Inventory control systems are built on the foundation laid by materials
management techniques such as ABC-VED analysis, standardization and
codification. Setting up an inventory control system without the pre-use of
these techniques is like building a castle in the air. The importance of ABC-
VED analysis is brought out in the light of the inability to measures precisecosts on the basis of which inventory levels could be set Standardization and
codification help in variety reduction and make inventory control purposeful.
Inventories, built to act as a cushion between supply and demand, serve the
following needs: it is sufficient to take care of the requirements of demand till
the next supply arrives, it is sufficient to take care of probable delays in
supply as well as probable variations in demand.
The problems that to be tackled are: the determination of the level of
inventory for placing a replenishment order, the quantity to be ordered, theamount of delay in supplies and the amount of variations in demand which
the inventory should be able to withstand. The problems can be resolved by
the cost implications. Costs, which are relevant for consideration, are
discussed in the following paragraphs.
Relevant Costs
Basically there are four costs relevant for consideration in developing an
inventory model. These are: (1) the cost of placing a replenishment order, (2)
the cost of carrying inventory, (3) the cost of under stocking, and (4) the cost
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of overstocking. The cost of ordering and the inventory carrying cost are
viewed as the supply side costs and help in the determination of the quantity
to be ordered for each replenishment. The understocking and overstocking
costs are viewed as the demand side costs and help in the determination the
amount of variations in demand and the delay in supplies, which theinventory should withstand.
Cost of ordering
Every time an order is placed for stock replenishment, certain are involved,
and, for most practical purposes, it can be assumed that the cost per order is
constant. The ordering costC o may very, dependent upon the type of items:
raw materials like steel against production components like casting. However,
it is assumed that an estimate Co can be obtained for a given range of items.This cost of ordering, Co includes:
Paper work costs, typing and dispatching an order.
Follow-up costs the follow-up required to ensure timely suppliers- includes
the travel cost for purchase follow-up, telephone, telex and postal bills.
Costs involved in receiving the order, inspection, checking and handing to the
stores.
Any set up cost of machines if charged by the supplier, either directly
indicated in quotations or assessed through quotations for various quantities.
The salaries and wages to the purchase department. This is relevant forconsideration if the purchase function is carried out at same level with the
existing staff. If the level of purchasing activity decreases significantly,
obviously a proportional amount of personnel will be transferred to other
departments.
If the level of purchasing increases, the extra load will be tackled by paying
overtime to existing staff or by recruiting new personnel. This additional cost
can be viewed as the marginal cost of orders. The ordering cost in a typical
Indian firm is around Rs. 100 per order, but experience shows that this costvaries considerably depending upon the efficiency of the purchasing
department
Some firms operate on the basis of receipt cost particularly when dealing
with staggered delivers. The mathematical models can be suitably modified to
get the economic receipt quantity instead of economic order quantity.
Cost of Inventory Carrying
This cost Cc is measured as a percentage of the unit cost of the item. This
measure, therefore, gives a basis for estimating what it actually costs a firm to
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carry stock. This cost includes: 1) interest on capital, (2) insurance and tax
charges, (3) storage costs-any labour, excluding handing of receipts of new
orders-the costs of provision of storage area and facilities like bins, racks,
etc (4) allowance for deterioration or spoilage, (5) Salaries of stores staff,
and (6) obsolescence. The inventory carrying cost varies and in a typicalIndian industry is about 30 percent. A major portion of this is accounted for
by he interest on capital, which depends on the fiscal policies of the
government. A few firms differentiate the costs as fixed and variable. In the
analysis of and use of mathematical formula, only the variable costs of
ordering should be considered as the fixed costs will be constant irrespective
of the number of orders placed or the inventory carried
Understocking CostThis cost, Ku is the cost incurred when an item is out of stock. It includes the
cost of lost production during the period of stock out and extra cost per unit,
which might have to be paid for an emergency purchase.
Overstocking Cost
This cost K o is the inventory carrying (which is calculated per year) for a
specific period of time. The time varies in different contexts- it could be the
lead time of procurement or the entire life-time of a machine. In the case of
one-time purchases, overstocking cost would be: purchase price-scrap price.Based on the above costs several scientific models have been developed and
these are discussed separately for consumables and for spares in the
following chapters. The need for using these models in India has been
stressed by various committees. For example, the report of the committee* on
public undertakings mentions: For proper inventory control, it is essential to
adopt the scientific practices and techniques that have been developed in this
regard.
Spare parts management
Spare parts management is an important section of any system and a part that
needs much planning and organization. The right parts much be ready when
need to prevent the process to stop and the project to be slowed down to
much. On the other hand, too many spare parts will mean a both unpractical
and expensive situation.
Spare Parts Management Indicators
There is a saying: What you cant measure, you cant improve. The saying
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are not necessarily always true, but it is interesting, because I think a
derivative of the saying is true: What you measure, is usually what you
get.
Reducing Inventory ValueIt is common for plants to have a lot of focus on reducing inventory value.
Inventory value is one of those numbers that acts like salt in a wound for
corporate accountants. No, it doesnt matter if its high or low, it always
hurt to look at the number. Most of the time we dont know if the number is
too high or too low, we just know we want the number to be lower.
Cost of Keeping Spare Parts and Materials.
The cost for keeping inventory is usually an estimated number, often calledinventory interest (or similar), that varies from 10-40% depending on
company accounting rules. The cost included storeroom, storeroom
personnel,
depreciation, etc. If you have a spare parts and materials inventory value
of 10 Million, it costs the company 1-4 Millions (10-40%) a year to keep
that spare parts and materials inventory.
The Problem
Since it is common that inventory value is the only number the plant reallycares about, it tends to get reduced. But, anyone can reduce inventory value
very easily, IF its the only thing that matters. I can tell you to scrap
all spare parts right now bringing your spare parts and materials inventory
to zero. But the consequences will be devastating to production since we
dont have any spare parts.
Measure a Counterweight
Spare parts inventory value is important, but to effectively reduce spareparts inventory value, the counterweight has to be measured as well. The
counterweight to inventory value can be stock-outs for example (times we
get the spare part needed divided by total request for spare parts). When
stock outs go over around 4-5%, you will start seeing signs of people not
trusting the storeroom. These signs are spare parts in supervisors office,
satellite stores, spare parts in crafts peoples toolboxes etc.
inventory Management:
Inventory is a list for goods and materials, or those goods and materials
themselves, held available in stock by a business. It is also used for a list of the
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contents of a household and for a list for testamentary purposes of the
possessions of someone who has died.
Origins of the word Inventory
The word inventory was first recorded in 1601. The French term inventaire,
or "detailed list of goods," dates back to 1415.Business inventory
The reasons for keeping stock
There are three basic reasons for keeping an inventory:
1. Time - The time lags present in the supply chain, from supplier to user at
every stage, requires that you maintain certain amount of inventory to use in
this "lead time"
2. Uncertainty - Inventories are maintained as buffers to meet uncertainties in
demand, supply and movements of goods.3. Economies of scale - Ideal condition of "one unit at a time at a place where
user needs it, when he needs it" principle tends to incur lots of costs in terms
of logistics. So bulk buying, movement and storing brings in economies of
scale, thus inventory.
All these stock reasons can apply to any owner or product stage.
Buffer stock is held in individual workstations against the possibility that
the upstream workstation may be a little delayed in long setup or change-over
time. This stock is then used while that change-over is happening. This stock
can be eliminated by tools like SMED.These classifications apply along the whole Supply chain not just within a
facility or plant.
Where these stocks contain the same or similar items it is often the work
practice to hold all these stocks mixed together before or after the sub-
process to which they relate. This 'reduces' costs. Because they are mixed-up
together there is no visual reminder to operators of the adjacent sub-
processes or line management of the stock which is due to a particular cause
and should be a particular individual's responsibility with inevitableconsequences. Some plants have centralized stock holding across sub-
processes which makes the situation even more acute.
Special terms used in dealing with inventory:
Stock Keeping Unit (SKU) is a unique combination of all the components that
are assembled into the purchasable item. Therefore any change in the
packaging or product is a new SKU. This level of detailed specification assists
in managing inventory.
Stockout means running out of the inventory of an SKU.
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"New old stock" (sometimes abbreviated NOS) is a term used in business to
refer to merchandise being offered for sale which was manufactured long ago
but that has never been used. Such merchandise may not be produced any
more, and the new old stock may represent the only market source of a
particular item at the present time.Typology:
1. Buffer/safety stock
2. Cycle stock (Used in batch processes, it is the available inventory excluding
buffer stock)
3. De-coupling (Buffer stock that is held by both the supplier and the user)
4. Anticipation stock (building up extra stock for periods of increased demand
- e.g. ice cream for summer)
5. Pipeline stock (goods still in transit or in the process of distribution - haveleft the factory but not arrived at the customer yet)
Inventory examples
While accountants often discuss inventory in terms of goods for sale,
organizations - manufacturers, service-providers and not-for-profits - also
have inventories (fixtures, furniture, supplies, ...) that they do not intend to
sell. Manufacturers', distributors', and wholesalers' inventory tends to cluster
in warehouses. Retailers' inventory may exist in a warehouse or in a shop or
store accessible to customers. Inventories not intended for sale to customers
or to clients may be held in any premises an organization uses. Stock ties upcash and if uncontrolled it will be impossible to know the actual level of
stocks and therefore impossible to control them.
Whilst the reasons for holding stock are covered earlier, most manufacturing
organizations usually divide their "goods for sale" inventory into:
Raw materials - materials and components scheduled for use in making a
product.
Work in process, WIP - materials and components that have begun their
transformation to finished goods. Finished goods - goods ready for sale to customers.
Goods for resale - returned goods that are salable.
Spare parts
For example:
Manufacturing
A canned food manufacturer's materials inventory includes the ingredients to
form the foods to be canned, empty cans and their lids (or coils of steel or
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aluminum for constructing those components), labels, and anything else
(solder, glue, ...) that will form part of a finished can. The firm's work in
process includes those materials from the time of release to the work floor
until they become complete and ready for sale to wholesale or retail
customers. This may be vats of prepared food, filled cans not yet labeled orsub-assemblies of food components. It may also include finished cans that are
not yet packaged into cartons or pallets. Its finished good inventory consists
of all the filled and labeled cans of food in its warehouse that it has
manufactured and wishes to sell to food distributors (wholesalers), to grocery
stores (retailers), and even perhaps to consumers through arrangements like
factory stores and outlet centers.
Logistics or distribution
The logistics chain includes the owners (wholesalers and retailers),manufacturers' agents, and transportation channels that an item passes
through between initial manufacture and final purchase by a consumer. At
each stage, goods belong (as assets) to the seller until the buyer accepts them.
Distribution includes four components:
1. Manufacturers' agents: Distributors who hold and transport a consignment
of finished goods for manufacturers without ever owning it. Accountants refer
to manufacturers' agents' inventory as "matriel" in order to differentiate it
from goods for sale.
2. Transportation: The movement of goods between owners, or betweenlocations of a given owner. The seller owns goods in transit until the buyer
accepts them. Sellers or buyers may transport goods but most transportation
providers act as the agent of the owner of the goods.
3. Wholesaling: Distributors who buy goods from manufacturers and other
suppliers (farmers, fishermen, etc.) for re-sale work in the wholesale industry.
A wholesaler's inventory consists of all the products in its warehouse that it
has purchased from manufacturers or other suppliers. A produce-wholesaler
(or distributor) may buy from distributors in other parts of the world or fromlocal farmers. Food distributors wish to sell their inventory to grocery stores,
other distributors, or possibly to consumers.
4. Retailing: A retailer's inventory of goods for sale consists of all the products
on its shelves that it has purchased from manufacturers or wholesalers. The
store attempts to sell its inventory (soup, bolts, sweaters, or other goods) to
consumers.
It is a key observation in "Lean Manufacturing" that it is often the case that
more than 90% of a product's life prior to end user sale is spent in
distribution of one form or another. On the assumption that the time is not
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itself valuable to the customer this adds enormously to the working capital
tied up in the business as well as the complexity of the supply chain.
Reduction and elimination of these inventory 'wait' states is a key concept in
Lean.
High level inventory management
It seems that around about 1880[2] there was a change in manufacturing
practice from companies with relatively homogeneous lines of products to
vertically integrated companies with unprecedented diversity in processes
and products. Those companies (especially in metalworking) attempted to
achieve success through economies of scale - the gains of jointly producing
two or more products in one facility. The managers now needed informationon the effect of product mix decisions on overall profits and therefore needed
accurate product cost information. A variety of attempts to achieve this were
unsuccessful due to the huge overhead of the information processing of the
time. However, the burgeoning need for financial reporting after 1900 created
unavoidable pressure for financial accounting of stock and the management
need to cost manage products became overshadowed. In particular it was the
need for audited accounts that sealed the fate of managerial cost accounting.
The dominance of financial reporting accounting over management
accounting remains to this day with few exceptions and the financialreporting definitions of 'cost' have distorted effective management 'cost'
accounting since that time. This is particularly true of inventory.
Hence high level financial inventory has these two basic formulas which relate
to the accounting period:
1. Cost of Beginning Inventory at the start of the period + inventory purchases
within the period + cost of production within the period = cost of goods
2. Cost of goods - cost of ending inventory at the end of the period = cost of
goods soldThe benefit of these formulae is that the first absorbs all overheads of
production and raw material costs in to a value of inventory for reporting. The
second formula then creates the new start point for the next period and gives
a figure to be subtracted from sales price to determine some form of sales
margin figure.
Manufacturing management is more interested in inventory turnover ratio or
average days to sell inventory since it tells them something about relative
inventory levels.
Inventory turn over ratio (also known as inventory turns) = cost of goods
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sold/Average Inventory=Cost of Goods Sold/((Beginning Inventory + Ending
Inventory)and its inverse
Average Days to Sell Inventory=Number of Days a Year/Inventory Turn Over
Ratio=365 days a year/Inventory Turn Over Ratio
This ratio estimates how many times the inventory turns over a year. Thisnumber tells us how much cash/goods are tied up waiting for the process and
is a critical measure of process reliability and effectiveness. So a factory with
two inventory turns has six months stock on hand which generally not a good
figure (depending upon industry) whereas a factory that moves from six turns
to twelve turns has probably improved effectiveness by 100%. This
improvement will have some negative results in the financial reporting since
the 'value' now stored in the factory as inventory is reduced.
Whilst the simplicity of these accounting measures of inventory is very usefulthey are in the end fraught with the danger of their own assumptions. There
are in fact so many things which can vary hidden under this appearance of
simplicity that a variety of 'adjusting' assumptions may be used.
These include:
Specific Identification
Weighted Average Cost
Moving-Average Cost
FIFO, and LIFO.
Inventory Turn is a financial accounting tools for evaluating inventory and itis not necessary a management tool. Inventory management should be
forward looking. The methodology applied is based on historical cost of goods
sold. The ratio may not be able to reflect the usability of future production
demand as well as customer demand.
Business models including Just in Time (JIT) Inventory, Vendor Managed
Inventory (VMI) and Customer Managed Inventory (CMI) attempt to minimize
on-hand inventory and increase inventory turns. VMI and CMI have gained
considerable attention due to the success of third party vendors who offeradded expertise and knowledge that organizations may not possess.
Accounting perspectives
The basis of Inventory accounting:
Inventory needs to be accounted where it is held across accounting period
boundaries since generally expenses should be matched against the results of
that expense within the same period. When processes were simple and short
then inventories were small but with more complex processes then
inventories became larger and significant valued items on the balance
sheet[3]. This need to value unsold and incomplete goods has driven many
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new behaviors into management practice. Perhaps most significant of these
are the complexities of fixed cost recovery, transfer pricing, and the
separation of direct from indirect costs. This, supposedly, precluded
"anticipating income" or "declaring dividends out of capital". It is one of the
intangible benefits of Lean and the TPS that process times shorten and stocklevels decline to the point where the importance of this activity is hugely
reduced and therefore effort, especially managerial, to achieve it can be
minimized.
Accounting for Inventory:
Each country has its own rules about accounting for inventory that fit with
their financial reporting rules.
So for example, organizations in the U.S. define inventory to suit their needs
within US Generally Accepted Accounting Practices (GAAP), the rules definedby the Financial Accounting Standards Board (FASB) (and others) and
enforced by the U.S. Securities and Exchange Commission (SEC) and other
federal and state agencies. Other countries often have similar arrangements
but with their own GAAP and national agencies instead.
It is intentional that financial accounting uses standards that allow the public
to compare firms' performance, cost accounting functions internally to an
organization and potentially with much greater flexibility. A discussion of
inventory from standard and Theory of Constraints-based (throughput) cost
accounting perspective follows some examples and a discussion of inventoryfrom a financial accounting perspective.
The internal costing/valuation of inventory can be complex. Whereas in the
past most enterprises ran simple one process factories, this is quite probably
in the minority in the 21st century. Where 'one process' factories exist then
there is a market for the goods created which establishes an independent
market value for the good. Today with multi-stage process companies there is
much inventory that would once have been finished goods which is now held
as 'work-in-process' (WIP). This needs to be valued in the accounts but thevaluation is a management decision since there is no market for the partially
finished product. This somewhat arbitrary 'valuation' of WIP combined with
the allocation of overheads to it has led to some unintended and undesirable
results.
Financial accounting
An organization's inventory can appear a mixed blessing, since it counts as an
asset on the balance sheet, but it also ties up money that could serve for other
purposes and requires additional expense for its protection. Inventory may
also cause significant tax expenses, depending on particular countries' laws
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regarding depreciation of inventory, as in Thor Power Tool Company v.
Commissioner.
Inventory appears as a [[current asset]] on an organization's balance sheet
because the organization can, in principle, turn it into cash by selling it. Some
organizations hold larger inventories than their operations require in orderinflating their apparent asset value and their perceived profitability.
In addition to the money tied up by acquiring inventory, inventory also brings
associated costs for warehouse space, for utilities, and for insurance to cover
staff to handle and protect it, fire and other disasters, obsolescence, shrinkage
(theft and errors), and others. Such holding costs can mount up: between a
third and a half of its acquisition value per year.
Businesses that stock too little inventory cannot take advantage of large
orders from customers if they cannot deliver. The conflicting objectives ofcost control and customer service often pit an organization's financial and
operating managers against its sales and marketing departments. Sales
people, in particular, often receive sales commission payments, so unavailable
goods may reduce their potential personal income. This conflict can be
minimized by reducing production time to being near or less than customer
expected delivery time. This effort, known as "Lean production" will
significantly reduce working capital tied up in inventory and reduce
manufacturing costs (See the Toyota Production System).
The role of a cost accountant on the 21st-century in a manufacturingorganization
By helping the organization to make better decisions, the accountants can
help the public sector to change in a very positive way that delivers increased
value for the taxpayers investment. It can also help to incentives progress and
to ensure that reforms are sustainable and effective in the long term, by
ensuring that success is appropriately recognized in both the formal and
informal reward systems of the organization.
To say that they have a key role to play is an understatement. Finance isconnected to most, if not all, of the key business processes within the
organization. It should be steering the stewardship and accountability
systems that ensure that the organization is conducting its business in an
appropriate, ethical manner. It is critical that these foundations are firmly
laid. So often they are the litmus test by which public confidence in the
institution is either won or lost.
Finance should also be providing the information, analysis and advice to
enable the organizations service managers to operate effectively. This goes
beyond the traditional preoccupation with budgets how much have we
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spent so far, how much have we left to spend? It is about helping the
organization to better understand its own performance. That means making
the connections and understanding the relationships between given inputs
the resources brought to bear and the outputs and outcomes that they
achieve. It is also about understanding and actively managing risks within theorganization and its activities.
FIFO vs. LIFO accounting:
When a dealer sells goods from inventory, the value of the inventory is
reduced by the cost of goods sold (CoG sold). This is simple where the CoG has
not varied across those held in stock; but where it has, then an agreed method
must be derived to evaluate it. For commodity items that one cannot track
individually, accountants must choose a method that fits the nature of the
sale. Two popular methods which normally exist are: FIFO and LIFOaccounting (first in - first out, last in - first out). FIFO regards the first unit that
arrived in inventory as the first one sold. LIFO considers the last unit arriving
in inventory as the first one sold. Which method an accountant selects can
have a significant effect on net income and book value and, in turn, on
taxation. Using LIFO accounting for inventory, a company generally reports
lower net income and lower book value, due to the effects of inflation. This
generally results in lower taxation. Due to LIFO's potential to skew inventory
value, UK GAAP and IAS have effectively banned LIFO inventory accounting.
Standard cost accountingStandard cost accounting uses ratios called efficiencies that compare the
labour and materials actually used to produce a good with those that the same
goods would have required under "standard" conditions. As long as similar
actual and standard conditions obtain, few problems arise. Unfortunately,
standard cost accounting methods developed about 100 years ago, when
labor comprised the most important cost in manufactured goods. Standard
methods continue to emphasize labor efficiency even though that resource
now constitutes a (very) small part of cost in most cases.Standard cost accounting can hurt managers, workers, and firms in several
ways. For example, a policy decision to increase inventory can harm a
manufacturing managers' performance evaluation. Increasing inventory
requires increased production, which means that processes must operate at
higher rates. When (not if) something goes wrong, the process takes longer
and uses more than the standard labor time. The manager appears
responsible for the excess, even though s/he has no control over the
production requirement or the problem.
In adverse economic times, firms use the same efficiencies to downsize, right
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size, or otherwise reduce their labor force. Workers laid off under those
circumstances have even less control over excess inventory and cost
efficiencies than their managers.
Many financial and cost accountants have agreed for many years on the
desirability of replacing standard cost accounting. They have not, however,found a successor.
Theory of Constraints cost accounting:
Eliyahu M. Goldratt developed the Theory of Constraints in part to address the
cost-accounting problems in what he calls the "cost world". He offers a
substitute, called throughput accounting, that uses throughput (money for
goods sold to customers) in place of output (goods produced that may sell or
may boost inventory) and considers labour as a fixed rather than as a variable
cost. He defines inventory simply as everything the organization owns that itplans to sell, including buildings, machinery, and many other things in
addition to the categories listed here. Throughput accounting recognizes only
one class of variable costs: the truly variable costs like materials and
components that vary directly with the quantity produced.
Finished goods inventories remain balance-sheet assets, but labour efficiency
ratios no longer evaluate managers and workers. Instead of an incentive to
reduce labour cost, throughput accounting focuses attention on the
relationships between throughput (revenue or income) on one hand and
controllable operating expenses and changes in inventory on the other. Thoserelationships direct attention to the constraints or bottlenecks that prevent
the system from producing more throughput, rather than to people - who
have little or no control over their situations.
National accounts
Inventories also play an important role in national accounts and the analysis
of the business cycle. Some short-term macroeconomic fluctuations are
attributed to the inventory cycle.
Distressed inventoryinventory Management.
Inventory is a list for goods and materials, or those goods and materials
themselves, held available in stock by a business. It is also used for a list of the
contents of a household and for a list for testamentary purposes of the
possessions of someone who has died.
Origins of the word Inventory
The word inventory was first recorded in 1601. The French term inventaire,
or "detailed list of goods," dates back to 1415.
Business inventory
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The reasons for keeping stock:
There are three basic reasons for keeping an inventory:
1. Time - The time lags present in the supply chain, from supplier to user at
every stage, requires that you maintain certain amount of inventory to use in
this "lead time"2. Uncertainty - Inventories are maintained as buffers to meet uncertainties in
demand, supply and movements of goods.
3. Economies of scale - Ideal condition of "one unit at a time at a place where
user needs it, when he needs it" principle tends to incur lots of costs in terms
of logistics. So bulk buying, movement and storing brings in economies of
scale, thus inventory.
All these stock reasons can apply to any owner or product stage.
Buffer stock is held in individual workstations against the possibility thatthe upstream workstation may be a little delayed in long setup or change-over
time. This stock is then used while that change-over is happening. This stock
can be eliminated by tools like SMED.
These classifications apply along the whole Supply chain not just within a
facility or plant.
Where these stocks contain the same or similar items it is often the work
practice to hold all these stocks mixed together before or after the sub-
process to which they relate. This 'reduces' costs. Because they are mixed-up
together there is no visual reminder to operators of the adjacent sub-processes or line management of the stock which is due to a particular cause
and should be a particular individual's responsibility with inevitable
consequences. Some plants have centralized stock holding across sub-
processes which makes the situation even more acute.
Special terms used in dealing with inventory:
Stock Keeping Unit (SKU) is a unique combination of all the components that
are assembled into the purchasable item. Therefore any change in thepackaging or product is a new SKU. This level of detailed specification assists
in managing inventory.
Stockout means running out of the inventory of an SKU.
"New old stock" (sometimes abbreviated NOS) is a term used in business to
refer to merchandise being offered for sale which was manufactured long ago
but that has never been used. Such merchandise may not be produced any
more, and the new old stock may represent the only market source of a
particular item at the present time.
Typology
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1. Buffer/safety stock2. Cycle stock (Used in batch processes, it is the available inventory
excluding buffer stock)
3. De-coupling (Buffer stock that is held by both the supplier and the user)
4. Anticipation stock (building up extra stock for periods of increaseddemand - e.g. ice cream for summer)
5. Pipeline stock (goods still in transit or in the process of distribution -
have left the factory but not arrived at the customer yet)
Inventory examples
While accountants often discuss inventory in terms of goods for sale,
organizations - manufacturers, service-providers and not-for-profits - also
have inventories (fixtures, furniture, supplies, ...) that they do not intend to
sell. Manufacturers', distributors', and wholesalers' inventory tends tocluster in warehouses. Retailers' inventory may exist in a warehouse or in
a shop or store accessible to customers. Inventories not intended for sale
to customers or to clients may be held in any premises an organization
uses. Stock ties up cash and if uncontrolled it will be impossible to know
the actual level of stocks and therefore impossible to control them.
the reasons for holding stock are covered earlier, most manufacturing
organizations usually divide their "goods for sale" inventory into:
Raw materials - materials and components scheduled for use in making a
product. Work in process, WIP - materials and components that have begun their
transformation to finished goods.
Finished goods - goods ready for sale to customers.
Goods for resale - returned goods that are salable.
Spare parts
For example:Manufacturing
A canned food manufacturer's materials inventory includes the
ingredients to form the foods to be canned, empty cans and their lids (or
coils of steel or aluminum for constructing those components), labels, and
anything else (solder, glue, ...) that will form part of a finished can. The
firm's work in process includes those materials from the time of release to
the work floor until they become complete and ready for sale to wholesale
or retail customers. This may be vats of prepared food, filled cans not yet
labeled or sub-assemblies of food components. It may also include finished
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cans that are not yet packaged into cartons or pallets. Its finished goods
inventory consists of all the filled and labeled cans of food in its warehouse
that it has manufactured and wishes to sell to food distributors
(wholesalers), to grocery stores (retailers), and even perhaps to
consumers through arrangements like factory stores and outlet centres.Logistics or distribution
the logistics chain includes the owners (wholesalers and retailers),
manufacturers' agents, and transportation channels that an item passes
through between initial manufacture and final purchase by a consumer. At
each stage, goods belong (as assets) to the seller until the buyer accepts
them. Distribution includes four components:
1. Manufacturers' agents: Distributors who hold and transport a
consignment of finished goods for manufacturers without ever owning it.Accountants refer to manufacturers' agents' inventory as "materiel" in
order to differentiate it from goods for sale.
2. Transportation: The movement of goods between owners, or between
locations of a given owner. The seller owns goods in transit until the buyer
accepts them. Sellers or buyers may transport goods but most
transportation providers act as the agent of the owner of the goods.
3. Wholesaling: Distributors who buy goods from manufacturers and other
suppliers (farmers, fishermen, etc.) for re-sale work in the wholesale
industry. A wholesaler's inventory consists of all the products in itswarehouse that it has purchased from manufacturers or other suppliers. A
produce-wholesaler (or distributor) may buy from distributors in other
parts of the world or from local farmers. Food distributors wish to sell
their inventory to grocery stores, other distributors, or possibly to
consumers.
4. Retailing: A retailer's inventory of goods for sale consists of all the
products on its shelves that it has purchased from manufacturers or
wholesalers. The store attempts to sell its inventory (soup, bolts, sweaters,or other goods) to consumers.
It is a key observation in "Lean Manufacturing" that it is often the case that
more than 90% of a product's life prior to end user sale is spent in
distribution of one form or another. On the assumption that the time is not
itself valuable to the customer this adds enormously to the working capital
tied up in the business as well as the complexity of the supply chain.
Reduction and elimination of these inventory 'wait' states is a key concept
in Lean.
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High level inventory management
It seems that around about 1880[2] there was a change in manufacturing
practice from companies with relatively homogeneous lines of products to
vertically integrated companies with unprecedented diversity in processesand products. Those companies (especially in metalworking) attempted to
achieve success through economies of scale - the gains of jointly producing
two or more products in one facility. The managers now needed
information on the effect of product mix decisions on overall profits and
therefore needed accurate product cost information. A variety of attempts
to achieve this were unsuccessful due to the huge overhead of the
information processing of the time. However, the burgeoning need for
financial reporting after 1900 created unavoidable pressure for financialaccounting of stock and the management need to cost manage products
became overshadowed. In particular it was the need for audited accounts
that sealed the fate of managerial cost accounting. The dominance of
financial reporting accounting over management accounting remains to
this day with few exceptions and the financial reporting definitions of
'cost' have distorted effective management 'cost' accounting since that
time. This is particularly true of inventory.
Hence high level financial inventory has these two basic formulas which
relate to the accounting period:1. Cost of Beginning Inventory at the start of the period + inventory
purchases within the period + cost of production within the period = cost
of goods
2. Cost of goods - cost of ending inventory at the end of the period = cost of
goods sold
The benefit of these formulae is that the first absorbs all overheads of
production and raw material costs in to a value of inventory for reporting.
The second formula then creates the new start point for the next periodand gives a figure to be subtracted from sales price to determine some
form of sales margin figure.
Manufacturing management is more interested in inventory turnover ratio
or average days to sell inventory since it tells them something about
relative inventory levels.
Inventory turnover ratio (also known as inventory turns) = cost of goods
sold/Average Inventory=Cost of Goods Sold/((Beginning Inventory +
Ending Inventory)and its inverse
Average Days to Sell Inventory=Number of Days a Year/Inventory Turn
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Over Ratio=365 days a year/Inventory Turn Over Ratio
This ratio estimates how many times the inventory turns over a year. This
number tells us how much cash/goods are tied up waiting for the process
and is a critical measure of process reliability and effectiveness. So a
factory with two inventory turns has six months stock on hand whichgenerally not a good figure (depending upon industry) whereas a factory
that moves from six turns to twelve turns has probably improved
effectiveness by 100%. This improvement will have some negative results
in the financial reporting since the 'value' now stored in the factory as
inventory is reduced.
Whilst the simplicity of these accounting measures of inventory is very
useful they are in the end fraught with the danger of their own
assumptions. There are in fact so many things which can vary hiddenunder this appearance of simplicity that a variety of 'adjusting'
assumptions may be used.
These include:
Specific Identification
Weighted Average Cost
Moving-Average Cost
FIFO, and LIFO.
Inventory Turn is a financial accounting tools for evaluating inventory and
it is not necessary a management tool. Inventory management should beforward looking. The methodology applied is based on historical cost of
goods sold. The ratio may not be able to reflect the usability of future
production demand as well as customer demand.
Business models including Just in Time (JIT) Inventory, Vendor Managed
Inventory (VMI) and Customer Managed Inventory (CMI) attempt to
minimize on-hand inventory and increase inventory turns. VMI and CMI
have gained considerable attention due to the success of third party
vendors who offer added expertise and knowledge that organizations maynot possess.
Accounting perspectives
the basis of Inventory accounting
Inventory needs to be accounted where it is held across accounting period
boundaries since generally expenses should be matched against the results
of that expense within the same period. When processes were simple and
short then inventories were small but with more complex processes then
inventories became larger and significant valued items on the balance
sheet [3]. This need to value unsold and incomplete goods has driven
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much new behaviour into management practice. Perhaps most significant
of these are the complexities of fixed cost recovery, transfer pricing, and
the separation of direct from indirect costs. This, supposedly, precluded
"anticipating income" or "declaring dividends out of capital". It is one of
the intangible benefits of Lean and the TPS that process times shorten andstock levels decline to the point where the importance of this activity is
hugely reduced and therefore effort, especially managerial, to achieve it
can be minimized.
Accounting for Inventory
each country has its own rules about accounting for inventory that fit with
their financial reporting rules.
So for example, organizations in the U.S. define inventory to suit their
needs within US Generally Accepted Accounting Practices (GAAP), therules defined by the Financial Accounting Standards Board (FASB) (and
others) and enforced by the U.S. Securities and Exchange Commission
(SEC) and other federal and state agencies. Other countries often have
similar arrangements but with their own GAAP and national agencies
instead.
It is intentional that financial accounting uses standards that allow the
public to compare firms' performance, cost accounting functions internally
to an organization and potentially with much greater flexibility. A
discussion of inventory from standard and Theory of Constraints-based(throughput) cost accounting perspective follows some examples and a
discussion of inventory from a financial accounting perspective.
The internal costing/valuation of inventory can be complex. Whereas in
the past most enterprises ran simple one process factories, this is quite
probably in the minority in the 21st century. Where 'one process' factories
exist then there is a market for the goods created which establishes an
independent market value for the good. Today with multi-stage process
companies there is much inventory that would once have been finishedgoods which is now held as 'work-in-process' (WIP). This needs to be
valued in the accounts but the valuation is a management decision since
there is no market for the partially finished product. This somewhat
arbitrary 'valuation' of WIP combined with the allocation of overheads to
it has led to some unintended and undesirable results.
Financial accounting :
an organization's inventory can appear a mixed blessing, since it counts as
an asset on the balance sheet, but it also ties up money that could serve for
other purposes and requires additional expense for its protection.
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Inventory may also cause significant tax expenses, depending on particular
countries' laws regarding depreciation of inventory, as in Thor Power Tool
Company v. Commissioner.
Inventory appears as a [[current asset]] on an organization's balance sheet
because the organization can, in principle, turn it into cash by selling it.Some organizations hold larger inventories than their operations require
in order inflating their apparent asset value and their perceived
profitability.
In addition to the money tied up by acquiring inventory, inventory also
brings associated costs for warehouse space, for utilities, and for insurance
to cover staff to handle and protect it, fire and other disasters,
obsolescence, shrinkage (theft and errors), and others. Such holding costs
can mount up: between a third and a half of its acquisition value per year.Businesses that stock too little inventory cannot take advantage of large
orders from customers if they cannot deliver. The conflicting objectives of
cost control and customer service often pit an organization's financial and
operating managers against its sales and marketing departments. Sales
people, in particular, often receive sales commission payments, so
unavailable goods may reduce their potential personal income. This
conflict can be minimized by reducing production time to being near or
less than customer expected delivery time. This effort, known as "Lean
production" will significan