INVENTORY MANAGEMENT

Inventory Management: Concept, Motives and Objectives of Inventory Management!

 

Concept of Inventory:

What is inventory? Inventory refers to those goods which are held for eventual sale by the business enterprise. In other words, inventories are stocks of the product a firm is manufacturing for sale and components that make up the product. Thus, inventories form a link between the production and sale of the product.

The forms of inventories existing in a manufacturing enterprise can be classified into three categories:

(i) Raw Materials:

These are those goods which have been purchased and stored for future productions. These are the goods which have not yet been committed to production at all.

(ii) Work-in-Progress:

These are the goods which have been committed to production but the finished goods have not yet been produced. In other words, work-in-progress inventories refer to ‘semi-manufactured products.’

(iii) Finished Goods:

These are the goods after production process is complete. Say, these are final products of the production process ready for sale. In case of a wholesaler or retailer, inventories are generally referred to as ‘merchandise inventory’.

Some firms also maintain a fourth kind of inventory, namely, supplies. Examples of supplies are office and plant cleaning materials, oil, fuel, light bulbs and the like. These items are necessary for production process. In practice, these supplies form a small part of total inventory involving small investment. Therefore, a highly sophisticated technique of inventory management is not needed for these.

The size of above mentioned three types of inventories to be maintained will vary from one business firm to another depending upon the varying nature of their businesses. For example, while a manufacturing firm will have all three types of inventories, a retailer or a wholesaler business, due to its distinct nature of business, will have only finished goods as its inventories. In case of them, there will be, therefore, no inventories of raw materials as well as work-in- progress.

 

Motives for Holding Inventories:

A simple but meaningful question arises:

Why do firms hold inventories while it is expensive to hold inventories? The reply to this question is the motives behind holding inventories in an enterprise.

Researchers report that there are three major motives behind holding inventories in an enterprise:

1. Transaction Motive

2. Precautionary Motive

3. Speculative Motive

A brief description about each of these motives follows in seriatim:

1. Transaction Motive:

According to this motive, an enterprise maintains inventories to avoid bottlenecks in its production and sales. By maintaining inventories; the business ensures that production is not interrupted for want of raw material, on the one hand, and sales also are not affected on account of non-availability of finished goods, on the other.

2. Precautionary Motive:

Inventories are also held with a motive to have a cushion against unpredicted business. There may be a sudden and unexpected spurt in demand for finished goods at times. Similarly, there may be unforeseen slump in the supply of raw materials at some time. In both the cases, a prudent business would surely like to have some cushion to guard against the risk of such unpredictable changes.

3. Speculative Motive:

It influences the decision to increase or reduce inventory levels to take advantages of price fluctuations. In order to maintain an uninterrupted production it becomes necessary to hold adequate stock of materials since there is a time lag between the demand for materials and its supply due to some unavoidable circumstances.

Besides, there are two other motives for holding of inventories — viz., to receive the benefit of quantity discount on account of bulk purchases and to avoid the anticipated rise in price of raw material.

The work-in-progress builds up since there is production cycle. Actually, the stock of work-in-progress is to be maintained till the production cycle completes. Similarly, stock of finished goods has also to be held since there is a time lag between the production and sales.

When goods are demanded by the customers, it cannot imme­diately be produced and as such, for a continuous and regular supply of goods, minimum stock of finished goods is to be maintained. Stock of finished goods should also be maintained for sudden demands from customers and for seasonal sales.

Benefits and Costs of Holding Inventories:

Holding inventories bears certain advantages for the enterprise.

The important advantages but not confined to the following only are as follows:

1. Avoiding Losses of Sales:

By holding inventories, a firm can avoid sales losses on account of non-supply of goods at times demanded by its customers.

2. Reducing Ordering Costs:

Ordering costs, i.e., the costs associated with individual orders such as typing, approving, mailing, etc. can be reduced, to a great extent, if the firm places large orders rather than several small orders.

3. Achieving Efficient Production Run:

Holding sufficient inventories also ensures efficient production run. In other words, supply of sufficient inventories protects against shortage of raw materials that may at times interrupt production operation.

Costs of Holding Inventories:

However, holding inventories is not an unmixed blessing. In other words, it is not that everything is good with holding inventories. It is said that every noble acquisition is attended with risks; he who fears to encounter the one must not expect to obtain the other. This is true of inventories also. There are certain costs also associated with holding inventories. Hence, it is necessary for a firm to take these costs into consideration while planning for inventories.

These are broadly classified into three categories:

1. Material Costs:

These include costs which are associated with placing of orders to purchase raw materials and components. Clerical and administrative salaries, rent for the space occupied, postage, telegrams, bills, stationery, etc. are the examples of ordering costs. The more the orders, the more will be the ordering costs and vice versa.

2. Carrying Costs:

These include costs involved in holding or carrying inventories like insurance charges for covering risks, rent for the floor space occupied, wages to laborers, wastages, obsolescence or deterioration, thefts, pilferages, etc. These also include opportunity costs. This means had the money blocked in inventories been invested elsewhere in the business, it would have earned a certain return. Hence, the loss of such return may be considered as an ‘opportunity cost’.

The above facts underline the need for inventory management, i.e., to decide the optimum volume of inventories in the firm/enterprise during the period

The problem before the management of the enterprise is to balance the following opposing costs:

Cost to have Inventory:

1. Return on investment in material purchase

2. Storage cost of materials

3. Handling cost of materials

4. Handling Equipment

5. Obsolescence and

6. Spoilage and shelf life of various input materials.

Cost not to have Inventory:

1. Stock out conditions leading to costs

2. Demand x Profitability x Future

3. Loss of customers

4. Down Time cost of infrastructure! Facilities

5. Labour idleness and idleness of production cycle and

6. Capacity and other related costs.

Objectives of Inventory Management:

The investment in inventory is very high in most of the organisations engaged in manufacturing, wholesale and retail trade. The amount of investment is sometimes more in inventory than in other assets.

About 90% part of working capital is invested in inventories. It is necessary for every management to give proper attention to inventory management. A proper planning of purchasing, handling, storing and accounting should form a part of inventory management. An efficient system of inventory management will determine (a) what to purchase (b) how much to purchase (c) from where to purchase (d) where to store, etc. The purpose of inventory management is to keep the stock in such a way that neither there is overstocking nor understocking. The overstocking will mean a reduction of liquidity and starving of other production processes. Understocking, on the other hand, will result in stoppage of work. The investment in inventory should be kept under reasonable limits. The main objectives of inventory management are operational and financial. The operational objectives mean that the materials and spares should be available in sufficient quantity so that work is not disrupted for want of inventory. The financial objective mean that investments in inventories should not remain idle and minimum working capital should be locked in it. Any comprehensive system of control covering all types of inventor)’ is directly or indirectly aimed at accomplishing a great variety of purposes. The followings are the objectives of inventory management:

Most of them are as follows:

(i) Financial Objectives:

The major financial objective of holding the inventory is to keep the investment involved within the enterprise’s cash position so that the working capital is not thrown seriously out of balance.

(ii) To Create a Buffer Stock Between the Input and Output:

So that, the outgoing flow of products is as little dependent on the input material characteristics as possible.

(iii) To Ensure Against Delay in Deliveries:

The delay in delivery of finished product to the buyer is avoided by holding inventory stock of finished goods.

(iv) To Allow for a Possible Increase in Output if so Required:

Market requirements may disturb the manufacturing programme of the enterprise. Depending upon the production requirements stocks are to be maintained and supplied.

(v) To Ensure Against Scarcity of Materials in the Market:

Sometimes input materials may become scarce and difficult to get when there are large fluctuations in output and demand for them. A reserve stock of raw materials is must for smooth manufacturing operations.

(vi) To Make Use of Quantity Discounts:

Input materials and components/parts may be cheaper when purchased in bulk quantities owning to quantity discounts and lower transportation costs/charges.

(vii) To Utilize to Advantage Price Fluctuations:

Price fluctuation may have a marked effect on the procurement policy of an enterprise or organization, if these fluctuations are to be utilized to advantage of the unit, materials have to be purchased in adequate quantities when prices are lowest.

All the above reasons or objectives involve cost. The inventory control is mainly concerned with making optimum decisions regarding above variables which are subject to control. Inventory is an idle resource which is usable to have value.

TECHNIQUES OF INVENTORY MANAGEMENT

Inventory management consists of effective control and administration of inventories. Inventory control refers to a system which ensures supply of required quantity and quality of inventories at the required time and at the same time prevents unnecessary investment in inventories. It needs the following important techniques.

 

Techniques based on the order quantity of Inventories

Order quantity of inventories can be determined with the help of the following techniques:

1.       Stock Level:

Stock level is the level of stock which is maintained by the business concern at all times. Therefore, the business concern must maintain optimum level of stock to smooth running of the business process. Different level of stock can be determined based on the volume of the stock.

2.       Minimum Level:

The business concern must maintain minimum level of stock at all times. If the stocks are less than the minimum level, then the work will stop due to shortage of material.

  

3.       Re-order Level

Re-ordering level is fixed between minimum level and maximum level. Re-order level is the level when the business concern makes fresh order at this level. Re-order level=maximum consumption × maximum Re-order period.

4.       Maximum Level

It is the maximum limit of the quantity of inventories, the business concern must maintain. If the quantity exceeds maximum level limit then it will be overstocking. Maximum level = Re-order level + Re-order quantity – (Minimum consumption × Minimum delivery period

5.       Danger Level

It is the level below the minimum level. It leads to stoppage of the production process. Danger level=Average consumption × Maximum re-order period for emergency purchase

6.       Average Stock Level

It is calculated such as, Average stock level= Minimum stock level + ½ of re- order quantity

7.       Lead Time

Lead time is the time normally taken in receiving delivery after placing order s with suppliers. The time taken in processing the order and then executing it is known as lead time.

8.       Safety Stock

Safety stock implies extra inventories that can be drawn down when actual lead time and/ or usage rates are greater than expected. Safety stocks are determined by opportunity cost and carrying cost of inventories. If the business concerns maintain low level of safety stock, it will lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying costs.

Economic Order Quantity (EOQ):

How much inventory should be added when inventory is replenished is a major problem in inventory management, i.e., how much to buy or produce at a time is really a problem to the management. If bulk quantities are purchased, the cost of carrying will be high and on the contrary, if small quantities are purchased at frequent intervals, ordering cost will be high.

Therefore, the quantity to be ordered at a given time should be economic, taking mainly two factors into account, viz., ordering costs and carrying costs.

In short, it represents the most favourable quantity to be ordered at the reorder level EOQ is a problem of balancing the two conflicting kinds of costs — cost of carrying (arising out of balance purchases) and cost of not carrying (arising out of frequent purchases in small lots).

To sum up, EOQ is determined at the point where the carrying costs are approximately equal to the cost of not carrying (the ordering costs), where the total cost is minimum.

However, the natures of the above costs are discussed below:

Cost of Carrying:

1. Handling and transportation

2. Clerical.

3. Rent, Insurance and other Costs of storage

4. Interest on capital blocked.

5. Pilferage and normal loss of holding.

Cost of not Carrying:

1. Extra cost of purchasing, handling and transportation

2. Frequent stock-outs resulting in disrup­tion of production schedules and con­sequently extra costs of overtime set­ups, hiring and training.

3. Foregone quantity discounts and con­tribution margins on lost sales.

4. Additional cost of uneconomic produc­tion runs.

5. Loss of customer goodwill.

6. Risk of obsolescence.

The EOQ model is illustrated below with the help of the following diagram:

In the above diagram, the ordering costs, inventory carrying cost and the total costs are plotted The diagram shows that the carrying costs vary directly with the size of the order whereas ordering costs vary inversely with the size of the order. The total cost (i.e., the sum of two costs) curves at first go downwards due to the fact that at this stage the fixed costs of ordering are spread over many units.

But at the next stage, this curve goes upward because of the fact that at this stage, decrease in average ordering costs is more than what is offset by the additional inventory carrying costs. The point P denotes the optimum order where the total cost is the minimum. There- fore, UP units are considered as the EOQ.

It should be remembered that the EOQ is not a stock level. It lies between the Maximum Stock Level and Minimum Stock Level. However, the EOQ will be determined in such a way as would help in earning the advantages of bulk purchases on the one side, and would keep the other costs (such as interest on capital) as minimum as possible on the other.

The above principle can be illustrated with the help of the following formula:

where, I = the annual consumption, i.e., annual quantity used in units.

P = the ordering cost/cost per purchase order.

S = the annual cost of carrying one unit in stock for one year i.e., carrying cost percentage × cost of one unit

The above model is based on the following assumptions:

(i) The supply position of the materials will be in such a way as will enable a firm to place as many order as it desires,

(ii) Cost of materials or finished goods remains constant during the year;

(iii) Quantity-discount is not allowed;

(iv) Production and/or sales are evenly distributed over the period under consid­eration; and

(v) Variable inventory carrying cost per unit and ordering cost per order remain constant throughout the year.

TECHNIQUES BASED ON THE CLASSIFICATION OF INVENTORIES 

It is the inventory management techniques that divide inventory into three categories based on the value and volume of the inventories; 10% of the inventory’s  item contributes to 70% of value of consumption and this category is known as a category. About 20% of the inventory item contributes about 20% of value of consumption and this category is called category B and 70% of inventory item contributes only 10% of value of consumption and this category is called C category.

Aging Schedule of Inventories

Inventories are classified according to the period of their holding and also this method helps to identify the movement of the inventories. Hence, it is also called as,

FNSD analysis— Where,

F = Fast moving inventories

N = Normal moving inventories S = Slow moving inventories

D = Dead moving inventories

This analysis is mainly calculated for the purpose of taking disposal decision of the inventories.

VED Analysis

This technique is ideally suited for spare parts in the inventory management like ABC analysis. Inventories are classified into three categories on the basis of usage of the inventories

V = Vital item of inventories # E = Essential item of inventories

D = Desirable item of inventories

HML Analysis

Under this analysis, inventories are classified into three categories on the basis of the value of the inventories.

H = High value of inventories

M = Medium value of inventories L = Low value of inventories

Valuation of Inventories

Inventories are valued at different methods depending upon the situation and nature of manufacturing process. Some of the major methods of inventory valuation are  mentioned as follows:

1.    First in First out Method (FIFO)

2.    Last in First out Method (LIFO)

3.    Highest in First out Method (HIFO)

4.    Nearest in First out Method (NIFO)

5.    Average Price Method