Management of Inventory

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CHAPTER IV

MANAGEMENT OF INVENTORY

Inventory represents by for the largest portion of current asset in business organizations. Accordingly, accomplishment of profit maximization goal of a firm calls for efficient management of inventories.

Inventories or stock of the product a company is manufacturing for sale and components that make up the product. The various forms in which inventories exist in a manufacturing company are,

Raw materials: - Raw materials are those basic inputs that are converted in to finished product through the manufacturing process. Raw materials inventories are those units, which have been purchased and stored for future productions.

Work in Progress: - WIP are semi-manufactured products. They represent products that need more work before they become finished products for sale.

Finished Goods: - Finished goods inventories are those completely manufactured products which are ready for sale. Stocks of raw materials and work in progress facilitate production, while stock of finished goods is required for smooth marketing operations.

A fourth kind of inventory, the firms also maintain Suppliers or stores or spares. Suppliers include office and plant cleaning materials like soap, booms, oil, fuel, etc. These materials do not directly enter production, but are necessary for production process.

NEED TO HOLD INVENTORIES

Maintaining inventories involving tying up of the company’s funds and incurrence of storage and handling costs. Then also the companies hold inventories. There are three general motives for holding inventories:

1. Transaction Motive: - It emphasis the need to maintain inventories to facilitate smooth production and sales operations.
2. Precautionary Motive: - It necessitates holding of inventories to guard against the risk of unpredictable changes in the demand and supply forces and other factors.
3. Speculative Motive:- It influences the decision to increase or reduce inventory levels to take advantage of price fluctuations.

It is not possible for a company to procure raw materials whenever it is needed. A time lag exists between demand for raw materials and its supply. So a company should maintain adequate stock of raw materials for a continuous supply to the factory for an uninterrupted production.

Others factors which may necessitate purchasing and holding of raw material inventories are quantity discounts and anticipated price increase.

ROLE OF FINANCE MANAGER IN INVENTORY MANAGEMENT

While the finance manager has direct responsibility of managing cash, marketable securities and accounts receivables. Operating responsibility of managing inventories in a firm is well with in the realm of the production manager and the purchase manager and outside the province of the finance manager. Purchase and production managers are more directly concerned with raw materials policies, production manager with work in progress and production and sales manager with finished goods inventories.

However, the finance manager is responsible for supplying necessary funds to support the firm’s investment in inventories. Where finances are a limiting factor, he should be prepared to help directly in shipping inventory policies that are consistent with the realities of the firm’s financial position. The firm’s short funds, the finance manager can play a direct part in reducing capital requirement by exploring opportunities of cutting inventory investments. He should help the firm in fixing lead-time and setting leanest stock levels consistent with safety recognizing that complete safety has a prohibitive cost. The participating actively and helpfully in the formulation of inventory policies designed to speedy turnover and maximizes return in investment. In view if these finance manager must equip him with various methods, which can achieve efficient management of inventories.

OBJECTIVES OF INVENTORY MANAGEMENT

The aim of inventory mgt should be to avoid excessive and inadequate levels of inventories and to maintain sufficient inventory for the smooth production and sales operation. An effective inventory mgt should:

ü  Ensure a continuous supply of raw materials to facilitate uninterrupted production.

ü  Maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes.

ü  Maintain sufficient finished goods inventory of smooth sales operation, and efficient customer service.

ü  Minimize the carrying cost and time.

ü  Control investment in inventories and keep it at an optimum level.

ü  To minimize losses through deterioration, pilferage, wastage and damage.

ü  To avoid both over stocking and under stocking inventory.

Both excessive and inadequate inventories are not desirable. The firm is faced with the problem of meeting two conflicting needs:

Ø  To maintain a large size of inventory for efficient and smooth production and sales operation.

Ø  To maintain a minimum investment in inventories to maximize profitability.

The objective of inventory mgt should be to determine and maintain optimum level of inventory investment.

INVENTORY MANAGEMENT TECHNIQUES {TOOLS}

Effective inventory mgt requires an effective control system for inventories. A proper inventory control not only helps in solving the acute problem of liquidity but also increases profits and causes substantial reduction in the working capital of the concern. The following are the important tools and techniques of inventory.

1. Determination of stock Level
2. Determination of Safety Level
3. Selecting a proper system of Ordering for Inventory
4. Determination of Economic Order Quantity
5. A.B.C Analysis
6. VED Analysis
7. Inventory Turnover Ratios
8. Aging Scheduled of Inventories
9. Classification and Codification of Inventories
10. Preparation of Inventory Reports

1. DETERMINATION OF STOCK LEVELS

An efficient inventory mgt requires that a firm should maintain and optimum level of inventory where inventory cost are minimum and at the same time there is no stock-out which may result in loss of sale or stoppage of production. Various stock levels are discussed as such:

a. Minimum Level: - This represents the quantity, which must be maintained in hand at all times. If stocks are less than the minimum level then the work will stop due to shortage of material.

Minimum Level = Reorder level – (Normal consumption x normal reorder period)

The following factors should be taken in to consideration while fixing minimum stock level:

Lead Time: - A purchasing firm requires some time to process the order and time is also required by the supplying firm to execute the order. The time taken in processing the order and then executing it is known as lead-time.

Rate of Consumption: - It is the average consumption of materials in the factory.

Nature of Material: - The nature of material also affects the minimum level. If a material is required only against special order of the customer then minimum stock level will not be required for such material.

b. Re-ordering Level:- When the quantity of material reaches a certain figure then fresh order is send to get materials again. The order is send before the material reaches minimum stock level. Re ordering level or Ordering level is fixed between minimum level and maximum level.

Re-ordering level = Max. Consumption x Max. Re order period

c. Maximum Level: - It is the quantity of material beyond which a firm should not exceed its stocks. If the quantity exceeds maximum level then it will be over stocking. Max. Stock level depends up on the following factors:

• The availability of capital for the purchase of material
• The maximum requirements of materials at any point of time.
• The availability of space for storing the material
• The rate of a consumption of materials during lead time
• The cost of maintaining the stores
• The possibility of fluctuating in prices
• The nature of material (perishable or durable)
• Restrictions imposed by the govt.
• The possibility of change in fashion will also affects the maximum level

Maximum Stock Level = Re order level + Re order quantity – (Minimum consumption x Minimum re order period)

d. Danger Level: - It is the level beyond which materials should not fall in any case. If danger level arises then immediate steps should be taken to replenish the stocks even if more cost is incurred in arranging the materials.

Danger level = Average consumption x Max. Re-order period for emergency purchase.

e. Average stock level: - The average stock level is calculated as such:

Average Stock level=Minimum stock level + 1/2 of re-order quantity

OR

Minimum stock level + Max. Stock level / 2

2. Determination of safety stocks.

Safety stock is a buffer stock to meet some unanticipated increase in usage. The usage of inventory cannot be perfectly forecasted. It fluctuates over a period of time. The demand for materials may fluctuate and delivery of inventory may also be delayed and in such a situation the firm can face a problem of stock-out. The stock-out can prove costly by affecting the smooth working of the concern. In order to protect against the stock-out arising out of usage fluctuations, firms usually maintain some margin of safety or safety stocks.

3. Ordering system of inventory

The basic problem of inventory is to decide the reorder point. This point indicates when an order should be placed. The reorder point is determined with the help of three things: -

1. Average consumption rate
2. Duration of lead time
3. EOQ

When the inventory is depleted to lead time consumption the order should be placed. There are three prevalent systems of ordering and a concern can choose any one of these:

v   Fixed order quantity system generally known an EOQ system

v   Fixed period order system or periodic reordering system or periodic review system.

v   Single order and scheduled part delivery system.

v    

4. Economic Ordering Quantity {EOQ}

EOQ is the size of the lot to be purchased which is economically viable. This is the quantity of materials, which can be purchased at minimum cost. Generally, EOQ is the point at which inventory-carrying costs are equal to order costs.

a. Ordering Cost (Buying Cost): - These are the costs, which are associated with the purchasing or ordering of materials. It includes: -

• Requisitioning
• Order placing
• Transportation
• Receiving, inspecting and storing
• Clerical and staff
•  

Set-up Costs: - Buying cost will arise only when some purchases are made. When materials are manufactured in the concern then these costs will be known as set-up costs. It includes the cost of following activities:

• Preparing and processing the stock orders
• Setting up machinery for manufacturing materials
• Tooling machines set up
• Handling machines, tools and equipments
• Overtime.

b. Carrying Cost: - These are the costs for holding the inventory. These costs include:

Ø   The cost of capital invested in inventories

Ø   Warehousing

Ø   Clerical and Staff

Ø   Insurance cost

Ø   Handling charges etc.

Determination of EOQ

1. Graphic Approach: -

          The EOQ can be found out graphically

Total carrying cost increase as the order size increases. The ordering cost decreases as the order size increases. The total cost is the sum of two costs, which behave differently with order size. The EOQ occurs at the point Q, where the total cost is minimum. Thus, the firms operating profit is maximized at point Q.

It should be noted that the total cost of inventory are fairly insensitive to moderate change in order size. It may, therefore, be appropriate to say that there is an Economic Order range, not a point. To determine this range, the order size may be changed by some percentage and the impact on total cost may be studied. If the total costs do not change significantly, the firm can change EOQ with in the range with out any loss.

Assumptions of EOQ

I.                   The supply of goods is satisfactory

II.                The quantity to be purchased by the concern is certain

III.             The prices of goods are stable

b. Order formula approach: - An easy way to determine EOQ is to use the order formula approach.

Total ordering Cost = (Annual requirements x per order cost) ÷ Order size

TOC = AO ÷ Q

O = Ordering cost

A = Annual requirement

Q = Order size

Average Inventory = Order size             Q

--------------       =  ------

2                             2

Total Carrying Cost = Average Inventory x Per unit Carrying Cost

= QC  ÷ 2

Total Cost = Total Carrying Cost + Total Order Cost

= QC + AO  ÷ Q

EOQ = √2AO

-------               Where; A = Annual consumption in rupees or Units

C                                   O = Cost of Placing an Order

C = Inventory Carrying Cost of One unit

c. Trial and Error Method or Analytical Approach

in the ordinary course of business use purchase different quantity of materials at different  time. While analyzing it we can ascertain at some point of purchase i.e., at the purchase of certain quantity, the purchase is more economical and we can purchase the materials at this quantity.

Optimum Production Run: - The use of the EOQ approach can be extended to production runs to determine the optimum size of manufacture. Two costs involved are set-up costs and carrying costs. Production costs or set-up costs will reduce with bulk production runs, but carrying costs will increase as large stocks of manufactured inventories will be held. The economic production size will be the one where the total of set-up and carrying costs is minimum.

ELS [Economic Lot (or production) size], means the size inventory to be taken into production.

ELS = √ 2AS/C

Where, A = total estimated production

S = set-up cost

C = carrying cost

Quantity Discount: - Many suppliers encourage their customers to place large orders by offering them quantity discount. With quantity discount, the firm will save on the per unit purchase price. However, the firm will have to increase its order size more than the EOQ level to avail the quantity discount. This will reduce the number of orders and increase the average inventory holdings. Thus, in addition to discount savings, the firm will save on ordering cost, but will incur additional carrying cost. The net return is the difference between the resultant savings and additional carrying cost. If the net return is positive, the firm’s order size should equals the quantity necessary to avail the discount, if negative its order size should equal to EOQ level.

Discount savings = Discount rate x Purchase price x Annual Quantity

5. Inventory Control

1. ABC analysis or Control by importance and Exceptions (CEI) or Selective Inventory Control

                    Usually a firm has to maintain several types of inventories. It is not derivable to keep the same degree of control on all the times. The firm should pay maximum attention to those items whose value is highest. The firm should be selective in its approach to control investment in various types of inventories. This analytical approach is called the ABC analysis and tends to measure the significance of each item of inventories in terms of value. The high value items are classified as ‘A items’ and would be under the tightest control. ‘C items’ represents relatively least value and would be under simple control. ‘B items’ fall in between in these two categories and require reasonable attention of management. The ABC analysis concentrated on important items and is also known as Control by Importance and Exceptions (CIE). As the items are classified in the importance of their relative value, this approach is also known as Proportional Value Analysis (PVA).

Steps of ABC analysis

Ø  Classify the items of inventories, determining the expected use in units and the price per unit for each item.

Ø  Determine the total value of each item by multiplying the expected units by its unit price.

Ø  Rank the items in accordance with the total value, giving first rank to the item with the highest total value and so on.

Ø  Compute the ratios (percentage) of number of units of each item to total units of all items and the ratio of total value of each item to total value of all items.

Ø  Combine the items on the basis of their relative value to form three categories- A, B and C.

Graphic presentation of ABC analysis

2. VED analysis

                The VED analysis is used generally for spare parts. The requirements and urgency of spare parts is different from that of materials. The demand for spares depends upon the performance of the plant and machinery. Spare parts are classified as Vital (V), Essential (E) and Desirable (D). The vital spares are a must for running the concern smoothly and these must be stored adequately. The non-availability of vital spares will cause havoc in the concern. The E type of spare are also necessary but their stocks may be kept at low figures. The stocking of D type of spares may be avoided at time. If the lead-time of these spares is less than stocking of these spares can be avoided.

6. Inventory Turnover Ratios

Inventory turns over ratios are calculated to indicate whether inventories have been used efficiently or not. The purpose is to ensure the blocking of only required minimum funds in inventory. The inventory turn over ratio is also known as Stock velocity.

Inventory Turnover Ratio = Cost of Goods Sold                                                Net sales

-------------------------------         OR      ------ ----------------

Average Inventory at Cost   (average) inventory

Inventory Conversion Period = Days in a year

-------------------------------

Inventory turn over Ratio

7. Aging Schedule of Inventories

Classification of inventory according to the period (age) of their holding also helps in identifying slow moving inventories there by helping in effective control and management.

8. Classification and Codification of Inventories

The inventories of a manufacturing concern may consist of raw materials, WIP, finished goods, spares, consumable stocks etc. All these categories may have their subdivisions. The raw materials used may be of three or four times, finished goods may also be of more than one type, spares may be of a number of types and so on. For a proper recording and control of inventory, a proper classification of various types of items is essential, the inventory should first be classified and then cod numbers should be assigned for their identification.

9. Inventory Reports

From effective inventory control, the mgt should be kept informed with the latest stock position of different items. Preparing periodical inventory reports usually does this.

RISK AND COST OF HOLDING INVENTORIES

The holding of inventories involves blocking of a firm’s fund and incurrence of capital and other costs. It also exposes the firm to certain risks.

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