3.

5 INVENTORY MANAGEMENT

Introduction
Every enterprise needs inventory for smooth running of its
activities. It serves as a link between production and distribution
processes. There is, generally, a time lag between the recognition of
need and its fulfilment. The greater the time – lag, the higher the
requirements for inventory.
The investment in inventories constitutes the most significant part
of current assets/working capital in most of the undertakings. Thus, it is
very essential to have proper control and management of inventories. The
purpose of inventory management is to ensure availability of materials in
sufficient quantity as and when required and also to minimise investment
in inventories.
Meaning and Nature of inventory

In accounting language it may mean stock of finished goods only. In

a manufacturing concern, it may include raw materials, work in process
and stores, etc. Inventory includes the following things:
(a) Raw Material: Raw material form a major input into the
organisation. They are required to carry out production activities
uninterruptedly. The quantity of raw materials required will be
determined by the rate of consumption and the time required for
replenishing the supplies. The factors like the availability of raw
materials and government regulations etc. too affect the stock of raw
materials.
(b) Work in Progress: The work-in-progress is that stage of
stocks which are in between raw materials and finished goods. The raw
materials enter the process of manufacture but they are yet to attain a
final shape of finished goods. The quantum of work in progress depends
upon the time taken in the manufacturing process. The greater the time
taken in manufacturing, the more will be the amount of work in progress.
(c) Consumables: These are the materials which are needed to
smoothen the process of production. These materials do not directly
enter production but they act as catalysts, etc. Consumables may be
classified according to their consumption and criticality.
(d) Finished goods: These are the goods which are ready for
the consumers. The stock of finished goods provides a buffer between
production and market. The purpose of maintaining inventory is to ensure
proper supply of goods to customers.
(e) Spares: Spares also form a part of inventory. The
consumption pattern of raw materials, consumables, finished goods are
different from that of spares. The stocking policies of spares are different
from industry to industry. Some industries like transport will require more
spares than the other concerns. The costly spare parts like engines,
maintenance spares etc. are not discarded after use, rather they are kept
in ready position for further use.
Purpose/Benefits of Holding Inventors

There are three main purposes or motives of holding inventories:

(i) The Transaction Motive which facilitates continuous
production and timely execution of sales orders.
(ii) The Precautionary Motive which necessitates the holding
of inventories for meeting the unpredictable changes in demand
and supplies of materials.
(iii) The Speculative Motive which induces to keep inventories
for taking advantage of price fluctuations, saving in re-ordering
costs and quantity discounts, etc.
Risk and Costs of Holding Inventors

The holding of inventories involves blocking of a firm’s funds and

incurrence of capital and other costs. It also exposes the firm to certain
risks. The various costs and risks involved in holding inventories are as
below:
(i) Capital costs: Maintaining of inventories results in
blocking of the firm’s financial resources. The firm has,
therefore, to arrange for additional funds to meet the cost of
inventories. The funds may be arranged from own resources or
from outsiders. But in both cases, the firm incurs a cost. In the
former case, there is an opportunity cost of investment while in
later case the firm has to pay interest to outsiders.
(ii) Cost of Ordering: The costs of ordering include the
cost of acquisition of inventories. It is the cost of preparation
and execution of an order, including cost of paper work and
communicating with supplier. There is always minimum cot
involve whenever an order for replenishment of good is placed.
The total annual cost of ordering is equal to cost per order
multiplied by the number of order placed in a year.
(iii) Cost of Stock-outs: A stock out is a situation when
the firm is not having units of an item in store but there is
demand for that either from the customers or the production
department. The stock out refer to demand for an item whose
inventory level is reduced to zero and insufficient level. There is
always a cost of stock out in the sense that the firm faces a
situation of lost sales or back orders. Stock out are quite often
expensive.
(iv) Storage and Handling Costs. Holding of
inventories also involves costs on storage as well as handling of
materials. The storage costs include the rental of the godown,
insurance charge etc.
(v) Risk of Price Decline. There is always a risk of
reduction in the prices of inventories by the suppliers in holding
inventories. This may be due to increased market supplies,
competition or general depression in the market.
(vi) Risk of Obsolescence. The inventories may become
obsolete due to improved technology, changes in requirements,
change in customer’s tastes etc.
(vii) Risk Deterioration in Quality: The quality of the
materials may also deteriorate while the inventories are kept in
stores.
Inventory Management

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.
There are conflicting interests of different departmental heads over
the issue of inventory. The finance manager will try to invest less in
inventory because for him it is an idle investment, whereas production
manager will emphasise to acquire more and more inventory as he does
not want any interruption in production due to shortage of inventory. The
purpose of inventory management is to keep the stocks in such a way that
neither there is over-stocking nor under-stocking. The over-stocking will
mean reduction of liquidity and starving of other production processes;
under-stocking, on the other hand, will result in stoppage of work. The
investments in inventory should be kept in reasonable limits.
Objects of Inventory Management

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 means that investments in
inventories should not remain idle and minimum working capital should
be locked in it. The following are the objectives of inventory
management:
(1) To ensure continuous supply of materials spares and finished
goods so that production should not suffer at any time and the
customers demand should also be met.
(2) To avoid both over-stocking and under-stocking of inventory.
(3) To keep material cost under control so that they contribute in
reducing cost of production and overall costs.
(4) To minimise losses through deterioration, pilferage, wastages and
damages.
(5) To ensure perpetual inventory control so that materials shown in
stock ledgers should be actually lying in the stores.
(6) To ensure right quality goods at reasonable prices.
(7) To maintain investments in inventories at the optimum level as
required by the operational and sales activities.
(8) To eliminate duplication in ordering or replenishing stocks. This is
possible with help of centralising purchases.
(9) To facilitate furnishing of data for short term and long term
planning and control of inventory.
(10) To design proper organisation of inventory. A clear cut
accountability should be fixed at various levels of management.
Tools and Techniques of inventory Management

Effective Inventory management 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 management and
control:

1. Determination of Stock Levels.

2. Determination of Safety Stocks.
3. Determination of Economic Order Quantity
4. A.B.C. Analysis
5. VED Analysis
6. Inventory Turnover Ratios
7. Aging Schedule of Inventories
8. Just in Time Inventory
1. Determination of Stock Levels
Carrying of too much and too little of inventories is detrimental to
the firm. If the inventory level is too little, the firm will face frequent
stock-outs involving heavy ordering cost and if the inventory level is too
high it will be unnecessary tie-up of capital. Therefore, an efficient
inventory management requires that a firm should maintain an optimum
level of inventory where inventory costs are the minimum and at the
same time there is not 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 materials.
Following factors are taken into account while fixing minimum
stock level:
Lead Time: A purchasing firm requires some time to process the
order and time is also required by 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. The rate of consumption will be decided on the basis pas
experiences and production plans.
Nature of Material: The nature of material also affects the minimum
level. If material is required only against special orders of customer then
minimum stock will not be required for such materials.
Minimum stock level = Re-ordering level-(Normal
consumption
x Normal Re-order period).
(b) Re-ordering Level: When the quantity of materials reaches at a
certain figure then fresh order is sent to get materials again. The order is
sent before the materials reach minimum stock level. Reordering level is
fixed between minimum and maximum level. The rate of consumption,
number of days required to replenish the stock and maximum quantity of
material required on any day are taken into account while fixing
reordering level.
Re-ordering Level = Maximum
Consumption x Maximum Re-order period.
(c) Maximum Level: It is the quantity of materials beyond which a
firm should not exceed its stocks. If the quantity exceeds maximum level
limit then it will be overstocking. A firm should avoid overstocking
because it will result in high material costs.
Maximum Stock Level = Re-ordering Level+ Re-
ordering Quantity
-(Minimum Consumption x Minimum
Re-ordering 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 stock even if more cost is incurred in arranging the
materials. If materials are not arranged immediately there is possibility
of stoppage of work.
Danger Level = Average Consumption x Maximum
reorder period
for emergency purchases.
(e) Average Stock Level
The average stock level is calculated as such:
Average Stock level = Minimum Stock Level +½ of re-
order quantity
2. Determination of Safety Stocks
Safety stock is a buffer to meet some unanticipated increase in
usage. 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. Two costs are
involved in the determination of this stock i.e. opportunity cost of stock-
outs and the carrying costs. The stock out of raw materials cause
production disruption resulting in higher cost of production. Similarly, the
stock out of finished goods result into failure of firm in competition, as
firm cannot provide proper customer service. If a firm maintains low level
of safety frequent stock out will occur resulting in large opportunity
coast. On the other hand larger quantity of safety stock involves higher
carrying costs.
3. Economic Order Quantity (EOQ)
A decision about how much to order has great significance in
inventory management. The quantity to be purchased should neither be
small nor big because costs of buying and carrying materials are very
high. Economic order quantity 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 costs. Generally, economic order quantity is the
point at which inventory carrying costs are equal to order costs. In
determining economic order quantity it is assumed that cost of a
managing inventory is made of solely of two parts i.e. ordering costs and
carrying costs.
(A) Ordering Costs: These are costs that are associated with
the purchasing or ordering of materials. These costs include:
(1) Inspection costs of incoming materials.
(2) Cost of stationery, typing, postage, telephone charges etc.
(3) Expenses incurred on transportation of goods purchased.
These costs are also know as buying costs and will arise only when some
purchases are made.
(B) Carrying Costs: These are costs for holding the inventories.
These costs will not be incurred if inventories are not carried. These costs
include:
(1) The cost of capital invested in inventories. An interest will be
paid on the amount of capital locked up in inventories.
(2) Cost of storage which could have been used for other purposes.
(3) Insurance Cost
(4) Cost of spoilage in handling of materials
Assumptions of EOQ: While calculating EOQ the following
assumptions are made.
1. The supply of goods is satisfactory. The goods can be purchased
whenever these are needed.
2. The quality to be purchased by the concern is certain.
3. The prices of goods are stable. It results to stabilise carrying
costs.
Economic order quantity can be calculated with the help of the following
formula:

where, A = Annual consumption in rupees.

S = Cost of placing an order.
I = Inventory carrying costs of one unit.
where, A = Annual consumption in rupees.
S = Cost of placing an order.
I = Inventory carrying costs of one unit.
Illustration 1: The finance department of a Corporation provides the
following information:
(i) The carrying costs per unit of inventory are Rs.
10
(ii) The fixed costs per order are Rs. 20]
(iii) The number of units required is 30,000 per year.
Determine the economic order quantity (EOQ) total number of orders in a
year and the time gap between orders.
Solution: The economic order quantity may be found as follow
4. A-B-C Analysis
Under A-B-C analysis, the materials are divided into three
categories viz, A, B and C. Past experience has shown that almost 10 per
cent of the items contribute to 70 percent of value of consumption and
this category is called ‘A’ Category. About 20 per cent of value of
consumption and this category is called ‘A’ Category. About 20 per cent
of the items contribute about 20 per cent of value of consumption and
this is known as category ‘B’ materials. Category ‘C’ covers about 70 per
cent of items of materials which contribute only 10 per cent of value of
consumption. There may be some variation in different organisations and
an adjustment can be made in these percentages.
A-B-C analysis helps to concentrate more efforts on category A
since greatest monetary advantage will come by controlling these items.
An attention should be paid in estimating requirements, purchasing,
maintaining safety stocks and properly storing of ‘A’ category materials.
These items are kept under a constant review so that substantial material
cost may be controlled. The control of ‘C’ items may be relaxed and
these stocks may be purchased for the year. A little more attention
should be given towards ‘B’ category items and their purchase should be
undertaken a quarterly or half-yearly intervals.
5. VED Analysis
The VED analysis is used generally for spare parts. The
requirements and urgency of spare parts is different from that of
materials. A-B-C analysis may not be properly used for spare parts. 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 spares are also necessary but their stocks may
be kept at low figures. The stocking of D type of spares may be avoided
at times. If the lead time of these spares is less, then stocking of these
spares can be avoided.
6. Inventory Turnover Ratios
Inventory turnover 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
Turnover Ratio also known as stock velocity is normally calculated as
sales/average inventory or cost of goods sold/average inventory cost.
Write short notes on:
(a) ABC Analysis of inventory control
(b) Economic order quantity
2 Define safety stock. How is it determined? What is the role of
safety stock in inventory management?
3. What is the need for holding inventory? Why inventory
management is important?
4. Explain briefly techniques of inventory management.