Chapter

INVENTORY MANAGEMENT
LEARNING OBJECTIVES
• Highlight the need for and nature of inventory
• Explain the techniques of inventory management
• Focus on the need for analyzing inventory problem as an
investment decision
• Discuss the process for managing inventory

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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 minimize 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.
Nature of Inventory
• Stocks of manufactured products and the material that make
up the product.
• Components:
• raw materials
• work-in-process
• finished goods
• stores and spares (supplies)

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Raw Material

Raw Material
Raw material form a major input into the organization. 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.
Work in Progress:
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:
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:

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:
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.
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.
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.
Storage and Handling Costs.
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 god own, insurance charge etc.
Risk
• 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.
Risk
Risk of Obsolescence. The inventories may become obsolete due to
improved technology, changes in requirements, change in customer’s
tastes etc.

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.
Cont.
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 emphasize to acquire more and more inventory as he
does not want any interruption in production due to shortage of
inventory.
Cont.
• 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:

Cont.
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 minimize 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.
Cont.
(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 centralizing purchases.
(9) To facilitate furnishing of data for short term and long term
planning and control of inventory.
(10) To design proper organization 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,
Cont.
• Determination of Economic Order Quantity
• A.B.C. Analysis
• VED Analysis
• Inventory Turnover Ratios
• Aging Schedule of Inventories
• Just in Time Inventory
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:
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.
Carrying Costs:
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
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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 stabilize carrying
costs.
Economic order quantity can be calculated with the help of the
following formula:
What is the main insight from EOQ?
There is a tradeoff between profitability and liquidity

Total cost

Cost
Carring costs

Ordering costs

Order Quantity (Q*)

Cont.

2AO
EOQ =
c
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.
A = 30,000
S = Rs.20
I = Rs.10
Now, EOQ = ( 2 x 30,000x 20) ¸ 10 )1/2 = 346 units
So, the EOQ is 346 units and the number of orders in a year would be
30,000/346 = 86.7 or 87 orders. The time gap between two orders
would be 365/87 = 4.2 or 4 days.
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.
Aging Schedule of Inventories
• Classification of inventories according to the period (age) of their
holding also helps in identifying slow moving inventories thereby
helping in effective control and management of inventories. The
following table show aging of inventories of a firm.
Item Name/Code Age Classification Date of Acquisition Amount (Rs.) %age to
total

011 0-15 days June 25,1996 30,000 15

002 16-30 days June 10,1996 60,000 30
003 31-45 days May 20,1996 50,000 25
004 46-60 days May 5,1996 40,000 20
005 61 and above April 12,1996 20,000 10

2,00,000 100
INVENTORY CONTROL SYSTEMS

• ABC Inventory Control System

• Just-in-Time (JIT) Systems
• Computerized Inventory Control Systems

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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 organizations and an adjustment can be made in
these percentages.
The information is shown in the following diagram:

Class No. of Items (%) Value of Items (%)

A 10 70

B 20 20

C 70 10
Cont.
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.
Just in Time Inventory (JIT)
JIT is a modern approach to inventory management and goal is
essentially to minimize such inventories and thereby maximizing the
turnover. In JIT, affirm keeps only enough inventory on hand to meet
immediate production needs. The JIT system reduces inventory carrying
costs by requiring that the raw materials are procured just in time to be
placed into production. Additionally, the work in process inventory is
minimized by eliminating the inventory buffers between different
production departments. If JIT is to be implemented successfully there
must be high degree of coordination and cooperation between the
suppliers and manufacturers and among different production centers.
Inventory Management Process

• Explicitly state the inventory policy

• Create an inventory monitoring cell
• Management group for controlling purchases
• Periodic meetings between purchase, materials planning and
production executives
• Monthly reviews of total inventory at plant/corporate level
• Dovetail inventory control to the total budgeting system
• Identify critical inventory items for closer scrutiny

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