1.

Introduction

Inventory management is the most significant part of the working capital management in

majority of the business organizations, since inventories constitute on an average about 60

percent of the total current assets. The success of any industry depends upon the effective

utilization of its inventory. The inventory manager is expected to ensure right inventory at right

time with right quality from a right place at right price in order to minimize the cost of

manufacturing of products or services. The most difficult area to the management of a firm is the

management of inventory. A firm neglecting the management of inventories will be jeopardizing

its long-run profitability and may fail ultimately. For any organization, it is possible to reduce its

level of inventories to a considerable extent without any adverse effect on the production and

sales, by using the simple inventory management techniques. This reduction of inventory volume

carries a positive impact on the profitability of the organization.

12 Types of Inventories:

The management of inventory starts from the identification of suppliers passes through

various stages and finally reaches the consumer. The various forms of Inventory in which it
exists

are 3 types. They are:

i) Raw material: these are the basic materials that are converted into finished products

ready for consumption, which can be stored for future production.

ii) Work- in- process: this is the stage at which further process is required to reach the

final stage of production.

iii) Finished goods: this is the stage of the products which are ready for dispatch for

consumption.
iv) Apart from these three levels of inventories, there is one more form of inventory, i.e.,

stores and spares, which is usually a marginal portion of the total inventory.

3 Motives for Holding Inventory:

In a country like India inventories (stocks) are necessarily to be held without which

production cannot be imagined. The motives for holding inventories are 3 types such as

transaction precautionary and speculation motive.

i) Transaction motive:

To ensure continuous business transactions raw materials are held. Without adequate

inventories it is hardly possible to imagine continuity of production. If enough raw materials are

not held, production activities cannot be carried out regularly. If for any reason production is

stopped for want of raw materials the salaries to staff, depreciation, rent, etc., will cause severe

loss to the firm.

ii) Precautionary motive:

Sometimes accidents, machine break down, lay off, strike, etc. occur without prior notice

under which situation, production should not suffer. Hence, inventories are necessarily to be

carried out for smooth going of production and sales even in adverse times.

iii) Speculation motive:

Changes in technology, market conditions, cause sudden rise or fall in prices of supplies. To

cope with the changing conditions, businessman carries inventories. Price fluctuations affect

demand and supply aspects of goods which will in turn affect production and sales activities. To

avoid such odd situations inventory holding is appropriate.

Basic Business Finance 11.3 Inventory Management

4. Need for Inventory

Production without halt will be possible by holding enough inventories. Otherwise, firm has to

incur heavy costs for keeping the machine idle.

ii) Continuous supply market:

Proper inventory management will ensure finished goods without interruption and customer

satisfaction could be possible.

iii) No stock - out problem:

Shortage of inventories often cause stock - out problem, thereby consumers shift to competitors.

iv) Cost saving:

Enough inventories will ensure continuous production, in the absence of which cost of
production

will be high.

v) More margin of profit:

Cost saving would enable the problems to enjoy better profit margin and ultimately higher
returns

to the firm.

vi) Advantage of price gain:

Prices fluctuate due to changes in supply and demand factors when prices rise, the firms holding

inventories will enjoy sudden profits.

vii) Scarcity:

At times raw materials may become scarce due to sudden changes in supply or power failures. In

these situations inventories holding would enable the firms.

5 Characteristics of Inventory
i) Stock out problem: If adequate stocks are not maintained, the firm faces stock out

problem. i.e., risks for not maintaining adequate stocks. If raw materials are not

adequate, production schedules suffer and interrupted production will not ensure

regular supply of goods whereby firm looses its market. If production activities are

stopped due to irregular supply of raw materials and other inputs, cost of

production will be high since fixed costs per unit will be more.

ii) Lead time: It is the time taken from the initiation of order till the arrival of goods.

Lead time may vary from one day to many days. It depends upon the availability

of item, distance, transportation, etc. The time gap can be reduced through proper

inventory planning.

iii) Quantity discounts: If goods are produced on large scale producers will enjoy

economies of scale. These economies or savings occur where fixed costs are

distributed over large production; ultimately cost of production per unit will be

lower. Sometimes production will extend to customers by giving quantity

discounts. This is a peculiar characteristic associated with inputs mainly raw

materials and other consumables.

6 Costs of Inventory

There are various kinds of costs involved in inventory management policies.

i) Ordering costs:

Costs incurred in placing order with suppliers of raw materials, consumables and other inputs are

called ordering costs. These costs include stationary, requisitioning, mailing expenses, telephone

bills, correspondence charges, typing, salaries, dispatching, inspection, checking, travel, follow
up
costs, etc. Larger the order size lower the cost per unit. Thus, ordering costs can be minimized

by placing order for bigger quantity.

ii) Carrying costs:

Warehousing, insurance, wastage, loss due to theft, deterioration, obsolescence etc., are called

inventory carrying costs. These costs are more as the level of stock is higher. These costs are also

known as holding costs.

iii) Stock-out costs:

Normally, whenever customers place order, the suppliers should be ready to dispatch the items.

At times, the items when not readily available, the suppliers make the customers to wait. But

customers (with out waiting) will go to competitors for the supplies immediately. Thus, the

regular supplier looses the profit which he would have got. This is known as opportunity cost or

lost sales cost

iv) Storage costs:

Costs pertaining to warehousing of goods or inventory are generally called as storage costs.

Example: rent, lighting, interest, insurance, checking, etc.

v) Obsolescence cost:

When goods are stored more quantity than demand for it, the quality deteriorates and models will

become outdated. At times, they have to be sold at heavy discounts since the quality of goods is

poor and design or model is outdated. This loss is called as obsolescence costs.

vi) Set up costs:

Normally production is made regularly an item for few days / weeks. Wherever, order is placed

for different items; the producer changes the regular processing and shift to new process to make
it
suitable to new order placed. Thus, when processing is shifted, the firm incurs costs of design,

loss of clerical time consumption of, components and spares, etc. All these constitute set up
costs.

7 Consequences of Excessive Inventory

* Unnecessary tie of up of funds,

* Interest burden,

* Low profitability,

* Deterioration in quality of goods,

* Theft and obsolescence,

* Excessive carrying costs,

8 Objectives of Inventory Management

The objectives of the inventory management are to ensure maximum and uninterrupted

production with minimum investment in inventory. Thus, the efficient inventory management

results the following advantages:

i) ensure continuous production;

ii) anticipate price changes and take advantage of it

iii) control investment and keep inventory at optimum level;

iv) maintain sales operations and delivery commitments.

v) increase operational efficiency and production levels

vi) economy in purchasing

9 Inventory Control Techniques:

The essence of inventory management is to maximize profits with minimum investment on

inventory. To achieve this objective the firm should determine the optimum level of inventory by
answering the following two questions. They are:

* How much should be ordered?

* When should it be ordered?

The first question, how much to order, relates to the problem of determining the economic

order quantity and the second one is identification of reorder point.

Economic order quantity (EOQ) : For efficiency, in inventory management the

often encountered question, is for how much quantity one has to ‘order for’. But it varies from

item to item. The optimum quantity which is economically viable is called “economic order

quantity” or “economic lot size”. An order size should neither be high nor low. Higher the order

size, an enterprise practice, more the carrying costs the firm incurs. Smaller the order size more

the ordering costs the company incurs, since the firm places order many times a year. Here,

management has to trade-off between big and small size and reaches optimum size, where the
total

cost per unit is minimum.

11.9.3 Graphical Approach:

The economic order quantity can also be found out graphically in Figure 11.4 which illustrates

the economic order quantity function. The ordering, carrying and total costs curves are plotted in

the graph on vertical axis and the horizontal axis is used to present the order size. It can be

noticed in the figure that the total carrying costs increase as the order size increases, because on
an

average, a larger inventory level will be maintained, and ordering costs decline with increase in

order size because larger order size leads less number of orders. The behavior of total cost line is

noticeable since it is a sum of two types of costs which behave differently with the order size.
Thus, the economic order quantity occurs at the point Q*, where the total cost is the minimum
and

with it the firm is able to maximize its operating profit.

Figure 11.3 Economic order quantity

Total Cost

Cost Rs. Carrying Costs

Order Costs

0 100 200 300 400

Size of Order (Units)

11.9.4 Quantity Discount:

In practice, many suppliers encourage their customers to place large orders by offering them

quantity discounts, With this quantity discounts, 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 holding.
Thus,

in addition to discount savings, the firm will save on ordering costs, but will incur additional

carrying costs, if the net return is positive, the firm’s order size should equal the quantity

necessary to avail the discount, otherwise it should be equal to EOQ level.

11.9.5 Reorder point

The reorder point is that level of inventory at which or when a firm has to place order

for an inventory items. To determine the reorder point under certainty, one should know the lead

time, average usage and economic order quantity. The lead time is the duration of time taken in
Basic Business Finance 11.9 Inventory Management

replenishing inventory after the order has been placed. In the normal circumstances, the lead time

and consumption level do not fluctuate. Under such a situation, the reorder point is simply that

inventory level which will be maintained for consumption during the lead time, that is lead time

multiplied with average usage of the inventory If the lead time is nil the re-order point will be the

zero level of inventory.

11.9.6 Safety Stock:

In practice, the usage of inventory is generally not known with certainty and it fluctuates

during the given period of time. In addition to the usage, the lead time is also subject to some

variations. Therefore, when we allow for uncertainty in usage as well as in lead time, a safety

stock is advisable. The required amount of safety stock to be maintained depends on several

factors, viz., usage of inventory, lead time period, stock-out costs, costs of carrying the inventory,

etc. Normally manager of inventory do add safety stock while calculating the average inventory.

Safety stock = lead time x number of units consumed per day

11.9.7 Ageing schedule:

The inventory items are grouped-into basing on the number of days / months they have

been lying in warehouse. More the no. of days / months an item is held in warehouse, it is said to

old. The economic value of an item depends upon its quality, usage and relevance. Utility value
of

old items i.e., lying in go downs for a long time will be low.

The ageing schedule helps in assessing liquidity value of inventory. More the age of the

inventory, less is the liquidity of the firm. If many items are lying in go downs for a long time, it

can be said that the liquidity of the firm is poor. A firm having more items of recent purchases
will have more and more i.e., liquidity since their utility (in terms of quality) is high.

The liquidity position of the firm can be gauged from the following Illustration - 11. 3.

Illustration: 11.3

Age of Items Firm A % Firm B %

in total value in total value

1 month old 15.00 35% 35.00 65%

above 1 month and

less than 3 months 20.00 30.00

Above 3 months and

Below 6 months 30.00 30% 20.00 20%

Above 6 months and

Below 1 year 35.00 35% 15.00 15%

Total 100.00 100% 100.00 100%

Now, firm B is stronger, in liquidity point of view as it has 65% (out of total value) of its

inventory is 3 month old. Firm A is relatively poor state since of inventory position 65% of its

Centre for Distance 11.10 Acharya Nagarjuna University

inventory is purchased beyond 3 months. From this illustration it is evident that firm with latest

purchases will be strong in business. Here both firms are holding inventories worth Rs. 100 lakhs

each. But, Firm B is found to relatively be strong after analysis.

11.10 Inventory Control Systems:

In a large organization, where more number of inventories are maintaining, it is not

desirable to keep the same degree of control on all the items. In order to effectively manage these

inventories, every firm needs an inventory control system. In an organization, the size of the
inventory, nature of the materials, type of inventory and size of the firm dictate the selection of
an

inventory control system. In practice, there is several inventory control systems are in vogue. The

following are some of the systems which are following by the firms for controlling the inventory.

(i) ABC Analysis:

Large number of firms has to maintain several types of inventories. Therefore, the firm should

pay maximum attention to those items whose value is the highest. Hence, the firm should be

selective in it’s approach to control investment in various types of inventories. This approach for

maintaining the inventory in the organization is called the ABC analysis which measures each

item of inventory in terms of its value. The highest valued items are categorized as ‘A’ items the

lowest valued items are grouped a ‘C’ category and the moderate items are branded as ‘B’ items.

More over, all these items may not be consumed everyday. Since A items are very costly, tight

control is used, B items are under reasonable control and C items are under simple no control,

since they are of low value. A tight control may be applied for high-value items and relatively

loose control for low-value items. Thus, the control by importance and exception by the firm

attains the maximization of profitability on its investment.

. The graphical representation shows that items A, which is only 16 per cent in the total

units of all the items, represents 60 per cent in terms of value. Whereas, ‘C’ items though

represent 50 per cent in the total number are of only 20 per cent in terms of value and ‘B’ items

occupied middle place. Thus, ‘A’ items are under tight control while planning, ordering, checking

storing, dispatching, etc. and if any negligence on the part of management would cause heavy
loss

because items are of high values.

Item Units % of Number Unit Total % of Cumulative

Total quantity Cumulative Price value total percentage of

Percentage value value

1 1000 10 15 10 10000 19.15

2 500 5 50 25000 47.89 67.06

Basic Business Finance 11.11 Inventory Management

3 1600 16 35 3 4800 9.19

4 1900 19 4 7600 14.55 23.76

5 3000 30 1.20 3600 6.89

6 1000 10 50 0.50 500 0.95 9.18

7 1000 10 0.70 700 1.34

Total 10000 100 100 -- 52200 100.00 100.00

Stocks are also divided into 3 categories such as Vital, Essential and Desirable, which

helps for planning, controlling and other inventory decisions are taken more carefully and

seriously for items of vital category next comes essential and followed by desirable items. The

division of materials based on consumption pattern also helps the management to control the

inventory rightly. According to this approach, the inventory items are categorized into fast

moving, slow moving and non moving. Inventory decisions are very carefully taken in the case
of

‘not moving category’. In the case of item of fast moving items, the manager can take decisions

quite easily because any error happened will not trouble the firm so seriously. Since risk is less in
fast moving items, because they can be consumed quickly unlike the non - moving category
which

are carried in the go downs for more time period. As risk is high in case of slow - moving and
nonmoving - items, the inventory decisions have to be taken carefully without affecting the
objectives

of profitability and liquidity of the organization.

(ii) Just-in-Time System:

As a matter of fact, inventory costs are high and controlling inventory is complex

because of uncertainties in supply, dispatching, transportation, etc. Lack of coordination between

suppliers and ordering firms is causing severe irregularities, ultimately the firm ends-up in

inventory problems. Toyota Motors in Japan has first time suggested just - in - time approach in

1950s to minimize the investment on inventory. According to this system material or any

component for manufacturing of goods/services arrive to the site just few hours before they are
put

to use. Thus, the supply of material is synchronized with the production cycle, eliminates the

necessity of carrying large inventories and saves lot of carrying and other costs of storages.

Since, it requires close coordination between suppliers and the ordering firms, and therefore,
only

units with systems approach will be able to implement it.

(iii) Out-Sourcing System:

A few years ago there was a tendency on the parts of many companies to manufacture

all components in-house. Now, more and more companies are adopting the practice of
outsourcing. It is a way of getting the work from outside the organization, which is not possible
or

economical to get it within the organization. More specifically, it results reduction in the cost of
production, shortening of the purchasing cycle and saving of administration and supervisory

expenditure. It is a more popular concept in Information Technology field and now it is a step

Centre for Distance 11.12 Acharya Nagarjuna University

beyond IT area and becoming a strategic choice of companies looking to achieve cost reduction

while improving their service quality, increasing shareholder value and focusing on their core

business capabilities.

(iv) Computerized Inventory Control System:

It is an automatic system of counting inventories, recording withdrawals and revising the

balance. In this method, there is an in-built system of placing order as the computer notices that

the reorder point has been reached. In the present business world, majority companies are

adopting the computerized inventory control system, which enables a firm to easily track large

items of inventories. Today, it is inevitable for large business firms which carry thousands of

inventory items. The success of this system is more depended on the development of the

communication new work.

11.11 Measures to assess the inventory management

Following are the ratios in use to measure the effectiveness of the inventory management.

i) Inventory turnover ratio : Cost of goods sold / average total inventories.

The higher the ratio, more the efficiency of the firm

ii) Work in process turnover ratio

Here, in this ratio also higher the ratio, more the efficiency of the firm.

iii) Weeks inventory finished goods on hand

This ratio reveals that the lower the ratio, the higher the efficiency of the firm

iv) Weeks raw material on order

v) Average age of raw material inventory

This ratio says that the lower the ratio the higher the efficiency of the firm.

vi) Average age of finished goods inventory

This ratio comes that the lower the ratio the higher the efficiency of the firm.

vii) Out of stock index

This ratio indicates the lower the ratio higher the efficiency of the firm.

viii) Spare parts index

This ratio reveals that the higher the ratio the more the efficiency of the firm.

Basic Business Finance 11.13 Inventory Management

11.12 Summary:

Inventory constitutes about 60 per cent of the total current assets of any manufacturing

organization in India. There are several forms of this inventory, i.e., raw material, work-
inprocess; semi-finished, finished and spare materials. There are three motives for holding

inventory. The objective of inventory management is maximization of the value of the firm. The

inventory costs are broadly grouped them as carrying costs and ordering costs. In order to attain

the objective of inventory management the firm should minimize these costs. There are mainly

two issues involved in the management of inventory, viz., how much to order and when to order.

The first one relates to calculation of economic order quantity and the second one is with respect

to re-order point In practice the determination of the reorder level is depends on the lead time
and

usage of inventory in the firm. Apart from these issues, there are other areas of inventory

management to make use for effective management of inventory.

1. A B C Inventory Control System: it is a method that controls expensive inventory items more

closely than less expensive items.

2. Economic Order Quantity: it is the order quantity at which the total inventory costs are

minimized over the firm’s planning period.

3. Safety Stock: Inventory stock held in reserve as a cushion against uncertain demand and

replenishment lead time.

4. Stock-out-Cost: It is the stock level at which not having sufficient stock to issue for
production.

11.14 Self Assessment Questions

1. What is inventory and why should it be held?

2. Explain the costs associated with inventory management

3. What is economic order quantity? How do you calculate it?

4. Explain the various inventory control systems and its relevance in Indian Industries.

5 What is the risk return trade-off? How it is associated with inventory management?

6. From the following details what should be the ideal level of inventory

Annual consumption = 1,00,000

Cost of the material = Rs. 5/- per unit

Ordering cost = Rs.20/- per order

Inventory carrying cost = 36% of the inventory cost

Centre for Distance 11.14 Acharya Nagarjuna University

Lead time = 30 days

Safety stock = 20 days consumption.

ordering cost is Rs. 50/-. It takes 15 days to receive a shipment after an order is

initiated and the firm intends to hold inventories for 30 day’s usage as safety stock.

Calculate the EOQ and reorder point.

8. XYZ Co. Ltd., uses 20,000 units every year. Inventory carrying cost is Rs.50/-.

Cost per order is Rs.500/-. Decide the annual order costs and total inventory costs,

if the firm orders in quantities of 5,000, 10,000 respectively.

9. From the following data, suggest whether the firm can avail of the quantity

discount.

Annual usage - 10,000 units. Cost per order - Rs. 600/-

Price Per unit Rs. 100/- Carrying cost 10% of inventory value

10.. From the following information

i) Rank the items on the basis of usage value.

ii) Record the percentage of usage items

iii) Classify the items into 3 categories i.e., A, B and C

Item Annual usage Price Per Unit

(number of items ) (Rs.)

A 1400 200

B 6000 400

C 1200 500

D 300 600

E 1500 700

F 1300 800
G 8400 900

H 90600 100

I 4000 200

Basic Business Finance 11.15 Inventory Management

J 100 1000

K 50 1100

L 400 1200

11.14 Further Readings

1. Psrigham, E.F. Fundamentals of Financial Management, Dryden Press, Chicago.

2. James C. Van Horne, Financial Management and Policy, Prentice Hall of India, New

Delhi.

3. Solomon Ezra, Theory of Financial Management, Columbie University Press, New

Delhi.

4. Pandey, I.M., Financial Management, Vikas publishing Home, New Delhi

5. Prasanna Chandra, Financial Management : Theory and Practice, Tata Mc Graw Hill,

New Delhi.

KSNR