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Unit 6

Inventory-A physical resource that a firm holds in stock with the intent of selling it or
transforming it into a more valuable state.
Inventory System- A set of policies and controls that monitors levels of inventory and
determines what levels should be maintained, when stock should be replenished, and
how large orders should be
Types of Inventory

Production supply (raw materials) the initial input into the production process
and it is completely under unprocessed stage.

Work-in-process (semi-finished goods): items beyond the raw material stage but
not yet at the completed product stage

Finished goods completed goods: these are shippable inventories ready to be

delivered to distribution centres, retailers, or directly to customers.

Objectives of inventory management

a. Maintain the sufficient stock of raw material in the period of short supply and anticipate
price changes.
b. Ensure a continuous supply of material to production department facilitating

uninterrupted production
Minimize the carrying cost and time
Maintain the sufficient stock of finished goods for smooth sales operation
Protect the inventory against deterioration, obsolescence and unauthorized use.
Minimize investment in inventory and keep it at an optimum level.

Zero Inventory
Reducing amounts of raw materials and purchased parts and subassemblies by
having suppliers deliver them directly.
Reducing the amount of works-in process by using just-in-time production.

Reducing the amount of finished goods by shipping to markets as soon as possible.

Inventory Positions in the Supply Chain

1. Economic Order Quantity: it answers the question how much to purchase or how much
quantity is to be order at any one point of time. There are two types of cost associated with
ordering the quantity. The first is the ordering cost and the other one is the carrying cost.
Ordering cost is the cost of placing an order. These costs include costs like handling and
transportation costs, stationery costs, costs incurred for inviting quotations and tenders etc.
The carrying cost is the cost associated with carrying the inventory. The cost of carrying the
inventory such as warehouse charges, insurance, lighting, losses due to handling, spoilage,
breakage etc.
Carrying costs will go on increasing if the quantity of material in inventory goes on increasing.
If orders are more frequent, ordering costs will go on increasing but as the material ordered will
be in less quantity, the carrying costs will decrease. On the other hand, if number of orders are
reduced, the quantity per order will increase and the carrying cost will increase Both, the
carrying costs and the ordering costs are variable costs, however their behavior is exactly
opposite of each other.
In this situation, the most desirable quantity to be ordered is that quantity at which both, the
ordering costs and carrying costs will be minimum. This quantity is called as Economic Order
Quantity. This quantity can be calculated with the help of the following formula.
Economic Order Quantity =

2 DO /C

U = Annual demand / annual consumption in units

O = Cost of placing and receiving an order per order

C = Carrying cost per unit per annum

Annual ordering cost = no. of orders placed per year x order cost per order
Annual ordering cost =



Where D = annual demand in units for the inventory system

Q = no. of units per order
S = ordering cost per order
Annual carrying cost -= average inventory level x carrying cost per unit per year
Annual carrying cost = Q/2 x C
Where Q = no of units per order
C = carrying cost
Optimal order quantity is found when annual ordering cost is equal to annual carrying cost



2DO =

2 xC

Q2 x C

Economic Order Quantity(Q) =

2 DO /C

Assumptions of EOQ are as follows.

The concerned material will be available all the time without any difficulty.
The price of the material will remain constant.
Ordering cost and carrying costs are variable.
Impact of quantity discounts on the prices is negligible.
Demand is known and constant
Lead time is known and constant
Stock outs can be completely avoided.

Reorder point: the quantity to which inventory must fall in order to signal that an order must be
placed to replenish an item.
Lead time: the length of time between the placement of an order for an inventory item and when
the item is received in inventory.
Reorder point = (demand /day) (lead time for a new order in days) = dxL
Demand per day (d) = D/no. of working days in a year
Where D = total annual demand
Fixation of Level : Another important aspect of material procurement is not to purchase too
much or too little. Similarly the timing of the purchase is also important. Fixation of levels of
materials is done precisely with these objectives in mind
Maximum Level : This is the highest level of material beyond which the inventory
of material is not allowed to increase. Obviously this level is fixed with the objective
of avoiding overstocking.
Maximum Level = Re-order Level + Re-order Quantity [Minimum Consumption x
Minimum Reorder period]
Minimum Level : This level is fixed with the objective of avoiding shortage of
Minimum Level = Ordering Level [Average rate of consumption x Re-order period]
Re-order Level : This level is fixed for deciding the time of placing an order. If the
stock of materials reaches this level, fresh order is placed so that by the time the

material is procured, the level of material may fall up to minimum level but not
below that. This level is fixed in the following manner.
Re-order Level = Maximum Usage per Period x Maximum Re-order Period
2. Average Level : This level is the average of the maximum and minimum level and
computed in the following manner.
Average Level = Maximum Level + Minimum Level / 2

Danger Level : Generally the danger level of stock is indicated below the minimum stock
level. Sometimes, depending on the practices of the fi rm and circumstances prevailing, the
danger level is determined between the re-order level and minimum level.

Inventory Control: One of the important aspects of the overall material management is the
inventory control. It is necessary to avoid the overstocking as well as under stocking. For
ensuring this, maximum level, minimum level, re-order level are fixed. For inventory control,
the following methods are used.
Perpetual Inventory System: Under this system, a continuous record of receipt and
issue of materials is maintained by the stores department and the information about the
stock of materials is always available. Entries in the Bin Card and the Stores Ledger are
made after every receipt and issue and the balance is consolidated on regular basis with
the physical stock.
ABC System: In this technique, the items of inventory are classified according to the
value of usage. It is based on the principle that a small portion of the items may
represent the bulk amount of money value of the total inventory, while a relatively large
number of items may form a small part of the money value of the stores. According to
this approach to inventory control, high value items are more closely controlled than low
value items. Materials are classified as A, B and C according to their value.
A category: 5% to 10% of the items represent 70% to 75% of the money value.
B category: 15% to 20% of the items represent 15% to 20% of the money value.
C category: 70% to 75% of the items represent 5% to 10% of the money value.
Just in Time Inventory: This is the latest trend in inventory management. This principle
emphasizes that there should not be any intermediate stage like storekeeping. Material
purchased from supplier should directly go to the assembly line, i.e. to the production
department. There should not be any need of storing the material. The storing cost can be saved
to a great extent by using this technique. The benefits of Just in time system are as follows,

o Right quantities are purchased or produced at right time.

o Cost effective production or operation of correct services is possible.
o Inventory carrying costs are eliminated totally.
o The stores function is eliminated and hence there is a considerable saving in the stores cost.
o Losses due to breakage, wastage, pilferage etc are avoided.
VED Analysis: This analysis divides items into three categories in the descending
order of their criticality as follows.
V stands for vital items and their stock analysis requires more attention. The
reason is that if these items are not available, the resulting stock outs will cause

heavy losses due to stoppage of production.

E means essential items. Such items are considered essential for efficient
running but without these items, the system will not fail. Care must be taken to

see that they are always in stock.

D stands for desirable items, which do not affect production immediately but

availability of these items will lead to more efficiency and less fatigue.
FSND Analysis:. This analysis divides the items of inventory into four categories in

the descending order of their usage rate as follows.

F stands for fast moving items and stocks of such items are consumed in a short span of
time. Stock of fast moving items must be observed constantly and replenishment orders

be placed in time to avoid stock out position.

N means normal moving items and stocks of such items are consumed over a period of
time, i.e. say one year. The order levels and quantities for such items should be on the

basis of a new estimate of future demand to minimize the risks of a surplus stock.
S indicates slow moving items, stocks of such items are consumed in a period of two

years or so. These items must be reviewed carefully before eliminating them.
D stands for dead stock which means that there will not be any further demand for the
same. It is necessary to identify these items and if there cannot be any alternative use for
the same, should be eliminated.

Pricing of Issues
One of the important aspects of issue control is of pricing of the issues. Material is issued to
production and it is necessary to find out the consumption value of the material

1. First In First Out:- it stands for first in first out. Material received first will be issued first.
The price of the earliest consignment is taken first and when that consignment is exhausted, the
price of the next assignment is adopted and so on.
it 2. Last In First Out [LIFO]:- it stands for last in first out. Material received latest will be
issued first. The price of the latest consignment is taken first and when that consignment is
exhausted, the price of the earlier assignment is adopted and so on.
3. Highest In First Out [HIFO]:- Under this method, the materials with highest prices are
issued first, irrespective of the date upon which they are purchased. The basic assumption is that
in fluctuating and inflationary market, the cost of material are quickly absorbed into product
cost to hedge against risk of inflation.
4. Simple Average Cost Method:- Under this method, the issues are charged at the average
price of the material purchased without taking into consideration the quantities involved in the
5. Weighted Average Method:- This method takes into consideration the prices as well as
the quantities of materials purchased. Thus weighted average is computed after each receipt by
dividing the total amount by the total quantity. The issue is charged at prices arrived at
according to this calculation.