INTRODUCTION Inventories constitute the most significant part of current assets for a large majority of companies in India. On an average, inventories are approximately 60 per cent of current assets in public limited companies in India. Because of the large size of inventories maintained by firms, a considerable amount of funds is required to be ‘committed to them. Itis, therefore, absolutely imperative to manage inventories efficiently and effectively, in order to avoid unnecessary investment. A firm neglecting the ‘management of inventories will be jeopardizing its long- run profitability and may fail ultimately. Itis possible for a company to reduce its levels of inventories to a considerable degree, e.g., 10 to 20 per cent, without any adverse effect on production and sales, by using simple inventory planning and control techniques. The reduction in excessive’ inventories carries a favourable impact on a company’s profitability. NATURE OF INVENTORIES Inventories are stock of the product a company is manufacturing forsale and components that make up the product. The various forms in which inventories exist in a manufacturing company are: raw materials, work-in- process and finished goods, ‘% Raw materials are those basic inputs that are converted into finished product through the ‘manufacturing process. Raw material inventories are those units which have been purchased and stored for future productions. % Work-in-process inventories are semi manufactured products. They represent products thatneed more work before they become finished products for sale. “Finished goods inventories are those completely manufactured products which are ready for sale. Stocks of raw materials and work-in-process facilitate production, while stock of finished goods is required for smooth marketing operations. Thus, inventories serve as a link between the production and consumption of goods. The levels of three kinds of inventories for a firm depend. on the nature of its business. A manufacturing, firm will have substantially high levels of all three kinds of inventories, while a retail or wholesale firm will havea very high level of finished goods inventories and no raw,material and work-in-process inventories. Within manufacturing firms, there will be differences. Large heavy engineering companies produce long production cycle products; therefore, they carry large inventories. On the other hand, inventories of a consumer product company will not be large because of short production cycle and fast turnover. Firms also maintain a fourth kind of inventory, supplies or stores and spares. Supplies include office and plant maintenance materials like soap, brooms, oil, fuel, light bulbs, etc. These materials do not directly enter production, but are necessary for production process, ‘Usually, these supplies are small partof the total inventory and do not involve significant investment. Therefore, a sophisticated system of inventory control may not be maintained for them. ‘NEED TO HOLD INVENTORIES ‘The question of managing inventories arises only when the company holds inventories. Maintaining inventories involves tying up of the company’s funds and incurrence of storage and handling costs. Irit is expensive to maintain inventories, why do companies hold inventories? There are three general motives for holding inventories.! Transactions motive, which emphasizes the need to maintain inventories to facilitate smooth production and sales operations. Precautionary motive, which necessitates holding, of inventories to guard against the risk of unpredictable changes in demand and supply forces and other factors. Speculative motive, which influences the decision to increase or reduce inventory levels to take advantage of price fluctuations, A company should maintain adequate stock of materials for a continuous supply to the factory for an uninterrupted production, [tisnot possible fora company to procure raw materials whenever it is needed. A time lag exists between demand for materials and its supply. Also, there exists uncertainty in procuring raw materials time, on many occasions. The procurement of materials may be delayed because of factors such as strike, transport disruption or supply. Therefore, the firm should maintain sufficient stock of raw materials ata given time to streamline production. Other factors which may necessitate purchasing and holding of raw material « inventories are quantity discounts and anticipated price. increase. The firm may purchase large quantities of raw materials than needed for the desired production and sales, levels to obtain quantity discounts of bulk purchasing. At times, the firm would like to accumulate raw materials in anticipation of a price rise. Work-in-process inventory builds up because of the production cycle. Production cycle isthe time span between Inventory Management 701 introduction of raw material into production and, emergence of finished product at the completion of production cycle. Till the production cycle completes, stock of work-in-process has to be maintained. Efficient firms constantly try to make production cycle smaller by improving their production techniques. Stock of finished goods has to be held because production and sales arenotinstantaneous. A firm cannot Produce immediately when customers demand goods. Therefore, to supply finished goods on a regular basis, their stock has to be maintained. Stock of finished goods has also to be maintained for_sudden demands from customers, In case the firm’s sales are seasonal in nature, Substantial finished goods inventories should be kept to meet the peak demand. Failu to g _when demanded, would. eA Joss. of the irm’s sales to competitors. The level of finished goods inventories wot pet ‘upon the coordination hand sales and production as well as on production time. CHECK YOUR CONCEPTS OBJECTIVE OF INVENTORY MANAGEMENT Inthe context of inventory management, the firm is faced with the problem of meeting two conflicting needs: {% To maintain a large size of inventories of raw material and work-in-process for efficient and smooth production and of finished goods for anninterrtupted sales operations. ‘Tomaintaina minimum investmentin inventories, to maximize profitability. Both excessive and inadequate inventories are not desirable, These are two danger points within which the firm should avoid, The objective of inventory management should he to determine and maintain optimum level of inventory investment. The optimum level of inventory will lie between the two danger points of excessive and inadequate inventories. The firm should always avoid a situation of over investment or under-investment in inventories. The major dangers of over investment are: (@) unnecessary tie-up of the firm’s funds and loss of profit, (b) excessive carrying costs, and (¢) risk of liquidity. The excessive level of inventories consumes funds of the firm, which then cannot bbe used for any other purpose, and thus, it involves an opportunity cost, The carrying costs, such as the costs of storage, handling, insurance, recording and inspection, & 1. Starr, Martin, K. and David W, Mille, Incentory Control: Theory and Practice. Englewood Clits, NJ, Prentice-Hall, 1962, p17.702 Financial Management also increase in proportion to the volume of inventory These costs will impair the firm’s profitability further. _. Excessive inventories..carried for long,period, increase eR): ‘of liquidity. \it may not be possible to sell “7 ‘inventories in time and at full value. Raw materials are generally difficult to sell as the holding period increases. ‘There are exceptional circumstances where it may pay to the company to hold stocks of raw materials. This is possible under conditions of inflation and scarcity. Work- in-process is far more difficult to sell. Similarly, difficulties, may be faced to dispose off finished goods inventories as time lengthens. The downward shifts in market and the seasonal factors may cause finished goods to be sold at low prices. Another danger of carrying excessive pee is the physical d s ation of | leventorisyehile in storage. In ¢a36 of certain goods or raw materials deterioration occurs with the passage of time, or it may -be due to mishandling and improper storage facilities. these factors-are within the control of management; ‘unnecessary-investment in inventories can, thus, be cut, down... ‘Maintaining an inadequate level of inventories is also dangerous. The consequences of uunder-investment in inventories are: (a) prdduction hold-ups and (2) failure to meet delivery commitments. Inadequate raw materials and work-in-process inventories will result in frequent production interruptions. Similarly, if finished goods inventories are not sufficient to meet the demand of customers regularly, they may shift to competitors, which ‘will amount to a permanent loss to the firm, he aim of inventory management, thus, should be to avoid excessive and inadequate levels of inventories and to maintain sufficient inventory for the smooth production and sales operations,JFfforts should be made to place an order at the right time with the right source to quire the right quantity at the right price and quality. (anettective inventory management shoul ensure a continuous supply of raw materials, to facilitate uninterrupted production. %_ maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes. % maintain sufficient finished goods inventory for smooth sales operation, and efficient customer service. minimize the carrying cost and time, and ‘% control investment in inventories and keep it at an optimum level. CHECK YOUR CONCEPTS 2. Extensive standard writings exist on inventory management models. See Martin and Miller, op. cit, 1962, articles by Magee, J "Guides of Inventory Policy” I-Il, Harcard Business Review, 34 Jan.~Feb. 1956), pp. 49-60 (March-April 195 June 1956), pp. 57-70. INVENTORY MANAGEMENT TECHNIQUES In managing inventories, the firm’s objective should be in consonance with the shareholder wealth maximization principle. To achieve this, the firm should determine the optimum level of inventory./Efficiently controlled inventories make the firm flexiblé: Inefficient inventory control results in unbalanced inventory and inflexibility— the firm may sometimes run out of stock and sometimes ‘may pile up unnecessary stocks. This increases the level of ipyestment and makes the firm unprofitable. Rage inventories efficiency, answers should be ht to the following two questions: % How much should be ordered? % When should it be ordered? The first question, how much to order, relates to the problem of determining economic order quantity (EOQ), and is answered with an analysis of costs of maintaining, certain level of inventories. The second question, when to order, arises because of uncertainty and is a problem of determining the reorder point.” Economic Order Quantity (EOQ) ‘One of the major inventory management problems to be resolved is how much inventory should be added when inventory is replenished. If the firm is buying raw materials, it has to decide the lots in which it has to be purchased on replenishment. If the firm is planning a production run, the issue is how much production to schedule (or how much to make). These problems are called order quantity problems, and the task of the firm is to determine the optimum or economic order quantity (or economic ot size). Determining an optimum inventory level involves two types of costs: (a) ordering costs and ©) carrying costs. The economic order quantity is that inventory level that minimizes the total of ordering and, carrying costs. Ordering costs ‘The term ordering costs is used in case of raw materials (or supplies) and includes the entire costs, ‘of acquiring raw materials. They include costs incurred in the following activities: requisitioning, purchase, ordering, transporting, receiving, inspecting and storing (Glore placement). Ordering costs increase in proportion .to the number of orders placed. The clerical and staff costs, owever, donot have to vary in proportion to the number of orders placed, and one view is that so long as they are committed costs, they need not be reckoned in computing the ordering cost. Alternatively, it may be argued the number of orders increases, the clerical and staff costs tend to increase) If the number of orders are drastically reduced, the idle clerical and staff force can be used in bes deparsnegie Tbs, thse cots ay be neil the ordering costs-Itis more appropriate to include clerical and staff costs on a pro rata basis. pp. 103-16 andoO ae ot od ay 7) : tay Ordering costs increase with the number of orders; thusthe more frequently inventory is acquired, the higher the firm’s ordering costs. On the other hand, if the firm maintains large inventory levels, there will be few orders placed and ordering costs will be relatively small. ‘Thus, Ordering costs decrease with increasing size of inventory. Carrying costs Costs incurred for maintaining a given level of inventory are called carrying costs. They include storage, insurance, taxes, deterioration and obsolescence. The storage costs comprise cost of storage space (warehousing cost), stores handling costs and dericaland staff service costs (administrative costs), incurred in recording and providing special facilities such as fencing, lines, racks etc. Table 29.1 provides summary of ordering, and carrying cost * Roquisitioning * Warehousing + Order placing + Handling + ‘Tansportation * Clerical and staff + Rocoiving, inspecting + Insurance and storing * Clerical and staff * Deterioration and obsolescence Carrying costs vary with inventory size. This behaviour is contrary to that of ordering costs which decline with increase in inventory size. The economic size of inventory would thus depend on trade-off between carrying costs and ordering costs. Ordering and carrying costs trade-off The optimum inventory size is commonly referred to asleconomic order quantity. It is that order size at which area of ordering and holding are the minimum, We can follow three approaches—the trial and error approach, the formula approach and the graphic approach—to determine the economic order quantity (EOQ). We assume that total annual demand is known with certainty and usage of materials is steady. Also, ordering cost per order and carrying cost per unit are assumed to be constant. Trial and error approach The trial and error, or analytical, approach to resolve the order quantity problem. can be illustrated with the help of a simple example. Let us assume the following data for a firm: Estimated annual requirements, A 1,200 units Purchasing cost per unit, P (Rs) 50 Ordering cost (per order), O (Rs) 37.50 Carrying cost per unit, ¢ (Re) 1 A number of alternatives are available to the firm. It ‘may purchase its entire requirement of 1,200 units in the beginning of the year, in one single lot or in 12 monthly lots of 100 units each and so on. If only one order of 1,200 ae ay ett pnd sye Inventory Management 703 units is placed, the firm will have a starting inventory of 1,200 units. With the constant consumption, the inventory size will reduce in a systematic way and will reach zero level at the end of the year. As the firm will hold 1,200, ‘units in the beginning and zero unit at the end of the year, the average inventory held during the year will be 600, units, (i.e., (1200 + 0)/2 = 600 units), representing an average value of Rs 30,000 (600 x Rs 50). On the other hand, if the monthly purchases are made, 12 orders of 1100 units each will be placed during the year. Thus, the firm will have 100 units at the start of a month and zero unit at the end of the month and the average inventory held will be 50 units (i.e., (100 + 0)/2 = 50 units), representing anaverage value of Rs 2,500 (50 x Rs 50). Many. other possibilities can be worked out in the same manner. If the objective is to minimize the inventory investment, then monthly orders or even less than that, if possible, may be favoured. However, this may not be most economical ‘Todetermine the economical order size, implications of both carrying and order costs should be studied.’ If we assume annual requirements as known and steady usage, the inventory levels under different lot size alternatives are shown in Figure 29.1. For illustrative purposes, we have depicted only two alternatives— placing one order in the beginning or 12 monthly orders. The single order plan (say, Plan I) involves an average inventory level of 600 units, starting with the highest level of 1,200 units and ending with zero level. On the other hand, the multiple order plan entailing 12 orders results in an average inventory level of 50 units. ‘The multiple order plan (say, Plan Il) involves less investment in inventories; but itis not necessarily the most economic plan. To determine optimum order quantity, a comparison of total costs at different lot sizes should be made, The computations are shown in Table 29.2. ‘Table 29.2: Total Costs of Various Orders Order 1,200 600 400 300 240 200 150 120 100 size () Average 600 300 200150 120 100 75 60 50 Inventory (@2) Number of = 3.4 6 orders (Al, Annual, carying cost (Rs) (cQ/2) Annual 37.5 75 112.5 150 187.5 225 300 375 450 ordering costs Rs) (04/Q) Total 637.5 375 312.5 300 307.5 325 375 435 500 annual costs (Rs) 8 10 12 600 300 200150 120 100 75 60 50 3. Ramamoorthy, V.E., Working Capital Management, Chennai, IEMR, 1976, pp. 156-57.}704 Financial Management Interms of the total annual costs, Plan Ilis preferable, as ithas a total annual cost of Rs 500 as against the total annual cost of Rs 637.5 of Plan I. But for an economic solution, other alternatives should also be considered. Computations in Table 29.2 show that the total annual cost is minimum, ie,, Rs 300 when the number of orders in the yearis 4. The economic order quantity, therefore, is. Analytical, approach is somewhat tedious to calculate the OQ. An easy way to determine EOQ is to use the order- formula approach. Let us illustrate this approach." Suppose the ordering cost per order, O, is fixed. The total order costs will be number of orders during the year multiplied by ordering cost per order. IfA represents total annual requirements and Q the order size, the number of orders will be A/Q and total order costs will be: Total ordering cost _(Annual requirement x Per order cost) Order size od: Q Toc: Ordersize _Q Average inventory = SSSA 8 and total carrying costs will be: Tolal carrying cost = Averageinventory x Per unit carrying cost toc 2 2 If Qis the order size and usage is assumed to be steady, the average inventory will be: Q) @) The (otal inventory cost, then, is the sum of total camying and ordering costs: Total cost =Total carrying cost +Total order cost @, 40 TC: 2° Oo oy Equation (4) reveals that for a large order quantity, Q, the carrying cost will increase, but the ordering costs will decrease. On the other hand, the carrying costs will be lower and ordering cost will be higher with the lower, order quantity. Thus, the total cost function represents a (1) trade-off between the carrying costs and ordering costs for determining the FOQ. Let us further assume that carrying cost per unit, cis constant. The total carrying costs will be the product of the average inventory units and the carrying cost per unit. To obtain the formula for EOQ, Equation (4) is 1000 Stock 200 30 = Q/%plan NINNANSAAAN Tine 12 Figure 29.1: Inventory Level Over Time 4, Also see Van Home, J.C, Financial Management and Policy, Prentice-Hall of India, 1985, pp. 416-19. 5 bid, 985, pp. 156-57, Different ting Equation (A) with respect to Q Setting Equation (5B) to zero: 2 Q2=240, 96, AO ree ace, a0 Q 2° QF Aifferentiated with respect to Q and setting the derivative ‘equal to zero, we obtain: &)Economic order quantity _ Pxquantity required xordering cost rying px \ : ) 6 je note from Equation (5) that EOQ changes directly ith total requirements, A, and order cost O, and has an inverse relationship with the carrying cost, c. However, the square-root sign restrains the relationship in both cases. Thus, if the usage is double, the economic order quantity is not doubled; it will increase by, or about 1.4 times.” To illustrate the use of EOQ formula, let us assume data of the example, taken to illustrate the trial and error approach. As assumed earlier, if the total requirement is. 1,200 units, ordering cost per order is Rs 37.50 and carrying cost per unit is Re 1, the economic order quantity will be: 2x1, 200x375 FO. This corresponds wi and error approach. Graphic approach The economic order quantity can also be found out graphically. Figure 29.2 illustrates the EOQ function. In the figure, costs—carrying, ordering and total—are plotied on vertical axis and horizontal axis is used to represent the order size. We note that 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 a larger order size means less number of orders. The behaviour of total costs line is noticeable since it isa sum of two types of costs which behave differently with order size. The total costs decline in the first instance, but they start rising when the decrease in average ordering cost is. ‘more than offset by the increase in carrying costs.” The economic order quantity occurs at the point Q* where the total costis minimum. Thus, the firm’s operating profitis maximized at point Q*. Itshould be noted that the total costs of inventory are fairly insensitive to moderate changes 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 cn total costs may be studied. If the total costs do not change very significantly, the firm can change EOQ within the range without any loss.* 300 units 1 the answer found outby trial Optimum production ran The use of the EOQ approach can be extended to production runs to determine the ‘optimum size of manufacture. Twocosts involved areset- up costs and carrying costs. Set-up costs inchude costs on 6. Van Home, op, cit, 1985, p. 419. 7. Van Home, op. cit 1985, activities: preparing and processing the stock orders, preparing drawings and specifications, tooling machines set-up, handling machines, tools, equipments and materials, over time etc. 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. mnomiie production size will be the one where the total of set-up and the carrying ‘costs is minimum. _ Banari Minima Ordering cost Costs oF ‘Order size Q Figure 29.2: Economic Order Quantity Equation (5) can be used to determine economic lot (or production) size (ELS), simply by replacing order costs Oby set-up costs S. That is: ELS: © Where A is the total estimated production, S is the set-up cost and is the carrying cost. Suppose the estimated production for the next year is 90,000 units, set-up cost Per production run is Rs 50 and the carrying cost is Re 1 er unit, the economic lot size will be: ¢ [2% 90,000%50 1 = 3,000 units per production run ELS= 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 toincrease 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. The net return is the difference between the resultant savings and additional carrying costs. If the net return is positive, the firm's order size should equal the quantity necessary to avail the discount; if negative its order size should equal EOQ level 8 Synder, Arthur, Principles of lnventory Management, Financial Execuive, XXXII (April 196).‘706 Financial Management Let us assume in the illustration in the preceding section that the firm is offered 0.5 per cent (0.005) or Re 0.05 per unit quantity discount on orders of 400 units or more. The net return should be calculated for deciding, whether the order size should be increased from 300 to 400 units The discount savings will be: Discount rate Purchase price x Annual quantity =dxPxA = 0.005% 501200 =Rs300 ” The savings on ordering costs will be: -of where O is per order cost, A is the annual requirement A 6) (units), Q* is the EOQ and Q’ is the discount quantity. We obtain savings as follows: 1200 _ 1200 = 3755 200 _ 1200 ak 300” 400 | = 37.50 (4-3) =Rs37.50 ‘The additional carrying costs will be: Coens 2c Lafg-o') ©) Using values for c= Re 1, Q’ = 400 units and Q* = 300 units, we obtain additional carrying costs as follows: =1/2(400 -200) = Rs 50 The net return is given by the following equation: (10) Since the net return is positive, the firm should have an order quantity of 400 units. Reorder Point problem, how much to order, is solved by determining the economic order quantity, yet the-answer should be sought to the second problem{when to orde®sThis is a problem of determining the reorder point. The reorder Point is that inventory level at which an order should be placed to replenish the inventory. To determine the reorder point under certainty, we should know: (a) Jéad time, (b) average usage, and (Q eednomic order quantity. Lead time is the time normally taken in replenishing inventory after the order has been placed. By certainty, ‘wemean that usage and lead time do not fluctuate. Under such a situation, reorder point is simply that inventory level which will be maintained for consumption during the lead time. That i Reorder point = Lead x Average usage (11) To illustrate, let us assume that the economic order quantity is 500 units, lead time is three weeks and average ‘usage is 50 units per week. If there is no lead time, that is, delivery of inventory is instantaneous, the new order will be placed at the end of tenth week, as soon as EOQ reaches zero level. But, if the lead time is three weeks, the new order should be placed at the end of seventh week, when there are 150 units left to consume during the lead time. Assoon as the lead time ends and inventory level reaches zero, the new stock of 500 units will arrive. Thus, the reorder point is 150 units (50 units x 3 weeks). This is illustrated in Figure 29.3. which shows that the order will, be placed at the end of seventh week, where 150 units are Jeft for consumption during the lead time. At the end of tenth week, the firm will get a supply of 500 units. If the ead time is nil, the re-order point will be the zero level of inventory. Boo si JAvcage 259, inventory IReoner 150 pont Teal im Figure 29.3: Reorder Point under Certainty Safety stock In our example, the reorder point was ‘computed under the assumption of certainty. Itis dificult to predict usage and lead time accurately. The demand for material may fluctuate from day-to-day or from week- to-week. Similarly, the actual delivery time may be different from the normal lead time. If the actual usage increases or the delivery of inventory is delayed, the firm can face a problem of stock-out which can prove to be costly for the firm. Therefore(in order to guard against the stock-out, the firm may maintain a salety-stock: x minimum or buffer inventory as cushion against expected increased usage and/or delay in delivery time] Assume iivthe previous example, the reasonable expected stock- out is 25 units per week. The firm should maintain a safety stock of 75 units (25 units x 3 weeks). Thus, the reorder point will be 150 units + 75 units = 225 units. The ‘maximum inventory will be equal to the economic order quantity plus the safety stock, Le., 500 units + 75 units = 575 units. Thus, the formula to determine the reorder point when safety stock is maintained is as follows: Reorder point = Lead x Average usage + Safety stock a2)Figure 29.4 shows the reorder point under the assumption of the safety stock. CONCEP 1. What is economic order quantity (EOQ)? What are carrying costs and order costs? 3, How is economic order quantity determined? 4. How does quantty discount affect the economic order quantity? 5, What is meant by optimum production run? 6. What is re-order point? 7. What is safety stock? ANALYSIS OF INVESTMENT IN INVENTORY It is a major responsibility of the financial manager to oversee the management of inventory, since inventories represent investment of the firms’ large funds in practice. is an investment decision. The analysis should therefore “involve an evaluation of the profitability of investment in, inventory. The goal of the inventory policy should be ‘maximization of the firm’s value. The inventory policy will maximize the firm’s value at a point at which incremental or marginal return from the investment in inventory equals the ineremental or marginal cost of funds used to finance the investment in inventory. You may recall that the cost of funds is the required rate of return to the suppliers of funds, and it depends on the risk of the investment opportunity. Incremental Analysis Like the investment in receivables, the investment in inventory should be analyzed involving the following four steps: Inventory Management 707 Estimation of operating profit Estimation of investment in inventory Estimation of the rate of return on investment in inventory Comparison of the rate of return on investment with the cost of funds. ‘The incremental analysis should be used to compute the values of operating profit, investment in inventory, rate of return and cost of funds. A change in the inventory. policy is desirable if the incremental rate of return exceeds the required rate of return. The following example illustrates the process of analyzing investment in inventory.” cs % & % Bansal Engineering Limited (BEL) produces many products, The managing diryctor has estimated sales for the next year as Rs 176 crore and gross profit Rs 70 crore, alter deducting cost of goods sold of Rs 106 crore. The average working capital requirements to support the forocast sales are estimated a follows: decision to determine or change the level of inventory. se Cash. 175 1.0 Receivables 3,520 20.0 Inventories: Raw Materials 704 Work-in-process 816 Finished goods 390 ‘Total 5,705 Less: Current liabilities 1,305 Working capital 4,400 The company uses sales forecasts as the basis for production and inventory of finished goods. The shortage of funds forced the company to tightly control inventories and maintain finished goods inventory below the target lovels, as desired by the sales forecasts. The company has Maxim faventry verge Reorder point Safety 09 Toad tine Figure 29.4: Reorder Point under Unertainty 9, See case titled Electricircuit, Inc, in Andrews, VL, ef. al, Financial Management: Cases and Readings, Richard D. Irwin, 1962, for @ similar, but comprehensive example, For a similar analysis also see Solomon, E. and J. Pringle, Ar Introduction to Financial Management, Prentice-Hall of India, 1978, pp. 218-21.708 Financial Management boon losing orders to competitors because of stock-outs resulting from the tight inventory control. ‘The problem of lost sales forced management to reconsider its inventory policy. The company is therefore considering adopting a system of safety stocks to avoid stock-out problem. It would like to estimate the costs and benefits of all new options, It was, therefore, thought necessary to compile data on possible inventory levels, lost sales on account of stock-outs and annual cost of ‘maintaining higher levels of finished goods inventory. Table 29.3 provides these estimates ‘Table 29.3: Bansal Engineering Limited: Impact of Alternative Inventory Policies Current 490 772 27 A 610 550 34 B 770 350 42 c 1013 180 56 D 1276 90. 70 B 1406 30. 7 It can be seen from Table 29.3 that the company can affect reduction in stock-outs and thus increase sales by increasing levels of finished goods inventory. To do s0, however, the company will incur additional carrying costs including warehousing, handling, administration, set up, insurance ete. Notice that interest cost is not considered because the rate of return on investment is compared with the cost of funds which includes interest cost. The expected ‘operating profit of each inventory policy will depend on the contribution from increased sales minus the additional ‘carrying costs. The aim of the firm should be to maximize operating profit in relation to investment, viz. expected return on investment. This will take account of risk and cost of funds used to finance investment in inventory of finished goods. Let us calculate the rate of retum on investment. Incremental operating profit The first step in computing the rate of return, r, is to estimate incremental operating profit, AOP, In case of BEL, we know the amount of sales which the company can gain by shifting to higher levels of inventory. We also know that cost of goods sald (CGS) is about 60 per cent (Rs 106 crore CGS in relation to Rs 176 crore sales), and therefore, contribution ratio is 40 per cent. In the absence of information, we can make the assumption that cost of goods sold is in terms of variable cost and other costs do not increase with increase in sales. Given 40 per cent contribution ratio, we can calculate incremental contribution, ACONT, from increased sales, ASALES, resulting from moving to higher levels of inventory. We obtain incremental operating profit when ‘we subtract the incremental carrying costs, ACOST, from incremental contribution. In the present example, AOP = ACONT - ACOST (a3) where OP is operating profit, CONT contribution and COST carrying cost and A (delta) represents change or increment in variable. We have assumed that carrying, costs are 5.5 per cent ofthe finished goods inventory (Table 29.3). Table 29.4 shows calculation of incremental ‘operating profits before tax (OPBT) and after tax (OPAT).. ‘Table 29.4: Bansal Engineering Limited: Calculation of Incremental Operating Profit, AOP GurrenttoA 22289 7 841 AtoB 200-80. 8 72 36 BtoC 160 64 «14 «505 CtoD 100 «400-1426 Dok 40 16 Z 7s Incremental investment ‘The next step in analysis is to estimate the incremental inventory investment, AINV, required to move from one inventory policy to next. We notice from Table 29.5 that if the company moves from current policy to policy A, investment in finished goods inventory increases by Rs 120 lakh (from Rs 490 lakh to Rs 610 lakh) and so on. Ideally, the investment in inventory. should be measured in terms of out-of-pocket costs. It should also be noticed that to support increase in sales, resulting from higher levels of inventory, the company will also require investment in other current assets which, will partially be financed by current liabilities. Thus, incremental investment, AINVST will be the sum of ( increased finished goods inventories, AINV, and (ii) corresponding increase in other net working capital, ANWC, to support higher level of sales resulting from the increased level of finished goods inventory: AINVST = AINV + ANWC a, Excluding finished goods inventory, net working capital for BEL works out to be 22.2 per cent of increased sales, based on the forecasts of next year. The incremental investment is calculated in Table 29.5 using this percentage for net working capital. Table 29.5: Bansal Engineering Limited: Calculation of Incremental Investment, AINVST = AINV + ANWC (Rs lakh) CurrenttoA 12049 169 (0169 AtoB 16044 2040373 BtoG 24336 2790852 CoD 26322 285 0937 DwE 130 9 1391076 Return on investment Once we have calculated incremental operating profit and incremental investment, ‘we can relate them to compute rate of return on investment (*)as follows:AP. ‘AINVST a5) ‘Table 29.6 shows calculations for before-tax and after- tax expected rate of return. We notice that the company yields an attractive expected rate of return of 48.5 percent, before-tax or 24.3 per cent, after-tax when it increases its investment in inventories by Rs 1,69,000. But the successive increments of investment in finished goods inventories regain less lost sales and therefore, less lost operating profit. Asa result, incremental expected rate of return declines. The incremental return from policy E is only 65 per cent before tax or 3.2 per cent after tax. Table 29.6; Bansal Electricals Limited: Calculations for Before-tax and After-tax Expected Rate of Return Current to A 485% 24.3% AloB 35.3% 17.6% BoC 17.9% 9.0% CtoD 9.1% 40% Diok 6.5% 32% Choice of policy The choice of the inventory policy by the management of BEL will depend on the required rate of return on incremental (or marginal) investment in inventories. The concept of the required rate of return, K, hhas been discussed earlier in this book. At this stage, we shall emphasize that the required rate of return is not the borrowing rate. It depends on the risk of investment. Higher the risk, higher the required rate of return. If BEL, increases its investment in inventories, its risk increases. For example, the company may not be able to realize receivables, or inventory may become obsolete if itcannot sell goods because of recession or other unfavourable ‘market conditions, ‘Thus the choice of inventory policy will depend on a ‘comparison of the expected rate of retum and the required rate of return. The firm should invest in higher level of inventory ifr 2k. Assuming that BEL’S after-tax required rate of return is 9 per cent, it can adopt policy Csince the marginal rate 4s just equal to the required rate of return. In Figure 29.5 this is shown at point C. At point C, the inventory policy is optimum as the value of the firm is maximized; at any other point the net wealth of the firm will be less. Note that the incremental rate of return declines as the firm invests mote in inventory. The loosening of the inventory policy will increase risk, and therefore, the required rate of returm increases, Iriskis zero, the required rate of return ‘will be equal to risk-free rate of return.!° 410. Solomon and Pringle, op. cit, 1978, p. 222 Inventory Management Optimum level ot iventory | 20 15 Return (%) Incremental rate of tum 400600800 Investment 1000 1200" Figure 29.5: Optimal Inventory Policy In the example, both return and cost are estimates; there can be some error of estimation. Therefore, if the firm is conservative and wants to play safe, itmay choose policy B where the expected rate of return is much higher than the required rate of return. Another factor thatmerits consideration in the present case is the finds availability. BEL is currently facing the problem of shortage of funds. It will need to invest total additional funds of Rs 652 lakh if it chooses policy C. If the firm finds it difficult to raise enough funds to finance higher level of finished goods inventory, it may settle for an inventory policy which requires maintaining lower level of finished goods inventory. But by doing so, the firm will fail to maximize its value. Thus, there is an opportunity cost of the shortage of funds. We take another example to further explain the analysis of investment in inventories. ILLUSTRATION 28.2: Investment in Inventories Divya Paints Limited is a medium-size company, manufacturing about 30 varieties of industrial paints. The company is known for its quality of products and prompt service, The demand of Divya’s paints is much more than what the company can supply. Sunil Baluja, the managing director of the company, is a chartered account, and he plans his sales and investmont in inventories in such @ way that he is able to maximize his gross margin. The following aro Divya's curront yoar data for sales, gross margin, profit before tax, inventory and net assets employed. Profit before tax is arrived at after deducting selling, general and administrative expenses from gross margin. The variable part of these expenses is about 9 per cont of sales, The managing director considers delivery timo, usage rate and price whilo determining ite order size and inventory level. He considers an inventory turnover of 5.0 as minimum for his businoss. The firm's current inventory tumovor is 5.55. He has been adjusting his order710 Financial Management size for anticipated price rise. Because of high inflation, prices are generally expected to rs ‘Sales 13,558,625 Gross margin 2,684,608 Profit before tax 540,232 Inventory 2,443,932 Not assets 4,978,808 Net working capital 3,528,622 Sunil Baluja has a policy for taking advantage of this price fluctuation. He has invested about Rs 180,000 in inventories in anticipation of price increase and expects to make a profit of about Rs 50,000 on this investment. Is, {his ‘speculative" investment in inventory profitable to the firm? ‘The firm earns a return of about 28 per cent on this investment: Speculative profit before tax __50,000 ~~ Speculative investment ~ 180,000 0.278 or 27.8% On the othor hand, the firm's return on net assets (RONA) employed is only 10.9 per cent (and if we exclude speculative inventory and its profit, firm's ROI is 10 per cont) Profit before tax Not assets 4,978,808 1109 or 10.9% ‘The speculative investment seems attractive even if wwe calculate the firm's return on ‘operating’ inventory: Inventories excluding speculative investment (operating inventory) (Rs) 2,203,932 ‘Before-tax profit excluding speculative profit (Rs) 490,282 Rofore-tax rate of return on inventory excluding spoculative investment 21.7% What we should consider, in fact, is the altemative use of funds if they are released from ‘speculative’ inventory investment. The firm can use these funds in ‘operating’ inventory to generate additional sales, ASALES. Since demand oxceeds supply, the firm will not find any difficulty in expanding its sales (assuming capacity is availablo), The inventory turnover, excluding speculative inventory, is: 13,558,625, 2,443,932-180,000 ‘Thus if the firm used Rs 180,000 worth inventory for_/ operation, it could generate additional sales, ASALES, equal to the following amount: ASALES = 180,000%6 = Rs 1,080,000 and since the firm's gross margin ratio is 19.8 por cont, Inventory turnover 2,684,608 13,558,625 0.198 or 19.8% Gross margin rat it will be able to generate additional gross margin, AGMAR, calculated as follows: AGMAR = 1,080,000 0.198 = Rs 213,840 Deducting other variable costs at the rate of 9 per cent of additional sales, the firm will gain an incremental before tax operating profit, AOPBT, of: AOPBT = 2,13,840 ~(1,080,000 x0.09) = 218,840~97,200 5 116, 640 It should be recognized that incremental sales, ASALES, will require additional investment in other working capital, such as receivables etc, In case of Divya, it is 8 per cent of sales as shown below: NWC (excluding inventories) to sles 528,62: 2 13,558,625 = 0.08 or 8% ‘Thus, the incremental investment, AINVST, is} AINVST = AINY + ANWC 180,000 + (1,080,000 0.08) = Rs 266,400 and the incremental before-tax rate of return on incremental is as follows: AOPBT _ 116,640 ‘AINVST ~ 266,400 = 0.438 0r 43.8% {before tax) We find that the incremental return on investment on ‘operating’ inventory (43.8 per cent) is much higher than, the return on ‘speculative’ investment (28 per cent). The firm should stop price speculation and use the funds so released in ‘operating’ inventory to generate additional sales. This will holp the firm to incroase its value. R CO: CHECK YOU! Coon) Why is inventory considered as an investment decision? ‘How will you calculate investment in inventory? ‘How is incremental analysis of inventory investment done? 2 3: INVENTORY CONTROL SYSTEMS A firm needs an inventory control system to effectively ‘manage its inventory. There are several inventory control