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Inventory Management

Inventory management is concerned with keeping enough product on hand to avoid running out while at the same time maintaining a small enough inventory balance to allow for a reasonable return on investment. A major problem with managing inventory is that the demand for a corporations product is to a degree uncertain. Inventory is difficult to manage because it crosses so many lines of responsibility. Types of Inventories:Raw materials: - An inventory of raw material allows separation of production scheduling from arrival of basic inputs to the production process. Factors affecting the amount of the raw materials include proximity to the supplier, relationship with the supplier, predictability of the production process, lead time required to place an order & transportability & perishability of materials. Work-in-progress:An inventory of partially completed units allows the separation of different phases of the production process. The amount of work-in-progress inventory is a in part a function of the type of product, the measurement period, & the nature of the production process. Finished Goods:An inventory of finished goods allows separation of production from selling. With a stock of finished merchandise on hand, a firm can fill orders as they are received rather than depend upon the completion of production to satisfy customer demands. Cash & Marketable Securities:Cash & Marketable securities can be thought of as an inventory of liquidity that allows separation of collection from disbursement. Without this liquidity inventory, payment of bills would be tied to collection of accounts, in some cases, with payment delayed until accounts receivable are collected. Motives for Holding Inventory:Transaction Motive:Transaction motive for holding inventory is to satisfy the expected level of activities of the firm. Precautionary motive:It is to provide a cushion in case the actual level of activity is different than anticipated. Firms may hold inventories for fear of stock-outs & losing its goodwill.

Speculative motive:The speculative motive for holding inventory might entice a firm to purchase a larger quantity of materials than normal in anticipation of making abnormal profits. Advance purchase of raw materials in inflationary times is one form of speculative behavior. A second reason for speculative inventory purchase may involve an anticipated change in a product. Contractual Requirements:It may be necessary to carry a certain level of inventory to meet a contractual agreement. Some manufacturers require dealers to maintain a specified level of inventory in order to be the sole representative in a particular territory. Cost of Holding Inventories:Purchase or Acquisition Cost:Goods may be directly purchased (raw materials for manufacturer & finished goods for retailers) or manufactured in-house. When it is purchased, the purchase price net of quantity discounts plus freight, insurance, loading, unloading etc shall be the acquisition cost. For goods manufactured in-house the unit cost of production inclusive of factory overheads shall constitute the acquisition cost. Ordering or Set-up Costs:Every time an order is placed for stock replenishment, certain costs are involved. The ordering cost may vary, dependent upon the type of item. Cost of ordering includes:Paper work cost, typing & dispatching an order Follow up costs- the follow-up required to ensure timely supplies include the travel cost for purchase, follow-up, telephone, telex, & postal bills. Cost involved in receiving the order inspection, checking & handling to the stores Any set up cost of machines if charged by the supplier either directly indicated in quotations or assessed through quotations for various quantities. The salaries & wages to the purchase department are relevant for consideration if the purchasing function is carried out at the same level with the existing staff. Ordering or set-up costs do not vary with the size of the order but with the number of orders or set-ups. Carrying Costs:Carrying cost constitute all cost of holding items in inventory for a given period of time. They are either expressed in rupees per unit per period or as a percentage of the inventory value per period. The cost has two parts:-

a) Cost of physical carrying of inventories like storage cost, insurance rates & taxes, handling, shrinkage, deterioration & obsolescence. b) Financial cost of funds engaged in inventories which is generally the opportunity cost of alternative investments. Stock-Out Cost:These costs are incurred whenever a business is unable to fill orders because the demand for an item is greater than the amount currently available in inventory. It includes such cost as back order cost, lost profit due to loss of present sales, & also cost of losing goodwill of the firm which affects future sales & profit. Other characteristics of Inventory Situations:Lead times: - obtaining inventory usually requires a time lag from the initiation of the process until the inventory starts to arrive. This lead time may be a few minutes or it may be many months & depends in part on whether the firm is producing goods for its inventory or is ordering these goods from another firm. Sources & Levels of Risk:Uncertainties play a significant role in inventory situations. Uncertainties usually involve lead times & demand levels, but situations where other variables are uncertain also occur. Wherever there are substantial uncertainties & where the costs of stock-out are important, strategies for addressing risk must be formulated. Static v/s Dynamic Problems: - Inventory problems are usually divided into two types based on the characteristics of the goods involved. In static inventory problems, the goods have a one-period life; there can be no carryover of goods from one period to the next. Inventory situations where decision involves the number of newspaper to print, the number of greeting cards to purchase, or the number of calendars to produce are static inventory problems. In dynamic inventory problems, the goods have value beyond the initial period; they do not lose their value completely over time. Inventory situations such as that faced by a service station in determining how much gasoline to purchase are dynamic inventory problems. Replenishment Rate:Once goods start to be received from a vendor or from the firms own production processes, there are differences among goods in the rate at which they are received. Small orders from vendors are likely to be received all at once. Example:-M/s ABC has placed in order for 10 cases of paper towels. & M/S XYZ Ltd has ordered 10 truckloads of paper towels.

Determining the type of Control required:Ultimate goal of an inventory control programme is to provide maximum customer service at a minimum cost. Some the methods used are:Explosion process:In many organizations, production requirements are based directly on the sales forecast. For each of its products, the company prepares a bill of materials- a list of the parts (& their quantities) needed for various products. To determine overall material requirements, each sub-assembly or part on bill of materials is extended or multiplied by the planned number of finished products. The explosion process is greatly simplified if electronics data-processing equipment is available. After the production level is set, cards are punched to initiate a manufacturing c=order for each product. It is possible to obtain the amount of each material or item needed to fill the overall requirement. Each cards representing each part or sub-assembly necessary to complete the order. Past-usage Methods:The other method used for determining production requirements relies on past usage, rather than on the sales forecast. If a certain item was used at a rate of 100 units per month during the past year it is likely to be used at the same rate in future. If the production rate is expected to be higher or lower than in the past period, the past usage figure may be altered accordingly by an application of a factor that represents the anticipated percentage of change. In general, the past-usage method is not as accurate as the explosion method. Changes in product mix or product design may adversely affect the results of the past usage method. In addition, it does not sufficient account of shifting production levels. Value-volume Analysis:Many firms use the value-volume analysis to determine which inventory accounts should be controlled by the explosion method & which should be controlled by the past-usage method. In a value-volume analysis the number of each item used in the past year is multiplied by its unit to find the annual activity for the item. In most cases, the volume analysis reveals that a relatively small percentage (10% to 20%) of the items in inventory account for a large percentage (70% to 80%) of annual activity. Mostly the cost of the inventory is concentrated in a few high activity inventory accounts. It is an important concept, because those items with a high level of activity must be more closely controlled than the ones with relatively low activity levels.

ABC Approach:One of the most widely recognized concepts of inventory management is referred to as ABC inventory control. The maintaining appropriate control according to the potential savings associated with a proper level of such control. Ex:- An item having an inventory cost of Rs 10,000 has a much greater potential for saving of expenses related to maintaining inventories than an item with a cost of Rs 20/-. The ABC approach is a means of categorizing inventory items into 3 classes. A, B, C according to the potential amount to be controlled. When items have been classified, appropriate control techniques are developed for each class of inventory. A items justify the use of price control techniques, where C items should be controlled by mean of general control techniques. The primary criteria for classifying items into A & B categories are the annual rupees usage. This is accomplished by multiplying the annual unit usage of each inventories item by its unit cost & then listing all items in descending order according to annual rupee usage. This listing should also include C column to show the cumulative annual rupees usage by line item. A typical distribution in a manufacturing operation shows that the top 15% of the line items, in terms of annual rupee usage, represent 80% of the total annual rupees usage. These items are normally classified as A items. The next 15% of the line items, in terms of annual rupees usage reflect an additional 15% of the annual rupees usages & are designated as B items. The C items represent the remaining 70% of the items in inventory & account for only 5% of the total rupee usage. In some case the ABC classification will be developed independently for different types of inventory such as finished goods, raw materials & service parts. Besides the ABC classification, there are number of other classification emphasizing on particular aspects. These are:HML Classification: - The HML (high, Medium, Low) classification is similar to ABC classification, but in this case instead of the assumption value of item, the unit value of the item is considered. The cut off points will depend on the individual units. For example, kerosene would be a low value item for a jeweler & a high-value item for a small shopkeeper. The focus here is directed to control the purchase prices. XYZ Classification: - While the ABC classification has the value of consumption at the basic, the XYZ classification has the value of inventory stored as the basis of differentiation. This study is usually undertaken once a year during the annual stock checking exercises. X items are those whose inventory values are high while Z items are those whose values are low. This classification therefore helps in identifying the items which are being extensively stocked. If the management is not alert, one can expect C items to be in the X category. Therefore, the XYZ & ABC classifications are used in conjunctions & controls can be affected on the items according to whether they are AX, BY, CZ & so on.

VED Classification: - The VED (vital, essential, desirable) classification is applicable largely to spare parts. Stocking of spare parts is based on strategies different from those of raw materials because their consumption pattern is different. While consumption of raw materials depends directly on the market demand on production, the demand for spare parts depends on the performance of the plant & machinery. Statistically, demand for spares follows the Poisson distribution & therefore, spares are classified as vital, essential & desirable. This implies that vital class of spares has to be stocked adequately & so on. Also ABC & VED classifications can be combined to advantage. A combination of XYZ & VED methods can give an idea of what are the items that can be disposed off to train the inventory. FSN Classification:Movement analysis forms the basis for FSN (fast moving, slow moving & nonmoving) classification & the items are classified according to their assumption pattern. If these is a rapid change in technology, this classification will have to be updated more often. FSN analysis is specially useful to combat obsolete items. SDF & GOLF Classification:It should not be overlooked that inventory levels are also dependent on the source. A scare item with a long lead time will have a higher safety stock for the same consumption level. The SDF (scarce, difficult, easy to obtain) classification & the GOLF (Government, Ordinary, Local Foreign sources) classification are systems where classification is done on the basis of general availability & the source of suppliers. SOS Classification:Raw materials, specially agricultural inputs are generally classified by the SOS (seasonal, off-seasonal) system since the prices during the season would generally be lower.

Valuation of Inventories:The fundamental basis of major valuation methods is the accounting flow of inventories, not their physical flow. Operationally, this means that when a piece of material is charged to production or taken to inventory it need not necessarily be at a cost at which it is acquired but at a cost determined by a particular accounting mode. This has the advantage of standardizing the costing system & the accounting records, though it is always desirable to have a system where the difference between the cost flow & physical flow is minimized. Methods of valuation are:First-in-First out (FIFO):This is the most widely used method of valuation. Under this method, it is assumed that materials are issued to production (or cost of goods sold in case of trade) in order of their receipt in store. This implies that inventory cost will be computed on the assumption that goods sold or materials consumed are

those which have been on store for the longest period & hence, those remaining in the stock shall represent the latest purchase or production. The latter means that the period-end inventory will be closer to market value.