INVENTORY MANAGEMENT AND CONTROL

INTRODUCTION
The

need for inventory. It also provides a cushion for future price fluctuations. The purpose of inventory management is to ensure availability of materials in sufficient quantity as and when required and also to minimise investment in inventories.

MEANING AND NATURE OF INVENTORY

The dictionary meaning of inventory is stock of goods, or a list of goods. The work Inventory is understood differently by various authors, in accounting language it may mean stock of finished goods only. In a manufacturing concerns, it may include raw materials, work in process and stores, etc. Raw Material: The quantity of raw materials required will be determined by the rate of consumption and the time required for replenishing the supplies. The factors like the availability of raw materials and government regulations, etc. too affect the stock of raw materials.

a.

b.

Work-in-Progress: The work-in-progress is that stage of stocks which are in between raw materials and finished goods. The greater the time taken in manufacturing, the more will be the amount of work in progress. Consumables: These materials do not directly enter production but they act as catalyst, etc. There can be instances where these materials may account for much value than the raw materials. The fuel oil may form a substantial part of cost. Finished Goods: These are the goods which are ready for the consumers. The stock of finished goods provides a buffer between production and market. The purpose of maintaining inventory is to ensure proper supply of goods to consumers. In some concerns the production is undertaken on order basis, in these concerns there will not be a need for finished goods. The need for finished goods inventory will be more when production is undertaken in general without waiting for specific orders.

c.

d.

e.

Spares: Spares also form a part of inventory. Some industries like transport will require more spares than the other concerns. The costly spare parts like engines, maintenance spares etc. are not discarded after use, rather they are kept in ready position for further use. All decision about spares are based on the financial cost of inventory on such spares and the costs that may arise due to their nonavailability.

PURPOSE / BENEFITS OF HOLDING INVENTORIES

i. ii.

iii.

Although holding inventories involves blocking of a firms funds and the cost of storage and handling, every business enterprise has to maintain a certain level of inventories to facilitate uninterrupted production and smooth running of business. There are three main purpose or motives of holding inventories. The Transaction Motive which facilitates continuous production and timely execution of sales orders. The Precaution Motive which necessitates the holding of inventories for meeting the unpredictable changes in demand and supplies of materials. The Speculative Motive which induces to keep inventories for taking advantage of price fluctuations, saving in reordering cost and quantity discount, etc.

RISK AND COSTS OF HOLDING INVENTORIES

The various costs and risks involved in holding inventories are as below: Capital Costs: Maintaining of inventories results in blocking of the firms financial resources. The funds may be arranged from own resources or from outsides. In the former case, there is an opportunity cost of investment while in the later case, the firm has to pay interest to the outsides.

i.

ii.

Storage and Handling costs: The storage costs include the rental of the godown, insurance charges, etc. Risk of Price Decline: This may be due to increased market supplies, competition or general depression in the market.
Risk of Obsolescence: The inventories may become obsolete due to improved technology, changes in requirements, change in customers tastes, etc. Risk Deterioration in Quality: The quality of the materials may also deteriorate while the inventories are kept in store.

iii.

iv.

v.

INVENTORY MANAGEMENT

It is necessary for every management to give proper attention to inventory management. A proper planning of purchasing, handling, storing and accounting should form a part of inventory management. An efficient system of inventory management will determine (a) what to purchase (b) how much to purchase (c) from where to purchase (d) where to store, etc. There are conflicting interests of different departmental heads over the issue of inventory. The finance manger, production manager. The purpose of inventory management is to keep the stocks in such a way that neither there is over-stocking nor under-stocking. The investments in inventory should be kept in reasonable limits.

OBJECTS OF INVENTORY MANAGEMENT

The

main objectives of inventory management are operational and financial. The operational objective mean that the materials and spares should be available in sufficient quantity so that work is not disrupted for want of inventory. The financial objective means that investments in inventories should not remain idle and minimum working capital should be locked in it.

1.

2. 3. 4. 5. 6. 7.

8.
9.

To ensure continuous supply of materials, spares and finished goods so that production should not suffer at any time and the customers demand should also be met. To avoid both over-stocking and under-stocking of inventory. To maintain investments in inventories at the optimum level as required by the operational and sales activities. To keep material cost under control so that they contribute in reducing cost of production and overall costs. To eliminate duplication in ordering or replenishing stocks. This is possible with the help of centralising purchases. To minimise losses through deterioration, pilferage, wastages and damages. To ensure perpetual inventory control so that materials shown in stock ledgers should be actually laying in the stores. To ensure right quality goods at reasonable prices. To facilitate furnishing of date for short-term and long-term planning and control of inventory.

TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT AND CONTROL

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

The following are the important tools and technique of inventory management and control. Determination of stock levels. Determination of safety stocks. Selecting a proper system of ordering for inventory. Determination of economic order quantity. A.B.C. Analysis. V.E.D. Analysis. Inventory turnover ratios. Aging schedule of inventories Classification and codification of inventories Preparation of inventory reports.

1.

Determination of stock levels: Carrying of too much and too little of inventories is detrimental to the firm. If the inventory level is too little, the firm will face frequent stockouts involving heavy ordering cost and if the inventory level is too high it will be unnecessary tie-up of capital. Therefore, an affective inventory management requires that a firm should maintain an optimum level of inventory where inventory costs are the minimum and at the same time there is no stock-out which may result in lost of sale or stoppage of production. Various stock levels are discussed as such.
Minimum Level: This represents the quality which must be maintained in hand at all times. If stocks are less than the minimum level then the work will stop due to shortage of materials. Following factors are taken into account while fixing minimum stock level:

a.

Lead Time: The time taken in processing the order and then executing it is known as lead time. It is essential to maintain some inventory during the period. Rate of Consumption: It is the average consumption of material in the factory. Nature of Material: If a material is required only against special orders of the customer than minimum stock will not be required for such materials. Minimum stock level can be calculated with the help of following formula: Minimum stock level = Re-ordering level (Normal consumption) Normal Re-order period)
Re-ordering Level: Re-ordering level or ordering level is fixed between minimum level and maximum level. Reordering level is fixed with the following formula: Re-ordering Level = Maximum Consumption Maximum Re-order period.

b.

c.

Maximum Level: It is the quantity of material beyond which a firm should not exceed its stocks. If the quantity exceeds maximum level limit then it will be overstocking. A firm should avoid overstocking because it will result in high material costs. Overstocking will mean blocking of more working capital, more space for storing the materials, more wastage of materials and more chances of losses from obsolescene. Maximum Stock Level = Re-ordering Level + Reordering Quantity (Minimum Consumption Minimum Re-ordering period).

d.

Danger Level: It is the level beyond which materials should not fall in any case. If danger level arises then immediate steps should be taken to replenish the stocks even if more cost is incurred in arranging the materials. If materials are not arranged immediately there is a possibility of stoppage of work. Danger level is determined with the following formula:
Danger Level = Average Consumption Maximum re-order period for emergency purchases.

e.

Average Stocks Level: The average stock level is calculated as such: Average Stock Level = Minimum Stock Level + of reorder quantity.

2. Determination of Safety Stocks

Safety stock is a buffer to meet some unanticipated increase in usage. The usage of inventory cannot be perfectly forecasted. It fluctuates over a period of time. The demand for materials may fluctuate and delivery of inventory may also be delayed and in such a situation the firm can face a problem of stock-out. The stock-out can prove costly by affecting the smooth working of the concern. In order to protect against the stock out arising out of usage fluctuations, firms usually maintain some margin of safety or safety stocks. The basic problem is to determine the level of quantity of safety stocks. Two costs are involved in the determination of this stock i.e. opportunity cost of stock-outs and the carrying costs. The stock outs of raw materials cause production distruption resulting into higher cost of production. Similarly, the stock-out of finished goods result into the failure of the firm in competition as the firm cannot provide customer service. If a firm maintain low level of safety frequent stock-outs will occur resulting into the large opportunity costs. On the other hand, the larger quantity of safety stocks involve higher carrying costs.

3. Ordering systems of Inventory

The basic problem of inventory is to decide the re-order point. This point indicates when an order should be placed. The re-order point is determined with the help of these things: (a) average consumption rate, (b) duration of lead time, (c) economic order quantity, when the inventory is depleted to lead time consumption, the order should be placed. There are three prevalent system of ordering and a concern can choose any one of these: Fixed order quantity system generally known as economic order quantity (EOQ) system; Fixed period order system or periodic re-ordering system or periodic review system; Single order and schedule part delivery system.

a.

b.
c.

4. Economic Order Quantity (EOG)

Economic order quantity is the size of the lot to be purchased which is economically viable. This is the quantity of materials which can be purchased at minimum costs. Generally, economic order quantity is the point at which inventory carrying costs are equal to order costs. In determining economic order quantity it is assumed that cost of managing inventory is made up solely of two parts i.e., ordering costs and carrying costs. Ordering costs: These are the costs which are associated with the purchasing or ordering of materials. These costs include:

1.

2. 3.

4.

Costs of staff posted for ordering of goods. A purchase order is processed and then placed with suppliers. The labour spent on this process is included in ordering costs. Expenses incurred on transportation of goods purchased. Inspection costs of incoming materials. Cost of stationery, typing, postage, telephone charges, etc.

These costs are also known as buying costs and will arise only when some purchases are made. When materials are manufactured in the concern then these costs will be known as setup costs. These costs will include costs of setting up machinery for manufacturing materials, time taken up in setting, cost of tools, etc. The ordering costs are totalled up for the year and then divided by the number of orders placed each year.

B.

Carrying Costs: These are the costs of holding the inventories. These costs will not be incurred if inventories are not carried. These costs include:
The cost of capital invested in inventories. An interest will be paid on the amount of capital lockedup in inventories. Cost of storage which could have been used for other purpose. The lost of materials due to deterioration and obsolescence. The materials may deteriorate with passage of time. The loss of absolescence arises when the materials in stock are not usable because of change in process or product. Insurance cost. Cost of spoilage in handling of materials.

1.

2. 3.

4. 5.

The longer the materials kept in stocks, the costlier it becomes by 20 percent every year. The ordering and carrying costs have a reverse relationship. The ordering cost goes up with the increase in number of orders placed. On with the increase in number of units, purchased and stored. It can be shown in the diagram shown.
The ordering and carrying costs of materials being high, an effort should be made to minimise these costs. The quantity to be ordered should be large so that economy may be made in transport costs and discounts may also be earned. On the other hand, storing facilities, capital to be locked up, insurance costs should also be taken into account.


1. 2. 3. 4.

Assumptions of EOQ: While calculating EOQ the following assumptions are made. The supply of goods is satisfactory. The goods can be purchased whenever these are needed. The quantity to be purchased by the concern is certain. The prices of goods are stable. It results in stabilising carrying costs. When above-mentioned conditions are satisfied, economic order quantity can be calculated with the help of the following formula:
EOQ 2AS I

Where

A = Annual consumption in rupees. S = Cost of placing an order. I = Inventory carrying costs of one unit.

EOQ and Quality Discount: Customer is offered some discount for bulk purchase or if the size of a single order is large. Thus, the price per unit of an item may decrease for buying larger quantities. The quantity discount affect inventory cost in three ways:
As the price per unit is reduced, the total price for the lot is reduced. The lot size is increased, the number of offers is reduced and as a result the total ordering cost is reduced. The average inventory holding increase and as a result the storage cost will increase.

i. ii.

iii.

 Thus,

to decide whether to avail the quantity discount or not, first of all EOQ is determined and then its total cost without quantity discount and with quantity discount is determined. In case, the total cost is less due to quantity discount the offer is accepted, other wise it is rejected. The following example illustrates the point.

i. ii.

Illustration 4. Economic Enterprises require 90,000 units of a certain item annually. The cost per unit is Rs.3, the cost per purchase order Rs. 300 and the inventory carrying cost Rs. 6 per unit per year. What is the Economics Order Quantity? What Should the firm do if the suppliers offer discount as below:
Order Discount

4500-5999
6000 and above

2%
3%

Solution. (i)

EOQ

2AS I

Where, A = Annual Usage in units = 90,000 S = Cost of placing an order = Rs. 300 I = Inventory carrying costs of one unit. = Rs. 6
EOQ

2 90 ,000 300 90 ,000 3,000 units 6

As the supplier offers discount on order quantity, we shall calculate the total cost of 3000 units, 4500 units and 6000 units as below:

Order Size

Average Inventory

Annual requirements (units)

No. of orders (3 divided 1)

Price per unit

Cost of purchase (3) X (5) Rs.

Carrying cost at Rs. 6 per unit (Rs.)

Total ordering cost at Rs. 300 per order (Rs.)

Total Cost (6 + 7 + 8) (Rs.)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

3,000 45,00 6,000

1,500 2,250 3,000

90,000 90,000 90,000

30 20 15

3.00 2.94 2.91

2,70,000 2,64,600 2,61,900

9,000 13,500 18,000

9,000 6,000 4,500

2,88,000 2,48,100 2,48,400

Since the total cost at order of 4500 units is the lowest, the firm should place order for 4500 units and obtain 2% discount.

5. A-B.C Analysis

The materials are divided into a number of categories for adopting a selective approach for material control. Under A-B-C analysis, the materials are divided into three categories viz, A, B and C. Past experience has shown that almost 10 percent of the items contribute to 70 percent of value of consumption and this category is called A Category. About 20 percent of the items contribute about 20 percent of value of consumption and this is known as category B materials. Category C covers about 70 percent of items of materials which contribute only 10 percent of value of consumption. There may be some variation in different organisations and an adjustment can be made in these percentages.

The information is following diagram: Class

shown

in

the

A B C

No. of Items % 10 20 70

Value of Items % 70 20 10

A-B-C analysis helps to concentrate more efforts on category A since greatest monetary advantage will come by controlling these items. An intention should be paid in estimating requirements, purchasing, maintaining safety stocks and properly storing of A category materials. These items are kept under a constant review so that a substantial material cost may be controlled. The control C items may be relaxed and these stocks may be purchased for the year. A little more attention should be given towards B category items and their purchase should be undertaken at quarterly or half-yearly intervals.
The following example will explain the advantage of A-B-C analysis:

Suppose three items P,Q,R have been used their consumption is Rs. 2,40,00, Rs. 24,000 and Rs. 2,400 respectively. Let us presume that A-B-C classification is not done and annual orders are 12 in number. Each item will be ordered 4 times and average inventory will be:
Item
P Q R Total

Annual No. of orders Average working consumption inventory (Rs.)

2,40,000 24,000 2,400 2,66,400 4 4 4 12 60,000 6,000 600 66,600

Suppose A-B-C analysis is followed and the number of orders will be according to the importance of the items. If the number of orders are 8, 3 and 1, for items P, Q and R respectively then the average inventory will be as follows:
Item Annual consumption No. of orders Average working inventory (Rs.)

P Q R
Total

2,40,000 24,000 2,400

2,66,400

4 4 4
12

30,000 8,000 2,400

40,400

 When

A-B-C analysis was not followed the average inventory was Rs. 66,600 and after following A-B-C analysis inventory came down to Rs. 40,400. Average value of inventory is nearly 1 times in the earlier situation, than as compared to the second situation.

6. VED Analysis

The VED analysis is used generally for spare parts. Spare parts are classified as Vital (V), Essential (E) and Desirable (D). The vital spares are a must for running the concern smoothly and these must be stored adequately. The non-availability of vital spare will cause havoc in the concern. The E type of spares are also necessary but their stocks may be kept at low figures. The stocking of D type of spares may be avoided at times. If the lead time of these spares is less, then stocking of these spares can be avoided. The classification of spares under three categories is an important decision. The classification of spares should be left to the technical staff because they know the need urgency and use of these spares.

7. Inventory Turnover Ratios

Inventory turnover ratios are calculated to indicate whether inventories have been used efficiently or not. The purpose is to ensure the blocking of only required minimum funds in inventory. The inventory turnover ratio also known as stock velocity is normally calculated as sales/average inventory or cost of goods sold/average inventory cost. Inventory conversion period may also be calculated to find the average time taken for clearing the stocks. Symbolically,

Cost of Good Sold Inventory Turnover Ratio Average Inventory at Cost Net Sales (Average) Inventory

8. Aging Schedule of Inventories

Classification

of inventories according to the period (age) of their holdings also helps in identifying show moving inventories thereby helping in effective control and management of inventories. The following table shown aging of inventories of a firm.

Item Name / Code

Age Classification Date of Acquisition

Amount (Rs.)

% age to Total

001

0-15 days

June 25, 2000

30,000

15

002

16-13 days

June 10, 2000

60,000

30

003

31-45 days

May 20, 2000

50,000

25

004

46-60 days

May 5, 2000

40,000

20

005

61 and above

April 12, 2000

20,000

10

2,00,000

100

9. Classification and Codification of Inventories

The inventories of a manufacturing concern may consist of raw materials, work in process, finished goods, spares, consumable stocks, etc. All these categories may have their sub-divisions. The raw materials used may be of 3-4 types, finished goods may also be of more than one type, spares may be of a number of types and so on. For a proper recording and control of inventory, a proper classification of various types of items is essential. The inventories should first be classified and then code numbers should be assigned for their identification.

The identification of short names are useful for inventory management not only for large concerns but also for small concerns. Lack of proper classification may also lead to reduction in production. Generally, material are classified according to their nature such as construction materials, consumable stocks, spares, lubricants, etc. The coding class of materials is assigned two digits and then two or three digits are assigned to the category of materials in that class. The third distinction is needed for the quality of goods and decimals are used to note this factor.

10. Inventory Reports

From effective control, the management should be kept informed with the latest stock position of different items. This is usually done by preparing periodical inventory reports. These reports should contain all information necessary for managerial action. On the basis of these reports management takes corrective action wherever necessary. The more frequently these reports are prepared the less will be the chances of lapse in the administration of inventories.

LEAD TIME

Lead time is the period that elapses between the recognition of a need and its fulfilment. There is a direct relationship between lead time and inventories. The level of inventory of an item depends upon the length of its lead time. Suppose, lead time is one month. Any action taken now will have an effect only one month later. So inventory for the current month must be in hand. During lead time there will be no delivery of materials and consuming departments will have to be served from the inventories held. Lead time has two components: Lead time for company (administrative lead time and the lead time for the producer know as delivery lead time from the placing of an order until the delivery of the ordered material.

Administrative lead time is in the hands of those who are dealing with material procurement. Delivery lead time has to be negotiated at the time of preparing purchase contract. It is often seen that bulk of the lead times is taken up by administrative lead time. This is the time over which company has control but still too much time is taken up in receiving and inspecting of goods. Stock control or purchase section of the organisation should maintain lead time schedules for all groups of materials

PREPETUAL INVENTOYR SYSTEM

The stock taking may either be done anually or continuously. In the latter method, the stock taking continues throughout the year. A schedule is prepared for stock taking of various bins (store rooms). One bin is selected at random and the goods are checked as per shown in the bin card. Then some other bin is selected at random and so on. The institute of cost and management Accountants, London define perpetual inventory system as a system of records maintained by the controlling departments, which reflects the physical movements of stocks and their current balance.

Procedure of Perpetual Inventory System

1.

2. 3.

4. 5.

The upto date position in stores ledger and bin cards should be made to know the current balance of stores. The programme is planned in such a way that in a year every item is checked 3-4 times. The stores which have not been inspected as yet should not be mixed with other stores because no entries are made for such items. There is a surprise checking every time. The physical stock available in the store after counting, weighing etc. is recorded on sheets provided for this purpose.

Advantages of Perpetual Inventory System

1.

Quick Calculation of Closing Stock: Under perpetual inventory system, the stock is checked regularly throughout the year. It helps in preparing Profit and Loss A/c and Balance Sheet without loss of time.

2.

Helpful in Formulating Purchase Polices: This system of stock taking is also helpful formulating purchase policies. The store-keeper is in know of the requirements of various departments. He can also tell the time, quantity and quality of materials needed by production departments. Such information is very useful in preparing purchase policies.

Check on Stores Personnel: The system of continuous stock taking acts a check on personnel incharge of stores. They are not told of checking programme in advance. This system also prevents pilferage of stores.
Helpful in Production Planning: Production planning can be done according to the availability of materials in stores because management is constantly kept informed of stores position. Investments Under Check: There are minimum and maximum stock levels within which stock limits are maintained. This system helps in avoiding under stocking and over stocking of stores and investments in inventory are kept under check.

 Errors

and Shortages Easily Detected: The regular checking of stocks helps in detecting errors and shortages in stores. There are may be a wrong entry in either stores ledger or in bin card. Such mistakes will be detected while stocks are checked. Efficiency of Organisation: The regular supply at proper time will enhance the efficiency of the whole organisation.

Increasing

JUST IN TIME (JIT) INVENTORY CONTROL SYSTEM

The term JIT refers to a management tool that helps to produce only the needed quantities at the needed time. According to the official terminology of C.I.M.A., JIT is a technique for the organisation of workflows, to allow rapid, high quality, flexible production whilst minimizing manufacturing work and stock level. There are broadly two aspects of JIT (i) just in time production, and (ii) just in time purchasing. Just in time inventory control system involves the purchase of materials in such a way that delivery of purchased material is assured just before their use or demand. The philospohy of JIT control system implies that the firm should maintain a minimum (zero level) of inventory and rely on suppliers to provide materials just in time to meet the requirements. The traditional inventory control system, on the other hand, requires maintaining a healthy level of safety stock to provide protection against uncertainties of production and supplies.

Objective of JIt
1. 2. 3. 4. 5. 6.

The ultimate goal of JIT is to reduce wastage and enhance productivity. The important objectives of JIT include: Minimum / zero inventory and its associated costs. Elimination of non-value added activities and all wastes. Minimum batch / lot size. Zero breakdowns and continuous flow of production. Ensure timely delivery schedules both inside and outside the firm. Manufacturing the right product at right time.

Features of JIT
a.

b.

c. d. e.

It emphasises that firms following traditions inventory control system overestimate ordering cost and underestimate carrying costs associated with holding of inventories. It advocates maintaining good relations with suppliers so as to enable purchase of right quantity of material at right time. It involves frequent production / order runs because of smaller batch/lot sizes. It requires reduction in set up time as well as processing time. Purchase of produce in response to need rather than as per the plans and forecasts.

Advantages of JIT Inventory Control System

i. ii. iii.

iv.

v.

The right quantities of materials are purchased or produced at the right time. Investment in inventory is reduces. Wastes are eliminated. Carrying or holding cost of inventory is also reduced because of reduced inventory. Reduction in costs of quality such as inspection, costs of delayed delivery, early delivery, processing documents etc. resulting into overall reduction in cost.