INVENTORY MANAGEMENT

The task of inventory planning can be highly complex in manufacturing

environments. At the same time, it rests on fundamental principles. The
system used for inventory must tie into the operations of the firm. Inventory
planning and management must be responsive to the needs of the firm. The
firm should design systems, including reports that allow it to make proper
business decisions.

Purpose of Inventory Management

INVENTORY MANAGEMENT must tie together the following objectives, to
ensure that there is continuity between functions:
 Company’s Strategic Goals
 Sales Forecasting
 Sales & Operations Planning
 Production & Materials Requirement Planning.

Inventory Management must be designed to meet the dictates of market

place and support the company’s Strategic Plan. The many changes in the
market demand, new opportunities due to worldwide marketing, global
sourcing of materials and new manufacturing technology means many
companies need to change their Inventory Management approach and
change the process for Inventory Control.

Inventory Management system provides information to efficiently manage

the flow of materials, effectively utilize people and equipment, coordinate
internal activities and communicate with customers. Inventory Management
does not make decisions or manage operations, they provide the information
to managers who make more accurate and timely decisions to manage their
operations.

INVENTORY is defined as the blocked Working Capital of an organization in

the form of materials. As this is the blocked Working Capital of organization,
ideally it should be zero. But we are maintaining Inventory. This Inventory is
maintained to take care of fluctuations in demand and lead time. In some
cases it is maintained to take care of increasing price tendency of
commodities or rebate in bulk buying.

Traditional Supply Chain solutions such as Materials Requirement Planning,

Inventory Control, typically focuses on implementing more rapid and efficient
systems to reduce the cost of communicating information between and
across the Inventory links in the SCM.COM focuses in optimizing the total
investment of materials cost and workload for every Inventory item
throughout the chain from procurement of raw materials to finished goods
Inventory. Optimization means providing a balance of supply to meet the
demand at a minimum total cost, Inventory level and workload to meet
customers service goal for each items in the link of Inventory Chain .

It is strategic in the sense that top management sets goals. These include
deployment strategies (Push versus Pull), control policies, the determination
of the optimal levels of order quantities and reorder points and setting safety
stock levels. These levels are critical, since they are primary determinants of
customer service levels.

Keeping in view all concerns, the latest concept of Vendor Managed

Inventory is used to optimize the Inventory. We are entering into Vendor
Managed Inventory, Annual Rate Contracts with manufacturers or their
authorized dealers, who maintain Inventory on our behalf and supply the
items as and when required.

VMI reduces stock-outs and optimize inventory in supply chain. Some

features of VMI include:
 Shortening of Supply Chain
 Centralized Forecasting
 Frequent communication of inventory, stock-outs and planned promotions
Trucks are filled in a prioritized order, e.g. items that are expected to
stock out have top priority then items that are furthest below targeted
stock levels then advance shipments of promotional items

Despite the many changes that companies go through, the basic principles of
Inventory Management and Inventory Control remain the same. Some of the
new approaches and techniques are wrapped in new terminology, but the
underlying principles for accomplishing good Inventory Management and
Inventory activities have not changed.

The Inventory Management system and the Inventory Control Process

provides information to efficiently manage the flow of materials, effectively
utilize people and equipment, coordinate internal activities, and communicate
with customers. Inventory Management and the activities of Inventory
Control do not make decisions or manage operations; they provide the
information to Managers who make more accurate and timely decisions to
manage their operations.

The basic building blocks for the Inventory Management system and
Inventory Control activities are:
 Sales Forecasting or Demand Management
 Sales and Operations Planning
 Production Planning
 Material Requirements Planning
 Inventory Reduction

The emphases on each area will vary depending on the company and how it
operates, and what requirements are placed on it due to market demands.
Each of the areas above will need to be addressed in some form or another
to have a successful program of Inventory Management and Inventory
Control.

Inventory is usually a distributor’s largest asset. But many distributors aren’t

satisfied with the contribution inventory makes towards the overall success of
their business:
 The wrong quantities of the wrong items are often found on warehouse
shelves. Even though there maybe a lot of surplus inventory and dead
stock in their warehouse(s), backorders and customer lost sales are
common. The material a distributor has committed to stock isn’t available
when customers request it.
 Computer inventory records are not accurate. Inventory balance
information in the distributor’s expensive computer system does not
accurately reflect what is available for sale in the warehouse.
 The return on investment is not satisfactory. The company’s profits,
considering its substantial investment in inventory, is far less than what
could be earned if the money were invested elsewhere.

What is "Inventory Management"

Inventory management is the active control program which allows the
management of sales, purchases and payments.

Inventory management software helps create invoices, purchase orders,

receiving lists, payment receipts and can print bar coded labels. An
inventory management software system configured to your warehouse,
retail or product line will help to create revenue for your company. The
Inventory Management will control operating costs and provide better
understanding. We are your source for inventory management information,
inventory management software and tools.

A complete Inventory Management Control system contains the following

components:
 Inventory Management Definition
 Inventory Management Terms
 Inventory Management Purposes
 Definition and Objectives for Inventory Management
 Organizational Hierarchy of Inventory Management
 Inventory Management Planning
 Inventory Management Controls for Inventory
 Determining Inventory Management Stock Levels

Role of inventory management in working capital

Inventories are a component of the firm's working capital and, as such,
represent a current asset. Some characteristics are important in the broad
context of working capital management
ROLE IN WORKING CAPITAL
Inventories are a component of the firm's working capital and, as such,
represent a current asset. Some characteristics are important in the broad
context of working capital management, including:
1. Current Asset: It is assumed that inventories will be converted to cash in
the current accounting cycle, which is normally, one year. In some cases,
this is not entirely true, for example, a vintner may require that the wine be
aged in casks or bottles for many years. In spite of these and similar
problems, we will view all inventories as being convertible into cash in a
single year.

2. Level of Liquidity: Inventories are viewed as a source of near-all cash.

For most products, this description is accurate. At the same time, most firms
hold some slow-moving items that may not be sold for a long time. With
economic slowdowns or changes in the market for goods, the prospects for
sale of entire product lines may be diminished. In these cases, the liquidity
aspects of inventories become highly important to the manager of working
capital. At a minimum, the analyst must recognize that inventories are the
least liquid of current assets. For firms with highly uncertain operating
environments, the analyst must discount the liquidity value

PURPOSE OF INVENTORIES
The purpose of holding inventories is to allow the firm to separate the
processes of purchasing, manufacturing, and marketing of its primary
products. The goal is to achieve efficiencies in areas where costs are involved
and to achieve sales at competitive prices in the marketplace. Within this
broad statement of purpose, we can identify specific benefits that accrue
from holding inventories.
1. Avoiding Lost Sales: Without goods on hand, which are ready to be sold,
most firms would lose business. Some customers are willing to wait
particularly when an item must be made to order or is not widely available
from competitors. In most cases, however, a firm must be prepared to
deliver goods on demand. Shelf stock refers to items that are stored by the
firm and sold with little or no modification to customers. An automobile is an
item of shelf stock. Even though customers may specify minor variations, the
basic item leaves a factory and is sold as a standard item. The same situation
exists for many items of heavy machinery, consumer products, and light
industrial goods.
2. Gaining Quantity Discounts: In return for making bulk purchases, many
suppliers will reduce the price of supplies and component parts. The
willingness to place large orders may allow the firm to achieve discounts on
regular prices. These discounts will reduce the cost of goods sold and
increase the profits earned on a sale.
3. Reducing Order Costs: Each time a firm places an order, it incurs certain
expenses. Forms have to be completed, approvals have to be obtained, and
goods that arrive must be accepted, inspected, and counted. Later, an
invoice must be processed and payment made. Each of these costs will vary
with the number of orders placed. By placing fewer orders, the firm will pay
less to process each order.
4. Achieving Efficient Production Runs: Each time a firm sets up workers
and machines to produce an item, startup costs are incurred. These are then
absorbed as production begins. The longer the run, the smaller the costs to
begin producing the goods. As an example, suppose it costs $12,000 to move
machinery and begin an assembly line to produce electronic printers. If 1,200
printers are produced in a single three-day run, the cost of absorbing the
startup expenses is $10 per unit (12,000/1,200). If the run could be doubled
to 2,400 units, the absorption cost would drop to $5 per unit (12,000/2,400).
Frequent setups produce high startup costs; longer runs involve lower costs.

These benefits arise because inventories provide a "buffer" between

purchasing, producing, and marketing goods. Raw materials and other
inventory items can be purchased at appropriate times and in proper
amounts to take advantage of economic conditions and price incentives. The
manufacturing process can occur in sufficiently long production runs and with
pre-planned schedules to achieve efficiency and economies. The sales force
can respond to customer needs and demands based on existing finished
products. To allow each area to function effectively, inventory separates the
three functional areas and facilitates the interaction among them.

Reducing Risk of Production Shortages: Manufacturing firms frequently

produce goods with hundreds or even thousands of components. If any of
these are missing, the entire production operation can be halted, with
consequent heavy expenses. To avoid starting a production run and then
discovering the shortage of a vital raw material or other component, the firm
can maintain larger than needed inventories.

TYPES OF INVENTORY
Four kinds of inventories may be identified:
1. Raw materials Inventory: This consists of basic materials that have not
yet been committed to production in a manufacturing firm. Raw materials
that are purchased from firms to be used in the firm's production operations
range from iron ore awaiting processing into steel to electronic components
to be incorporated into stereo amplifiers. The purpose of maintaining raw
material inventory is to uncouple the production function from the purchasing
function so that delays in shipment of raw materials do not cause production
delays.
2. Stores and Spares: This category includes those products, which are
accessories to the main products produced for the purpose of sale. Examples
of stores and spares items are bolts, nuts, clamps, screws etc. These spare
parts are usually bought from outside or some times they are manufactured
in the company also.
3. Work-in-Process Inventory: This category includes those materials that
have been committed to the production process but have not been
completed. The more complex and lengthy the production process, the larger
will be the investment in work-in-process inventory. Its purpose is to
uncouple the various operations in the production process so that machine
failures and work stoppages in one operation will not affect the other
operations.
4. Finished Goods Inventory: These are completed products awaiting sale.
The purpose of finished goods inventory is to uncouple the productions and
sales functions so that it no longer is necessary to produce the goods before
a sale can occur.

Costs Associated with Inventories

The effective management of inventory involves a trade off between having
too little and too much inventory. In achieving this trade off, the Finance
Manager should realize that costs may be closely related.
The effective management of inventory involves a trade off between having
too little and too much inventory. In achieving this trade off, the Finance
Manager should realize that costs may be closely related. To examine
inventory from the cost side, five categories of costs can be identified of
which three are direct costs that are immediately connected to buying and
holding goods and the last two are indirect costs which are losses of
revenues that vary with differing inventory management decisions.
The five costs of holding inventories are:
1. Material Costs of Inventory:
These are the costs of purchasing the goods including transportation and
handling costs.
2. Ordering Costs:
Any manufacturing organization has to purchase materials. In that event, the
ordering costs refer to the costs associated with the preparation of purchase
requisition by the user department, preparation of purchase order and follow-
up measures taken by the purchase department, transportation of materials
ordered for, inspection and handling at the warehouse for storing. At times
even demurrage charges for not lifting the goods in time are included as part
of ordering costs.
3. Carrying Costs:
These are the expenses of storing goods. Once the goods have been
accepted, they become part of the firm's inventories. These costs include
insurance, rent/depreciation of warehouse, salaries of storekeeper, his
assistants and security personnel, financing cost of money locked-up in
inventories, obsolescence, spoilage and taxes.

4. Cost of funds tied up with Inventory:

Whenever a firm commits its resources to inventory, it is using funds that
otherwise might be available for other purposes. The firm has lost the use of
funds for other profit making purposes. This is its opportunity cost. Whatever
the source of funds inventory has a cost in terms of financial resources.
Excess inventory represents an unnecessary cost.
Ordering Costs of inventory:
Any manufacturing organization has to purchase materials. In that event, the
ordering costs refer to the costs associated with the preparation of purchase
requisition by the user department, preparation of purchase order and follow-
up measures taken by the purchase department, transportation of materials
ordered for, inspection and handling at the warehouse for storing. At times
even demurrage charges for not lifting the goods in time are included as part
of ordering costs. Sometimes, some of the components and/or material
required for production may have facilities for manufacture internally.
If it is found to be more economical to manufacture such items internally,
then ordering costs refer to the costs associated with the preparation of
requisition forms by the user department, set-up costs to be incurred by the
manufacturing department and transport, inspection and handling at the
warehouse of the user department. By and large, ordering costs remain more
or less constant irrespective of the size of the order although transportation
and inspection costs may vary to a certain extent depending upon order size.
But this is not going to significantly affect the behavior of ordering costs. As
ordering costs are considered invariant to the order size, the total ordering
costs can be reduced by increasing the size of the orders.
Suppose, the cost per order is $100 and the company uses 1200 units of a
material during the year. The size of the order and the total ordering costs to
be incurred by the company are given below.
Size of order (units) 100 150 200
Number of orders in a year 1 2 8
Total ordering costs @ $ 100 / order $1200 $800 $600

From the above example, it can be easily seen that a company can reduce its
total ordering costs by increasing the order size which in turn will reduce the
number of orders. However, reduction in ordering costs is usually followed by
an increase in carrying costs to be discussed now.

Carrying Inventory Costs:

These are the expenses of storing goods. Once the goods have been
accepted, they become part of the firm's inventories. These costs include
insurance, rent/depreciation of warehouse, salaries of storekeeper, his
assistants and security personnel, financing cost of money locked-up in
inventories, obsolescence, spoilage and taxes. By and large, carrying costs
are considered to be a given percentage of the value of inventory held in the
warehouse, despite some of the fixed elements of costs which comprise only
a small portion of total carrying costs. Approximately, carrying costs are
considered to be around 25 percent of the value of inventory held in storage.
The greater the investment in inventory, the greater the carrying costs. In
the example considered in the case of ordering costs, let us assume that the
price per unit of material is $40 and that on an average about half-of the
inventory will be held in storage. Then, the average values of inventory for
sizes of order 100, 150 and 200 along with carrying cost @ 25 percent of the
inventory held in storage are given below.
Size of orders (units): 100 500 200
Average value of inventory: $2000 $3000 $4000
Carrying cost @ 25 percent of above: $500 $750 $1000
From the above calculations, it can be easily seen that as the order size
increases, the carrying cost also is increasing in a directly proportionate
manner.

Cost of Running out of Goods:

These are costs associated with the inability to provide materials to the
production department and / or inability to provide finished goods to the
marketing department as the requisite inventories are not available. In other
words, the requisite items have run out of stock for want of timely
replenishment. These costs have both quantitative and qualitative
dimensions. These are, in the case of raw materials, the loss of production
due to stoppage of work, the uneconomical prices associated with `cash'
purchases and the set-up costs, which can be quantified in monetary terms
with a reasonable degree of precision.
As a consequence of this, the production department may not be able to
reach its target in providing finished goods for sale. Its cost has qualitative
dimensions as discussed below:
When marketing personnel are unable to honor their commitment to the
customers in making finished goods available for sale, the sale may be lost.
This can be quantified to a certain extent. However, the erosion of the good
customer relations and the consequent damage done to the image and good
will of the company fall into the qualitative dimension and elude
quantification.
Even if the stock-out cost cannot be fully quantified, a reasonable measure
based on the loss of sales for want of finished goods inventory can be used
with the understanding that the amount so measured cannot capture the
qualitative aspects.

INVENTORY MANAGEMENT TECHNIQUES

While the total ordering costs can be decreased by increasing the size of
order, the carrying costs increase with the increase in order size indicating
the need for a proper balancing of these two types of costs behaving in
opposite directions with changes in order size.
Again, if a company wants to avert stock-out costs it may have to maintain
larger inventories of materials and finished goods, which will result in higher
carrying costs. Here also proper balancing of the costs becomes important.
Thus, the importance of effective inventory management is directly related to
the size of the investment in inventory. To manage its inventories effectively,
a firm should use a systems approach to inventory management. A systems
approach considers in a single model all the factors that affect the inventory.
A system for effective inventory management involves three
subsystems namely
economic order quantity
Inflation point information
Reorder point
Learn about safety stock
The Reorder Point Formula

ECONOMIC ORDER QUANTITY

The economic order quantity (EOQ) refers to the optimal order size that will
result in the lowest total of order and carrying costs for an item of inventory
given its expected usage, carrying costs and ordering cost. By calculating an
economic order quantity, the firm attempts to determine the order size that
will minimize the total inventory costs.
Total inventory cost = Ordering cost + Carrying cost
Total ordering costs = Number of orders x Cost per order= $ U / Q X F
Where
U = Annual usage
Q = Quantity ordered
F = Fixed cost per order
The total carrying costs = Average level of inventory x Price per unit x
Carrying cost (percentage)

Total carrying costs

=$Q/2xPxC
= $ QPC over 2
Where
Q = Quantity ordered
P = Purchase price per unit
C = Carrying cost as %
As the lead-time (i.e., time required for procurement of material) is assumed
to be zero an order for replenishment is made when the inventory level
reduces to zero.
The level of inventory will be equal to the order quantity (Q units) to start
with. It progressively declines (though in a discrete manner) to level O by
the end of period 1. At that point an order for replenishment will be made for
Q units. In view of zero lead-time, the inventory level jumps to Q and a
similar procedure occurs in the subsequent periods. As a result of this the
average level of inventory will remain at (Q/2) units, the simple average of
the two end points Q and Zero.
From the above discussion the average level of inventory is known to be
(Q/2) units.

From the previous discussion, we know that as order quantity (Q) increases
the total ordering costs will decrease while the total carrying costs will
increase. The economic order quantity, denoted by Q*, is that value at which
the total cost of both ordering and carrying will be minimized. It should be
noted that total costs associated with inventory

T= $ UF / Q + $QPC / 2
Where the first expression of the equation represents the total ordering costs
and the second expression the total carrying costs.
The total cost curve reaches its minimum at the point of intersection between
the ordering costs curve and the carrying costs line. The value of Q
corresponding to it will be the economic order quantity Q*. We can calculate
the EOQ formula.
Behavior of costs associated with inventory for changes in order quantity. For
order quantity Q to become EOQ the total ordering costs at Q should be
equal to the total carrying costs.
Using the notation, it amounts to stating:
UF/Q + QPC / 2 (i.e.) 2UF = Q²PC or Q² = 2UF / PC units
To disguish EOQ from other order quantities, we can say:
2 UF* EOQ = Q* PC
In the above formula, when `U' is considered as the annual usage of
material, the value of Q* indicates the size of the order to be placed for the
material, which minimizes the total inventory-related costs. When `U' is
considered as the annual demand Q* denotes the size of production run.

Suppose a firm expects a total demand for its product over the planning
period to be 10,000 units, while the ordering cost per order is $100 and the
carrying cost per unit is $2. Substituting these values, EOQ = 2 x10, 000
x100 = 1000 units. 2
Thus, if the firm orders in 1000-unit lot size, it will minimize its total
inventory costs.

Inflation affects the EOQ: model in two major ways. First, while the EOQ
model can be modified to assume constant price increases, many times
major price increases occur only once or twice a year and are announced
ahead of time.

INFLATION AND EOQ

Inflation affects the EOQ model in two major ways. First, while the EOQ
model can be modified to assume constant price increases, many times
major price increases occur only once or twice a year and are announced
ahead of time. If this is the case, the EOQ model may lose its applicability
and may be replaced with anticipatory buying - that is buying in anticipation
of a price increase in order to secure the goods at a lower cost. Of course, as
with most decisions, there are trade off associated with anticipatory buying.
The costs are the added carrying costs associated with the inventory that you
would not normally be holding. The benefits of course, come from buying the
inventory at a lower price. The second way inflation affects the EOQ model is
through increased carrying costs. As inflation pushes interest rates up, the
cost of carrying inventory increases. In the EOQ model this means that C
increases, which results in a decline in the optimal economic order quantity.
Determination of Optimum Production Quantity: The EOQ Model can be
extended to production runs to determine the optimum production quantity.
The two costs involved in this process are: (i) set up cost and (ii) inventory
carrying cost. The set-up cost is of the nature of fixed cost and is to be
incurred at the time of commencement of each production run. The larger
the size of the production runs, the lower will be the set-up cost per unit.
However, the carrying cost will increase with increase in the size of the
production run. Thus, there is an inverse elationship between the set-up cost
and inventory carrying cost. The optimum production size is at that level
where the total of the set-up cost and the inventory carrying cost is the
minimum. In other words, at this level the two costs will be equal.
The formula for EOQ can also be used for determining the optimum
production quantity as given below:
E = 2U X P S
Where
E = Optimum production quantity
U = Annual (monthly) output
P = Set-up cost for each production run
S = Cost of carrying inventory per unit per annum (per month)

REORDER POINT SUBSYSTEM

In the EOQ model discussed we have made the assumption that the lead-
time for procuring material is zero. Consequently, the reorder point for
replenishment of stock occurs when the level of inventory drops down to
zero. In view of instantaneous replenishment of stock the level of inventory
jumps to the original level from zero level. In real life situations one never
encounters a zero lead-time. There is always a time lag from the date of
placing an order for material and the date on which materials are received.
As a result the reorder level is always at a level higher than zero, and if the
firm places the order when the inventory reaches the reorder point, the new
goods will arrive before the firm runs out of goods to sell. The decision on
how much stock to hold is generally referred to as the order point problem,
that is, how low should the inventory be depleted before it is reordered.
The two factors that determine the appropriate order point are the
procurement or delivery time stock which is the Inventory needed during the
lead time (i.e., the difference between the order date and the receipt of the
inventory ordered) and the safety stock which is the minimum level of
inventory that is held as a protection against shortages.
Therefore Reorder Point = Normal consumption during lead-time + Safety
Stock.
Several factors determine how much delivery time stock and safety stock
should be held. In summary, the efficiency of a replenishment system affects
how much delivery time is needed. Since the delivery time stock is the
expected inventory usage between ordering and receiving inventory, efficient
replenishment of inventory would reduce the need for delivery time stock.
And the determination of level of safety stock involves a basic trade-off
between the risk of stock-out, resulting in possible customer dissatisfaction
and lost sales, and the increased costs associated with carrying additional
inventory.
Another method of calculating reorder level involves the calculation of usage
rate per day, lead time which is the amount of time between placing an order
and receiving the goods and the safety stock level expressed in terms of
several days' sales.
Reorder level = Average daily usage rate x lead-time in days.
From the above formula it can be easily deduced that an order for
replenishment of materials be made when the level of inventory is just
adequate to meet the needs of production during lead-time.
If the average daily usage rate of a material is 50 units and the lead-time is
seven days, then Reorder level =Average daily usage rate x Lead time in
days = 50 units x 7 days = 350 units
When the inventory level reaches 350 units an order should be placed for
material. By the time the inventory level reaches zero towards the end of the
seventh day from placing the order materials will reach and there is no cause
for concern.

SAFETY STOCK
Once again in real life situations one rarely comes across lead times and
usage rates that are known with certainty. When usage rate and/or lead time
vary, then the reorder level should naturally be at a level high enough to
cater to the production needs during the procurement period and also to
provide some measure of safety for at least partially neutralizing the degree
of uncertainty.
The question will naturally arise as to the magnitude of safety stock. There is
no specific answer to this question.
However, it depends, inter alia, upon the degree of uncertainty surrounding
the usage rate and lead-time. It is possible to a certain extent to quantify the
values that usage rate and lead-time can take along with the corresponding
chances of occurrence, known as probabilities. These probabilities can be
ascertained based on previous experiences and/or the judgmental ability of
astute executives. Based on the above values and estimates of stock-out
costs and carrying costs of inventory it is possible to work out the total cost
associated with different levels of safety stock.
Once we realize that the higher the quantity of safety stock, the lower will be
the stock-out cost and the higher will be the incidence of carrying costs, the
formula for estimating the reorder level will call for a trade-off between
stock-out costs and carrying costs. The reorder level will then become one at
which the total stock-out costs (to be more precise, the expected stock-out
costs) and the carrying costs will be at its minimum.

The Reorder Point Formula .

Even in a relatively simple situation considered in the example above, the
amount of calculations involved for arriving at the reorder level is large. In
real life situations the assumption of independence in the probability
distributions made in the example above may not be valid and the number of
time periods may also be large. In such cases the approach adopted earlier
can become much more complex.
That is the reason why one can adopt a much simpler formula which gives
reasonably reliable results in calculating at what point in the level of
inventory a reorder has to be placed for replenishment of stock. The formula
along with its application is given below, using the notation developed earlier.

Reorder point = S x L + F ( S x Rx L)
Where
S = Usage in units
L = Lead time in days
R = Average number of units per order
F = Stock out acceptance factor

The stock-out acceptance factor, `F', depends on the stock-out percentage

rate specified and the probability distribution of usage (which is assumed to
follow a Poisson distribution). For any specified acceptable stockout
percentage the value of `F' can be obtained from the figure presented below.

The total system for inventory management

TOTAL SYSTEM
The three subsystems are tied together in a single inventory-management
system. The inventory management system can also be illustrated in terms
of the three subsystems that comprise it. The figure below ties each
subsystem together and shows the three items of information needed for the
decision to order additional inventory.
Inventory planning
The production side
The marketing side
Inventory data base
 
INVENTORY PLANNING
An important task of working-capital management is to ensure that
inventories are incorporated into the firm's planning and budgeting process.
Sometimes, the level of inventory reflects the orders received by the general
manager of the plant without serious analysis as to the need for the
materials or parts. This lack of planning can be costly for the firm, either
because of the carrying and financing costs of excess inventory or the lost
sales from inadequate inventory. The inventory requirements to support
production and marketing should be incorporated into the firm's planning
process in an orderly fashion.

THE PRODUCTION SIDE

The first step in inventory planning deals with the manufacturing mix of
inventory items and end products. Every product is made up of a specified
list of components. The analyst must recognize the different mix of
components in each finished product. Each item maintained in inventory will
have a cost. This cost may vary based on volume purchases, lead time for an
order, historical agreements, or other factors. For the purpose of preparing a
budget, each item must be assigned a unit cost. Once the mix of components
is known and each component has been assigned a value, the analyst can
calculate the materials cost for each product, which is the weighted average
of the components, and the individual products.

THE MARKETING SIDE

The second step in inventory planning involves a forecast of unit
requirements during the future period. Both a sales forecast and an estimate
of the safety level to support unexpected sales opportunities are required.
The Marketing Department should also provide pricing information so those
higher profit items receive more attention.

INVENTORY DATA BASE

An important component of inventory planning involves access to an
inventory database. A database is a collection of data items arranged in files,
fields and records. Essentially, we are working with a structured framework
that contains the information needed to effectively manage all items of
inventory, from raw materials to finished goods. This information includes the
classification and amount of inventories, demand for the items, cost to the
firm for each item, ordering costs, carrying costs, and other data.
The first component of an inventory database deals with the movement of
individual items and the second component of inventory management data
involves information needed to make decisions on rendering or replenishing
the items.

The ABC System of Inventory Management

In the case of a manufacturing company of reasonable size the number of
items of inventory runs into hundreds, if not more. From the point of view of
monitoring information for control it becomes extremely difficult to consider
each one of these items. The ABC analysis comes in quite handy and enables
the management to concentrate attention and keep a close watch on a
relatively less number of items which account for a high percentage of the
value of annual usage of all items of inventory.
A firm using the ABC system segregates its inventory into three groups - A, B
and C. The items are those in which it has the largest dollar investment.

The A group consists of the 10 percent of the inventory items that account
for 70 percent of the firm's dollar investment. These are the most costly or
the slowest turning items of inventory.
The B group consists of the items accounting for the next largest investment.
The B group consists of the 20 percent of the items accounting for about 20
percent of the firm's dollar investment.
The C group typically consists of a large number of items accounting for a
small rupee investment. C group consists of approximately 70 percent of all
the items of inventory but accounts for only about 10 percent of the firm's
dollar investment. Such items as screws, nails, and washers would be in this
group.

Classifying the inventory into A, B, and C items allows the firm to determine
the level and types of inventory control procedures needed. Control of the A
items should be most intensive due to the high rupee investments involved,
while the B and C items would be subject to correspondingly less
sophisticated control procedures.

The general procedure for categorization of items into `A', `B' and `C'
The advantages of this system
The required plan of ABC selective control
Methods that can be adopted to value the raw material
The valuation of work-in-process and finished goods inventory

The general procedure for categorization of items into `A', `B' and `C'
groups is briefly outlined below:
• All the items of inventory are to be ranked in the descending order of their
annual usage value.
• The cumulative totals of annual usage values of these items along with
their percentages to the total annual usage value are to be noted alongside.
• The cumulative percentage of items to the total number of items is also to
be recorded in another column.
• An approximate categorization of items into A, B, and C groups can be
made by comparing the cumulative percentage of items with the cumulative
percentage of the corresponding usage values.

The advantages of the ABC system are as follows:

1. It ensures closer control on costly items in which a large amount of capital
has been invested.
2. It helps in developing a scientific method of controlling inventories, Clerical
costs are reduced and stock is maintained at optimum level.
3. It helps in achieving the main objective of inventory control at minimum
cost. The stock turnover rate can be maintained at comparatively higher level
through scientific control of inventories.
The system of ABC analysis suffers from a serious limitation. The system
analyses the items according to their value and not according to their
importance in the production process. It may, therefore, sometimes create
difficult problems. For example, an item of inventory may not be very costly
and hence it may have been put in category C. However, the item may be
very important to the production process because of its scarcity. Such an
item as a matter of fact requires the utmost attention of the management
though it is not advisable to do so as per the system of ABC analysis. Hence,
the system of ABC analysis should not be followed blindly.

The required plan of ABC selective control can now be drawn as follows:
ABC PLAN
Items in Item % of total Value cum. %
Order of number items total category value.
ranking

MONITORING OF STORES AND SPARES

Just like ABC Analysis for classification of inventories, there is an inventory
management technique called VED. Analysis for monitoring and control of
stores and spares inventory by classifying them into 3 categories viz., Vital,
Essential and Desirable. The mechanics of VED analysis are similar to those
of ABC Analysis.

PRICING OF INVENTORIES
There are different ways of valuing the inventories and knowledge of these
methods of valuing stocks is essential for an efficient inventory management
process.

The following methods can be adopted to value the raw material:

 First-In-First-Out (FIFO): When a firm adopts the FIFO method to price its
raw material, the issue of material from the stores will be in the order
which it was received. Thus the pricing will be based on the cost of
material that was obtained first.
 Last-In-First-Out (LIFO): In the LIFO method, the material issued will be
priced based on the material that has been purchased recently.
 Weighted Average Cost Method: The pricing of materials will be alone on
weighted average basis (weights will be given based on the quantity).
 Standard Price Method: Material is priced based on a standard cost, which
is predetermined. When the material is purchased the stock account will
be debited with the standard price. The difference between the purchase
price and the standard price will be carried into a variance account.
 Replacement / Current Price Method: In this method material is priced at
the value that is realizable at the time of the issue.

 
VALUATION OF WORK-IN-PROCESS AND FINISHED STOCK
The valuation of work-in-process and finished goods inventory depends to a
certain extent on the method of pricing the raw material and to a large
extent on the method of costing used to apportion the fixed manufacturing
overheads. Direct Costing and Absorption Costing are the two techniques
used for allocation of costs to the inventory.

Direct costing is based on the traceability of cost to the cost objective. All
indirect costs (which may include fixed manufacturing overheads) are
charged to the income statement and are known as period costs. If the fixed
costs are directly identifiable, then it is considered for inventory valuation.
Absorption costing is a technique, which treats the fixed manufacturing
overheads as product costs. Thus, all costs i.e. both fixed and variable will be
assigned to the inventory value.

This difference in approach to costing will affect the inventory value and also
the profits. The direct costing method lowers the inventory value (by not
considering the indirect costs) and increases profits with a decrease in
inventory level (when the inventory level decreases the direct costs come
down while the fixed costs remain the same). Contrary to this the inventory
valuation will be higher for stocks valued under absorption costing method as
it considers all the fixed manufacturing overheads.