Importance of Inventory

Accounting control of inventories is concerned with the proper recording of the receipt
and consumption of the material as well as the flow of goods through the plant into
finished stock and eventually to customers.
The aim of holding inventories is to allow the firm to separate the process of purchasing,
manufac-turing, and marketing of its primary products. Inventories are a component of
the firm’s working capital and as such represent a current account.
Inventories are also viewed as a source of near all cash. The purpose is to achieve
efficiencies in areas where costs are involved. The scientific inventory control results in
the reduction of stocks on the one hand and substantial decline in critical shortages on
the other.

(i) Reducing Risk of Production Shortages:

Firms mostly manufacture goods with hundreds of components. The entire production
operation can be halted if any of these are missing. To avoid the shortage of raw
material the firm can maintain larger inventories.

(ii) Reducing Order Cost:

Where a firm places an order, it incurs certain expenses. Different forms have to be
completed. Approvals have to obtained, and goods that arrive must be accepted,
inspected and counted. These costs will vary with the number of orders placed. Smaller
the inventories lesser the capital needed to carry inventories.

(iii) Minimize the Blockage of Financial Resources:

The importance of inventory control is to minimize the blockage of financial resources. It
reduces the unnecessary tying up of capital in excess inventories. It also improves the
liquidity position of the firm.

(iv) Avoiding Lost Sales:

Most firms would lose business without goods on hand. Generally, a firm must be
prepared to deliver goods on demand. By ensuring timely availability of adequate supply
of goods, inventory control helps the firm as well as consumers.
(v) Achieving Efficient Production Scheduling:
The manufacturing process can occur in suffi-ciently long production runs and with
preplanned schedules to achieve efficiencies and economies. By maintaining
reasonable level of inventory production scheduling becomes easier for the
management.

(vi) Gaining Quantity Discounts:

While making bulk purchases many suppliers will reduce the price of supplies and
component supplies will reduce the price of supplies and component parts. The large
orders may allow the firm to achieve discounts on regular basis. These discounts in turn
reduce the cost of goods and increase the profits.

(vii) Taking the Advantage of Price Fluctuations:

When the prices of the raw materials are low the firm makes purchases in economic lots
and maintains continuity of operations. By reducing the cost of raw materials and
procuring high prices for its goods the firm maximizes profit. This with the help of
inventory control the firm takes advantage of price fluctuations.

(viii) Tiding over Demand Fluctuations:

Inventory control also helps the firm in tiding over the demand fluctuation. These are
taken care of by keeping a safety stock by the firm. Safety stock refers inventories
carried to protect against variations in sales rate, production rate and procurement time.
Inventory control aims at keeping the cost of maintaining safety stock minimum.

(ix) Deciding timely Replenishment of Stocks:

Inventory control results in the maintenance of necessary records, which can help in
maintaining the stocks within the desired limits. With the help of adequate records, the
firm can protect itself against thefts, wastes and leakages of inventories. These records
also help in deciding about timely replenishment of stocks.
What Is Inventory Management?
Inventory management refers to the process of ordering, storing, and using a company's
inventory. These include the management of raw materials, components, and finished
products, as well as warehousing and processing such items.

For companies with complex supply chains and manufacturing processes, balancing the
risks of inventory gluts and shortages is especially difficult. To achieve these balances,
firms have developed two major methods for inventory management: just-in-time and
materials requirement planning: just-in-time (JIT) and materials requirement planning
(MRP).

Methods in Inventory Management

Just-In-Time Method
The just in time method (JIT) of inventory management involves companies planning to
receive items as they are needed instead of maintaining high levels of inventory. One
benefit of this inventory management method is that companies do not have a great
deal of money tied up in inventory levels; they reduce storage and insurance costs and
the cost of liquidating unused inventory. Another benefit of the just in time method is
that companies reduce waste.
Challenges of the just in time method of inventory management come into play when
manufacturers and retailers have to work together to monitor the availability of
manufacturing resources and consumer demand. Just in time inventory management
also is considered risky because companies take a gamble with being unable to fill
orders; being out of stock reduces revenue and may harm customer relations.

Materials Requirement Planning Method

The materials requirement planning method (MRP) of inventory management involves
companies scheduling material deliveries based on sales forecasts. Typically, a
computer-based inventory management system, MRP breaks down inventory
requirements into planning periods so that production can be completed efficiently while
keeping inventory levels and storage costs at a minimum. Another benefit of MRP
inventory management is that it aids production managers in planning for capacity
needs and allocating production time.
One of the most significant disadvantages of the MRP inventory management method is
that the systems often are expensive and involve a time-consuming implementation
period. It also may be challenging for companies to put quality information into the MRP
system to gain accurate forecasts; to reap the full benefits of MRP inventory
management, organizations must be prepared to maintain current and accurate bills of
materials, part numbers, and inventory records.

Inventory Models
1. Economic Ordering Quantity (EOQ) Model:
One of the important decisions to be taken by a firm in inventory management is how
much inventory to buy at a time. This is called ‘Economic Ordering Quantity (EOQ).
EOQ also gives solutions to other problems like:
(i) How frequently to buy?
(ii) When to buy?
(iii) What should be the reserve stock?

Assumptions: Like other economic models, EOQ Model is also based on certain
assumptions:
1. That the firm knows with certainty how much items of particular inventories will be
used or demanded for within a specific period of time.
2. That the use of inventories or sales made by the firm remains constant or unchanged
throughout the period.
3. That the moment inventories reach to the zero level, the order of the replenishment of
inventory is placed without delay.

Determination of EOQ:
EOQ Model is based on Baumol’s cash management model. How much to buy at a
time, or say, how much will be EOQ is to be decided on the basis of the two costs:
(i) Ordering Costs, and (ii) Carrying Costs.

2. ABC Analysis:
This is also called ‘Selective Inventory Control.’ The ABC analysis of selective inventory
is based on the logic that in any large number, we usually have ‘significant few’ and
‘insignificant many.’ This holds true in case of inventories also. A firm maintaining
several types of inventories does not need to exercise the same degree of control on all
the items.

3. Inventory Turnover Ratio:

Inventory can also be managed by using accounting ratios like Inventory Turnover
Ratio. Inventory ratio establishes relationship between average inventory and cost of
inventory consumed or sold during the particular period.
This is calculated with the help of the following formula: Cost of Good Consumed or
Sold during the year/Average Inventory during the year.
A comparison of current year’s inventory ratio with those of previous years will unfold
the following points relating to inventories:

Fast-Moving Items:
This is indicated by a high inventory ratio. This also means that such items of inventory
enjoy high demand. Obviously, in order to have smooth production, adequate
inventories of these items should be maintained. Otherwise, both production and sales
will be adversely affected through uninterrupted supply of these items.

Slow-Moving Items:
That some items are slowly moving is indicated by a low turnover ratio. These items
are, therefore, needed to be maintained at a minimum level.

Dormant or Obsolete Items:

These refer to items having no demand. These should be disposed of as early as
possible to curb further losses caused by them.

DEMAND

Demand is the number of units of a specific product that its consumers are willing
to purchase at each price. As such, it can be expressed as a mathematical equation. For
example, if consumers are willing to purchase 10 units of a product and two fewer units
per $1 increase in price, that can be written as q = 10 - 2p, where q is quantity and p is
price.
INDEPENDENT DEMAND

Independent demand is demand for a finished product, such as a computer, a

bicycle, or a pizza. Dependent demand, on the other hand, is demand for component
parts or subassemblies. For example, this would be the microchips in the computer, the
wheels on the bicycle, or the cheese on the pizza.

PROBABILISTIC MODEL

Probabailistic models incorporate random variables and probability distributions

into the model of an event or phenomenon. While a deterministic model gives a single
possible outcome for an event, a probabilistic model gives a probability distribution as a
solution.

A probabilistic method or model is based on the theory of probability or the fact

that randomness plays a role in predicting future events. The opposite is deterministic ,
which is the opposite of random.

Probabailistic models incorporate random variables and probability distributions

into the model of an event or phenomenon. While a deterministic model gives a single
possible outcome for an event, a probabilistic model gives a probability distribution as a
solution. These models take into account the fact that we can rarely know everything
about a situation. There’s nearly always an element of randomness to take into account.

SAFETY STOCK

Safety stock is an additional quantity of an item held in the inventory to reduce the
risk that the item will be out of stock. It acts as a buffer stock in case sales are greater
than planned and/or the supplier is unable to deliver the additional units at the expected
time.