INVENTORY MANAGEMENT

LEARNING OBJECTIVES
• The need for and nature of inventory
• Techniques of inventory management
• Need for analyzing inventory problem as an
investment decision
• Process for managing inventory
 Meaning of Inventory
Inventories are unconsumed or unsold goods purchased
or manufactured. According to AS 2 ( revised )
inventories are assets :
 Held for sale in the ordinary course of business
 In the process of production for such sale or
 In the form of materials or supplies to be
consumed in the production process or in the
rendering of services.

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 Nature of Inventory
• Stock of items kept to meet future demand
• Purpose of inventory management
– how many units to order
– when to order
Stocks of manufactured products and the material
that make up the product.
Components: types of firms
i. raw materials
ii. work-in-process (partially completed) products (WIP)
iii. finished goods (being transported)
iv. stores and spares (supplies)
 Need for Inventories

• Transaction motive
• Precautionary motive (for usage & delivery )
• Speculative motive (for price changes)
 Objectives of Inventory Management

• To maintain a large size of inventories of raw

material and work-in-process for efficient and
smooth production and of finished goods for
uninterrupted sales operations.

• To maintain a minimum investment in

inventories to maximize profitability.
 Inventory Costs
Carrying cost
cost of holding an item in inventory
Ordering cost
cost of replenishing inventory
Shortage cost
temporary or permanent loss of sales when
demand cannot be met

Safety stock
stock:: buffer added to on hand inventory during lead
time
Stock out
out:: an inventory shortage
Service level
level:: probability that the inventory available during
lead time will meet demand
 An effective inventory management

• Ensure a continuous supply of raw materials, to

facilitate uninterrupted production
• Maintain sufficient stocks of raw materials in periods
of short supply and anticipate price changes
• Maintain sufficient finished goods inventory for
smooth sales operation, and efficient customer service
• Minimize the carrying cost and time
• Control investment in inventories and keep it at an
optimum level
 Inventory Management Techniques
• Economic order quantity (EOQ)
optimal order quantity that will minimize total
inventory costs
• ordering costs: requisitioning, order placing,
transportation, receiving, inspecting and storing,
administration
• carrying costs: warehousing, handling, clerical and
staff, insurance, depreciation and obsolescence
• ordering and carrying costs trade-off:
Economic order quantity (EOQ)…
 Assumptions of Basic EOQ Model
 Demand is known with certainty and is constant over time
 No shortages are allowed
 Lead time for the receipt of orders is constant
 Order quantity is received all at once
 Inventory Order Cycle
Order quantity, Q
Demand
rate
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt
 Inventory Management Techniques
• Reorder point under certainty
– lead time
– average usage
Reorder point = Lead time x average usage
Inventory Management Techniques…
 Cont…
Reorder point under uncertainty
• safety stock
Reorder point = (Lead time x average usage) + safety stock
 Inventory Investment Analysis
• Estimation of
– incremental operating profit
– incremental investment in inventory
– the incremental rate of return (IRR)
• Comparison of the incremental rate of return
with the required rate of return (RRR)
• Optimum inventory: IRR=RRR
 INVENTORY CONTROL SYSTEMS
• ABC Inventory Control System
• Just-in-Time (JIT) Systems
• Out-sourcing
• Computerized Inventory Control Systems
 ABC Classification
• Class A
 5 – 15 % of units
 70 – 80 % of value
• Class B
 30 % of units
 15 % of value
• Class C
 50 – 60 % of units
 5 – 10 % of value
 ABC Classification: Example
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
 ABC Classification: Example
(cont.)
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUE COST ANNUAL%USAGE
QUANTITY CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7350 5.0 11.0
2 14,000 16.4 4.0
A40 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 B60 30.0
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 % OF TOTAL
18.0 180%QUANTITY
OF TOTAL
58.0
CLASS ITEMS VALUE
5 3,000
7 3.510 13.0 170 71.0
10 2,400
A 9, 8, 2.8
2 12.0
71.0 C 83.0
8 320 50 15.0
7 1,700
B 1, 4, 2.0
3 17.0
16.5 100.0
25.0
C9 510
6, 5, 10, 7 12.5 60 60.0
$85,400
10 20 120
Example 10.1
ABC Analysis
 Inventory Management Process
• Explicitly state the inventory policy
• Create an inventory monitoring cell
• Management group for controlling purchases
• Periodic meetings between purchase, materials
planning and production executives
• Monthly reviews of total inventory at
plant/corporate level
• Dovetail inventory control to the total budgeting
system
• Identify critical inventory items for closer scrutiny
 Inventory and Supply Chain Management
• Bullwhip effect
– demand information is distorted as it moves away from
the end-use customer
– higher safety stock inventories to are stored to
compensate
• Seasonal or cyclical demand
• Inventory provides independence from vendors
• Take advantage of price discounts
• Inventory provides independence between stages
and avoids work stop-pages
 Two Forms of Demand

Dependent
Demand for items used to produce final
products
Tires stored at a Goodyear plant are an
example of a dependent demand item
Independent
Demand for items used by external customers
Cars, appliances, computers, and houses are
examples of independent demand
inventory
 Inventory and Quality Management
• Customers usually perceive quality service as
availability of goods they want when they
want them
• Inventory must be sufficient to provide high-
quality customer service in TQM
 Inventory Control Systems

Continuous system (fixed-

(fixed-order
order--
quantity)
constant amount ordered when
inventory declines to
predetermined level
Periodic system (fixed-
(fixed-time
time--period)
order placed for variable amount
after fixed passage of time
 Economic Order Quantity (EOQ)
Models

• EOQ
– optimal order quantity that will
minimize total inventory costs
• Basic EOQ model
• Production quantity model
 Assumptions of Basic EOQ
Model

Demand is known with certainty and is constant over time

No shortages are allowed
Lead time for the receipt of orders is constant
Order quantity is received all at once
 Inventory Order Cycle
Order quantity, Q
Demand
rate
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt
 EOQ Cost Model
Co - cost of placing order D - annual demand
Cc - annual per-
per-unit carrying cost Q - order quantity

CoD
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
CoD CcQ
Total cost = +
Q 2
 EOQ Cost Model

Deriving Qopt Proving equality of costs

at optimal point
CoD CcQ
TC = +
Q 2 CoD CcQ
=
TC CoD Cc Q 2
= +
Q Q2 2
2CoD
C0D Cc Q2 =
Cc
0= +
Q2 2
2CoD
2CoD Qopt =
Qopt = Cc
Cc
 EOQ Cost Model (cont.)
Annual
cost ($) Total Cost
Slope = 0
CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost = Q

Optimal order Order Quantity, Q

Qopt
 EOQ Example
Cc = Rs.0.75 per Kg Co = Rs.150 D = 10,000 Kg

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = (0.75) TCmin = 2,000 + 2

Qopt = 2,000 Kg TCmin = Rs.750 + Rs.750 = Rs.1,500

Orders per year = D/Qopt Order cycle time = 311 days/(D

days/(D/Qopt)
= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days
 Reorder Point: Example

Demand = 10,000 yards/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154 yards/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 yards

 Safety Stocks

Safety stock
buffer added to on hand inventory during lead time
Stockout
an inventory shortage
Service level
probability that the inventory available during lead
time will meet demand
 Variable Demand with
a Reorder Point
Q
Inventory level

Reorder
point, R

0
LT LT
Time
 Reorder Point with
a Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
 Objectives of Inventory Valuation

 Determination of Income :
Gross profit is the excess of sales over cost of goods sold.
Cost of Goods sold = Opening Inventory + Purchases – Closing
Inventory
 Determination of Financial Position:
The inventory at the end of the period is to be shown as a
current asset in the Balance Sheet of the business. In case
the inventory is not valued properly, the balance sheet will
not disclose the correct financial position of the business.

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 Inventory Systems
 Periodic Inventory System: The quantity and value of
inventory is found out only at the end of the accounting
period after having a physical verification of the units in
hand. No information is provided regarding quantity and
value of materials in hand on a continuous basis. No
accounting is done for shrinkage, losses, theft and wastage.
 Perpetual inventory System : Also known as automatic
Inventory System. It is ‘ A method of recording inventory
balances after every receipt and issue to facilitate regular
checking and to avoid closing down for stock taking.’ Details
about quantity and value of stock are available on a
continuous basis.

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 Methods of Valuation of Inventories
Inventory should be valued at the lower of ‘ historical cost’ and
‘net realizable value’.
Historical Cost : It is the aggregate of cost of purchase, cost of
conversion and other costs incurred in bringing the
inventories to their present location and conditions.
The various methods of assigning historical costs to inventory
and goods sold are as under:
i. Specific Identification Method: Each item of inventory is
identified with its cost. The total of various costs so
identified, constitutes the value of the inventory. This
technique of inventory valuation can only be adopted by a
company handling a small number of items. For a large
number of inventory items, it is nearly impossible to
identify the cost of each individual item. 40
 Methods of Valuation of Inventories ( Contd )
ii. First In First Out ( FIFO ): It is assumed that the material first
received is the first to be issued or sold. Thus the inventory at
any point of time is presumed to be composed of items most
recently acquired.
Advantages:
i) It values stock nearer to current market price.
ii) It is based on cost, hence no unrealized profit enters into
the financial accounts of the company.
Disadvantages:
i) Involves complicated calculations and hence increases the
possibility of clerical error.
ii) Comparison between different jobs using the same type of
material gets sometimes difficult. A job commenced a few
minutes after another job may have to bear a different
charge for material because the first job completely
exhausted the supply of material of the particular lot.
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 Methods of Valuation of Inventories ( Contd )
Last In First Out ( LIFO ): The last item of material purchased is the
first to be issued or sold. Hence, inventory consists of items
purchased at the earliest cost.
Advantages :
i) It takes into account the current market conditions while valuing
material issued to different jobs or calculating the cost of
goods sold.
ii) The method is based on cost and hence no unrealized profit or
loss is made on account of use of this method.
FIFO, LIFO and market fluctuations:
In periods of rising prices :FIFO will result in lower cost of goods
sold and higher closing stock of inventory. Thus profits will be
inflated and there will be a higher tax liability. Using LIFO will
result in lower closing stock of inventory, higher cost of goods
sold, lower profitability and hence lower tax liability.

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 Methods of Valuation of Inventories ( Contd )
In Periods of falling prices : FIFO will result in higher cost of
goods sold, lower profitability and lower tax liability.
Reverse will be the case if LIFO is followed.
iv. Highest in First Out : Materials or goods purchased at the
highest prices are treated as being first issued or sold,
irrespective of the date of purchase.
v. Base Stock method :Based on the contention that each
enterprise maintains a minimum quantity of material in its
stock. This base stock is deemed to be created out of the
first lot purchased and therefore valued at this price and is
carried forward as a fixed price. Any quantity over and
above the base stock is valued in accordance with any
other appropriate method. LIFO method is generally used
for the same.
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 Methods of Valuation of Inventories ( Contd )
iv. Next in First Out :Issues are made at the price of materials
which has been ordered but not yet received. The attempt
is to value material issued at a price which is nearest to
market price.
v. Weighted Average Price Method: Based on the assumption
that once the material is put into a common bin, it loses its
separate identity. Hence the inventory consists of no
specific batch of goods. It is priced on the basis of average
prices paid for the goods, weighted according to the
quantity purchased at each price.

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 Methods of Valuation of Inventories ( Contd )
Net Realizable Value :Net realizable value means ‘the estimated
selling price in the ordinary course of business less costs of
completion and less costs necessary to be incurred in order
to make the sale’. Ascertainment of net realizable value and
its comparison with historical cost can be done using any of
the following methods :
i. Aggregate or total inventory method : The total cost price of
the different items of inventory is calculated and compared
with the total of net realizable value of the different items of
inventory. Valuation is done at the price lower of the two.
ii. Group Method: Groups are formed of homogenous items of
inventory . The cost and net realizable value of each group is
ascertained. The lower of the two is taken for inventory
valuation.
iii. Item by Item method: The cost and net realizable of each
item is found out and valuation is done at the lower of the
two.
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Inventory Valuation for Balance Sheet Purposes
If Inventory is taken on a date after the balance sheet date: Ex. If
the Balance Sheet is prepared on 31st December 1991 and
inventory is taken on 31st January, 1992, the following
adjustments will be required:
Inventory as on 31st Jan, 1992
Less : Purchases made between 1st Jan, 1992 to 31st Jan, 1992
Less : Sales returns ( at cost price) 1st Jan 1992 to 31st Jan 1992
Add: Sales ( at cost price ) 2nd Jan 1992 to 31st Jan 1992
Add: Purchase Returns 2nd Jan 1992 to 31st Jan 1992
Value of inventory as on 31st December 1991
If Inventory is taken on a date before the balance sheet date: In
this case, the above adjustments will be done in a reverse
order.
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Calculate the value of Cost of Goods Sold and Closing
Inventory by using Average Cost Method of valuation of
inventory in perpetual system. Data is given below:-
If there is increase in prices in last few months and
management wants to show higher profits than which
inventory method should be used why?
Date Purchases/ Issue No. of Units Cost/ Unit
Mar-01 Inventory in Hand 300 units Rs. 10
Mar-04 Issued 200 units
Mar-08 Purchases 800 units Rs. 11
Mar-18 Issued 700 units
Mar-25 Purchases 300 units Rs. 12
Mar-28 Issued 300 units
Mar-31 Purchases 500 units Rs. 13
Apr-01 Issued 300 units