Working Capital Management :

PART II: Managing Inventory

By Chalith Kavinda

Semester I
School of Accounting and Business
Institute of Chartered Accountants of Sri Lanka
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Lesson Outline
Introduction
01
02 Effective Inventory Management

Inventory Management Techniques

03
Inventory Investment Analysis
04 and Inventory Control Systems

Inventory Management Process

05
Introduction
Introduction
Nature of Inventories
The various forms in which inventories exist in a manufacturing company are;

• Raw materials
• Work-in-process
• Finished goods

Need to hold Inventories

• Transaction motive, which emphasizes the need to maintain inventories to facilitate smooth
production and sales operations
• Precautionary motive, which necessitates holding of inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors.
• Speculative motive, which influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.
 Objective 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.
 Effective
Inventory
Management
 An effective Inventory
Management Could
• 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, and
• Control investment in inventories and keep it at an
optimum level.
 Inventory
Management
Techniques
Inventory Management Techniques

Economic Order Quantity

2AO
EOQ =
c
Re-Order Point Under Certainty
Reorder point = Lead time x average usage

Re-Order Point Under Uncertainty

Reorder point = (Lead time x average usage) + safety
stock
 Inventory Management Techniques Cont.….

Minimum Total cost EOQ 500

Carrying cost

EOQ
Average inventory 250
Cost

Re-order point 150

Ordering cost

Q Order size (Q) 0 1 2 3 4 5 6 7 8 9 10

Economic Order Quantity Lead time
Re-order Point under Certainty
Inventory Management Techniques Cont.….

Maximum 575
inventory Average usage

EOQ
Average inventory 288

Re-order point 225

Maximum usage
Safety stock 75

0 1 2 3 4 5 6 7 8 9 10
Lead time
Re-order Point under Uncertainty
Inventory Investment
Analysis and Inventory
Control Systems
Inventory Investment Analysis
• Estimation of incremental operating profit
• Estimation of incremental investment in inventory
• Estimation of 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
A firm needs an inventory control system to effectively manage its inventory. There are
several inventory control systems in vogue. They range from simple systems to very
complicated systems. The nature of business and the size dictate the choice of an inventory
control system.

ABC Inventory Control System

Just-in-time (JIT) System
Out-sourcing
Computerized Inventory Control System
Inventory Management
Process
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
Thank You