Professional Documents
Culture Documents
Working Capital is defined as the funds which are required for the day to day operations of the
firm. Working capital is that part of a firm’s capital which is required to hold current assets of
the firm.
Working capital is a measure of a company's liquidity, operational efficiency and its short-term
financial health. If a company has substantial positive working capital, then it should have the
potential to invest and grow. If a company's current assets do not exceed its current liabilities,
then it may have trouble growing or paying back creditors, or even go bankrupt.
Working capital is also called revolving, circulating or short term capital. Every business require
the funds for its establishment which is called fixed capital and require funds to carry out its day
to day operations like purchase of raw material, payment of wages etc. which is called working
capital.
Generally there are two concepts of working capital. They are gross working capital and net
working capital. But they are defined by different names. They are explained below:
1) Gross working capital: It is also called simply ‘working capital’. It refers to the total of all
the current assets of the firm. Current assets are the assets which are meant to be converted into
cash within a year or an operating cycle. Stock of raw materials, stock of semi-finished goods,
stock of finished goods, trade debtors, bills receivable, prepaid expenses, cash at bank and cash
in hand are examples of current assets.
2) Net working capital: It is defined as accounting concept. It means excess of current assets
over current liabilities. It helps in finding out firm’s capability to meet short term liabilities as
well as indicates the financial soundness of the enterprise.
Example
Suppose the total current assets and total current liabilities of a firm amount to Rs 90,000 and Rs
40,000 respectively. Then, gross working capital of the firm is Rs 90,000 while net working
capital of the firm is Rs 50,000 and this sum of Rs 50,000 will be financed by long-term funds.
Thus, net working capital is that part of the working capital which is financed by long-term
funds.
Permanent and Temporary Working Capital:
From the point of view of the period for which capital is required, working capital can be divided
into two categories namely permanent working capital and temporary working capital.
It refers to that minimum amount of investment in current assets that has always to be true. It is
the working capital required to carry out the minimum level of activities of the business. It is also
called core working capital, regular working capital or fixed working capital.
It refers to that part of total working capital which is required by a firm over its permanent
working capital. It is required because the actual level of activities of the business most of the
time exceeds the minimum level of activities.
As the level of business activities fluctuates, the volume of temporary working capital also may
keep fluctuating. Temporary working capital is also known as fluctuating or variable or
circulating working capital.
The firm must estimate its working capital very accurately because excessive working capital
results in unnecessary accumulation of inventory and wastage of capital whereas shortage of
working capital affects the smooth flow of operating cycle and business fails to meet its
commitment.
1-Nature of Business:
The type of business, firm is involved in, is the next consideration while deciding the working
capital. In case of trading concern or retail shop the requirement of working capital is less
because length of operating cycle is small.
2-Scale of Operation:
The firms operating at large scale need to maintain more inventory, debtors, etc. So they
generally require large working capital whereas firms operating at small scale require less
working capital.
During boom period the market is flourishing so more demand, more production, more stock,
and more debtors which mean more amount of working capital is required. Whereas during
depression period low demand less inventories to be maintained, less debtors, so less working
capital will be required.
4-Seasonal Factors:
The working capital requirement is constant for the companies which are selling goods
throughout the season whereas the companies which are selling seasonal goods require huge
amount during season as more demand, more stock has to be maintained and fast supply is
needed whereas during off season or slack season demand is very low so less working capital is
needed.
If a company is using labour intensive technique of production then more working capital is
required because company needs to maintain enough cash flow for making payments to labour
whereas if company is using machine-intensive technique of production then less working capital
is required because investment in machinery is fixed capital requirement and there will be less
operative expenses.
6-Credit Allowed
Credit policy refers to average period for collection of sale proceeds. It depends on number of
factors such as creditworthiness, of clients, industry norms etc. If company is following liberal
credit policy then it will require more working capital whereas if company is following strict or
short term credit policy, then it can manage with less working capital also.
7-Credit Availed:
If raw material and other inputs are easily available on credit, less working capital is needed. On
the contrary, if these things are not available on credit then to make cash payment quickly large
amount of working capital will be needed.
Availability of raw material also influences the amount of working capital. If the enterprise
makes use of such raw material which is available easily throughout the year, then less working
capital will be required, because there will be no need to stock it in large quantity.
9-Growth Prospects:
Growth means the development of the scale of business operations (production, sales, etc.). The
organisations which have sufficient possibilities of growth require more working capital, while
the case is different in respect of companies with less growth prospects.
High level of competition increases the need for more working capital. In order to face
competition, more stock is required for quick delivery and credit facility for a long period has to
be made available.
11-Inflation
Inflation means rise in prices. In such a situation more capital is required than before in order to
maintain the previous scale of production and sales. Therefore, with the increasing rate of
inflation, there is a corresponding increase in the working capital.
12-Conditions of Supply
The working capital requirements of the company depends on the conditions of supply:
If the supply of raw materials is regular, then the company can keep less inventory (stock). So, it
will require less working capital. But, if the supply is irregular then the company has to hold
more stock. Therefore, in such a case, it will need more working capital.
1- Adequate working capital is needed to maintain a regular supply of raw materials, which in
turn facilitates smoother running of production process.
2- Working capital ensures the regular and timely payment of wages and salaries, thereby
improving the morale and efficiency of employees.
It is said that working capital is the lifeblood of a business. Every business needs funds in order
to run its day-to-day activities.
2-Without adequate working capital an entity cannot meet its short-term liabilities in time.
3. A firm having a healthy working capital position can get loans easily from the market due to
its high reputation or goodwill.
1- It renders the firm unable to avail itself of attractive discounts from suppliers.
2- As the firm is found unable to honour its short-term obligations in time, it loses some of its
creditworthiness. As a result it faces tight credit terms.
3- The firm finds it difficult to grow, profitable projects are not undertaken due to paucity of
working capital.
4- Fixed assets are not fully and efficiently utilised because of inadequacy of working capital. It
decreases firm’s profitability.
5-Operating inefficiencies creep in. There may be interruptions in production. The result is that
the profit targets are not met.
2- It may be an indication of excessively liberal credit policy and slack collection from
customers resulting in higher incidence of bad debts.
Working capital is composed of various current assets and current liabilities, which are as
follows:
These assets are generally realized within a short period of time, i.e. within one year.
(d) Pre-payments
Current liabilities are those which are generally paid in the ordinary course of business within a
short period of time, i.e. one year.
Example: A fixed asset which is expected to provide cash flow for 5 years should be financed
by approx 5 years long-term debts. Assuming the company needs to have additional inventories
for 2 months, it will then seek short term 2 months bank credit to match it.
B) Conservative approach: it is conservative because the company prefers to have more cash
on hand. That is why, fixed and part of current assets are financed by long-term or permanent
funds. As permanent or long-term sources are more expensive, this leads to “lower risk lower
return”.
Working capital financing is done by various modes such as trade credit, cash credit/bank
overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of
credit, factoring, commercial paper, inter-corporate deposits etc.
This is simply the credit period which is extended by the creditor of the business. Trade credit is
extended based on the creditworthiness of the firm which is reflected by its earning records,
Cash Credit
Cash credit is more commonly offered to businesses than individuals. It requires that a security
be offered up as collateral on the account in exchange for cash. This security can be a tangible
asset, such as stock, raw materials, or another commodity. The credit limit extended on the cash
credit account is normally a percentage of the value of the collateralized security.
Overdraft
An overdraft is an extension of credit from a lending institution that is granted when an account
reaches zero. The overdraft allows the account holder to continue withdrawing money even when
the account has no funds in it or has insufficient funds to cover the amount of the withdrawal.
Basically, an overdraft means that the bank allows customers to borrow a set amount of money.
There is interest on the loan, and there is typically a fee per overdraft.
Working capital loans are as good as term loan for a short period. These loans may be repaid in
installments or a lump sum at the end. The borrower should take such loans for financing
permanent working capital needs. The cost of interest would not allow using such loans for
temporary working capital.
For a business, it is another good service provided by commercial banks for working capital
financing. Every firm generates bills in the normal course of business while selling goods to
debtors. Ultimately, that bill acts as a document to receive payment from the debtor. The seller
who requires money will approach the bank with that bill and bank will apply the discount on the
total amount of the bill based on the prevailing interest rates and pay the remaining amount to the
seller. On the date of maturity of that bill, the bank will approach the debtor and collect the
money from him.
Bank Guarantee
It is primarily known as non-fund based working capital financing. Bank guarantee is acquired
by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of the
agreed task which may be repaying the money or providing of some services etc. A buyer ‘B1’ is
buying some products from seller ‘S1’. In this case, ‘B1’ may acquire a bank guarantee from the
bank and give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may acquire
a bank guarantee and hand it over to ‘B1’ to save him from the risk of getting lower quality
goods or late delivery of goods etc.
Letter of Credit
It is also known as non-fund based working capital financing. Letter of credit and bank guarantee
has a very thin line of difference. Bank guarantee is revoked and the bank makes payment to the
holder in case of non-performance of the opposite party whereas, in the case of a letter of credit,
the bank will pay the opposite party as soon as the party performs as per agreed terms. So, a
buyer would buy a letter of credit and send it to the seller. Once the seller sends the goods as per
the agreement, the bank would pay the seller and collects that money from the buyer.
Factoring
Factoring is an arrangement whereby a business sells all or selected accounts payables to a third
party at a price lower than the realizable value of those accounts. The third party here is known
as the ‘factor’ who provides factoring services to business. The factor would not only provide
financing by purchasing the accounts but also collects the amount from the debtors. Factoring is
of two types – with recourse and without recourse. The credit risk of nonpayment by the
debtor is borne by the business in case of with recourse and it is borne by the factor in the case of
without recourse.
Commercial paper
It is also called CP, is a short-term debt instrument issued by companies to raise funds generally
for a time period up to one year. It is an unsecured money market instrument issued in the form
of a promissory note and was introduced in India for the first time in 1990.
Companies that enjoy high ratings from rating agencies often use CPs to diversify their sources
of short-term borrowings. This gives investors an additional instrument. hey are typically issued
by large banks or corporations to cover short-term receivables and meet short-term financial
obligations, such as funding for a new project. They can be issued in denominations of Rs 5 lakh
or multiples thereof.
Working Capital Management (WCM) refers to all the strategies adopted by the company to
manage the relationship between its short term assets and short term liabilities with the objective
to ensure that it continues with its operations and meet its debt obligations when they fall due. In
other words, it refers to all aspects of administration of current assets and current liabilities.
Efficient management of working capital is a fundamental part of the overall corporate strategy.
• Inventory
1. Cash Management:
Cash is one of the important components of current assets. It is needed for performing all the
activities of a firm, i.e. from acquisition of raw materials to marketing of finished goods.
Therefore it is essential for a firm to maintain an adequate cash balance. One of the important
functions of a finance manager is to match the inflows and outflows of cash so as to maintain
adequate cash.
he important components of current assets. It is needed for performing all the activities of a firm,
i.e. from acquisition of raw materials to marketing of finished goods. Therefore it is essential for
a firm to maintain an adequate cash balance. One of the important functions of a finance
manager is to match the inflows and outflows of cash so as to maintain adequate cash.
Meaning of Cash:
With reference to cash management cash has two meanings—ready cash and near cash. Currency
notes, coins, bank balances are the examples of ready cash where as marketable securities,
treasury bills, etc. are the examples of near cash. Management of cash means management of
both ready cash as well as near cash.
John Maynard Keynes identified the following three reasons( motives) for holding cash:
Transaction Motive:
This refers to holding of cash to meet regular payments such as purchases, wages, operating
expenses, etc.
Precautionary Motive:
This refers to holding of cash to meet unexpected demands for cash such as to meet the extra
cash payment for purchase of raw materials due to increase in cost of raw materials.
Speculative Motive:
This refers to holding of cash to take advantage of favorable market conditions such as to
purchase excess quantity of raw materials for getting a handsome discount.
A fund manager is responsible for maintaining adequate cash balances so that the liquidity
position of the firm remains strong. It is necessary for him/her to know what should be the
optimum cash balance and in what quantity marketable securities should be purchased or sold.
There are several models of cash management to determine the optimum level of cash balances.
Baumol Model:
This Model, also known as Inventory Model was developed by William J. Baumol, and is based
on the combination of Inventory Theory and Monetary Theory. According to this model, the
optimum level of cash is that level of cash where the cost of carrying and transaction cost are
minimum. Here, carrying cost means the interest foregone on marketable securities and
transaction cost refers to cost of liquidating marketable securities.
is required to be kept aside to overcome the period expected as the period of cash shortage. This
period may either be short and temporary or last for a longer duration of time. Normal and
regular payment of cash leads to small cutbacks in the cash balance at periodic intervals. Making
this payment to different workers on different days of a week can balance these reductions.
Another practice for balancing the level of cash is to schedule cash disbursements to creditors
during the period when accounts receivables collected amounts to a large sum but without
putting the helpfulness at stake.
2. Contingency Cash Requirement: There may arise certain cases, which fall beyond the
forecast of the management. These establish unexpected calamities, which are too difficult to be
provided in the normal course of the business. Such contingencies always demand for special
cash requirements that was not assessed and provided for in the cash budget. Denials of
wholesale product, huge amount of bad debts, strikes, and lockouts are some of these
contingencies. Only a prior experience and investigation of other similar companies prove
supportive as a customary practice. A useful procedure is to shield the business from such
3. Availability of External Cash: This factor also has immense significance in the cash
management which refer to the availability of funds from outside sources. There resources help
in providing credit facility to the firm, which materialized the firm's objectives of holding
minimum cash balance. As such if a firm succeeds in obtaining sufficient funds from external
sources such as banks or private financers, shareholders, government agencies, the need to
4. Maximizing Cash Receipts: Nearly, all financial managers have objective to make the best
possible use of cash receipts. Cash receipts if tackled carefully results in minimizing cash
requirements of a concern. For this purpose, the comparative cost of granting cash discount to
customer and the policy of charging interest expense for borrowing must be appraised
continually to determine the ineffectiveness of either of the alternative or both of them during
that particular period for maximizing cash receipts. Some techniques proved helpful in this
i. Concentration Banking: In this system, a company launches banking centres for collection of
cash in different areas. Thus, the company instructs its customers of neighbouring areas to send
their payments to those centres. The collection amount is then deposited with the local bank by
these centres as early as possible. Whereby, the collected funds are transferred to the company's
ii. Local Box System: Under this system, a company rents out the local post offices boxes of
different cities and the customers are asked to forward their remittances to it. These remittances
are picked by the approved lock bank from these boxes to be transferred to the company's central
iii. Reviewing Credit Procedures: This type of technique assists to determine the impact of
slow payers and bad debtors on cash. The accounts of slow paying customers should be revised
to determine the volume of cash tied up. Besides this, evaluation of credit policy must also be
conducted for introducing essential modifications. As a matter of fact, too strict a credit policy
involves rejections of sales. Thus, restricting the cash inflow. On the other hand, too lenient, a
credit policy would increase the number of slow payments and bad debts again reducing the cash
inflows.
iv. Minimizing Credit Period: Shortening the terms allowed to the customers would definitely
quicken the cash inflow side-by-side reviewing the discount offered would prevent the customers
from using the credit for financing their own operations gainfully.
v. Others: There is a need to introduce various procedures for managing large to very large
remittances or foreign remittances such as, persona pick up of large sum of cash using airmail,
Minimizing Cash Disbursements: The intention to minimize cash payments is the ultimate
benefit derived from maximizing cash receipts. Cash disbursement can be brought under control
by stopping deceitful practices, serving time draft to creditors of large sum, making staggered
Maximizing Cash Utilization: It is emphasized by financial experts that suitable and optimum
utilization leads to maximizing cash receipts and minimizing cash payments. At times, a concern
finds itself with funds in excess of its requirement, which lay idle without bringing any return to
it. At the same time, the concern finds it imprudent to dispose it, as the concern shall soon need
it. In such conditions, company must invest these funds in some interest bearing securities.
Gitman suggested some fundamental procedures, which helps in managing cash if employed by
1. Pay accounts payables as late as possible without damaging the firm's credit rating, but take
2. Turnover, the inventories as quickly as possible, avoiding stock outs that might result in
3. Collect accounts receivables as early as possible without losing future loss sales because of
high-pressure collections techniques. Cash discounts, if they are economically justifiable, may be
concerned with minimizing fruitless cash balances, investing temporarily excess cash usefully
and to make the best possible arrangements for meeting planned and unexpected demands on the
firm's cash. Cash Management must have objective to reduce the required level of cash but
minimize the risk of being unable to discharge claims against the company as they arise. There
are five cash management functions:
1. Cash Planning: Experts emphases the wise planning of funds that can lead to huge success.
For any management decision, planning is the primary requirement. According to theorists,
way, to think before acting and to act in the light of facts rather than of a guess." Cash planning
is a practise, which comprises of planning for and controlling of cash. It is a management process
of predicting the future need of cash, its available resources and various uses for a specified
period. Cash planning deals at length with formulation of necessary cash policies and procedures
in order to perform business process constantly. A good cash planning aims at providing cash,
not only for regular but also for irregular and abnormal requirements.
2. Managing Cash Flows: Second function of cash management is to properly manage cash
flows. It means to manage efficiently the flow of cash coming inside the business i.e. cash inflow
and cash moving out of the business i.e. cash outflow. These two can be effectively managed
when a firm succeeds in increasing the rate of cash inflow together with minimizing the cash
over payments contribute to better management of cash. Whereby, a business can protect cash
and thereof would require lesser cash balance for its operations.
Controlling the Cash Flows: It has been observed that prediction is not an exact knowledge
variance with the results actually obtained. Due to this, control becomes an unavoidable function
of cash flow cycle, greater would be the number of times a firm can convert its goods and
services into cash and so lesser will be the cash requirement to finance the desired volume of
business during that period. Additionally, every business is in possession of some concealed
cash, which if traced out significantly decreases the cash requirement of the enterprise.
Optimizing the Cash Level: It is important that a financial manager must focus to maintain
sound liquidity position i.e. cash level. All his efforts relating to planning, managing and
controlling cash should be diverted towards maintaining an optimum level of cash. The prime
need of maintaining optimum level of cash is to meet all requirements and to settle the
obligations well in time. Optimization of cash level may be related to establishing equilibrium
between risk and the related profit expected to be earned by the company.
Investing Idle Cash: Idle cash or surplus cash is described as the extra cash inflows over cash
outflows, which do not have any specific operations or any other purpose to solve currently.
Usually, a firm is required to hold cash for meeting working needs facing contingencies.
In banking area, cash management is a marketing term for some services related to cash flow
offered mainly to huge business customers. It may be used to describe all bank accounts (such as
checking accounts) provided to businesses of a certain size, but it is more often used to describe
specific services such as cash concentration, zero balance accounting, and automated clearing
house facilities. Sometimes, private banking customers are given cash management services.
Financial instruments involved in cash management include money market funds, treasury bills,
1. Funds availability as per need on day zero, day one, day two, day three etc. i.e. Corporate can
Accounts receivable typically comprise more than 25 percent of a firm's assets. The term
receivables is described as debt owed to the firm by the customers resulting from the sale of
goods or services in the ordinary course of business. There are the funds blocked due to credit
sales. Receivables management denotes to the decision a business makes regarding to the overall
credit, collection policies and the evaluation of individual credit applicants. Receivables
Management is also known as trade credit management. Robert N. Anthony, explained it
as "Accounts receivables are amounts owed to the business enterprise, usually by its
customers. Sometimes it is broken down into trade accounts receivables; the former refers to
amounts owed by customers, and the latter refers to amounts owed by employees and others".
Receivables are forms of investment in any enterprise manufacturing and selling goods on credit
basis, large sums of funds are tied up in trade debtors. When company sells its products, services
on credit, and it does not receive cash for it immediately, but would be collected in near future, it
is termed as receivables. A firm conducts credit sales to shield its sales from the rivals and to
entice the potential clienteles to buy its products at favourable terms. Generally, the credit sales
are made on open account which means that no formal reactions of debt obligations are received
from the buyers. This enables business transactions and reduces the paperwork essential in
connection with credit sales.
Accounts Receivables Management denotes to make decisions relating to the investment in the
current assets as vital part of operating process, the objective being maximization of return on
investment in receivables. It can be established that accounts receivables management involves
maintenance of receivables of optimal level, the degree of credit sales to be made, and the
debtors' collection.
Receivables are useful for clients as it increases their resources. It is preferred particularly by
those customers, who find it expensive and burdensome to borrow from other resources. Thus,
not only the present customers but also the Potential creditors are attracted to buy the firm's
product at terms and conditions favourable to them.
Maintenance of receivable
1.Level of Sales:
The primary factor in determining the volume of debtors/receivables is the level of credit sales.
Increase in credit sales means a corresponding increase in debtors, and vice versa. No doubt the
level of sales can be used to forecast changes in receivables, i.e., if a firm predicts an increase of
50% in its credit sales for the next period, it will probably experience also an increase of 50% in
debtors/receivables.
2.Terms of Trade:
A change in credit policy has a direct impact on debtors. Thus, if credit terms are relaxed, it will
lead to increase in the amount of debtors, and vice versa.
3.Credit Policies:
The level of debtors/receivables balance is closely related with the collection policy of the firm.
Practically, credit policy determines the amount of risk that a firm is to undertake in its sales
activities.
Accounts receivable consist of the credit a business grants its customers when selling goods or
services.1They take the form of either trade credit, which the company extends to other
companies, or consumer credit, which the company extends to its ultimate consumers. The
effectiveness of a company’s credit policies can have a significant impact on its total
performance.. For a business to grant credit to its customers, it has to do the following:
The increased volume of sales will be increased the cost and risk of bad debts
Credit to only creditworthy customers will save costs like bad debt losses, collection
costs and investigation costs etc
Quality of trade accounts should be decided so that credit facilities are extended only
upto the optimum level.
It means the period allowed to the customers for making the payment
Concern fixes its own terms of credit depending upon its customers and volume of sales.
Financial manager compare the cost of discount and the amount of fund realized
Discount should be allowed only if its cost is less than the earnings.
Additional period allowed for this facility may prompt some more customers to avail
discount and make payments.
Evaluation of credit applications and finding out the credit worthiness of customers
should be undertaken
Collecting credit information about the customers is the first step in implementing credit
policy.
Information should be adequate and proper analysis about the financial position of the
customers is possible.
Sources of collecting credit information are financial statements, credit rating agencies,
reports from banks etc.
Credit analysis will determine the degree of risk associated, the capacity of the customer
to borrow and his ability and willingness to pay.
After analyzing the creditworthiness of the customer, decision has to take whether the
credit is to be extended and then upto what level.
Match the creditworthiness of the customer with the credit standard of the company.
If customers creditworthiness is above the credit standards then the credit is allowed.
Such policy will enable early collection of dues and will reduce bad debts losses.
Some customers may not appreciate the efforts of the concern and may shift to another
concern thus causing reduced sales and profits.
Advantages of accounts receivable management:
1. Increased Sales: Offering goods or services on credit enhances sales, by holding old
customers and attraction potential customers.
2. Increased Market Share: When the firm is able to maintain old customers and attract new
customers automatically market share will be bigger to the extent new sales.
3. Increase in profits: Increase sales, leads to increase in profits, because it need to produce more
products with a given fixed cost and sales of products with a given sales network in both cost per
unit comes down and the profit will be better.
Management of Inventory
Inventory management is basically related to task of controlling the assets that are produced to
be sold in the normal course of the firm's procedures. In supply chain management, major
variable is to effectively manage inventory. The significance of inventory management to the
company depends on the extent of its inventory investment.
1. The operational objective is to uphold enough inventory, to meet demand for product by
efficiently organizing the firm's production and sales operations.
1. Raw materials: Raw materials are those inputs that are transformed into completed goods
throughout manufacturing process. Those form a major input for manufacturing a product. In
other words, they are very much needed for uninterrupted production.
3. Finished products: Finished products are those products which are totally manufactured and
company can immediately sell to customers. The stock of finished goods provides a buffer
between production and market.
4. Stores and spares: It comprises of office and plant cleaning materials like soap, brooms, oil,
fuel, light, bulbs and are purchased and stored for the purpose of maintenance of machinery.
Component of inventory
Inventory control encompasses managing the inventory that is previously in the warehouse,
stockroom or store. This is to know the type of products are "out there", how many each item and
where it is kept. It means having accurate, complete and timely inventory transactions record and
avoiding differences between accounting and real inventory levels. Two tools commonly used to
ensure inventory accuracy and control are ABC analysis and cycle counting.
Types of Inventory
The aim of carrying inventories is to separate the operations of the firm. It means to make each
function of the business independent of each other function so that delays or closures in one area
do not affect the production and sale of the final product There are many types of inventory.
The common categories of inventory include raw materials inventory, work-in-process
inventory, and finished-goods inventory.
Raw-Materials Inventory: Raw materials inventory include basic materials purchased from
other firms to be used in the firm's production operations. These goods may include steel,
lumber, petroleum, or manufactured items such as wire, ball bearings, or tires that the firm does
not produce itself. Regardless of the specific form of the raw-materials inventory, all
manufacturing firms maintain a raw-materials inventory. The intention is to separate the
production function from the purchasing function that is, to make these two functions
independent of each other so delays in the delivery of raw materials do not cause production
delays. If there is a delay, the firm can satisfy its need for raw materials by liquidating its
inventory.
1. The transaction motive: Firm may hold the inventories in order to facilitate the smooth and
continuous production and sales operations. It may not be possible for the company to obtain raw
material whenever necessary. There may be a time lag between the demand for the material and
its supply. Therefore, it is needed to hold the raw material inventory. Similarly, it may not be
possible to produce the goods instantly after they are demanded by the customers. Hence, it is
needed to hold the finished goods inventory. The need to hold work-in-progress may arise due to
production cycle.
2. The precautionary motive: Firms also prefer to hold them to protect against the risk of
unpredictable changes in demand and supply forces. For example, the supply of raw material
may get delayed due to the factors like strike, transport disruption, short supply, lengthy
processes involved in import of the raw materials.
3. The speculative motive: Firms may like to buy and stock the inventory in the quantity which
is more than needed for production and sales purposes. It is done to get the advantages in terms
of quantity discounts connected with bulk purchasing or expected price rise.
Methods of inventory Management
1. ABC ANALYSIS
ABC analysis stands for Always Better Control Analysis.Certain products need more
attention than others. Using an ABC analysis lets you prioritize your inventory management by
separating out products that require a lot of attention from those that don’t. Do this by going
through your product list and adding each product to one of three categories:
Items in category A require regular attention because their financial impact is significant but
sales are unpredictable. Items in category C require less oversight because they have a smaller
financial impact and they're constantly turning over. Items in category B fall somewhere in-
between.
In Just in Time method of inventory control, the company keeps only as much inventory as it
needs during the production process. With no excess inventory in hand, the company saves the
cost of storage and insurance. The company orders further inventory when the old stock of
inventory is close to replenishment. This is a little risky method of inventory management
because a little delay in ordering new inventory can lead to stock out situation. Thus this method
requires proper planning so that new orders can be timely placed.
Pros of JIT
Less deadstock
Cons of JIT
Risk of stockouts
Economic Order Quantity technique focuses on taking a decision regarding how much quantity
of inventory should the company order at any point of time and when should they place the
order. In this model, the store manager will reorder the inventory when it reaches the minimum
level. EOQ model helps to save the ordering cost and carrying costs incurred while placing the
order. With the EOQ model, the organization is able to place the right quantity of inventory.
The minimum safety stock is the level of inventory which an organization maintains to avoid the
stock-out situation. It is the level when we place the new order before the existing inventory is
over. Like for example, if the total inventory in an organization is 18,000 units, they place a new
order when the inventory reaches 15,000 units. Therefore, the 3,000 units of inventory shall form
part of the minimum safety stock level.
5.BULK SHIPMENT
This method banks on the notion that it is almost always cheaper to purchase and ship goods in
bulk. Bulk shipping is one of the predominant techniques in the industry, which can be applied
for goods with high customer demand. The downside to bulk shipping is that you will need to lay
out extra money on warehousing the inventory, which will most likely be offset by the amount of
money saved from purchasing products in huge volumes and selling them off fast.
factors affect inventory management
1. Consumer demand
Maintaining the right stock levels accordance with the consumer demand is a key factor directly
affect inventory management flow. Example, we might receive a higher demand for item B than
item A during the holiday season and experience a high demand for item A than item B during
Summer. Thus, there is no point of ordering the same amount from each item when ordering
stocks throughout the year as one or the other will always overstock or stockout all the time. To
always have the items in the right amount in your stocks, you can use data collected from sales to
identify user behaviours and patterns so you can predict future consumer demands.
2.Financials
Getting financials right is crucial when it comes to inventory management as every step of the
process involves a great deal of financial risk. Spending too much on inventory can cause money
problems and spending too little can create unhappy customer reviews online. By planning the
spending of each inventory management task such as item ordering, tax costs associated with
stocks, transportation, storage…etc strategically we will be able to handle our inventory
management process smoothly reducing major cashflow problems. Additionally, it’s also
important to pay attention to fluctuations in the economy that affects the financial factor of
inventory management process.
3.Suppliers
Having a reliable group of suppliers is an essential factor to maintain a seamless inventory
management without comprising the customer satisfaction. It is huge in order to minimize delays
and shortages of stocks which can directly affect on production and then on order fulfillment. No
matter how reliable our suppliers are, having a backup supplier will always give us that extra
guarantee of a delay-free manufacturing process.
4.Products Amounts
Having the right item in the right quantity in our inventory will enhance not only the smoothness
of inventory management but also of the entire supply chain management process. Having a
good understanding of the inventory item levels, consumer demand, item shelf life…etc will help
we always maintain all the necessary items in the necessary level. For an example, it’s better to
order items that are shortly perishable in short amounts more frequently so you can avoid
wastes.
Thus, the productivity and the efficiency will get improved drastically. Tools like barcode
scanners, label printers, mobile computers…etc along with a good inventory management
software can double or even triple the speed of your inventory processes, as the new technology
involved with these will help you do the counting, recounting, receiving, picking…etc more
efficiently.
1. Inventory management guarantees adequate supply of materials and stores to minimize stock
outs and shortages and avoid costly interruption in operations.
2. It keeps down investment in inventories, inventory carrying costs, and obsolescence losses to
the minimum.
4. It removes duplication in ordering stock by centralizing the source from which purchase
requisition emanate.
7. Perpetual inventory values provide a stable and reliable basis for preparing financial
statements a better utilization.
3. Product obsolescence: If items are hold for long time, it may become outdated. Product may
become outmoded due to improved products, changes in customer choices, particularly in high
style merchandise, changes in requirements. Then this is a major risk and it may affect in terms
of huge revenue loss. It is costly for the firms whose resources are limited and tied up in slow
moving inventories.