Basic concepts of Inventory and Material management

Index 1 Definition of inventory.................................................................................................................1 2 Classification of inventory............................................................................................................1 3 Cost associated with inventory.....................................................................................................2 4 Inventory Control:.........................................................................................................................2 5 Inventory accounting principals....................................................................................................5 6 Order Quantity Methods...............................................................................................................8 7 Inventory flow in an Organization (From receipt till consumption and delivery)......................10 8 References...................................................................................................................................11
1 Definition of inventory
Inventory is usable but idle resources that have economic value for an organization. These resources can be direct or indirect to the business operations. Inventory can be of any form raw material to finished goods. Inventory status starts with raw material input which after being worked on and with addition with other direct or indirect inventory get converted into WIP, if the conversion is not complete. Once the final stage is reached the form of the WIP gets converted into finished goods. The conversion cycle is as follows:


Inventory is stock kept in order for the following reasons:  To meet the customer (internal & external) demand at the right time  To avoid lost sales due to stock outs  Economy of scale in production, purchase and logistics  To protect against the rising prices of the material in the market

2 Classification of inventory 2.1 Category wise
      Raw materials - materials and components scheduled for use in making a product. Work in process, WIP - materials and components that have begun their transformation to finished goods. Semi Finished assemblies Finished goods - goods ready for sale to customers. Goods for resale - returned goods that are salable. Maintenance and repair parts Safety stock (buffer stock): It is used to protect against the possibility of stock-outs when demand or supplies are subject to uncertainty or fluctuation. In transit stock (Pipeline stock): This represents material that is in transit, such as from a plant to a distribution center or a customer. Pipeline stocks are most prevalent with distribution inventories of finished goods


Function wise
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d) Stock-out costs: The demand increases than available inventory levels in between order lead time cause stock out situation to arise. In general organizations have plenty of SKUs. deteriorations etc and also insurance c) Ordering costs: costs associated in ordering an item. possibility of pilferage Based on these factors many methods are developed. In this method. interests on the account payables. obsolescence. a relationship is found between the percentage of items and the percentage of annual dollar usage: A : About 15% of the items account for about 80% of the dollar usage . or to help level the production rate to reduce the production rate changeover costs. unsettled government trade dispute or any unjustifiable price peak. Lot size stock: The inventory ordered is lot form in order to take benefit of bulk discount. ABC analysis is based on Pareto’s law. some of them are: 4. This includes purchase department’s overhead charges. Fours factors needs to considered in controlling inventory: a) What is the importance of the inventory item? b) How to control them? c) How much should be ordered at one time? d) When should an order be placed? Inventory is classified using the following criteria under various control methods:        Unit Cost Lead Time Annual Usage Quantity Cost of a Stock-out Storage requirements for an item Scarcity of resources. receiving and inspection etc. taxes. worker’s salary and handling equipment’s cost). e) Capacity-related costs: Costs associated with capacity creation in order to suit the production level. loss of customer. Hedging stock: it’s similar to anticipation stock but is built-up in anticipation of some event that may not actually come about. in transit insurance. storage cost (space. This will increase the carrying cost to be increased and also the related employment costs. back ordering costs. planned sales promotional campaign. b) Carrying costs: carrying cost includes various indirect cost associated with inventory. Anticipation stock: Type of inventory buildups that are produced and accumulated based on some strategy as preparing for peak season. this includes the actual price of item and other indirect costs such as freight. damage to brand value and goodwill etc. custom duties etc. like labor strike at supplier side.1 ABC Analysis: ABC analysis determines importance of items and thus allowing different levels of control based on the relative importance of items. This leads to loss of sales.handling charges. It is needed to classify them in order to have better control at a reasonable cost. handling. shipping and other costs. opportunity cost and risk cost associated with damage. raw materials Shelf life. which includes in-house transportation . 4 Inventory Control: Control of inventory is done by controlling individual items called Stock Keeping Units (SKUs).   3 Cost associated with inventory a) Item cost: The landing price paid for an item. to reduce ordering.

close follow-ups and expediting to reduce lead times. Group the items into A. complete accurate records. 3 Divide the annual dollar usage of each item by the aggregate annual usage to obtain percentage of total usage by each item. Allocate maximum resources and efforts for tightest control. ‘A’ items: High priority: Tighter control. 2 Add the total annual usages of all items to determine the aggregate annual dollar usage. Control Based on ABC Classification ABC classification helps in instituting various levels of controls on inventory.B : About 35% of the items account for about 15% of the dollar usage C : About 50% of the items account for about 5% of the dollar usage ABC Classification process Inputs required:  Annual usage in units for each item  Unit cost of each item Process Steps: 1 Calculate annual dollar usage for each item by multiplying Annual usage in units by the unit cost. Calculate the cumulative percentage of total usage from top to bottom of the list. Rank items by percentage of total usage in descending order (from highest to lowest). ‘B’ items: 4 5 6 . regular and frequent reviews. B and C groups based on cumulative percentage and the defined rules.

have plenty and carry safety stock Few common uses of ABC classifications are:  Cycle-counting frequency  Engineering priorities  Procurement priorities  Security  Replenishment systems  Investment decisions  Method of calculation 4. X is high demand. X category items will have lower variation and their demand can be predicted with more accuracy. Variance is calculated for demand of all items. are sometimes issues as “free stock” or forward holding. The items are arranged in increasing fashion of their Variation Coefficient and then starting 20% (count wise) of total items will be classified as X next 30% as Y and rest 50% as Z. Order large quantities. . ‘C’ items: Lowest priority: Simple and basic controls. • Y class is of lower criticality requiring standard controls and periodic reviews of usage.2 XYZ Analysis’ XYZ analysis is more used in relation of the customer demand for FG (finished goods). good records and normal processing with regular attention. • Z class require the least controls. then second 30% can be predicted with less accuracy and rest 50% item’s demand can not be forecasted at all as their demand in sporadic in nature. Y medium demand.Medium priority: Normal controls. Z very low or sporadic demand. The results of the XYZ analysis provide information that helps evaluate how each inventory part should be monitored and controlled. These controls are typically: • X class items which are critically important and require close monitoring and tight control while this may account for large value these will typically comprise a small percentage of the overall inventory count.

. and low. Essential.5 HML Analysis: Items are classified according to the unit value as high. SOS Seasonal and Off-seasonal 5 Inventory accounting principals 5.7 4. It is used to control the purchase value of items.8 GOLF Government-controlled. Difficult to obtain or Easy to obtain as it is an off-the-shelf item. Slow. medium.6 4. FSN (Fast. which feeds a battery of equipments downstream such as servers. Essential is one which is necessary but is independent like desktop terminals and desirable item is like speakers.4. Desirable) Analysis: This classification is from the point view of operation particularly useful for spare parts control Vital equipment is one. It is based upon frequency of consumption so their control will be designed as per consumption pattern.3 VED (Vital. ordinarily available in the open market. slow can be brake assembly and non-moving can be an outdated cassette based music player for a car in a motor repair shop.1 Tracking of inventory: It is the process of keeping records of available inventory which is further used for determining the inventory value at a specified point of time. This is specifically used for spare parts. Non moving) Analysis etc. 4. locally available and foreign imported purchase SDE Scarce item or single source item. Fast items can be nuts n bolts.4 4. 4.

2.000 Beginning Inventory = 1.2. inexpensive parts. 5. Tracking or review is done at predefined cycles that can be daily.000 units @ $20 each LIFO $60.2 5. so this system provides us with up to date status on stock and quantity allocated on order for an item. 5. Four-Wall Inventory Systems: This system is used mainly for very fast moving items which do not require storage in warehouse.3 Perpetual: It is the tracking process in which records are maintained after each and every transaction.3 Monthly Inventory Purchases* Month January February March Total Units Purchased 1. The older inventory. The process needs high accuracy and speed in recognition of transactions. or monthly.1.1 5. In this system higher level of safety stock is needed for covering up variation in demands during cycle time and lead time Periodic systems are often used for MRO supply items or for other small. is left over at the end of the accounting period. therefore.5.000 1.2. depending on the consumption speed for an item. weekly.000 3.1 Deriving cost of inventory LIFO: This method assumes that the last unit coming into inventory is sold first.2 5.000 $15.000 1.2 5. Based on these on hand record is generated after each entry.1. Periodic: A periodic system does not keep track of each issue. The systems records inventory when it is received in factory or warehouse and is subtracted only when it leaves premises in finished goods form.000 .000 units purchased at $8 each (a total of 4. receipt.000 Cost/unit Total Value $10 $12 $15 $10. Average Costing System: This method takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory Example: Analyzing inventory of Orizon Company to understand various methods and how they affect the financial analysis of a company. withdrawal.000 units) Income Statement (simplified): January-March* Item Sales = 3.000 $12. As this cycle is so small that inventory need not to be stored in warehouse at any stage.000 Average $60. The recorded inventory level is used for periodic reporting and for cyclic replenishment.1.000 FIFO $60. FIFO: This method assumes that the first unit coming into inventory is the first sold.

Beginning Inventory Purchases Ending Inventory (appears on B/S) *See calculation below COGS Expenses Net Income 8.2.000 $30.25 each = $11. Inventory and COGS are valued using that price and variance is reported from the standard cost.000 $13.000 37.250 COGS = 8000+37000-11250 = 33750 5.750 10.250 $33. 5.000 x 8) + (1.4 Standard Costing System: In this method price (Standard) is assumed for an item based on the historical prices or on the basis of some other measures.3.000 15. Value added costing etc. This approach is very realistic for inventory valuation.000 units X $15 each = $15.000 37.000 x 10) + (1.2.000 x 12) + (1.000 units left for ending inventory: (4.000 units X $8 each = $8.000 $37.25 per unit Ending Inventory =1.Ending Inventory LIFO Ending Inventory Cost =1. Items are counted daily by trained employees.3.1 Methods of Counting Cycle counting: It is a continuous system which is applied on limited fast moving items.3 5.000 units .000 units left) We are trying to find out COGS and inventory asset balance in various methods Ending Inventory = Inventory in hand at the end of accounting period * Relevant Price Cost of Goods Sold= Beginning Inventory + Net Purchases .000 COGS = 8000+37000-8000 = 37000 FIFO Ending Inventory Cost =1. Replacement Cost system: This system values inventory based on the current price level at which it can be replenished.000 8.000 10.000 10.000 $16.000 units X $11.000 COGS = 8000+37000-15000 = 30000 Average Cost Ending Inventory = [(1.000 37.000 8.000 x 15)]/4000 units = $11.5 5. .250 *Note: All calculations assume that there are 1.000 units sold = 1.000 8.000 $20.000 11. Apart from the methods discussed there are other various systems such as Actual Cost systems.

3. As units are withdrawn from inventory to meet the demands. or lot-size. referred as saw-toothed graph. Its primary purpose is to validate the aggregate inventory values used for financial accounting statements and it may not have accurate Day-to Day status.4. 6. This inventory graph. On other hand. The prerequisites for this system include a forecast of requirements. EOQ can be used if annual usage can be determined. larger lot sizes result in more inventories and inventory is expensive to hold. once this value falls in safety stock level or below then order must be placed to avoid interruption in supply.4. Projected Available for Period n = Projected Available for Period (n-1) + Scheduled Receipts for Period n – Forecast Demand for Period n 5. This Minimizes total inventory cost.4 5. then an inventory receipt of same predetermined quantity should come at just about the time inventory would be depleted. the inventory declines gradually until it becomes zero (out of stock). It can be calculated by adding up all the demands over the planning horizon . forecasted demand and the beginning balance in a particular period the Project available for that period is calculated. is a classic model of inventory behavior when usage is uniform and relatively continuous. 6 Order Quantity Methods 6.1 Replenishment systems Time Based: Time Phased Order Point: Time phasing is a technique that has been borrowed from Material Requirement Planning (MRP) as a means to determine when replenishment orders must be placed to ensure a continuous supply of goods. Based on the scheduled receipts.1 EOQ: EOQ is the optimal quantity to order taking into consideration both the cost to carry inventory and the cost to order the item. It is usually less expensive to purchase (and transport) or produce a bunch of material at once than to order it in small quantities. 5. choices are based on the principle of economy of scale.5. if replenishment orders are placed at judicious times. where all items are counted in a short period of time. Due to volume it often requires shutdown of operations.2 Periodic physical counting: This is the most preferred method and is performed annually. However.1.1 Demand Based Methods All order quantity.2 Quantity based – Re-order Point: The reorder point method assumes that a perpetual method is employed to keep track of inventory so that on-hand balances are always known to the control system. lead-time of the item and order quantity.

Assumptions:         Constant unit price.and then “annualize” the demand by extending an average of the period demands to represent the data for a full year.(D x S) / Q² To optimize: set d(TC)/d(Q) = 0 . Carrying cost is some fixed percentage of the item cost so total carrying cost varies with inventory volume. constant carrying and ordering costs Known & constant demand Known & constant lead time Instantaneous receipt of material Constant consumption rate No quantity discounts Only order (setup) cost & holding cost No stock outs Calculation for Economic Order Quantity D= C= Q= S= I= H= Annual demand (units) Cost per unit ($) Order quantity (units) Cost per order ($) Holding cost (%) Holding cost ($) = I x C Total cost = (Q/2) x I x C + S x (D/Q)+D*C carry cost order cost inv cost Take the 1st derivative: d(TC)/d(Q) = (I x C) / 2 . So as the quantity in an order increases the ordering cost per unit goes down. Ordering cost is fixed cost per order irrespective or quantities added into it.

This system creates no unused lot size inventory and hence is best for ‘A’ class items and in a just-in-time environment.2. This method requires time-phased information. by a fixed order quantity (such as a carton or a truckload).2 Fixed order quantity A form of independent demand item management model in which an order for a fixed quantity is placed whenever stock on hand plus on order reaches a predetermined reorder level.2 6.2. The reorder point in either instance is large enough to cover the maximum expected demand during the replenishment lead time. Period Order Quantity (POQ): The approach uses a formula based on the EOQ but is solved for optimum number of periods to be covered by each order rather than for the optimum quantity. The order quantity changes whenever requirements change. The fixed order quantity may be determined by the economic order quantity. or by another model yielding a fixed result.Number of Orders = D / Q Ordering costs = S x (D / Q) Average inventory units = Q / 2 $ = (Q / 2) x C Cost to carry average inventory = (Q / 2) x I x C = (Q /2) x H Oi a pm t l Epce xet d Epce xet d Oe r r d N br u e m T e i m Q nt u ty ai O es r r d Bw n e e t e DS/ Q² = IC / 2 Q²/DS = 2 / IC Q²= (DS x 2 )/ IC Q = sqrt (2DS / IC) = * = Q 2 ⋅D ⋅S H D D = Demand per year = N = Q* O es r r d d = D D sY r a / e y a Wk g oi r n S = Setup (order) cost per order Wk g oi r n D sY r a / e y a = = Holding (carrying) cost T H= N d = Demand per day L = Lead time in days RP O = ⋅L d Re-Order Point 6. 6.1.1 Discrete Methods Lot for lot (L4L): Lot-for-lot ordering is the method of placing an order for each period that has requirements in the exact amount of the requirement. The number of orders per year is same as EOQ.2 7 Inventory flow in an Organization (From receipt till consumption and delivery) . 6. the carrying cost is reduced. Thus ordering cost remains same but as the order quantities are determined by actual demand. but the quantity ordered each time varies.

de . 4. Packing list. ABC/XYZ Analysis as a basis of differentiated scheduling from www. QC documents 8 References 1. 3. Design Spec. Items Receiving Department Inspections Yes Inspecti on Cleared NO Discrepancy Report Item.fir. 2. Basics of supply chain management: APICS-CPIM Certification Course: Study Guide Fundamentals of Operation Management 4e: Tata Mc Graw-Hill Companies Operation Management 8e by William J. Stevenson Lecture: Industrial Logistics.Warehouse: Inventory Records Inventory Data Sales Department: Order receiving Customer Order Allocate & Dispatch Yes Material availabili ty NO Purchasing Dept: Purchase Request Order Data Supplie r Challan.

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