CHAPTER 6

INVENTORY MANAGEMENT

Learning Objectives

This topic aims that the students be able to:

-Understand the concept of inventory management.

-Discuss inventory management, differing views, techniques, and international concerns.

-Explain the concept of economic order quantity

-Understand the concept of Just in Time (JIT) inventory system

Introduction

Investment in inventories constitutes the most significant part of current

assets/working capital in most of the undertakings. Thus, it is very essential to have proper
control and management of inventories. The purpose of inventory management is to ensure
availability of materials in sufficient quantity as and when required and to minimize
investment in inventories.

It is necessary for every management to give proper attention to inventory

management. A proper planning of purchasing, handling, storing and accounting should
form a part of inventory management. An efficient system of inventory management will
determine the following:

- What to purchase

-How much to purchase

-From where to purchase

-Where to store

There are conflicting interests and viewpoints of different division heads over the
issue of inventory. Below scenario is for a manufacturing setup.

-The financial manager's general disposition toward inventory levels is to keep them low and
to ensure that the firm's money is not being unwisely invested in excess resources.

-The marketing manager, on the other hand, would like to have large inventories of the
firm's finished products.
-The production manager's major responsibility is to implement the production plan so that
it results to the desired amount of finished goods of acceptable quality available on time at a
low cost.

-The purchasing manager is concerned solely with the raw materials inventories.

Inventory Management

It refers to the development and administration of inventory policies systems, and

procedures necessary to efficiently and satisfactorily meet inventory requirements at the
minimum cost possible. It requires the coordination of both purchasing and financing
functions to effectively manage inventory.

Normally, inventory utilization could be evaluated by the turnover formula.

Turnover formula can also be used as a measure of efficiency in purchasing stock
management and selling activities.

In most cases, the basic decision in a manufacturing, retail, and even in some service
companies is how many inventories must be kept on hand. As the inventory levels are
established, it becomes an important factor in a budgeting process.

Objectives of Inventory Management

1. To reduce inventories while maintaining customer service levels and quality. The firm can
free needed cash to finance both internal and external growth. Thus, it involves a delicate
balance between ordering costs. carrying or holding costs and shortage costs.

2. To establish production and inventory control.

The following must be noted in inventory management:

a. Control - Proper control system must be set up. This may include stock cards and other
records for inventory physical movements. though with the advancement of technology,
most inventory controls are through computers.

b. Information on inventory level must be properly communicated on time to avoid stock

out.

c. Inventory value Stored items have value and this value must be reflected in the
appropriate statements about inventory. For inventory management purposes, this value
includes:

1. Cost of carrying inventories:

-Desired rate of return on inventory investment (foregone interest on working capital tied
up in inventory)
-Risk of obsolescence, spoilage, theft, and deterioration

-Storage space costs (warehouse, depreciation or rental, security)

-Property taxes

-Insurance

ii. Cost of ordering or set up costs:

-Preparing purchase or production orders

1. Time spent in finding suppliers and expediting orders

2. Clerical costs of preparing purchase order

• Receiving (unloading, unpacking, inspecting)

1. Transportation costs

2. Receiving costs

Processing all related documents

Mailing and stationery costs

Other costs like telephoning and typing orders

iii. Shortage costs:

• Disrupted production when raw materials are unavailable

1. Idle workers

2. Extra machine setup

Lost sales resulting to dissatisfied customers

Loss of quantity discounts on purchases

Economic Order Quantity (EOQ)

The basic inventory problem a firm faces is one of minimizing the total cost of the
inventories. In solving this problem, the firm must also avoid the possibility of any stock-outs
which would result to customer loss and dissatisfaction Minimizing total inventory cost can
be dealt with the use of the EOQ, which assumes that the relevant costs of inventory can be
divided into order costs and carrying costs. Order costs are the fixed clerical costs of placing
and receiving an inventory order. Carrying costs are the variable costs per unit of holding an
item in inventory for a specific period.

EOQ is the order size or the appropriate number of units that must be ordered at
the least cost. EOQ is the optimal number of units to be ordered to maintain the minimum
cost.

Basic Assumptions in Using EOQ

1. Supply of goods is stable.

2. Demand occurs at a constant rate throughout the year.

3. Lead time on the receipt of the orders is constant.

4. The entire quantity ordered is received at one time.

5. The unit costs of the items ordered are constant. Thus, there can be no quantity discounts

6. There are no limitations on the size of the inventory.

Just-in-Time (JIT) System

A system of inventory control in which a manufacturer coordinates with suppliers so

that raw materials or component parts will be received just in time they are needed in the
production process. Similarly, completion of products will be made just in time they are to
be delivered to the customers.

Objective of JIT

The primary concern of the JIT system is to reduce carrying costs, particularly cost of
investment in inventory on hand itself, and other related control costs. To some extent, JIT
system reduces the need for the purchases to carry inventories by passing the problem back
to its suppliers. However, a supplier may also benefit from a coordinated production
schedule:

1. By having able to schedule production that runs better; and

2. By having to carry lower finished goods inventory safety stock.

If any of the above reasons is present, coordination between suppliers and users
lessens total inventory requirements and reduces total production costs. Accounting wise,
JIT simplifies the recording procedures detailed in cost accounting. The concern of financial
managers is how they can control the determinants of costs and how these can be
minimized.
Computerized Systems for Resource Control

A materials requirement planning (MRP) system is an inventory management

technique that applies EOQ concepts and a computer to compare production needs to
available inventory balances and to determine the schedule for ordering various items on a
product's bill of materials.

Manufacturing resource planning II (MRP II) is a sophisticated computerized system

that integrates data from numerous areas such as finance, accounting, marketing,
engineering, and manufacturing and generates production plans, as well as numerous
financial and management reports.

Enterprise resource planning (ERP) is a computerized system that electronically

integrates external information on the firm's suppliers and customers with the firm's
departmental data. Through this system, information from all available resources-human
and material can be instantly obtained in a fashion, thus eliminating production delays and
controls costs.