Inventory Management

(Inventory, Objectives, Control, Functions, Types, Techniques)

Inventory
The value of materials and goods held by an organization (1) to support production
(raw materials, subassemblies, work in process), (2) for support activities (repair,
maintenance, consumables), or (3) for sale or customer service (merchandise, finished
goods, spare parts).
Examples of inventory that a manufacturing business may have include:
i) Raw materials, such as wood, to make a shelf.
ii) Work-in-process inventory, such as an unfinished cake in food manufacturing.
iii) Finished goods inventory, such as a bed you've finished making.

What is inventory management?

Inventory management is the management of inventory and stock of supply chain

including aspects such as controlling and overseeing ordering inventory, storage of
inventory, and controlling the amount of product for sale.

Objectives of Inventory Management:

The main objectives of inventory management are operational and financial. The
operational objectives mean that the materials and spares should be available in
sufficient quantity so that work is not disrupted for want of inventory. The financial
objective means that investments in inventories should not remain idle and minimum
working capital should be locked in it.
The followings are the objectives of inventory management:
1. To ensure the continuous supply of materials spares and finished goods so that
production should not suffer at any time and the customer’s demand should also be
met.
2. To avoid both overstocking and under-stocking of inventory.
3. To maintain investment in inventories at the optimum level as required by the
operational and sales activities.
4. To keep materials costs under control so that they contribute to reducing the cost of
production and overall cost.
5. To minimize losses through deterioration, pilferage, wastages, and damages.
 6. To design proper organization for inventory management. Clear-cut accountability
should be fixed at various levels of the organization.
8. To ensure the right quality goods at reasonable prices. Suitable quality standards
will ensure proper quality stocks. The price analysis, cost analysis, and value analysis
will ensure payment of proper prices.
09. To facilitate furnishing of data for short-term and long-term planning and control
of inventory.
Objectives of Inventory Control
1. To maintain the overall investment at the lowest level, consistent with operating
requirements.
2. To supply the product, raw material, sub-assemblies, semi-finished goods, etc. to
its users as per their requirements at right time and at the right price.
3. To keep inactive, waste, surplus, scrap, and obsolete items at the minimum level.
4. To minimize holding, replacement, and shortage costs of inventories and
maximize the efficiency in production and distribution.
5. To treat inventory as an investment that is risky. For some items, the investment
may lead to higher returns, and for others fewer returns.
6. To protect against inflation since the prices of materials are constantly
increasing. Thus it is important to invest in inventories and save whenever the
price of the materials goes up. However, this benefit can only be availed if the
cost of holding inventory is taken care of.
7. To avail quantity discounts on bulk purchases.

Functions of Inventory Management:

1. The manager of the inventory has to take great care of time. (in processing and reaching
the inventory and does not get short in inventory).
2. Inventory management is also fed with the cost of all the raw items and their
subsequent costs in finished form making sure that the price of an item does not get too
high after including all the taxes and packaging costs.
3. It keeps account of all raw materials and makes an order for their reach in time so that
the processing operation does not come to halt.
4. It is also liable for keeping all records of the ready products which have to be shipped.

Types of Inventory
(There are two main types of inventory)
Manufacturing Inventory
It is the inventory held for the manufacturing and selling of goods. Based on the value
addition or stage of completion, the manufacturing inventories are further classified into
three types of inventory – Raw Material, Work-In-Progress, and Finished Goods.
➢ Raw materials inventory – Raw materials inventory are raw materials that your
business changes to produce its goods and/or services. For example, if you
manage an ice cream business, raw materials inventory could include milk you
use to make ice cream.
➢ Work-in-process inventory – Work-in-process inventory is any unfinished
goods that your business has made. If your business makes and sells chairs,
work-in-process inventory would include any unfinished chairs on hand that
your business has made.
➢ Finished goods inventory – Finished goods inventory includes any finished
goods that are ready to sell. If you have a retail business that buys and sells toys,
the toys you buy would be finished goods inventory.
Merchandise Inventory
It is the inventory of trading goods held by the trader. (Buy and sales)
Packing Material
Packing material is the inventory used for the packing of goods. It can be primary
packing or secondary packing. Primary packing is the packing without which the goods
are not usable. Secondary packing is the packing done for convenient transportation of
goods.
MRO Goods
MRO stands for maintenance, repair, and operating supplies like bearings, lubricating
oil, bolt, nuts for production, and stationery to Operating.
Goods in Transit
A business transports raw material, finished goods, etc from one site to other for sales,
purchase, further processing, etc are called Inventory / Goods in Transit.
Buffer Inventory (Safety Stock)
Buffer inventory is the inventory kept or purchased for the purpose of meeting future
uncertainties.
Anticipatory Stock
Based on the past experiences, a businessman is able to foresee the future trends of the
market and takes certain decisions for keeping stock is known as anticipatory stock.
Decoupling Inventory
The stock of input for all the machines should be sufficient to keep the factory running.
Such WIP inventory is called decoupling inventory.
Cycle Inventory
It is a type of inventory accumulated due to ordering in lots of sizes to avoid carrying
the cost of inventory.

Techniques of inventory management

Stock level
Excess and inadequate stocks both are harmful to the organization. Overstock results in
an extra investment of capital and understock affect the production process.
Re-order level
Reorder level is that level of material where new order should be placed considering the
daily usage rate and reorder period.
❖ Reorder level or Ordering level = Maximum rate of consumption × Maximum
reorder period.
❖ Alternatively, it will be = safety stock + lead time consumption
[lead time consumption will be = (Annual consumption) × lead time]
Re-order quantity
Re-order quantity is the quantity of materials that is purchased each time. This is also
termed as order size as economic order quantity.
Minimum stock level
It shows the minimum quantity of the material which must be maintained in hand at
every time.
• A manufacturing company does not face a shortage of materials.
• A trading company does not face a shortage of merchandise goods for re-selling.

❖ Minimum level of stock = Reorder level – (Average rate of consumption x

Average reorder period)
Maximum stock level
The level of maximum stock is fixed to remove the problem of overstocking. Stock is
normally not allowed to rise above the maximum level. Stock exceeding this level will
lead to blocking of capital and an unnecessary increase in stock holding cost.
❖ Maximum Level of Stock = (Reorder Level + Reorder Quantity) – (Minimum
rate of consumption x Minimum reorder period)
❖ Maximum Level may be alternatively fixed as Safety Stock + Reorder Quantity
or EOQ.
Average stock level
Average stock level refers to the normal or moderate stock level.
❖ Average stock level: (Minimum level + Maximum level) ÷2
Safety Stock
Safety stock is an additional quantity of an item held in inventory in order to reduce the
risk that the item will be out of stock.
❖ Safety Stock = (Annual Demand/365) x (Maximum Reorder Period – Average
Reorder Period)
Danger level
This is the level of material at which the issues of material are temporarily stopped.
 ❖ Danger level = It is slightly below the minimum level. It is a level at which
special efforts should be made to obtain supplies of materials, i.e.Minimum rate
of consumption × Emergency delivery time
Illustration I
Two components A and B are used as follows:
✓ Normal usage 50 units per week each
✓ Minimum usage 25 units per week each
✓ Maximum usage 75 units per week each
✓ Reorder Quantity A 300 units; B 500 units
✓ Reorder Period A 4 to 6 weeks, B 2 to 4 weeks
Calculate for each component:
(a) Reorder level,
(b) Minimum Level,
(c) Maximum level,
(d) Average Stock Level.
Solution:
(a) Reorder Level = Maximum Rate of Consumption x Maximum Reorder Period.
A = 75 x 6 = 450 units
B = 75 x 4 = 300 units
(b) Minimum Level = Reorder Level – (Average Rate of consumption x Average
Reorder Period)
A = 450 – (50 x 5) = 200 units
B = 300 – (50 x 3) = 150 units
(c) Maximum Stock Level
= (Reorder Level + Reorder Quantity) – (Minimum Consumption Rate x Minimum
Reorder Period)
A = (450 + 300) – (25 x 4) = 650 units
B = (300 + 500) – (25 x 2) = 750 units
(d) Average Stock Level = (Maximum Stock Level + Minimum Stock Level)/2
A = (650 + 200)/2 = 425 units
B = (750 + 150)/2 = 450 units
Average Stock Level can also be calculated by the formula.
Minimum Stock Level + ½ of Reorder Quantity
A = 200 + ½ x 300 = 350 units
B = 150 + ½ x 500 = 400 units
Illustration II:
If the minimum stock level and average stock level of raw material A are 4,000 and
9000 units respectively, find out its reorder quantity.
Solution:
Average stock level = Minimum stock level + ½ of Reorder Quantity
9000 = 4000 + ½ of Reorder Quantity
½ Reorder Quantity = 9000 – 4000 = 5000
Reorder Quantity = 10,000 units
Economic order quantity (EOQ)
Economic order quantity is the size of the lot to be purchased which is economically
viable or which can be purchased at minimum costs. Economic order quantity involves
two types of cost:
Carrying cost
All those costs which are incurred when we carry (or keep) the inventory in the store
for a certain period of time are known as total carrying costs. The carrying cost includes
the following cost:
(Clerical cost/ store administrative, Insurance and rent charges, Transportation,
spoilage, interest on capital or loan blocked on material)
Ordering cost
All those costs which are related to the purchase activities of inventory are ordering
costs. It is the cost of placing the order for the purchase of material.
Calculation of economic order quantity
The order quantity where the total ordering cost and carrying costs are equal is known
as the economic order quantity. The economic order quantity can be calculated under
the following methods;
EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)
Illustration I
ABC Ltd. is engaged in the sale of footballs. Its cost per order is Tk 400 and its
carrying cost unit is Tk 10 per unit per annum. The company has a demand for 20,000
units per year. Calculate the order size, total orders required during a year, total
carrying cost, and total ordering cost for the year.
Solution
EOQ = SQRT (2 × 20,000 × 400/10) = 1,265 units
Annual demand is 20,000 units so the company will have to place 16 orders (Tk. 20,000
÷ 1,265 Units). Total ordering cost is hence Tk 64,00 (Tk 400 ×16).
The average inventory held is 632.5 units (0+1,265) ÷ 2) which means total carrying
costs of Tk 6,325 (i.e. 632.5 × Tk 10).
That’s easier to visualize as a regular formula:

Q is the economic order quantity (units). D is demand (units, often annual), S is

ordering cost (per purchase order), and H is carrying cost per unit.
Illustration II
Say your clothing shop also sells men’s hiking shoes. The model you sell costs Tk 45
per pair. You sell 100 pairs of hiking boots a month, or 1,200 per year.
Your ordering cost is Tk 50 per order. You added up the total time spent by everyone
who’s involved in the ordering process, and you figure that the combined time to
process each order is one hour. Based on average salary and benefit costs, you assign a
Tk 50 cost per order.
The carrying cost per unit is Tk 3. That rate covers the occupancy costs and insurance
where the inventory is stored. The amount also accounts for the opportunity cost of
carrying the inventory.
Based on the data for the hiking boots, here’s your economic order quantity:

Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying
costs]
Economic order quantity = √ [(2 x 1,200 units x Tk 50) ÷ Tk3]
Economic order quantity = √ [Tk120,000 ÷ Tk3]
Economic order quantity = √40,000
Economic order quantity = 200
You just determined that the ideal order level is 200 units. At that level, you minimize
ordering and carrying costs.
Illustration III
A manufacturer uses 75,000 units of a particualr material per year. The material cost is
Rs. 1-50 per unit and the carrying cost is estimated to be 25% p.a. of average inventory
cost. The cost of placing an order is Rs. 18.
You are required to determine the Economic Order Quantity and frequency of orders
p.a.
Solution:
We know EOQ = √2AO/C
A = Annual consumption = 75,000 units
O = Ordering cost per unit = Rs. 18.
C = Carrying cost per unit = 25% of Rs. 1.5 = 0.375
... EOC = √2 × 75,000 × 18/0.375 = 2,691 units (approx).
Frequency of order p.a. = 28 (approx.)
ABC Analysis
ABC analysis of inventory is a method of sorting your inventory into 3 categories
according to how well they sell and how much they cost to hold:
A-Items – Best-selling items that don’t take up all your warehouse space or cost
B-Items – Mid-range items that sell regularly but may cost more than A-items to hold
C-Items – The rest of your inventory that makes up the bulk of your inventory costs
while contributing the least to your bottom line
Just In Time (JIT) Inventory Management
Just-in-Time Inventory Management is simply making what is needed, when it’s
needed, in the amount needed.
Many companies operate on a “just-in-case” basis – holding a small amount of stock in
case of an unexpected peak in demand.
JIT attempts to establish a “zero inventory” system by manufacturing goods to order; it
operates on a “pull” system whereby an order comes through and initiates a cascade
response throughout the entire supply chain.
Here are some of the benefits of just-in-time inventory:
➢ Minimize costs such as rent and insurance by reducing your inventory
 ➢ Less obsolete, outdated, and spoiled inventory
➢ Reduce waste and increase efficiency by minimizing or eliminating
warehousing and stockpiling, while maximizing inventory turnover
➢ Maintain healthy cash flow by ordering stock only when necessary
FIFO and LIFO
FIFO and LIFO are accounting methods used to value your inventory and report your
profitability.
FIFO (first in, first out) says the first items in your inventory are the first issue to leave
LIFO (last in, first out) says the last items in your inventory are the first to leave
The following are the details supplied by Mahi Corporation in respect of its raw
materials for the month of December 1988:

On 31.12.88 a shortage of 100 units was found. Find the values of issues and resulting
stocks on different dates using (i) LIFO. (ii) FIFO; and (iii) Simple Average methods.
Solution:
Working Notes:
1. Rate of stock issued on 10.12.88 = Rs. 5.00 + Rs. 6.00/2 = Rs. 5.50
2. Value of stock issued on 31.12.88 = Rs. 6.00 + Rs. (Here opening Stock rate i.e. Rs.
5 will not be considered as it has already been exhausted).

Which is Better - LIFO or FIFO?

To assess the relative value of LIFO and FIFO inventory cost, you need to look at the
way your inventory costs are changing:

• If your inventory costs are going up, or are likely to increase, LIFO costing may
be better, because the higher cost items (the ones purchased or made last) are
considered to be sold. This results in higher costs and lower profits.
• If the opposite it true, and your inventory costs are going down, FIFO costing
might be better. Since prices usually increase, most businesses prefer to use
LIFO costing.
• If you want a more accurate cost, FIFO is better, because it assumes that older
less-costly items are most usually sold first.
• If you handle food inventory management or operate any business with
perishable items, then you pretty much have to use FIFO.
• With that said, LIFO is a great method for non-perishable homogeneous goods
like stone or brick. So, if you get a fresh batch of items like these, you don’t
need to rearrange your warehouse or rotate batches since they’ll be the first ones
out anyway