Inventory Management

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Subject COMMERCE
Paper No and Title Paper No 8: Financial Management
Module No and Module No 40: Management of Inventory

Title
Module Tag COM_P8_M40
COMMERCE PAPER No. : 8: FINANCIAL MANAGEMENT

MODULE No. : 40: MANAGEMENT OF INVENTORY
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
2.1Meaning of Inventory
2.2Objectives of Inventory Management
2.3 Costs and benefits of Inventory Management
3. Techniques of Inventory Control
4. Classification problem
4.1ABC System
5. Order quantity problem
5.1EOQ Model
6. Order point
7. Safety Stocks
7.1 Costs related with safety stocks
8. Summary
1. Learning Outcomes
After studying this module, we shall be able to
 Know the meaning of inventory.
 Examine the objectives of inventory management.
 Understand the costs and benefits of inventory management.
 Analyze the various techniques of inventory control.
 Evaluate the management and control of inventory.

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2. Introduction
2.1 Meaning of Inventory
One of important components of current assets is inventory. Inventory explains the stock
of goods the firm has, either in the form of raw materials, semi-finished goods or finished
goods. The raw materials and semi-finished goods are converted into finished goods
through its manufacturing process. Finished goods are final goods, which are ready for
sale.
Effective inventory management would ultimately aim at maximization of the owner’s
wealth, which is consistent with the overall objective of financial management.
2.2 Objectives of Inventory Management
Inventory management deals with the following two conflicting

requirements:
 To minimize investments in inventory –Maintaining inventory

involves costs, thus, the objective of effective inventory management
will be to maintain the minimum possible inventory, in order to lower
down the costs.
 To ensure sufficient inventories to meet the production and sales
demand –Holding sufficient amounts of inventory ensures smooth
functioning of the firm.
2.3 Costs and Benefits of Inventory Management

In order to achieve the objective of maintaining optimal levels of inventory, the firms
need to undertake cost-benefits trade-off for inventory management

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Costs Benefits
Obsolscence Benefits in Sales
Opportunity cost Benefits in WIP
Benefits in
Carrying Costs
production
Benefits in
Ordering Costs
purchasing
Fig1: Costs and Benefits Trade-Off for Inventory Management
Costs of Holding Inventory
1. Ordering Costs: These are costs incurred for acquiring or ordering of inventory.
For replenishing of stock, firms need to order stock to ensure smooth production.
The costs linked with it are the nature of fixed costs like administrative tasks,
preparing purchase orders, receiving, inspecting, recording of stock as per the
purchase order, etc. These are fixed costs, which necessarily incurred with each
order. Higher the number of orders placed, more will be the ordering costs. Thus,
ordering costs are inversely related to the size of inventory.
2. Carrying cost: These are the costs linked with the maintenance of inventory.
These can include storage cost, handling costs, insurance of inventory, etc. Higher
the size of inventory, more will be the carrying costs.
3. Opportunity Costs: These refer to the expenses to finance the acquisition and
maintenance of inventory. Lesser the inventory, less funds would be tied up in
inventory and less will be its opportunity costs. If the funds are not tied up in
inventory, they can earn a return for the firm.
4. Obsolescence: Holding large amounts of inventory over a longer period of time
might also lead to obsolescence.

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Benefits of Holding Inventory
1. Benefits of purchasing: Purchasing raw materials in large quantities will help the
firm avail the discounts, which are offered on bulk purchases. This will reduce the
cost of acquiring and ordering inventory. Raw materials inventory gives the firm
flexibility in purchasing.
2. Benefits of production: Finished goods inventory helps in providing flexibility in
the production schedule. The firm needs to decide upon the production schedule –
whether it has to be continuous (through out the year) or as per the demand (if
seasonal demand) only. Having continuous production lowers down the cost of
discontinues in the production process.
3. Benefits in Work-in-progress: Shortening of the production process, will lead to
reduction in the work-in-progress inventory.
4. Benefits of sales: Inventory forms the link between production and sales. Having
sufficient inventory helps the firm meet the customers demand. It also helps the
firm to gain competitive advantage over its rivals.
Thus, the inventories should be increased only as long as the savings from holding
inventories is more than the costs of holding it.
3. Techniques of Inventory Management

The various problems associated with effective inventory control and the techniques for
tackling such problems are:
Inventory
Control
Order
Classification Order point Safety Stocks
Quantity
Reorder
ABC System EOQ Model
point
Fig 2. Problems with effective Inventory Control
The next section gives details about each of these problems.

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4. Classification Problem: ABC System

Classifying the inventory into various categories determines the type and degree of
inventory control required.
4.1 ABC System is an inventory categorization technique, which suggests that

inventories of a firm are not of equal value. Thus, the inventory is grouped into three
categories (A, B, and C) in order of their estimated importance.
'A' items are very important for an organization. Because of the high value of these
‘A’ items, frequent value analysis is required. In addition to that, an organization
needs to choose an appropriate order pattern (e.g. ‘Just- in- time’) to avoid excess
capacity. For these items, very tight control and accurate records are required.
'B' items are important, but of course less important than ‘A’ items and more
important than ‘C’ items. Therefore ‘B’ items are intergroup items. For these, very
tight control and accurate records are required.
'C' items are marginally important. For them, simplest controls possible and minimal
records are sufficient.
Example of ABC class are

 ‘A’ items – 20% of the items accounts for 70% of the annual consumption value
of the items.
 ‘B’ items – 30% of the items accounts for 25% of the annual consumption value
of the items.
 ‘C’ items – 50% of the items accounts for 5% of the annual consumption value of
the items.
However, sometimes an inventory item in “C Class” although inexpensive, may be

critical for the production process and may not be easily available. Thus, in such a case,
proper attention needs to be given for its effective management.
5. Order Quantity Problem: EOQ Model

After the classification and identification of the inventory into Class A, B and C, next is
the determination of the order quantity. Thus, the management needs to decide upon the
following:

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 How much inventory should be bought under one

order?
 Should the quantity ordered be large or small?
 Should the inventory be ordered under one lot or in several small lots?
The following diagram depicts the impact of holding large and small inventory quantity
levels:
Large Inventory Quantities Small Inventory Quantities
Smooth production Interruptions in

process production process
Lower ordering costs Higher ordering costs
Higher carrying costs Lower carrying costs
Fig 3. Deciding on the Order Quantity
5.1 Economic Order Quantity (EOQ) Model
The optimum level of inventory can be determined with a popular technique known as
Economic Order Quantity (EOQ). EOQ determines the optimum order quantity that
minimizes the total cost of inventory management.

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Fig 4. Economic Order Quantity Model
Q* represents the EOQ level of inventory which leads to minimum total inventory costs.
The aim is to find out the order size with lowest total cost (ordering plus carrying).
𝟐𝑨𝑩
𝑬𝑶𝑸 (𝑸 ∗) = √
𝑪
where,
A – annual usage of inventory
B – buying cost per order
C – carrying cost per unit
Example:
The annual usage for LLC Ltd. is Rs. 2,000 units. The cost per order is Rs.
100 and the carrying costs are Rs. 10 per unit. Thus,

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𝟐(𝟐𝟎𝟎𝟎)(𝟏𝟎𝟎)
EOQ (Q*) = √ = 200 units
𝟏𝟎
Limitations with EOQ

model:
Assumption of
Constant Need to maintain Assumption of
consumption & additional known annual
instant inventory demand
replenishment
Fig 5. Limitations of EOQ Model
 Assumption of constant consumption and instant replenishment: This may not

always happen. The suppliers may take time to deliver inventories, which may take
time to refill the stocks.
 Need to maintain additional inventory: There might be unexpected demand for
stocks. For the purpose of meeting the contingencies, the company needs to maintain
additional safety stocks.
 Assumption of known annual demand: There might be an instability between
expected demand and actual demand, which might lead to additional or reduction of
inventory levels.
6. Order point
EOQ helps to calculate the order size so as to reduce the carrying and the ordering costs.
6.1 Reorder point
Reorder point determines the point at which the order has to be placed to replenish the
stocks.

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Reorder point = Lead time in days

average* Daily usage of
inventory
Where, Lead time depicts the time taken in receiving the delivery of the stock, once the
order has been placed.
Example: The average daily consumption of stock is 10,000 units. The number of days
required to receive the delivery of stock after placing the order is 15 days. Thus, the
reorder point will be 10,000 units X 15 days = 1,50,000 units. This means the firm should
order for stock for replenishment as soon as the level reaches to 1,50,000 units. The EOQ
level, however, will determine the size of the order.
7. Safety Stock
As mentioned previously in the EOQ model, there might be discrepancy in anticipated
and actual demand, leading to extra or stock-out situation. Thus, to avoid such a situation,
firms tend to keep sufficient safety margin by having additional stock to guard against
stock-out situations. Hence, safety stocks represent additional stock, which acts as
buffer, or cushion against possible shortage of inventory caused either by increased usage
or delayed delivery of stocks.
7.1 Costs related with safety stocks:
Stock-out costs
Carrying costs
Fig 6. Costs related to safety stocks

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 Stock-out costs: These are costs related with shortage

of inventory. The firm may lose out on certain benefits if faced with any stock-out
situation. The loss may be in terms of reduced sales, loss of customers, impact on the
reputation of the firm, loss in production schedule, etc.
 Carrying costs: These costs would again be the cost of maintaining additional
inventory as buffer.
There needs to be a trade-off between the two, as larger safety stock would increase the
carrying costs but at the same time, reduce the stock-out costs.
8. Summary
 Inventory refers to stock of goods the firms has either in the form of
raw materials, semi-finished goods or finished goods.
 The conflicting objectives of inventory management are to minimize
investments in inventory, on one hand and on the other hand, to ensure
sufficient inventories to meet the production and sales demand.
 There are various costs and benefits associated with inventory

management. When the firm is deciding about the optimum levels of
inventory to be maintained, a proper trade-off between the costs and
benefits needs to be evaluated.
 The various problems with effective inventory control are classification
problem, order quantity problem, order point problem and safety stock.
 ABC System is an inventory categorization technique, which suggests
that inventories of a firm are not of equal value. Thus, the inventory is
grouped into three categories (A, B, and C) in order of their estimated
importance.
 EOQ determines the optimum order quantity that minimizes the total cost
𝟐𝑨𝑩
of inventory management. Symbolically, EOQ = √
𝑪
 Reorder point determines the point at which the order has to be placed to
replenish the stocks.
 Safety stocks represent additional stock, which acts as buffer against
possible shortage of inventory caused either by increased usage or
delayed delivery of stocks.
 The main costs related with safety stocks are stock-out costs and carrying
costs.


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Paper No and Title Paper No 8: Financial Management

Module No and Module No 40: Management of Inventory

COMMERCE PAPER No. : 8: FINANCIAL MANAGEMENT

COMMERCE PAPER No. : 8: FINANCIAL MANAGEMENT

2.2 Objectives of Inventory Management