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Inventory Management

Meaning of Inventory

The dictionary meaning of the word inventory is stock of goods In broader sense ‘Inventory’ refers to the stock pile of the product a firm is offering for sale and the components that make up the product

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In other words, the inventory is used to represent the aggregate of those items of tangible assets which areHeld for sale in the ordinary course of business In the process of production for such sale To be currently consumed in the production of goods or services available for sale


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Thus, inventory means and includes the following: Raw materials- these are goods that have to be used in the production finished goods Work in process- those raw materials which have been used in production process but have not been completed in to the final product are work in process Finished goods- These represent final or completed products which are available for sale in ordinary course of business

In terms of finance, inventory is defined as the sum total of value of raw materials, work in process and finished goods

Meaning of Inventory Management

It is inventory planning which covers the task of development and administration of policies, systems and procedures which minimize total costs relating to inventory decisions, and related functions such as customer service requirements, production scheduling, purchasing and so on Thus, inventory management means efficient control and management of capital invested in raw material and supplies, WIP and finished goods for the purpose of obtaining maximum return from the investment

Objectives of Inventory Management

Operating Objectives Financial Objectives

Operating Objectives

Regular flow of materials- the inventory management has to ensure maintaining of required quantity of material of desired quality at the required time so that there is regular and smooth flow of work Therefore, there should be proper control from the time orders are placed with the suppliers till the materials have been effectively utilized in the production


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Risk minimization- The firm should try to minimize the possibility of risk and losses due to Stock out (not holding inventory ) Obsolescence of stock with the change in demand such as fashions, designs, technology, likes and dislikes Deterioration Pilferage Theft Waste and unauthorized use

Avoiding of Stock-out Danger – Information about availability of materials or finished goods should be made available to the management so that planning for procurement at right time can be done If inventories are maintained at the optimum level keeping in view the operational requirements, the danger of stock out is eliminated

Financial Objectives

Minimum Investment – Overstocking of raw material and finished goods results in unnecessary tie up of the firm’s funds and loss of profit Investment of funds in inventory, costs in the form of opportunity cost and carrying cost and thereby reduces firm’s profitability The objective of inventory control system in a manufacturing firm to minimise the funds tied up in inventories

To minimize inventory costs- the investment can be minimized when a perfect match is brought between two sets of inventory costs i.e. procurement costs and inventory carrying costs This requires purchase of material at such quantities where purchasing and carrying costs are minimum This is possible by taking discount in bulk purchases

Costs of Holding Inventory

Cost of Material Purchased- It is the price we pay for the units we purchase These are the cost of purchasing the goods plus transportation and handling charges It can be calculated by adding the purchase price (less any discount), the delivery charges and the sales tax, if any

Ordering Cost-It is the fixed cost of placing and receiving an inventory order When orders are placed by the firm with suppliers to replenish inventory of raw materials, certain costs are involved which are known as ordering costs Thus, ordering costs refer to the costs incurred in placing an order for goods and receiving the supplies

Such costs vary in proportion to the number of orders placed and the number of items ordered More frequent orders accompanied by fewer purchases increases ordering costs or vice a versa Thus ordering costs are inversely related to the level of inventrory


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The ordering costs are classified under the following heads: Purchasing- the clerical and administrative costs such as staff salaries, postage, stationary, telephone etc. associated with the placing an order, purchasing, follow up, receiving and evaluating quotations Transportation and inspection – the costs of transportation and checking material for quality and quantity when they are received

3. Accounting – the costs of checking supplies against each order, making payments and maintaining records of purchases 4. Set up costs – when goods are manufactured internally instead of purchasing from outside the set up and tooling costs associated with each production runs

Carrying Costs-– Are the variable costs per unit of holding an item in inventory for a specified time period. When goods are received they are not immediately used in production of finished goods, but are stored for some time The expenses incurred in storing these goods are called carrying costs or holding costs

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In other words, the costs associated with holding a given level of inventory on hand are called inventory carrying costs and vary with the level and length of time, inventory is held. These are: Storage costs- such as rent , lighting, heating and refrigeration Handling costs- associated with movement of stock such as labour, cranes, etc.

3. Stores staffing, equipment maintenance, etc 4. Taxes, depreciation and insurance 5.Product deterioration and obsolescence 6. Spoilage, breakage, pilferage and loss due to perishable nature 7. Audit and accounting costs 8. Interest on capital (opportunity costs on investment tied up in inventory)  The carrying costs are calculated on an annual basis and are expressed as a percentage of average inventory value

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Stock- out costs or shortage costs- when a firm faces shortages of material or products, it incurs a cost If the firm is unable to fill an order it loses its sale It may be considered as an opportunity cost since the firm will be deprived of some benefits Thus the costs associated with the shortage of inventory are known as stock out or shortage cost


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The stock out costs include the following: Loss of profit due to lost sales Loss of future sales because customers may approach other manufacturers Loss of customer goodwill Loss of man and machine hours

Total cost – It is the sum of the all the above three costs related to inventory.