INVENTORY CONTROL

What is Inventory?
• Inventory is a stock of items held to meet future demand.

• The stock of any item or resource used in an organization

and can include: raw materials, finished products,
component parts, supplies, and work-in-process

• Single largest asset on the balance sheet

• Accounts for 40-60% of current assets

• Helps to improve ROI & working capital

 What is Inventory?
• You should visualize inventory as stacks of
money sitting on forklifts, on shelves, and in
trucks and planes while in transit. That’s what
inventory is—money. For many businesses,
inventory is the largest asset on the balance
sheet at any given time, even though it is
often not very liquid.
The Purpose of Inventory

So why do you need inventory?

 The Purpose of Inventory
• In environments where an organization suffers
from poor cash flow or lacks strong control over
– (i) electronic information transfer among all
departments and all significant suppliers
– (ii) lead times
– (iii) quality of materials received

• inventory plays important roles.

 The Purpose of Inventory
• Fluctuations in demand

– A supply of inventory on hand is protection: You

don’t always know how much you are likely to
need at any given time, but you still need to satisfy
customer or production demand on time.
 The Purpose of Inventory
• Unreliability of supply
– Inventory protects you from unreliable suppliers
or when an item is scarce and it is difficult to
ensure a steady supply.
 The Purpose of Inventory
• Price protection
– Buying quantities of inventory at appropriate times helps
avoid the impact of cost inflation. Note that contracting to
assure a price does not require actually taking delivery at
the time of purchase.

– Many suppliers prefer to deliver periodically rather than to

ship an entire year’s supply of a particular stock keeping
unit ( SKU) at one time.

– The acronym “SKU,” standing for “stockkeeping unit,” is a

common term in the inventory world. It generally stands
for a specific identifying numeric or alpha-numeric
identifier for a specific item.
 The Purpose of Inventory
• Quantity discounts
– Often bulk discounts are available if you buy in
large rather than in small quantities.
– For example, an electric jigsaw might normally cost
$10 per unit. If you order 300 or more saws at one
time, your supplier may lower the cost to $8.75.

• Lower ordering costs

– If you buy a larger quantity of an item less
frequently, the ordering costs are less than buying
smaller quantities over and over again.
 The Purpose of Inventory
• Geographical Specialization
– It allows geographical positioning across multiple
manufacturing & distributive units of an
enterprise.

• Decoupling
– Allows EOS within a single facility & permit each
process to function at max efficiency rather than
having the speed of the entire process constrained
by the slowest
Inventory Hides Problems

Bad
Design
Lengthy Poor
Setups Quality
Machine
Inefficient Unreliable
Breakdown
Layout Supplier
 To Expose Problems:
Reduce Inventory Levels

Bad
Design
Lengthy Poor
Setups Quality
Machine
Inefficient Unreliable
Breakdown
Layout Supplier
 Inventory Costs
• Dollars

• Space

• Labor to receive, check quality, put away, retrieve,

select, pack, ship, and account for

• Deterioration, damage, and obsolescence

• Theft
 Inventory Carrying Costs
• Inventory carrying cost is the expense associated with
maintaining inventory.

• Inventory expense is calculated by multiplying annual

inventory carrying cost percent by average inventory
value.

• Assuming an annual inventory carrying cost percentage

of 20 percent, the annual inventory expense for an
enterprise with $1 million in average inventory would
be $200,000 (20% x $1,000,000).
 Inventory Carrying Costs
• While the calculation of inventory carrying
expense is basic, determining the appropriate
carrying cost percent is less obvious.

• Determining carrying cost percent requires

assignment of inventory-related costs.

• Financial accounts relevant to inventory carrying

cost percent are capital, insurance, obsolescence,
storage, and taxes.
 Inventory Carrying Costs
• Capital Cost
– The appropriate charge to place on capital
invested in inventory varies widely.
– Any funds invested in inventory lose their earning
power, restrict capital availability, and limit other
investment.
– For example, if a firm expects a 20 percent
before-tax return on invested capital, similar logic
suggests that capital tied up in inventory should
be assessed or charged the same 20 percent.
 Inventory Carrying Costs
• Taxes
– Taxing authorities typically assess inventory held
in warehouses. The tax rate and means of
assessment vary by location. The tax expense is
usually a direct levy based on inventory level on a
specific day of the year or average inventory level
over a period of time.
 Inventory Carrying Costs
• Insurance
– Insurance cost is an expense based upon estimated
risk or loss over time.
– Loss risk depends on the product and the facility
storing the product.
– For example, high-value products that are easily
stolen and hazardous products result in high
insurance cost.
– Insurance cost is also impacted by facility
characteristics such as security cameras and sprinkler
systems that might help reduce risk.
 Inventory Carrying Costs
• Obsolescence
– Obsolescence cost results from deterioration of
product during storage.
– A prime example of obsolescence is product that
ages beyond recommended sale date, such as
food and pharmaceuticals.
– Obsolescence also includes financial loss when a
product becomes obsolete in terms of fashion or
model design.
 Inventory Carrying Costs
• Storage
– Storage cost is facility expense related to product
holding rather than product handling.
– Storage cost must be allocated on the
requirements of specific products since it is not
related directly to inventory value.
Inventory Carrying Costs
 Ordering Cost/Setup Cost
• Ordering Costs : incurred when ordering more inventory
and when setting up to go into production to fill the order

• Used in calculating order quantities, the costs that

increase as the number of orders placed increases.

• It includes the costs related to the clerical work of

preparing, releasing, monitoring and receiving orders, the
physical handling of goods, inspections and setup costs.”
 Cost of Backorders
• Backorders, lost sales, lost customers : A
backorder, also known as stock-out, is an
unfilled customer order or commitment
 Inter-Relationship of Inventory, Operating
Cost, & Service
• Inventory, Operating Cost, & Service Levels are inherently tied
to one another.

• Focus on reducing two of the three, without process change,

negatively impact the remaining.

• For example focusing on reducing operating cost means

pursuing increased efficiency through larger batch sizes to
reduce flush & setup cost. This typically increases lead times
due to manufacturing constraints, which in turn require larger
safety stocks (increased inventory) to cover demand variability.
 Inter-Relationship of Inventory, Operating
Cost, & Service
– Focus on Operating Cost and Service Levels will increase
Inventory Cost
– Focus on Inventory Cost and Service Levels will increase
Operating Cost
– Focus on Operating Cost and Inventory Cost will
decrease Service Levels

• Inventory Management Process balances inventory

and operating cost to achieve a specified Service
Level Agreement at the lowest total cost.
 Inventory Management
• Supply chain has limited capacity and thus it takes
time to replenish the goods that are sold.

• Inventory Management is the process that controls

the availability of products and raw materials and
manages supply and demand variability.

• It is the discipline of keeping the right material at

the right place at the right time.
 Inventory Management
• The purpose of Inventory Management Process (IMP) is to consistently and
effectively manage finished product and raw material inventories in
Manufacturing & Distribution Units.

• The standard process delivers the most economic inventory, based on the
variability of individual SKUs at each sales location, to ensure full
compliance with agreed to Customer Service Level Agreements.

• The economic inventory level balances inventory cost & manufacturing

cost.

• Customer Service Level Agreements are negotiated to manage inventory by

specifying On-Time-In-Full (OTIF) and Lead Time requirements.
 Inventory Management
• Inventory levels are dependent on:
– Customer Service Level Agreements (OTIF & Lead
Times)
– Supply Planning Strategies
– Number of Stocking Points
– Manufacturing & Distribution Lead Times
– Demand Variability
– Forecast Accuracy
– Balance of cost saving to increase batch sizes versus
increased cost of inventory
 Inventory Control Models
• PP&C techniques like MRP are too complicated
for small companies

• An alternative is to have simple inventory

control system
– Where inventory is replenished using some
mechanism as it is consumed
 Re-Order Cycle Control (ROCC)
• Level of inventory of an item is checked periodically;
also known as review period
– High turnover items require frequent checking
– Longer the review period and more is the risk

• A replenishment order is placed for a sufficient qty to

bring the inv level to a target level

• This is also known as Periodic Inventory System

 Re-Order Point Control
• The level of inventory of an item is checked each time
any item is issued

• If the inv. level has fallen to the re-order point, an

order is placed for a pre-determined reorder qty
(ROQ)

• It is also known as continuous or perpetual inventory

system
Independent Demand

vs

Dependent Demand
 Independent Demand vs Dependent Demand

• Independent Demand : demand for a stand

alone product such as motorcycle, car etc.

• Dependent Demand : Exists only because of

demand for something else such as demand
for motorcycle tire is dependent upon the
demand for the motorcycles
 Independent Demand vs Dependent Demand

• The demand for the number of chairs you need is

independent from the number of tables that you
need because quantity required is influenced by the
demand in the market for each item.

• The demand for chair legs or seats is mathematically

dependent on the demand for finished chairs.

• Four legs and one seat are required for each chair.
 Independent Demand vs Dependent Demand

• Independent demand calls for a replenishment

approach to inventory management.

• This approach assumes that market forces will

exhibit a somewhat fixed pattern.

• Therefore, stock is replenished as it is used in

order to have items on hand for customers.
 Independent Demand vs Dependent Demand

• Dependent demand calls for a requirements approach.

• When an assembly or finished item is needed, then the

materials needed to create it are ordered.

• There is no fixed pattern because an assembly created in the

past may never be produced again.

• The nature of demand, therefore, leads to different

concepts, formulae, and methods of inventory management.
 Independent Demand vs Dependent Demand

• Independent demand
– Uncertain / forecasted
– Continuous Review / Periodic Review

• Dependent demand
– “Requirements” / planned
– Materials Requirements Planning / Just in Time

38
 Economic Order Quantity
• It shows how we can balance the various costs of stock
to answer the question, ‘How much should we order?’

• The approach is to build a model of an idealized

inventory system and calculate the fixed order quantity
that minimizes total costs.

• This optimal order size is called the economic order

quantity (EOQ).
 Economic Order Quantity (EOQ)
Model

Assumptions of the Basic EOQ Model:

• Demand rate D is constant, recurring, and known

• Amount in inventory is known at all times
• Ordering (setup) cost S per order is fixed
• Lead time L is constant and known.
• Unit cost C is constant (no quantity discounts)
• Annual carrying cost is i time the average $ value
of the inventory
• No stock outs allowed.
• Material is ordered or produced in a lot or batch
and the lot is received all at once

41
 EOQ Inventory Order Cycle
Demand
Order qty, Q
Inventory rate
Level

ave = Q/2

Reorder point, R

0 Lead Lead Time

time time
As Q increases, Order Order Order Order
average inventory
level increases, but Placed ReceivedPlaced Received
number of orders
placed decreases 42
 EOQ Model Costs

S = cost of placing order D = annual demand

H = annual per-unit carrying cost Q = order quantity
Annual ordering cost = SD/Q Annual carrying cost = HQ/2
Total cost = SD/Q + HQ/2 Q* = Economic Order Quantity

43
Total Cost of Inventory – EOQ Model

44
 EOQ Example 1

If D = 1,000 per year, S = $62.50 per order, and H =

$0.50 per unit per year, what is the economic
order quantity?

2DS
Q* 
H
2 * 1000 * 62.5

0.5
 500

45
 Introduction
• From a financial point of view, inventory is an asset and
represents money that is tied up and cannot be used for
other purposes.

• As we know, inventory has a carrying cost—the costs of

capital, storage, and risk.

• Finance wants as little inventory as possible and needs

some measure of the level of inventory.

• Total inventory investment is one measure, but in itself

does not relate to sales.
 Introduction
• Two measures that do relate to sales are the
inventory turns ratio and days of supply:

– Inventory turns
– Days of supply
 Inventory Turns
• Ideally, a manufacturer carries no inventory.

• This is impractical, since inventory is needed to support

manufacturing and often to supply customers.

• How much inventory is enough? There is no one

answer.

• A convenient measure of how effectively inventories

are being used is the inventory turns ratio:

• Inventory turns =annual cost of goods sold / average inventory in dollars

 Inventory Turns
• For example, if the annual cost of goods sold is $1 million
and the average inventory is $500,000, then
• Inventory turns =$ 1,000,000 / $ 500,000
=2

• What does this mean?

• At the very least, it means that with $500,000 of inventory

a company is able to generate $1 million in sales.

• If, through better materials management, the firm is able

to increase its turns ratio to 10, the same sales are
generated with only $100,000 of average inventory.
 Days of supply
• Days of supply is a measure of the equivalent
number of days of inventory on hand, based
on usage.

• The equation to calculate the days of supply is:

• Days of supply= inventory on hand / average daily usage
 Value of Stock
• Organizations need accurate values for their assets –
including stock – as this directly affects their reported
performance.

• Any errors can bring serious consequences. For example,

if the valuation of stocks is too low then a company may
appears to have fewer assets than it really has.

• This may give an artificially high return on assets, and in

extreme cases allows the company to be bought at a
fraction of its true value.
 Value of Stock
• Actual cost
– identifies each unit in stock with the price actually paid for it.

• First-In-First-Out (FIFO)
– This assumes that the first units arriving in stock are the first sold, so the
value of remaining stock is set by the amount paid for the last units
bought.

• Last-In-First-Out (LIFO)
– assumes that the latest units added to stock are used first, so the value of
remaining stock is set by the amount paid for the earliest units bought.

• Weighted average cost

– finds the average unit cost over a typical period
DIFFERENT METHODS OF INVENTORY
ANALYIS
 ABC Analysis
• Another useful set of accounting information comes from an ABC
analysis.

• Inventory control can take a lot of effort and so for some items,
especially cheap ones, this effort is not worthwhile.

• Very few organizations, for example, include routine stationery or

coffee in their formal stock systems.

• At the other end of the scale are very expensive items that need special
care above the routine calculations.

• It would be useful to find the amount of effort worth putting into the
control of any item.

• An ABC analysis gives some guidelines for this.

 ABC Analysis of Stocks
• The origin of the ABC analysis – sometimes called Pareto
analysis, or the ‘rule of 80–20’

• In inventory control terms it means that 20 per cent of the

inventory items need 80 per cent of the attention, while
the remaining 80 per cent of items need 20 per cent of the
attention.

• In particular, ABC analyses define the following:

– A items are the few most expensive ones that need special care.
– B items are ordinary ones that need standard care.
– C items are the large number of cheap items that need little care
 ABC Analysis of Stocks
• Typically an organization might use an
automated system to deal with all B items.

• A items are more important, and although the

automated system might make some
suggestions, managers make the final decisions
after a thorough review of circumstances.

• C items are very cheap and are usually left out

of the automatic system, to be dealt with by
ad-hoc procedures.
 ABC Analysis of Stocks
• An ABC analysis starts by taking each item and
multiplying the number of units used in a year by the
unit cost.

• This gives the total annual use of items in terms of value.

• Usually, a few expensive items account for a lot of use,

while many cheap ones account for little use.

• If we list the items in order of decreasing annual use by

value, A items are at the top of the list and C items are
at the bottom.
ABC Analysis of Stocks
 VED ANALYSIS
•Based on critical value & shortage cost of an item
– It is a subjective analysis.
• Items are classified into:
Vital:
• Shortage cannot be tolerated.
Essential:
• Shortage can be tolerated for a short period.
Desirable:
 Shortage will not adversely affect, but may be using more
resources. These must be strictly Scrutinized

  V E D   ITEM COST

A AV AE AD CATEGORY 1 10 70%

B BV BE BD CATEGORY 2 20 20%

C CV CE CD CATEGORY 3 70 10%

CATEGORY 1 - NEEDS CLOSE MONITORING & CONTROL

CATEGORY 2 - MODERATE CONTROL.
CATEGORY 3 - NO NEED FOR CONTROL
SDE ANALYIS
Based on availability
Scarce
Managed by top level management
Maintain big safety stocks
Difficult
Maintain sufficient safety stocks
Easily available
Minimum safety stocks
FSN ANALYSIS
Based on
utilization.
Fast moving.
Slow moving.
Non-moving.
Non-moving
items must
be
periodically
reviewed to
prevent
expiry
&
obsolescence
HML ANALYSIS
Based on cost per unit
Highest
Medium
Low
This is used to keep
control over consumption
at departmental level for
deciding the frequency of
physical verification
THANK
YOU!