Unit - 4 (WC) Inventory Management

NOIDA INSTITUTE OF ENGINEERING & TECHNOLOGY
GREATER NOIDA
Course & Branch : MBA

Subject Name: Working Capital Management
Code: AMBAFM0412
Unit – 4
Inventory Management
By
Dr. Riyazuddin
Designation
Assistant Professor
School of Management
NIET, GREATER NOIDA
Inventory Definition
A stock of items held to meet future demand
Inventory is a list for goods and materials, or those goods and materials themselves, held
available in stock by a business.
 Inventories comprises of
(a) Raw Material
(b) Work in Progress
(c) Finished Goods
. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

Introduction
 Constitute significant part of current assets
 On an average approximately 60% of current assets in Public Limited
Companies in India
 A considerable amount of fund is required
 Effective and efficient management is imperative to avoid unnecessary investment
 Improper inventory management affects long term profitability and may fail ultimately
 10 to 20% of inventory can be reduced without any adverse effect on production and
sales by using simple inventory planning and control techniques

Types of Inventory

Nature of Inventories
 Raw Materials – Basic inputs that are converted into finished product
through the manufacturing process
 Work-in-progress – Semi-manufactured products need some more
works before they become finished goods for sale
 Finished Goods – Completely manufactured products ready for sale
 Supplies – Office and plant cleaning materials not directly enter production
but are necessary for production process and do not involve significant
investment.

Reasons To Hold Inventory
Meet variations in customer demand
 Meet unexpected demand
 Smooth seasonal or cyclical demand
Pricing related:
 Temporary price discounts
 Hedge against price increases
 Take advantage of quantity discounts
 Process & supply surprises
 Internal – upsets in parts of or our own processes
 External – delays in incoming goods

Objective of Inventory Management
 To maintain a optimum size of inventory for efficient and smooth
production and sales operations
 To maintain a minimum investment in inventories to maximize the
profitability
 Effort should be made to place an order at the right time with right source
to acquire the right quantity at the right price and right quality

An effective inventory management should
 Ensure a continuous supply of raw materials to facilitate uninterrupted production
 Maintain sufficient stocks of raw materials in periods of short supply and
anticipate price changes
 Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service
 Minimize the carrying cost and time
 Control investment in inventories and keep it at an optimum level.

An optimum inventory level involves three types of
costs
Ordering costs:- Carrying costs:-
 Quotation or tendering  Warehousing or storage
 Requisitioning  Handling
 Order placing  Clerical and staff
 Transportation  Insurance
 Receiving, inspecting  Interest
and storing  Deterioration,shrinkage,evaporation and
 Quality control
obsolescence
 Clerical and staff
 Taxes
Stock-out cost  Cost of capital
 Loss of sale
 Failure to meet
delivery
commitments
Dangers of Over investment
 Unnecessary tie-up of firm’s fund and loss of profit – involves opportunity
cost
 Excessive carrying cost
 Risk of liquidity- difficult to convert into cash
 Physical deterioration of inventories while in storage due to mishandling and
improper storage facilities

Dangers of under-investment
 Production hold-ups – loss of labor hours
 Failure to meet delivery commitments
 Customers may shift to competitors which will amount to a permanent
loss to the firm
 May affect the goodwill and image of the firm

Functions of Inventory Management
Track inventory
How much to order
When to order

Recap
• Inventories are broadly categorised in:
• Raw materials
• Work in progress
• Finished goods
• Stores
• Proper inventory management is important for efficient production and sales activities.
• Inventories must be properly monitored and controlled To tide over the demand fluctuations
by maintaining reasonable safety stock.

Summary
• Inventories are broadly categorised in:
• Raw materials
• Work in progress
• Finished goods
• Stores
• Proper inventory management is important for efficient production and sales
activities.
• Inventories must be properly monitored and controlled To tide over the

demand fluctuations by maintaining reasonable safety stock.

Quiz
1. Define the inventories and their nature.
2. Discuss the various types of inventories.
3. Why inventories are held under transaction motive.
4. Discuss precautionary motive of holding inventories.
5. Why do organisation hold the inventory under speculative motive?
6. Explain the objectives of inventory management.
7. Why inventory is are needed to be monitored and controlled with great caution?
8. Discuss the benefits of holding the inventories.

Classification of inventory
•ABC Classification
• HML Classification
• XYZ Classification
•VED Classification
•FSN Classification
•SDF Classification
•GOLF Classification
•SOS Classification

ABC Analysis (Always Better Control)
 one of the most commonly used inventory management methods
 ABC analysis groups items into three categories (A, B, and C) based on their level of
value within a business.
 ABC analysis sorts inventory into three main buckets:
a) A items: This is your inventory with the highest annual consumption value. It should be
your highest priority and rarely, if ever, a stockout.
b) B items: Inventory that sells regularly but not nearly as much as A items. Often inventory
that costs more to hold than A items.
c) C items: This is the rest of your inventory that doesn’t sell much, has the lowest inventory
value, and makes up the bulk of your inventory cost.

ABC Classification
 In most of the cases 10 to 20 % of

the inventory account for 70 to 80%
of the annual
 A typical manufacturing operation

shows that the top 15% of the items,
in terms of annual rupees usage
represent 80% of totalannual rupees
usage
 Next 15% of items lect 15% of annual
rupees
 Next 70% accounts only for 5% usage

XYZ Classification
•On the basis of value of inventory stored
•Whereas ABC was on the basis of value of consumption to value.
•X – High Value
•Y – Medium value
•Z – Least value
Aimed to identify items which are extensively stocked.

HML Classification
 On the basis of unit value of item
 There is 1000 unit of Q @ Rs. 10 and 10,000 units of W @ Rs. 5.
• Aimed to control the purchase of raw materials.
• H – High, M- Medium, L - Low

VED Classification
 a valuable technique for inventory management that can help businesses of all sizes to
improve their performance.
It is a simple but effective way to classify inventory items into three categories based on
their importance to the business
a) vital,
b) essential,
c) and desirable.

• Vital items:
• Keep a high safety stock level of vital items.
• Use multiple suppliers to reduce the risk of supply chain disruptions.
• Implement expedited shipping procedures for vital items.
• Essential items:
• Keep a moderate safety stock level of essential items.
• Use a single supplier for essential items, but have a backup supplier in place.
• Use standard shipping procedures for essential items.
• Desirable items:
• Keep a low safety stock level of desirable items.
• Use a single supplier for desirable items, but have a backup supplier in place.
• Use standard shipping procedures for desirable items.
FSN Classification
 According to the consumption pattern
 To combat obsolete items
 F – Fast moving
 S – Slow moving
 N – Non Moving

SDF & GOLF Classification
 Based on source of procurement
 S – Scarce, D- Difficult, E- Easy.
 GOLF
 G – Government, O – Ordinary, L – Local, F
• – Foreign.

SOS Classification
 Raw materials especially for agriculture units

 S – Seasonal
 OS – Off seasonal

Deciding on the inventory model
 Assume an analyst applies an inventory model that does not allow for spoilage to a
grocery chain’s ordering policy for lettuce and formulates the strategy of ordering lettuce
in large amounts every 14 days. A little thought will show that this is obliviously foolish.
This strategy implies that lettuce will be spoiled. However it is not a failure of inventory,
it is a failure to apply the correct model.

Different approaches
 Certainty approach
• Uncertain variables and risk are addressed separately
 Uncertainty approach
• Uncertain variables and risk are addressed simultaneously
 Deterministic approach
 Probabilistic approach

Index
•Assumption
• Seasonal fluctuation in demand are ruled out
• Zero lead time – Time lapsed between purchase order and inventory usage
• Cost of placing an order and receiving are same and independent of the units
ordered
• Annual cost of carrying the inventory is constant
• Total inventory cost = Ordering cost + carrying cost

Basic EOQ Model
• Economic order quantity (EOQ) is a formula that allows inventory managers to calculate
their ideal order size. By comparing the cost of holding and selling goods with annual
demand, businesses can determine the quantity they should order their materials in, and how
frequently they should do this each year.
• It’s an important figure for any business trying to minimise overspending while meeting
demand, and especially for any business looking to reduce its overall inventory costs.
• At the same time, EOQ has some key limitations that mean it’s not a formula every business
can use – we lay out its advantages and disadvantages below.

EOQ – Three Approaches
 Trial and Error method
 Order-formula approach
 Graphical approach

EOQ & Re-order point
 EOQ – gives answer to question “How much to Order”
 Re-order point – gives answer to question “when to order”

Trial & Error Method
•Assumptions:-
•Annual requirement (C)=1200 units Carrying cost (I) = Rs.1
•Ordering cost (O) =Rs.37.5

Order- Formula approach
1/2
• EOQ =(2CO/I)
•C = Annual demand
•O = Ordering cost per order I = Carrying cost per unit
• 1/2
•EOQ =(2*1200*37.5/1) = 300 units

Order- Formula approach

Graphical method to find EOQ
al cost /2
Tot t = CQ
g cos
arryin
Cost in RS.
Ordering cost
= DS/Q
0 EOQ
Order quantity

Extension of basic EOQ model
 This model can be extended to include quantity discounts,

were simple calculation for quantity discount is added.
Non zero lead time
. Subject: working capital Management 38

by: Dr.Riyazuddin Slide no. #1

Non – zero lead time
If the lead time is ‘n’ then procurement must be done prior to ‘n’ days, i.e. T-n as shown in
the figure
Reorder point
0 T1 - n T1 T2 - n T2 T3 - n T3 T4 - n T4
Time
Placement of a order
. Subject: working capital Management 39

Index
• So we have dealt with
•EOQ model Its extension

 Non – Instantaneous replenishment
 Quantity Discount
 One – period decision
. 05/04/2024
Subject: working capital Management 41
Special inventory model
• Discount Quantities
 If discount increases with the order quantity, then the price of inventory is no more
constant
• Hence a new approach is needed to find the best lot size
Total Annual holding Annual Annual cost of

= cost + ordering cost + materials
cost

Special inventory model
• One period decisions
•The newsboy problem
 If a newspaper seller does not buy enough papers to resell on the street corner, sales
opportunity is lost. If the seller buys too many, the overage cannot be sold because
nobody wants yesterdays newspaper.

Inventory management under uncertainty
1. Option price model
2. Risk adjusted discount cash flow (DFC) Model
3. Dynamic inventory model

Option price model
 Option is a contract that gives the holder a right to acquire or sell certain things at a
predetermined price without any obligation.
 Calculated by integrating the market information and inventory control.

Risk adjusted discount cash flow (DFC) Model
Suppose a television dealer decides to hold

• an additional inventory of 1000 television per month. The cost of holding inventory is
spread overtime.
Inflows = no: of units × probability × present value

Determination of Material Level and Stock Level
• Proper maintenance of stock items of each type of material is the main function of
stores department.
• Maintenance of large quantity of stock leads to huge investment in materials, large
space usage, dangers of deterioration in the quality and obsolescence of materials
• .On the other hand, less stock may result in frequent purchase, higher costs, work
stoppages, loss in production, etc. In order to avoid overstocking and under stocking of
materials in the storeroom, different levels of stocks are fixed.
They are
1. Re-order level
2.Maximum level
3.Minimum level4.
4.Average level
(a) Re-ordering level
• It is also known as ‘ordering level’ or ‘ordering point’ or ‘ordering limit’.
• It is a point at which order for supply of material should be made.
• This level is fixed somewhere between the maximum level and the minimum level
• in such a way that the quantity of materials represented by the difference between the re-
ordering level and
• the minimum level will be sufficient to meet the demands of production till such time as the
materials are replenished.
• Reorder level depends mainly on the maximum rate of consumption and order lead time.
• Re-order level =Maximum Rate of consumption x maximum lead time

(b) Maximum Level:
• Maximum level is the level above which stock should never reach.
• It is also known as ‘maximum limit’ or ‘maximum stock’.
• The function of maximum level is essential to avoid unnecessary blocking up of capital in
inventories, losses on account of deterioration and obsolescence of materials, extra
overheads and the temptation to thefts etc.
• Maximum Stock level = Reordering level + Reordering quantity —(Minimum

Consumption x Minimum re-ordering period)

(c) Minimum Level
• It represents the lowest quantity of a particular material below which stock should not be
allowed to fall.
• This level must be maintained at every time so that production is not held up due to the
shortage of any material.
• It is that level of inventories of which a fresh order must be placed to replenish the stock.
• Minimum Level = Re-ordering level — (Normal rate of consumption x Normal

delivery period)

(d) Average Stock Level:
• Average stock level is determined by averaging the minimum and maximum level of stock.
• This may also be expressed by minimum level + 1/2 of Re-ordering Quantity.

(e) Danger Level:
• Danger level is that level below which the stock should under no circumstances be allowed
to fall.
• Danger level is slightly below the minimum level and therefore the purchases manager
should make special efforts to acquire required materials and stores.
• Danger level = Average rate of consumption x Emergency supply time.

Cas lets
1. A cafe serving coffee and bakery goods needs to maintain the stock levels of the
ingredients required to prepare menu items, such as milk, sugar, coffee, flour, butter, rising
agents, fruits, etc. The owner must balance having enough fresh produce like fruits and
perishables like milk and butter without wastage. This ensures that the outlet can fulfill
customer orders without running out of crucial ingredients.
2. A firm that sells electronic gadgets manages stock levels for such products. They adjust
their inventory based on Market trend, new technological advancements, and
the product life cycle. The business has a reordering level of 3000 refrigerators and a
reorder quantity of 1500 refrigerators. The maximum monthly sales are 200 refrigerators,
the maximum lead time is 30 days, and the minimum is 22 days. Also, the minimum sales
per month is 120 refrigerators, and the minimum and maximum reorder times are 20 and
30 days, respectively.

Sollution
Minimum Level = (Maximum usage × Maximum lead time) – (Average usage × Average lead time)
Average Sales = (200 + 120) / 2 = 160 refrigerators
Average Lead Time = (30 + 22) / 2 = 26 days
Minimum Level = (200 × 30) – (160 × 26) = 6000 – 4160 = 1840 refrigerators
Maximum level = Reordering level + Reordering Quantity – (Minimum Consumption x Minimum
Reordering period)
Maximum Level = 3000 + 1500 – (120 x 20) = 2100 refrigerators
Reordering Level = Average Consumption x Maximum reorder period for emergency purchases.
Reordering Level = 160 x 30 = 4800 refrigerators
Average Stock Level = Minimum stock Level + 1/2 of Reordering Quantity
Average Stock Level = 1840 + 1/2 of 1500 = 2590 refrigerators
Danger Level = Average Consumption x Maximum reorder period for emergency purchases
Danger Level = 160 x 30 = 4800 refrigerators

Dynamic inventory model
1. Uncertain variables are identified
2. Probability associated with them is taken
3. Simulation techniques are applied

Emerging trends in inventory management
•Entering into log term contract at a fixed price to reduce uncertainties

•Just-in-time
•Kanbans – Japanese technique (Only produce when demand comes)
•Internet based ordering system
•Supply chain management Vendor development
•Investment in plant and machinery

Inventory control responsibility
Purchasing naturally has vest interest in inventories, even to the extend that in some
companies the purchasing and stores functions are combined.
Production looks after the work in progress
 Logistics plays a major role in inventory control
Inventories are economic importance to finance department
The fact that materials must be moved from one place to another is of importance to
materials department

Daily Quiz
1. Discuss the importance of inventory management.
2. Describe the objectives of inventory management.
3. Explain various types of inventories that are used in the business firm.
4. Explain the need for monitoring and controlling the inventories.
5. Discuss the ways to reduce the cost of the maintaining the inventories.

Weekly Assignment
1. Describe the Economic order quantity.

2. Explain the reorder point. How it helps to manage the inventories efficiently.
3. Describe the ABC Analysis for inventory management.
4. Discuss the advantages and disadvantages of ABC Analysis
5. Explain the VED analysis technique of inventory management.

MCQ s
1. Which of the following is not an inventory?
a. Machines
b. Raw material
c. Finished products
d. Consumable tools
2. The following classes of costs are usually involved in inventory decisions except
e. Cost of ordering
f. Carrying cost
g. Cost of shortages
h. Machining cost
. The cost of insurance and taxes are included in
a. Cost of ordering
b. Set up cost
c. Inventory carrying cost
d. Cost of shortages
4. The minimum stock level is calculated as

e. Reorder level – (Nornal consumption x Normal delivery time)
f. Reorder level + (Nornal consumption x Normal delivery time)
g. (Reorder level + Nornal consumption) x Normal delivery time
h. (Reorder level + Nornal consumption) / Normal delivery time

Unit - 4 (WC) Inventory Management

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NOIDA INSTITUTE OF ENGINEERING & TECHNOLOGY

Course & Branch : MBA

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

 Smooth seasonal or cyclical demand

 Hedge against price increases

 Take advantage of quantity discounts

 Process & supply surprises

 Internal – upsets in parts of or our own processes

 External – delays in incoming goods

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

How much to order

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

• Inventories must be properly monitored and controlled To tide over the

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

 In most of the cases 10 to 20 % of

 A typical manufacturing operation

 Next 70% accounts only for 5% usage

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

 Raw materials especially for agriculture units

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

 This model can be extended to include quantity discounts,

Non zero lead time

. Subject: working capital Management 38

. Subject: working capital Management 39

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

 Non – Instantaneous replenishment

 One – period decision

Total Annual holding Annual Annual cost of

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

Suppose a television dealer decides to hold

Inflows = no: of units × probability × present value

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1

• Re-order level =Maximum Rate of consumption x maximum lead time

. Subject: working capital Management by: Dr.Riyazuddin Slide no. #1