Inventory Management

irshadmfc@gmil.com
 Inventory
Institute of Chartered Accountants of India (ICAI) has defined inventory as “tangible property
held (i) for the sale in the ordinary course of business or (ii) in the process of production for
sale or (iii) for consumption in the production of goods or services for sale, including
maintenance supplies and consumable other than machinery spares”.

a) Raw Material b) Work-in-Progress c) Finished Goods and d) Supplies or stores and spares.
Need/Motives to hold inventories

 Transaction Motives: For smooth production and sale.

 Precautionary Motives: To guard against the risk of unpredictable

changes in supply and demand

 Speculative Motives: To take advantage of price fluctuations by either

increasing or decreasing the inventory levels depending upon the
situation.
 Objectives of inventory management
1. To minimize investment in inventories

2. To maintain a large size of inventories for uninterrupted sales operations

The job of the financial manager is to manage the conflicting objectives of the inventory
management by having a proper trade-off between the two and should avoid the situations of
either overinvestment and underinvestment in inventories.
 Dangers of overinvestment and
underinvestment in inventories
Dangers of Overinvestment:
1. Unnecessary tie-up of the firm funds and loss of profitabiltity
2. Excessive carrying cost
3. Risk of liquidity

Dangers of Underinvestment:
1. Production hold-ups
2. Failure to meet delivery commitments
 Cost of inventories
The costs associated with the inventory fall into two big categories
1. Ordering/Acquisition/Set-up Costs:
 These costs are associated with the acquisition or ordering of inventory.
 Apart from placing an orders outside, the various production departments have to acquire
materials form the stores. Any expenditure involved here is also a part of the ordering cost.
The components of ordering costs are:
 Preparing a purchase order or requisition form
 Receiving, inspecting, and recording the goods received to ensure both quantity and quality
There is inverse relationship between acquisition/ordering costs and the size of the inventory.
Thus costs can be minimized by placing fewer orders for a larger amount*.
 Cost of inventories
2. Carrying/Holding Costs:
These are the variable costs per unit of holding an item in inventory for a specified time period.
It has following two elements:
a) Costs arising due to storing of inventory
 Storage costs (tax, depreciation, insurance maintenance of the building, utilities and janitorial
services)
 Insurance of inventory against fire and theft
 Deterioration in inventory due to pilferage, fire, technical obsolescence, style obsolescence and
price decline
 Servicing cost like labor for handling inventory, clerical and accounting costs.
 Cost of inventories
b) The opportunity Cost of Funds:
This consists of expenses in raising funds (interest on capital) to finance the acquisition of
inventory. If funds were not locked up in inventory, they would have earned a return. This is
the opportunity cost of funds.

The carrying/holding costs and inventory size are positively related

3. Cost of Stock-outs: The loss of sales due to stock-out (it refers to a demand for an item
whose inventory level already reduced to zero)

c) Total Cost = Ordering cost + Carrying Cost

 Demand
The starting point for management of inventory is customer
demand*.

 Inside customers**

 Outside customers***
 Demand*

 Dependent Demand**

 Independent Demand***
Inventory Control Systems
 Techniques of Inventory management
 ABC Analysis{Classification Problem}

 Economic Order Quantity (EOQ) {Ordering Quantity

Problem}

 Just in Time (JIT) System

 VED (Vital, Essential and Desirable) Analysis

 ABC Analysis
In this analysis, the inventory items in an organization are classified on the basis of their
usage in monetary terms. It is very common to observe that usually a small number items
account for a large share of the total cost of materials and a comparatively large number of
items involve an insignificant share. Based on this criteria, the items are divided into three
categories:

A: Highly Important (High Consumption Value items)

B: Moderately Important (Moderate consumption value items)
C: Least Important (Low Consumption value items)
 Also Called Pareto Principle, as research was done in Italy and it was concluded that 80% of
the wealth of the country is controlled by 20% of the population.
 Joseph Duran in 1950 coined the term for this analysis as “Separating the Vital few from
the Trivial many”.
 Step-wise mechanics of the abc
Step – 1: Obtain a list of items along with information on their cost and the periodic (usually annual
consumption)
Step – 2: Determine the annual usage value for each of the items by multiplying unit cost with
number of units.
Step – 3: Express the value for each item as percentage of the aggregate/total usage value
Step – 4: Place the items in the descending order and calculate the cumulative value for each item
including the percentage values.
Step – 5: Determine an appropriate division for the A, B and C categories.
After having done the classification of inventories, the inventory decisions are made on the basis of
their classification
A item would call for a strict control and maximum attention and protection for stock-outs related
to them should be kept as high as possible, since the cost involved is substantial. Then next should
be placed on category B items and lastly category C items
Note: The general rule for classification ratio could be taken as A:65-75%, B:20-25% and remaining
for Category C.
 Basic principles of ABC analysis
1. The analysis does not depend upon the unit cost of the items but only on its annual
consumption value.

2. It does not depend on the importance of the item.

3. The limits of ABC categorization are not uniform but will depend upon the size of the
undertaking, its inventory as well as the number of items controlled.
Course of action for each category
 A items: High consumption value
1. Very strict control
2. No safety stocks
3. Frequent ordering or weekly deliveries
4. Weekly control statements
5. Maximum follow-up and expediting
6. Rigorous value analysis
7. As many sources as possible for each item
8. Accurate forecasts in material planning
9. Minimization of waste, obsolete and surplus
10. Individual postings
11. Central purchasing and storage
12. Maximum efforts to reduce lead time
13. Must be handled by senior officers
 B items: moderate value
1. Moderate control
2. Low safety stocks
3. Once in three months
4. Monthly control report
5. Periodic follow-up
6. Moderate value analysis
7. Two or more reliable sources
8. Estimates based on past data on present plans
9. Quarterly control over surplus and obsolete items
10. Small group postings
11. Combination purchasing
12. Moderate
13. Can be handled by middle management
 C items : low consumption value
1. Loose control
2. High safety stock
3. Bulk ordering once in six months
4. Quarterly control reports
5. Follow-up and expediting in exceptional cases
6. Minimum value analysis
7. Two reliable sources for each other item
8. Rough estimates for planning
9. Annual review over surplus and obsolete material
10. Group positioning
11. Decentralized purchasing
12. Minimum clerical efforts
13. Can be fully delegated
Advantage & Disadvantages of ABC
analysis
Advantages:
 By Controlling the inventory of A category items, the total inventory cost can be
considerably reduced

Disadvantages:
 Importance to item is given on its annual cnsumtpion and not on its criticality for the
production
 Periodical review is necessary to take into the account the changes in prices and
consumption
 Practical Problems
Problem: 01#: Perform ABC analysis using the following data:

Item Units Unit Price Item Units Unit

(₹) Price (₹)

01 700 5.00 07 6,000 0.20

02 2,400 3.00 08 300 3.5
03 150 10.00 09 30 8.00
04 60 22.00 10 2,900 0.4
05 3,800 1.50 11 1,150 7.10
06 4,000 0.50 12 410 6.20
 Practical Problems
Problem: 02#: the following is the information regarding the consumption and price per unit of
different items of inventory. Classify the items as per ABC analysis:

Item Units Unit Price (₹)

01 6,000 100
02 10,000 65
03 5,000 50
04 25,000 2
05 4,000 25
06 15,000 10
07 25,000 6
08 10,000 5
 Other Selective control techniques
VED (Vital, Essential and Desirable) Analysis:
HML (High, Medium and Low). Similar to ABC analysis but here unit cost is considered not annual
consumption. This is useful for keeping control over consumption at the department level.

SDE (Scarce, Difficult and Easy): This uses the criteria of the availability of the item. S means
scarce items which are in short supply. D means items which are available in local market can’t be
produced easily. E means items easily available in the local market

S-OS (Seasonal and Off-seasonal): This analysis is based on the nature of supplies. This
classification of items is done with the aim of determining proper procurement strategies.

FSN Analysis: Based on the consumption of pattern of the items, the FSN Classification calls for
classification of items, as Fast-moving, Slow-moving and Non-moving. The speed classification helps
the arrangement of stocks in the stores and in determining the distribution and handling patterns.

XYZ Analysis: It is based on the closing inventory value of different items. Items whose inventory
value are high are classed as X items while those with low in investment in them are termed as Z
items. Other items are the Y items whose inventory value is neither too high nor too low.
 Economic Order Quantity (EOQ)
Economic Order Quantity is the size of the lot to be purchased which is economically viable. This is the
quantity of material which can be purchased at minimum cost.

The EOQ model attempts to determine the orders size that will minimize the total inventory costs. The EOQ
model as a technique of inventory management defines three parameters for any inventory item.

1. Minimum level of that item depending upon the usage rate of that item, time lag in procuring the item
and unforeseen circumstances, if any
2. The re-order level of that item, at which next order for that item must be placed to avoid any chance of
stock-out, and
3. The re-order quantity for which each order must be placed.
Where
Minimum Stock Level = Re-Ordering Level-(Normal Consumption x Normal Re-Order Period)
Re-Ordering Level = Maximum Consumption x Maximum Re-Order Period
Maximum Level of Stock = Re-Order Level + Re-Ordering Quantity-(Minimum Consumption x Minimum Re-
Ordering Period)
 Assumption of EOQ Model
1. The total usage of a particular item for a given period (usually a year) is known with
certainty and that the usage rate is even through out the period
2. That there is no gap between placing an order and getting its supply
3. The cost per order of an item is constant and the cost of carrying inventory is also fixed
and is given as a percentage of average value of inventory
4. That there are only two costs associated with the inventory, and these are the cost of
ordering and the cost of carrying the inventory.

EOQ =
Where,
A = Total annual requirement for the item
Total Cost = *O+ *C
O = Ordering cost per order that item
C = Carrying cost per unit per annum
Graphical Representation of EOQ Model
Minimum Total
Cost Total Cost
Costs
Carrying Cost
(Rs)

Order Cost
Size of Order
(EOQ) Q*
 The Re-Order Level and the Inventory
Pattern
Inventory EOQ
Level

Re-Order Level

Minimum Inventory Level

Time

Time Lag
 Quantity Discounts and Order Quantity
The EOQ model assumes that the purchase price per unit is fixed and constant irrespective of the
number of units purchased by the firm. However, in practice, it is not so and very often, the seller
offers a discount for purchase of a particular quantity. Thus greater the order size, the lower will be
the cost per unit and total cost will also be low. But on the other hand total carrying cost of the
inventory will increase. Thus the quantity discount is worth taking only if the savings exceed the
additional cost of holding stock. For this, the following [procedure may be followed:

1. Find out the EOQ, Q as usual as of there is no quantity discount available

2. If this quantity, Q, is the quantity that helps the firm availing discount, then the ‘Q’ is the
optimal order size
3. If the ‘Q’ is less than the minimum quantity for availing discount, then the discount offer should
be evaluated in terms of the total cost of maintaining inventory with and without discount.
 Practical Problems
Problem:01: From the following information, find the EOQ.
Annual Usage, 10,000 Units
Cost of placing and receiving one order Rs 50
Cost of material per unit Rs 25
Annual Carrying Cost of one unit: 10% of inventory value.

Problem:02: Following information is given about materials

Annual Demand = Rs 2,00,000
Cost of placing and receiving one order = Rs 80
Annual carrying cost = 10% of inventory value
Find out EOQ
 Practical Problems
Problem: 03: The annual demand for a product is 6,400 units. The unit cost is Rs 6 and
inventory carrying cost per unit per annum is 25% of the average inventory cost. If the
cost of procurement is Rs 75, determine:
a) EOQ
b) Number of order per annum; and
c) Time between two orders

Problem: 04: ABC Ltd produces a product which has monthly demand of 4,000 units.
The product requires a component X which is purchased at Rs 20. For every finished
product, one unit of the component is required. The ordering cost is Rs 120 per order
and the holding cost is 10% p.a.
You are required to calculate:
a) EOQ
b) If the minimum lot size to be supplied is 4,000 units, what is the extra cost, the
company has to incur?
 Practical Problems
Problem: 05: Economic Enterprises requires 90,000 units of a certain item annually. The
cost per unit is Rs 3, the per purchase order is Rs 300, and the inventory carrying cost is
Rs 6 per unit per year.
Required:
a) What is the EOQ?
b) What should the firm do if the supplier offers discount as below:

Order Quantity Discount

4500 – 5999 2%
6000 above 3%
 Practical Problems
Problem: 06: The following information is available in respect of the inventory
costs of a firm:
Total annual consumption = 600 units
Cost per unit = Rs 6
Order cost = Rs 10 per order
Carrying cost = 20% of the value
Discount of 5% has been offered on an order of 200 units. Evaluate the discount
offer.