Financial Management – II

Inventory
Management

Dr. Meenu Verma 1

Inventory
 “Anything that can be stored, stacked or
stockpiled is materials”
 An element of cost
 A type of Current Assets
 Materials contains
 Raw Materials
 Work-in-progress
 Finished Goods
 Spare Parts, Tools & Consumables
Dr. Meenu Verma 2
Role of Inventory in Working Capital

 Current Assets
 Contains and generates liquidity
 Base for circulating liquidity

Dr. Meenu Verma 3

 Objectives of keeping inventories

 Avoid lost sales

 Gaining quantity benefits
(cost effectiveness)

 Reducing order cost

 Achieving efficiency in production
 Reduce the risk of production shortage

Dr. Meenu Verma 4

Various cost associated with inventory
 Materials Cost
 Purchase Cost
 Transportation Cost
 Handling Cost
 Installation Cost
 Ordering cost
 Carrying Cost
 Cost of funds tied up with inventories
 Cost of running out of goods

Dr. Meenu Verma 5

Techniques of Managing Inventory
 Economic Order Quantity (EOQ)
 Re-order Stock Level
 Safety Stock
 Others
 The ABC Analysis
 Monitoring of stores and spares
 Pricing of inventory (RM)
 FIFO

 LIFO

 Weighted Average Method

 Valuation of Work-in-progress and Finished Goods

Dr. Meenu Verma 6

Economic Order Quantity (EOQ)
 The quantity for which the order is placed
when stock reaches at re-order level

 The Economic Order Quantity (EOQ) is that

size of the order which gives maximum
economy in purchasing any materials and
ultimately contributes towards maintaining
the materials at the optimum level and the
minimum cost

Dr. Meenu Verma 7

 Ordering cost
 Cost of placing an order with the
supplier
 Cost of stationary

 Salaries of those who are engaged in

receiving ands inspection, placing orders

Dr. Meenu Verma 8

Carrying Cost
 Cost of holding the stocks in stores
 Cost of operating the stores (Salaries, Rent,
Stationary)
 The incidence of insurance
 Interest on capital locked up in stores
 Deterioration and wastage of materials

Dr. Meenu Verma 9

Mathematical Formulae

2.A.B
EOQ = C.S.

EOQ = Economic Order Quantity

A = Annual Consumption in Units
B = Cost per Unit
S = Storage or Carrying Cost as a percentage of average inventory
C = Cost per unit

Dr. Meenu Verma 10

Assumptions for using EOQ Model
 Constant or uniform demand
 Constant unit price
 Constant carrying cost
 Constant ordering cost
 No margin for safety stock because of the
assumption of instant delivery
 Independent orders

Dr. Meenu Verma 11

Impact of inflation on EOQ
 Because of the assumption of constant
price (C)
 It affects through increase in interest
cost of carrying (S)

Therefore the EOQ is to be modified anticipatory

buying if possible at lower prices.

Dr. Meenu Verma 12

Incremental benefits for
availing discount of bulk purchasing

 Increment or saving by discount

U U
- X F
Q* Q’

U = annual usage
Q* = EOQ
Q’ = minimum order size for discount

Dr. Meenu Verma 13

 Incremental additional carrying cost

= Q’ (C- D) S Q* CS
2 2

S = Storage or Carrying Cost as a percentage of average inventory

C = Cost per unit
Q* = EOQ
Q’ = minimum order size for discount
D = Discount

Dr. Meenu Verma 14

Net incremental benefit

= Total Discount + Savings in ordering

cost – increase in carrying cost

Dr. Meenu Verma 15

 Reorder stock level

= Normal consumption during lead time + safety

stock
OR
= average daily usage rate X lead time in days

Dr. Meenu Verma 16

Determination of optimum production quantity
 It involves two costs
 Set up cost (Fixed)
 Inventory carrying cost

2U X P
E=
S

E = Optimum Production quantity

U = annual usage
P = set up cost for each production run
S = cost of carrying inventory per unit per annum (per month)

Dr. Meenu Verma 17