Inventory Management

► Inventory management involves the control

of assets being produced for the purposes
of sale in the normal course of the
company’s operations.
► The objective of effective inventory
management is to minimise the total costs
direct & indirect associated with holding
inventories.
 Peculiar features
►A current asset
► Level of liquidity
► Liquidity lags :
 Creation lag
 Storage Lag
 Sale lag
 Circulating activity
 Purpose of holding inventory
► Allows the firm to separate the
purchasing,manufacturing & marketing functions
for achieving cost efficiencies vis-à-vis sales at
competitive prices in the market.
► Specific benefits from holding inventories:
 Avoiding lost sales
 Availing quantity discounts
 Reducing ordering costs
 Efficient production runs
 Avoiding risk of production shortages
 Inventory Costs
► Material costs: Cost of purchasing
► Ordering Cost:
 Ordering cost i.e. cost of placing & receiving an
order e.g. preparation of P.R.,P.O.,follow-
up,transportation & inspection costs.
 Higher the number of units per order lower will
be the total ordering cost.
 Total ordering cost= No. of orders per year x
ordering cost per order.
 Inventory Costs
► Carrying cost:
 It includes cost of storing & maintaining the materials in the
stores.e.g. insurance, rent,depreciation of warehouse,storage
cost,interest paid on amount blocked in
stores,obsolescence,spoilage.
 Higher the number of units per order higher will be the
carrying costs.
 Total carrying cost= ½ Reorder quantity * Carrying cost p.u.
per annum

 Stock-out costs
Costs associated with inability to provide -
 materials to production departments &/or
 finished goods to marketing departments

• Opportunity costs:
 Costs associated with loss of opportunity to make profits by
investing funds in the inventory.
 Excess inventory represents an unnecessary costs
 Inventory management techniques
There are 3 basic questions to be answered
w.r.t. efficient inventory management:
► How much inventory should be ordered in
one lot? – (Re-order quantity)
► At what level of inventory should the order
to procure inventory be placed?-(re-order
point system)
► How should records related to inventory be
kept?(Stock level sub-system)
 Re-order quantity
► The quantity to be ordered is decided on the
basis of following factors:
 Demand pattern
 Price of an item
 Lead time
 Various inventory costs
• The optimum ROQ is the one where the total
inventory cost is the minimum & is known as
Economic order quantity.
 Economic order quantity

► It refers to the optimal order size resulting in the lowest

total inventory costs given expected usage,carrying &
ordering costs.
► At this ROQ ordering costs equal carrying costs.
► EOQ= 2 x A x O

C
► Where A is annual usage of materials
O is ordering cost per order
C is the carrying cost per unit
 Limitations of EOQ
► The basic assumptions on which EOQ model is
based are it’s basic limitations..
 Uniform demand
 Constant unit price
 Constant carrying costs
 Constant ordering costs
 Instantaneous delivery
• These can be modified & provide a strong base to
Finance Manager for making inventory decisions
 Re-order level
► Re-orderlevel is that level when fresh order
should be placed with the suppliers for
procuring additional inventory equal to the
EOQ.

► ROL = Normal lead time x Normal usage

 Safety stock
► ROL based on normal consumption in normal lead
time assumes constant rate of consumption &
constant lead time which may not hold true.
► Hence to cater to the uncertainty as regards lead
time & usage some amount of safety stock is
desirable.
► Re-order point = ROL + Safety stock
► The level of safety stock is determined based on
the trade-off between expected stock-out costs
and carrying costs related to additional inventory
held.
 Inventory Control Techniques

► In practice when there are large number of items

in the inventory all items can not be controlled
with equal attention
► Hence for exercising proper degree of control the
items are divided into various groups(classes).
► This classification is made on the basis of the
degree of control or intensity of management
efforts that they require.
► These techniques are also known as multi-item
inventory control techniques.
 ABC analysis
► They are classified as A,B & C based on their
yearly value of consumption
► A items(10-20% of total number) represent 70-
80% of total value of consumption.Hence they
require special managerial attention.Fixed
interval inventory control system is useful.
► B items (20-30% of total number )represent
10-25% of total value of consumption.No
special managerial attention is required as also
overstocking should be avoided.
► C items(60-70% of total number) represent only
5-15% of total value of consumption.These are
trial items & hence can be attended in a casual
manner.For these fixed order quantity approach
can be adopted.
 ABC – A tool to selective control
A item B items C Items
(High Value) (Moderate (Low value)
► value)
Very low Low safety High safety
safety stocks stocks stocks

Frequent Less frequent Ordering in

ordering (Quarterly) bulk
(Weekly) (Twice a
year)
Weekly Monthly Quarterly
control control control
A item B items C Items
(High Value) (Moderate (Low value)
value)
Max. follow- Periodic Follow-up &
up,expediting follow-up expediting by
exception
Centralised Both Decentralised
purchasing & centralised & purchasing
storage decentralised
purchasing
Max. efforts Moderate Minimum
for reducing efforts efforts
lead time
 Steps in ABC analysis
1. Ascertain the unit cost & material usage of each item
for a period of time.
2. Arrange these items in descending order
of their consumption value.
3. Cumulate the usage value & also find the cumulative
percentage of usage value.
4. Obtain the cumulative % of items.
5. Classify them in A,B,C categories as follows:

Category Quantity Value

A 10 % 70 %
B 20 % 20 %
C 70 % 10 %
 Advantages of ABC
► Facilitatingmanagement by exception
► Optimum investment in inventory
► Reduction in carrying costs
► Selective control leading to high stock
turnover.
 VED analysis
► Classificationas per criticality & availability.
► V items are considered vital for smooth running
of the system & adequate stock must be
maintained all the time.
► E items are considered essential for efficient
running & non-availability reduces efficiency of the
system.
► D items are desirable i.e.non-availability does not
stop the system ,but availability of these leads to
increased efficiency.
 Just in time inventory system
► Inventory policy is decided with the aim of providing the
specified quality & quantity of finished goods to the
customers at the specified time.
► On this basis the requirement for
materials(timing & quantity ) is worked out.
Features
► Zero inventory with zero defects.
► 100 % on time delivery.
► Elimination of certain activities related to
inventories.