Chapter 16 Inventory Management and Control

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1 Chapter 16 Inventory Management and Control We shall be interested primarily in the control of material in manufacturing. Actually, we are concerned with the control of the flow of material from a raw state to a finished product. Most industries buy material, transport it to the plant, change the material into parts, assemble parts into finished products, and sell and transport the product to the customer. Figure 16.1 Flow of Materials through production cycle. Objectives of Inventory Management and Control The ultimate objective of all manufacturing controls is to realize a profit through the operation of the business. A more restricted objective of the control of material is to satisfy the customer by meeting the schedule for deliveries. Failure of deliver order on time is one principal cause of loss of business and customers. Effective control of the material throughout the manufacturing cycle reduces the chance of this problem arising. In any consideration of the nature of discrete part manufacturing it is plain that as material flows through the system. It is subjected to starts and stops. Material must wait for machines or materials handling equipment to become available and must be ordered in advance of production and stored in a warehouse or storage area. Inventories are thus a necessary part of the contemporary manufacturing environment, and they must be managed if profit are to accrue. It should be noted, however, that the introduction of elements of computer integrated manu-facturing have reduced, to some extent, manufacturing management s dependence on some type of inventories. Also, the Japanese concept of just-in-time production scheduling may reduce manufacturing s dependence on inventories. Inventory Classifications In the same manner that we identify the various functions in material management with the flow of goods, we can identify the different types of inventories or stocks of material maintained in a manufacturing plant. All plants use the same general classification of

2 inventories, including raw material, purchased parts, work-in-progress, finished goods, and supplies. Raw Material A raw material inventory includes all items that, after being received at the plant, require additional processing before becoming an identifiable part of the finished product. It is obvious that the finished product of one plant- such as roll, bar, and sheet steel- may be the raw material of the next industrial purchaser. Purchased Parts This classification of inventory is applied to component parts of a product that need no additional processing before being assembled into the finished product. In some cases this material may be classified as raw material inventory. More times than not, however, a separate classification is justified. The TV picture tube that is the finished product of one manufacturer becomes a purchased part to the television set manufacturer. Work in Process This classification of inventory is self-explanatory. All material that leaves either raw material stores of purchased parts stores enters the work-in-process inventory until the product is completed and placed in finished goods. Work-in-process is the inventory of material, the flow of which is controlled by production control procedures to be discussed in a later chapter. Finished Goods Again, this is self-explanatory it is the stock of finished products. Generally speaking, this classification applied to the quantities of finished goods that are held at the factory awaiting shipment. In many instances, however, it will include stocks held in warehouses owned and operated by the manufacturer, or stock held on dealers floors on consignment. In this latter case the value of the finished goods inventory is usually very high and a principal factor in the financial management of the company. A typical example of this is the piston ring manufacturer, who, in addition to supplying the original car manufacturer, also maintains large stocks of many different sizes of piston rings in automotive supply houses for quick service to the auto repairman. Usually, these stocks are on consignment; that is the piston ring manufacturer does not receive any payment for the goods until they have been sold by the distributor. Supplies All the materials needed for the operation of the plant that are not used as parts of the finished product are classified as supplies. In the chapter on cost accounting we have identified this inventory classification as indirect material. On the other hand, the material that becomes part of the finished product is called direct material. Lubricating

3 oils, sweeping compound, light bulbs, and many other items fall into the supply category. Optimum inventory The complex relationship between modern industry and its market presents a real problem in the size of inventories that should be maintained. Large inventories in the face of declining sales mean lower profits. Small and inadequate inventories in the face of an increasing market demand may result in the loss of sales to competitors and a decreased profit. Recognition of these conditions should indicate that the optimum inventory is not necessarily either the minimum or the maximum level of inventory; nor is it operation at a maximum inventory turnover. Inventory Turnover A very common index of inventory control, inventory turnover is the ratio of the value of the product shipped to the average investment in inventory for the same period. value of product shipped Inventory turnover = value of average inventory Obviously, the higher this index, the lower the inventory levels and the lower the cost of maintaining the inventories. Also, it is obvious that a high index indicates a shorter manufacturing cycle with all the saving inherent therein. Economic Lot Size Concept Throughout this century management scientists have devoted considerable effort to the mathematical formulation of inventory models. An elementary building block of this analysis has been the so-called economic lot size mode. Through the years, it has been used to determine manufacturing batch quantities for in-plant production orders or purchase orders and also for determination of optimum inventory levels. Rate of Usage The anticipated rate of usage of the part must be considered together with the time required to produce a replacement lot. Quantities should be established such that at all times stock will be available to the assembly departments. This principle is used by the materials control group in determining inventory levels. Ordering Cost Next in importance is the cost to acquire the item. In a manufacturing situation this would be a setup cost. If the part is purchased an ordering cost would be incurred. For a cost such as this, the quantity purchased or made is important the larger the quantity, the lower the per-piece cost.

4 Deterioration or obsolescence Another factor to be considered is the deterioration or obsolescence of a large stock of parts. All these factors must be weighed by management and an economic lot size determined that will result in the acquisition of parts at an optimum cost per unit. Availability of productive capacity for such lot sizes must be determined and included in the considerations. Economic manufacturing lot sizes must be checked periodically, as they are subject to revision owing to sales trends and variations in the factors mentioned above. Elementary lot size model The use of economic order quantity models has been in effect for many years, and the literature abounds with the many formulations that have been proposed. One of the problems that arises in the use of mathematical model is the fact that many factors have a bearing on optimum lot sizes, and one cannot weigh all of them in a simple formula. Figure 16.2 Cost Relationship for EOQ model Computer Assistance A full description of the possible and actual use of computers as an aid in the management and control of inventories is beyond the scope of this book. Obviously, how ever, when large quantities of numbers have to be kept readily available and be changed from time to time, the computer is the direction to go for assistance if its use can be justified. One can do much posting of numbers by hand for the rental or purchase price of a computer, but there will be a point in almost every company s operation when the inventory problem can best be handled by computer, most often using a database management system.

5 Inventory Costs Typically, sales personnel wish their company to stock large quantities of all items in the product line so they can meet even the most unreasonable demands of their customers. Typical production personnel wish to keep large quantities of parts on hand so there is never any danger of a production line having to shut down for lack of parts. Inventory people themselves often get carried away with descriptions of computer systems such as those just described and urge the adoption of such system often just for the sake of proving that it can be done. The point to make here is that all these things cost money, and these costs go beyond the money cost of the parts or products themselves. Since such costs are often lost in overhead cost calculations it is easy for managers to overlook them. Factors Influencing Inventory Management and Control Many factors influence inventory management and control. The principal effects of these factors are reflected most strongly in the levels of inventory and the degree of control planned in the inventory control system. Type of Product If the materials used in the manufacture of the product have a high unit value when purchased, a much closer control is usually in order. Jewelers are much more careful with their stock of diamonds than they are with display cases full of low-priced costume jewelry. This same principle holds in manufacturing. Type of Manufacture The close relationship between the type of product and the type of manufacture makes an analysis of the effect on inventory controls somewhat repetitious. Continuous manufacture is common to the manufacture of standard products. However, some standard products are made in batches. Where continuous manufacture is employed, the rate of production is the key factor. Here, as a matter of fact inventory control is of major importance and in reality controls the production of the product. Volume The volume of product to be made, as represented by the rate of production, may have little effect on the complexity of the inventory problem. Literally millions of brass bases for light bulbs are manufactured each month involving the control of only two principal items of raw inventory. Inventory Management

6 The planning of the control of inventory can be divided into two phases, inventory management and inventory control. Inventory management accomplishes the first phase, consisting of: 1. Determination of optimum inventory levels and procedures for their review and adjustment 2. Determination of the degree of control that is required for the best results 3. Planning and design of the inventory control system 4. Planning of the inventory control organization. Optimum Inventory Levels Earlier, we discussed how inventory management is responsible for determining the inventory level that will result in the best profit. We have already pointed out that the trend of sales must be watched closely and inventories adjusted in advance of the change in rate of production as determined by actual sales. But this is not the only factor that must be considered by inventory management when determining inventory levels. The planning for the actual production of the product may involve problems of leveling production, that is producing at a constant rate even though sales may fluctuate. In slack times products are built to stock; the finished goods inventory is increased to offset the demand anticipated when future sales surpass the production rate of the plant. The proper evaluation of this factor requires close cooperation with the manufacturing function. Degree to Control Inventory management must decide just how much control is needed to accomplish the objective. The least control as evidenced by systems, records, and personnel- that is required to perform the function efficiently is the best control. This problem of the degree of control can be approached from the viewpoint of quantity, location and time. Just-in-Time Concept Much publicity was given during the early 1980s to the Japanese style just-in-time inventory concepts. Entire books have been written on this subject and many articles have appeared in professional and trade journals. A recent, extensive literature search was conducted and identified over 860 just-in-time articles published in professional journals since We will just briefly describe the concept here. The goal of JIT is simple enough; get the material to its next processing point just at the time it is needed. Theoretically, then, no inventory will be needed. JIT can be implemented with manufacturing work-in-process or with material purchased from outside vendors. The latter will require coordination with these vendors. Generally, they

7 will cooperate if it is a case of getting the order or not, it may turn out that the vendor will carry the inventory. One truck transportation company obtains much of its business by catering to companies that must deliver parts to other companies just in time. The Toyota company in Japan has developed a scheduling discipline for internal control of inprocess material movement, called kanban, which substantially reduces WIP inventories and hence reduces the associated costs. Inventory Control The inventory control group puts the plans of inventory management into operation. These plans are seldom complete in every detail. The day-to-day planning required to meet production requirements the second phase of planning for inventory control is the responsibility of this group. Inventory Control Systems Control of manufacturing inventories is basically a problem of industrial communications. Earlier, we indicated that the complexity of these systems is directly proportional to the number of items in the inventories and to the number of transactions that have to be recorded to keep abreast of the movement of the material. It should be emphasized here that a great many of the inventory control systems in use in industry today are computer-oriented systems, however, the initial part of the discussion in this section will be concerned with basic concepts and data associated with inventory control procedures in general, without reference to capabilities of computer systems. When inventory forms are discussed, it is implied that these could also be records associated with a file in a database management system. The basic information normally carried on perpetual inventory records includes: 1. On order. This part of the record shows the quantity of material ordered but not received. Now order are added in this column and receipts subtracted. 2. Received. All receipts are posted here; there is no balance quantity in this column. 3. On hand. This balance figure represents the quantity of the item that should be in the stock room. Receipts are added to this column and issues subtracted. 4. Issued. A record of all quantities issued to the factory is entered in this column. 5. Allocated. In this column are entered the quantities to be reserved for later issue for specific order. Reserving of materials still in this stock room will ensure their availability when they are needed on the manufacturing floor.

8 6. Available. This is the quantity of material on hand that is still available for assignment to future orders. Pricing Inventories. There are four basic ways to price inventories for accounting purposes: 1. First in first out (FIFO) Under this procedure, all issues are priced at the cost of the oldest lot until that lot is used up. Then the price of the next oldest lot is used, and so on. In other words the first price into the inventory is the first price out of the inventory when issuing materials. 2. Last-in-first out (LIFO) under this procedure, all issues are priced at the cost of the newest lot until that lot is used up. Then the price of the next to newest lot is used, and so on. If, in the meantime, another lot comes in, the price of this even newer lot is used when issuing material until the entire quantity involved is issued, at which time the price reverts to the next newest unused quantity. 3. Average value. Under this system, the values of issues are computed by using the weighted average cost of the material in stock. As new material is received at slightly different prices a new computation must be made as to the weighted average cost of the total material on hand. 4. Standard costs. A standard cost is established for each material, and all disbursements are charged out at this standard value regardless of the price actually paid for the material. Basic Communication Forms The basic communication forms used in perpetual inventory control are: 1. Purchase Requisition. This form is prepared by inventory control when new quantities of material should be ordered. 2. Shop order. This form is prepared by inventory control when quantities of material need to be made by the shop for stock. 3. Receiving reports. These are the records of material received by the stock room. 4. Stores requisition. This form authorizes the issuance of any class of inventory material from a controlled storage to the shop. These requisition may be prepared by the production planner (as we well discuss under production control) or by foremen, supervisor, or other authorized personnel.

9 Inventory Control Records and Procedures A detailed discussion of the many records and procedures that are used for control of inventories is beyond the scope of this text. These are many commercial systems, such as Ditto, McCaskey Register, Remington Rand, International Business Machines, and others too numerous to mention. Inventory records may be posted in ledgers or on cards, with each entry made by hand. Basic data of inventory transactions may be typed into a computer terminal and the many calculations or reports can be prepared by computer; however the use of bar code and bar code scanners for point-of-transaction recording of data is fast becoming an accepted way of collecting inventory data. One can see this every day at grocery and department stores but it is also quite extensively used in industry. Bar codes, similar to those appearing on consumer goods, are seen in warehouses and production lines. Hand-held scanner/readers are interfaced with personal computers and are quite flexible for inventory control purposes. Bin Control We have discussed perpetual inventories at length. Again they are applicable to what we have previously designated as high or intermediate value inventory items. It is still evident that such procedures as we have touched on briefly are costly. For those items in which the cost of keeping such records cannot be justified, a bin control is usually adopted. Storerooms Storerooms (or stock rooms) are areas in which material is held in controlled storage. All material received in the area is counted and recorded, none is issued without the proper stores requisition. Controlling materials in such a manner costs money in terms of space, personnel, and handling. These costs must be offset by better service to the factory and reduced loss of materials. Physical Inventories A physical inventory is used to verify the balances shown on the perpetual inventory records and to obtain a correct count on all items of inventory that may be on a bin control system. Physical inventories may be taken in two different ways. Using the first method, plans may be made for a complete shutdown of manufacturing activity. Material Requirements Earlier sections of this chapter have presented what might be called a classical approach to inventory management and control. A some what more elaborate and computer based approach called material requirements planning (MRP) has been available to industry for over 25 years.

10 The previous system placed considerable emphasis on the when and how much questions of inventory management. The when was answered by the determination of order points, and how much was determined by calculations of economic order quantities (EOQ) or economic manufacturing quantities (EMQ). The literature abounds with formulations of these two determinations under various sets of conditions. Figure 16.9 Coordinating role of MRP.

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