Aspects of Inventory Management

Inventory Management Introduction Aspects of Inventory Management Meaning, Definition, Characteristic of Inventories Types and Functions of Inventory Motives for holding Inventories Factors Affecting Volume of Inventories Advantages of Inventory Disadvantages of Inventory Inventory Control Meaning, Definition Objectives of Inventory Control

Inventory Management Inventory Costs Inventory Control Techniques Economic Order Quantity Fixation of Stock Level ABC Analysis Codification Technique Inventory System Inventory Turnover Ratio Pricing of Raw Material and Valuation of Stock

Introduction Inventory, an very much important part of current assets as well as working capital. Every businessman kept inventory in response to the conditions in which the business operates. Normally it comprises raw material, work-in-progress and finished goods. It is the financial manager s responsibility to ensure procurement and proper monitoring of inventory. To achieve this, it is necessary to get well acquainted with the different aspects of inventories.

Aspects of Inventory Management Following are different aspects of inventory Management. 1. Meaning and Definition 2. Motives for holding Inventories 3. Cost of Holding Inventory 4. Techniques of Inventory Management 5. Order Quantity EOQ Model 6. Determinations of Stock Level 7. Valuation of Stock 8. ABC Analysis 9. Perpetual Inventory System

Meaning, Definitions, Characteristic The term inventory is used in much broader sense, it used as manpower inventory, equipment inventory, inventory of raw materials, inventory of finished goods, inventory of vehicles etc. Inventory can be define as, the physical stock of items that a business or production concern keeps in hand for efficient running of affairs of its productions. Inventory consist of raw material, work-in-progress and finished goods.

Meaning, Definitions, Characteristic On the basis of definitions following characteristics of inventories can be stated. 1. It ensure undisturbed production 2. It requires valuable space 3. It provides production economics 4. It is a physical stock of items of tangible assets 5. It is an result of many interrelated policies 6. Its used in the production for sale

Types and Functions of Inventory The various types of inventories for manufacturing and trading organisations can be stated as below; 1. Raw Materials and Consumable Stores 2. Work-In-Progress 3. Finished Goods Inventories The important functions of the inventories are; 1. It ensure continuity of supply of quality goods. 2. It helps to prevent excessive investment in stock 3. Inventories activise market 4. It helps in avoiding unnecessary wastage or losses 5. It ensure optimum investment in materials

Motives for Holding Inventories Inventories are typically not end in themselves. There are three basic motives for which inventories are hold. Those are as below; 1. Transaction Motive : Transaction implies total time of converting an intent into material. It expresses the need to maintain inventory to facilitates smooth production. 2. Precautionary Motive : Precaution means safety or minimum stock of inventory. Inventories are held due to usual inability to predict demand exactly. 3. Speculative Motive : In case of sensitive commodities the speculative element is more important. Speculation is due to fear of increase in price or demand exceeds supply.

Factors Affecting Volume of Inventories The procurement and quantity of inventory is based on following factors; 1. Availability of Finance 2. Quantity Discount Allowed 3. Ordering cost 4. Storage Space Available 5. Risk of Loss Due to Price Fluctuations 6. Economic Ordering Quantity 7. Time to Obtain Delivery of Goods

Advantages of Inventory A finance manager should operate level of inventory between excess and less. If he manages to do so, following advantages can be availed by organisation. 1. It helps to reduce carrying cost. 2. It ensure uninterrupted production. 3. Lot of manual work can be eliminated. 4. Ensures minimum wastages. 5. Effective utilization of floor space. 6. Effective material handling possible. 7. Better forecasting possible. 8. It helps to avoid over or under investment in inventory.

Disadvantages of Inventory As mentioned earlier finance manager should operate level of inventory between excess and less. If he doesn t manages to do so, following disadvantages are bound to be born by organisation. Disadvantages of Excess of Inventory : 1. It consumes the funds, which can t be used for other. 2. It increases cost of storage, insurance, transportation. 3. Delay due to over crowding of material. Disadvantages of Inadequate Inventory : 1. High risk of Liquidity 2. It might affect flow of production. 3. Organisation may fail to meet delivery commitments. 4. Failure to meet demands of consumers needs.

Inventory Control Meaning, Definition We have seen the demerits of excessive as well as inadequate inventory. To maintain adequate level of inventory, is thus a difficult job for finance manager. To overcome such task, inventory control can be used. The Inventory Control thus, define as, the systematic control over the procurement, storage and usage of material so as to maintain even flow of materials and at the same time avoiding excessive investment. The Inventory Control means control over material lying in the stores. It keeps continuous track of inventories.

Objectives of Inventory Control As we have seen earlier, inventory often constitute major part of working capital and therefore it has been correctly monitored. A good inventory management is good financial management. Inventory Control Management helps to efficient management of inventory, which ultimately results in the maximization of the owners wealth. The objectives and importance of Inventory Control Management are elaborated on next slide.

Objectives of Inventory Control 1. Availability of Materials 2. Better Service to Customers 3. Minimizing the Wastages 4. Optimum Level of Inventories 5. Economy in Purchasing 6. Increase Operational Efficiency 7. Optimum Level Investment in Raw Materials 8. Optimum Level Investment in Work-in-progress 9. Optimum Level Investment in Finished Goods

Inventory Costs While procuring inventory, certain costs has to be born by organisation. These costs can be depicted by chart as below. Inventory Costs Ordering Costs e.g. Inspection Section Cost, Cost of Stationery, Cost of Tenders Carrying Costs e.g. Rent, Interest on Capital, Cost of Lighting, Cost of Bins, Racks Over Stock Costs e.g. Stock left in hand when demand for it has terminated. Stock Out Costs e.g. When an item is out of stock is called

Inventory Control Techniques Inventory Control refers to effective as well as economical management of stock and flow of materials. In order to achieve this, following important inventory controlled techniques are to be applied; Economic Order Quantity Fixation of Stock Level ABC Analysis Codification Technique Inventory System Inventory Turnover Ratio Pricing of Raw Material and Valuation of Stock

Economic Order Quantity This is one of the important technique used to determine the optimum quantity of orders to be placed from suppliers. The main objective of this technique is minimise ordering and carrying costs. The EOQ technique can be determined by; (a) Tabular Method (b) Formula Method (c) Graphic Method.

E.O.Q. (Formula Method) The formula for EOQ can also be used for determining the optimum ordering quantity as given below; EOQ = 2AB CS Where, A = Economic Order Quantity B = Annual Consumption in Units C = Cost Per Unit S = Storage and Carrying Cost per annum

E.O.Q. (Assumptions) The calculations of the Economic Order Quantity is based on following assumptions; 1. Ordering and Carrying costs are constant per unit. 2. The anticipated consumption of materials during a particular period is known. 3. Cost per order is constant. 4. The forecast usage of materials for a given period usually one year.

E.O.Q. (Graphic Method) The Economic Order Quantity is determined keeping in view the ordering costs and carrying costs. With the interaction of these two costs, the economic ordering costs during that period and total cost to order and carry is the lowest, as it made clear in the aforesaid graph. From the above Diagram, it is clearly shows that carrying cost varies directly with the order size, where as the ordering cost varies inversely with the order size.

Illustration Find out the Economic Order Quantity and order schedule of raw materials and packing materials with the following data given to you. 1] Cost of Ordering : Raw Materials = Rs.1,000 per order Packing Materials = Rs.5,000 per order 2] Cost of Holding Inventory Raw Materials = 1 Paise per unit per month Packing Materials = 5 Paise per unit per month 3] Production Rate : 2,00,000 Units per month

Solution: Calculation of Economic Order Quantity EOQ = 2AB CS Where: EOQ = Economic Order Quantity A = Units Consumed in a Month B = Buying Cost per order C = Cost per Unit S = Inventory Carrying Cost per Month (a) Raw Materials : EOQ = 2 x 2,00,000 x 1000 0.01 = 40,00,00,00,000 = 2,00,000 units Thus one order for 2,00,000 units each month. (b) Packaging Materials : EOQ = 2 x 2,00,000 x 5000 0.05 = 40,00,00,00,000 = 2,00,000 units Thus one order for 2,00,000 units each month.

Illustration Calculate the Economic Order Quantity from the following particulars: Annual requirements per year 6,000 units Cost of materials per unit Rs.5 Carrying cost per item for one year Rs.1 Cost of placing and receiving one order Rs.60 Alternative order size in units 6,000, 3,000, 2,000, 1,200,1,000, 600 and 200.

Solution Cost of items purchased each year 6000 units x 5 Rs. 30,000 30,000 30,000 30,000 30,000 30,000 30,000 Order size units 6,000 3,000 2,000 1,200 1,000 600 200 No. of orders per year 1 2 3 5 6 10 30 Average inventory in units 3,000 1,500 1,000 600 500 300 100 Total carrying cost Rs. 3,000 1,500 1,000 600 500 300 100 Total carrying and ordering cost Rs. 60 120 180 300 360 600 1800 Total cost Rs. 30,060 31,620 31,180 30,900 30,860 30,900 31,900 Ans: EOQ is 1000 units of 6 orders per year at a minimum total cost Rs.30,860.

Working Notes: Number of orders = Average Inventory = Total Carrying costs = Total Ordering costs = Total cost = Annual consumption per year Order size Order size 2 Average inventory x carrying cost per unit No. of orders x cost per order Cost of items + Total carrying and ordering costs

Fixation of Stock Level Level of stock is the important aspect of inventory control. Over stocking resulted in to block of funds and increase in material holding as well as carrying costs, at the same time under stocking leads to stoppages in productions and overall performance of concern is suffers. So there is need to have some techniques to determine exact level of stock. The important techniques along with their respective formulas are depicted in chart form on next slide.

Fixation of Stock Level Techniques for Fixation of Stock Level Re-order Level {Lead Time x Average Usage} Minimum Stock Level {Re-order Level (Normal Consumption x Normal Re-order Period)} Maximum Stock Level {Economic Order Quantity + Safety Stock} Danger Level {Average Rate of Consumption x Emergency Supply Time} Average Stock Level {(Minimum Level + Maximum Level) / 2}

Illustration The following information is available in respect of a material X : Re-order Quantity = 1800 units Maximum Consumption = 450 units per week Minimum Consumption = 150 units per week Normal Consumption = 300 units per week Re-order Point = 3 to 5 weeks Calculate the following: (a) Re-order Level (b) Minimum Stock Level (c) Maximum Stock Level

Solution (a) Re-order Level: = Maximum Consumption x Maximum Re-order period. = 450 x 5 = 2,250 units (b) Minimum Stock Level: = Re-order Level (Normal Consumption x Normal Re-order period) = 2,250 (300 x 4) = 2,250 1,200 = 1,050 units (c) Maximum Stock Level: = Re-order Level + Re-order Quantity - (Minimum Consumption x Minimum Re-order period) = 2,250 + 1,800 (150 x 3) = 3600 units (d) Normal Re-order Period: = = Minimum Re-order Level + Maximum Re-order Level 4 weeks 2 = (3 + 5) weeks 2

ABC Analysis The most important technique which is based on gradation of items to their importance. This method is also known as, Proportional Value Analysis or Always Better Control. In this method materials are grouped into three categories, which are explain below; 1] A High Value Materials 2] B Medium Value Materials 3] C Low Value Materials

ABC Analysis % of Costs (Value) Item C Item B Item A % of Units

Procedure for ABC Analysis The procedure for implementing ABC Analysis is elaborated below; 1. Classify the items to their grade or specifications 2. Ascertain the cost per unit of each item and expected usage over a given period of time. 3. Determine the total cost of each item by multiplying the expected units by its unit price. 4. Rank the items in accordance with the total cost. 5. Calculate the percentages 6. Group the items on the basis of their relative value to form three categories viz. A, B, C.

Codification Technique This technique represents process of codification of each items by a unique number. The system of codification could be built by the end use of items. The advantages of this system is as below; 1. Codes ensures secrecy of material 2. It is essential for mechanical accounting 3. Easy identification of material is possible 4. It ensures effective control on materials 5. It minimise length of description of material 6. Codification facilitates less clerical work 7. It avoids duplication of material

Codification Technique Following are three important Methods of Codifications 1. Numerical Method: As the name suggest, in this method each number or digits are allotted to each item or material. For e.g. a electrical wire manufacturing company may adopt following codification technique to identify their end products, Wire = 3605, First two digits denotes cores and last two digits refers to Amperes. Similarly, Wire = 715, refers to 7 core 15 amperes wire and so on.

Codification Technique 2. Alphabetical Method: In this method unique alphabets are allotted to each item or material. For e.g., C for copper, S for Steel, and so on. 3. Alpha-Numeric Method: This method is combination of first two methods. To identify particular product both numbers and alphabets are allotted for each items. For e.g., a company which manufactures switches, may adopt following codifications to identify their end products; A1501: Here A = Suitability for supply AC or DC 1 = Pole Single or Double 5 = Amps. i.e. 5, 10, 15 etc. 01= Style i.e. 01 for economy, 02 for classic 03 for executive etc.

Inventory Systems The main aims of inventory control is as follows; a. To maintained balance inventory b. To ensure smooth flow of production c. To keep investment in inventory as low as possible So the stock verification is an important aspect to ensure a balance inventory. Below mentioned are the three systems adopted to verify stock in industries. 1. Periodic Inventory System 2. Perpetual Inventory System 3. Continuous Stock Taking Now we shall look each one of them in brief.

Inventory Systems 1] Periodic Inventory System: Under this system, value and quantity are verified and check at the end of accounting period after physical verification of stock. 2] Perpetual Inventory System: This system is also known as Automatic Inventory System. The I C M A of London defines this system as, a method of recording stores balances after every receipt and issue to facilitate regular checking to obviate stock taking. In this type transactions of stores are recorded in two sets, viz. Bin Cards and Stores Ledger. The former stores quantitative information as the later holds both quantitative and monetary values.

Inventory Systems This system has following advantages; 1. It facilitates rigid control over stock of materials. 2. It gives upto date information about materials in stock 3. Not necessary to stop production for stock taking 4. It helps to take the important decision for corrective actions 5. It enables to reconcile the stock records and document for accuracy 6. It assist to minimise pilferage and fraudulent practice

Inventory Systems 3] Continuous Stock Verification: From above two methods one can easily understands the importance of stock verification. Continuous stock taking ensures that the balances of all the items of stock are checked at least three to four times in a year by physical verification. It avoids long and costly procedure of closing down the stores for stock taking on periodical basis. This system not only serves as an essential tool of material control but also will help in proper presentation of accounting information to the management.

Continuous Stock Taking Inventory Systems The difference between Continuous Stock Taking and Periodic Stock Taking can be summarised as below; Periodic Stock Taking 1] It held throughout the year 1] It held once in a year 2] Stock discrepancies are detected and prevented without delay. 2] Under this system preventive measures is delayed process. 3] Normal work is not disturbed. 3] Normal work is bound to affect 4] Permanent personnels are required 5] This is long and costly procedure 6] Physical verification of materials are on random basis. 4] Temporary personnels are required 5] Relatively cheaper and shorter method 6] All materials are thoroughly checked.

Inventory Turnover Ratio This ratio is also called as Stock Turnover Ratio or Stock Velocity Ratio. This ratio indicates the investment made in stock is effectively utilised or not. High rate of this ratio indicates that the material are fast moving stock. This is a sign of good management. Whereas, low ratio refers to locking up of working capital on undesirable items. It is an indicator of the existence of poor quality material which is company unable to push through. On the basis of type of organisation, computation of this ratio is classified in to two; 1] Trading Concern 2] Manufacturing Concern

Inventory Turnover Ratio 1] Trading Concern: This type of concern are those which are engaged in the sale of goods and services purchased from other manufacturers. So there are no raw material or Working-in-progress. So to calculate this ratio the formula is as below; I. Turnover Ratio = Cost of Goods Sold Average Inventory or Sales Revenue Average Inventory Where, Cost of Goods Sold =(Op. Stock + Purchases + Direct Exp.) (Cl. Stock) Average Inventory = Opening Inventory + Closing Inventory 2

Inventory Turnover Ratio 1] Manufacturing Concern: This type of concern acquire raw material and used them to produce goods and services. As a result, these companies require to maintain a stock of Raw material, Work-in-progress and Finished Goods. The ratios for all these are as below; I. Turnover Ratio (Raw Material) = Where, Cost of Raw Material Consumed = Average Stock of raw Material = Cost of Raw Material Consumed Average Value of raw Material in stock (Opening Stock + Purchase of Raw Materials) Closing Stock of Raw Material Raw Materials Stock (Opening + Closing) 2

Inventory Turnover Ratio I. Turnover Ratio (Work-in-Progress) = Cost of Completed Works Average Stock of Work-in-Progress Where, Cost of Completed Works = Average Stock of Work-in-Progress = I. Turnover Ratio (Finished Goods) = Where, Cost of Goods Sold = Average Stock of Finished Goods = (Opening Stock of Work-in-Progress + Manufacturing Cost incurred during the period) Closing Stock of Work-in-Progress Work-in-Progress Stock (Opening + Closing) 2 Cost of Goods Sold Average Stock of Finished Goods (Opening Stock of Finished Goods + Cost of Production) Cl. Stock of Finished Goods Finished Goods Stock (Opening + Closing) 2

Illustration The following particulars calculate Stock Turnover Ratio : Gross Sales = Rs.5,00,000 Sales Return = Rs.25,000 Opening Stock = Rs.70,000 Closing Stock at Cost = Rs.85,000 Purchases = Rs.3,00,000 Direct Expenses = Rs.1,00,000

Solution Inventory Turnover Ratio = Cost of goods sold = Average Stock = Cost of goods sold Average inventory at cost Opening Stock + Purchases + Direct Expenses - Closing Stock = Rs.70,000 + 3,00,000 + 1,00,000 85,000 = Rs.3,85,000 Inventory Turnover Ratio = 3,85,000 77,500 Inventory Turnover Ratio = Opening Stock + Closing Stock 2 = 70,000 + 85,000 = Rs.77,500 2 4.97 times

Pricing of Raw Material Till now we have seen different aspects of inventory management, which are related to procurement, storage etc. now we are going to see pricing and valuation of material and stock. All receipts and issues of material from stores are important part of inventory management. The same is done with proper requisition, Bill of Materials etc. To ascertain accurate material cost, fixing of material issues and effective cost control are the primary objectives. For this reasons following points are consider as a key in valuation of material issues.

Pricing of Raw Material 1. Valuation of Total Cost of Material Purchase: Material costing is very important not only for consumption but also for value of material in stock. It is calculated by taking prices quoted by supplier as the basic and subtracting any discounts and adding any other expenses not covered. The discount allowed by supplier in following ways, a] Trade Discount b] Cash Discount and c] Quantity Discount. 2. Materials Issue Procedure: It is based on production programme. The material issued from stores must accompanied by either Indent of Material or Bill of Material. The store keeper is responsible to put record number on each requisition and post it in stores ledger.

Pricing of Raw Material 3. Pricing of Material Issued: It is considered as a key in estimating cost of production. Materials are issued from stores to work orders, based on the material requisition. But stock of material may consist of different consignment received at different dates and prices. There are different methods used for pricing of materials issued. The same are depicted in the chart form.

Methods Methods of Pricing of Raw Material Average Price Method First in First Out (FIFO) Last in Last Out (LIFO) Specific Price Method Base Stock Method Highest in First Out (HIFO) Average Cost Method Simple Average Method Weighted Average Method Periodic Sample Average Method Periodic Weighted Average Method Standard Price Method Inflated Price Method Market Price Method

Illustration: From the following particulars prepare a stores Ledger Account by Standard Price Method of issue of materials. The standard price of a material is fixed at Rs.10 per unit. 2003 Mar. 1 Opening stock of materials 1,000 units at Rs.15 per unit 3 Purchased 500 units at Rs.10 per unit 7 Issued 500 units 12 Purchased 1000 units at Rs.15 per unit 15 Purchased 800 units at Rs.10 per unit 19 Issued 700 units 22 Issued 500 units 27 Purchased 600 units at Rs.12 per unit 29 Issued 300 units 30 Purchased 100 units at Rs.14 per unit 31 Issued 400 units

Solution: Date Receipts Issues Balance March Qty. Rate Rs. Amt. Rs. Qty. Rate Rs. Amt. Rs. Qty. Rate Rs. Amt. Rs. 1 1,000 1,500 15 15,000 20,000 3 7 12 15 19 22 27 29 30 31 5,000 15,000 8,000 1,000 7,200 15,000 1,400 500 2,000 700 2,800 500 30,000 300 2,100 38,000 31,000 26,000 33,200 400 1,600 30,200 31,600 37,600 2,200 1,900 2,000 1,600 5,000 7,000 5,000 3000 4,000 10 10 10 10 10 10 15 10 12 14 500 1,000 800 600 100