UNIT 5
Inventory Control
5.1 Introduction
Inventory constitutes the most significant part of current assets of a large majority of companies. On an average, inventories are approximately 60% of current assets in any organization. Because of the large size of inventories maintained by a firm, a considerable amount of money is required to be committed to them. It is, therefore, absolutely imperative to manage inventories efficiently and effectively in order to avoid unnecessary investment. Management of inventory assumes importance due to the fact that investment in inventory constitutes one of the major investment in current assets.
5.2 Meaning of Inventory
“Inventory control is the technique of maintaining store-keeping items at the desired level, whether they be raw materials, goods in process or finished products. “
Inventory means all the materials, parts, supplies, expense tools and in process or finished products recorded on the books by an organization and kept in its stocks, warehouses or plants for some period of time. Inventory control keeps track of inventories. It is observed that “too much”, “too little” or badly balanced inventories are all to be avoided because they cost too much on many counts.
5.3 MOTIVES FOR HOLDING INVENTORIES
Company may hold the inventory with the various motives as stated below.
1. Transaction Motive
The company may be required to hold the inventories in order to facilitate the smooth and uninterrupted production and sales operation. It may not be possible for the company to procure raw materials whenever necessary. There may be a time lag between the demand for the material and its supply. Hence it is needed to hold the raw material inventory. Similarly, it may not be possible to produce the goods immediately after they are demanded by the customers. Hence it is needed to hold the finished goods inventory. The need to hold work in progress may arise due to production cycle.
2. Precautionary Motive
In addition to the requirement to hold the inventories for routine transaction, the company may like to hold them to guard against the risk of unpredictable changes in demand and supply forces.
Example:- The supply of raw materials may get delayed due to the factors like strike, transport, disruption, short supply, lengthy process involved in import of raw materials etc. Hence the company should maintain sufficient level of inventories to take care of such situation. Similarly, the demand for finished goods may suddenly increase (especially in case of seasonal types of products) and if the company is unable to supply them, it may mean gains of the competitors. Hence the company will like to maintain sufficient stock of finished goods.
3. Speculative Motive
The company may like to purchase and stock the inventory in the quantity, which is more than needed for production and sales purposes. This may be with the intention to get the advantages in terms of quantity discounts connected with bulk purchasing or anticipated price rise.
5.4 OBJECTIVES / FUNCTIONS OF INVENTORY MANAGEMENT
Though inventory control may not be treated as an executive function but it is one of the most important functions in an enterprise. The following are the main objective / function of inventory control.
1. To carry maximum inventory in order to facilitate efficient and smooth production and sales operation.
2. To minimize investment in inventory to maximize profitability.
3. To better use of men, material and capital.
4. For production economies.
5. Control of stock volume.
6. Control against theft, pilferage, etc.
Both over investment and under investment in inventories is undesirable as both involve the consequences.
Over investment involves the consequences like:-
1.Unnecessary blocking of funds in inventory and hence loss of profit.
2.Excessive storage and insurance cost.
3.Risk of liquidity:- The inventory once purchased and stored are normally difficult to dispose off at the same value. In other words, the value of inventory reduces with the increasing holding periods.
The under investment involves the consequences like:
1.If sufficient stock of raw materials and work in process is not available, it may result into frequent interruption in production.
2.If sufficient stock of finished goods is not available it may not be possible for the company to serve the customers properly and they may shift to the competitors.
Thus, the objective of inventory management is to avoid the situation of over investment as well as under investment. The level of inventory should be maintained at the optimum level. The Importance of inventory to an organization can be:-
1. Provides and maintains good customer service.
2. Enable smooth flow of goods through the production process.
3. Provides protection against the uncertainties of demand and supply.
4. Various production operations can be performed economically and independently.
It can allow temporary variation in operating rates.
5. Ensures a reasonable utilization of material, labor and capital etc.
However, inventory control has the following limitations
1. Efficient inventory control methods can reduce but cannot eliminate business risk.
2.The objective of better sales through improved service to customer. Reduction in inventories to reduce size of investment and reducing cost of production by smoother production operations are conflicting with each other.
3.The control of inventories is complex because of the many functions it performs. It should be viewed as shared responsibility.
5.5 TYPES OF INVENTORIES
Inventory is an essential part of an organization. Every business / manufacturing organization, however, big or small has to maintain some inventory. Types include:-
1. Raw material
2.Work-in-progress (Semi-finished goods)
3.Finished goods
4.Maintenance / Repair / Operating supplies (MRO)
1. Raw materials
These represents inputs purchased and stored to be converted into finished goods in future by making certain manufacturing process on the same.
2.Work-in-progress (Semi-finished goods)
These represents semi-manufactured products, which need further processing before they can be treated as finished products.
3.Finished goods
This represents the finished products ready for sale in the market.
4.Maintenance / Repair / Operating supplies
These represents that part of inventory, which does not become a part of final product but are required for production process. They may be in the form of cotton waste, oil and lubricants, soaps, brooms, light bulbs, etc.
Normally, they form a very minor part of total inventory and do not involve significant investment.
5.6 INVENTORY CONTROL TECHNIQUES
Firm’s uses different inventory control techniques to keep track of their inventories. Some of the techniques used by the firms are as stated below.
5.6.1 Economic Order Quantity
Economic order quantity, which is fixed in such a way that the total variable cost of managing the inventory can be minimized such cost basically, consists of two parts.
a) Ordering cost
Ordering cost consists of the costs associated with the administrative effort connected with preparation of purchase requisition, purchase enquires, comparative statements and handling of more numbers of bills and receipts.
b) Inventory carrying cost
The cost of carrying or holding the inventory which in turn consists of go down rent, handling expenses, insurance, opportunity cost of capital blocked i.e. interest etc.
There is a reverse relationship between these two types of costs i.e. if the purchase quantity increases, ordering cost may get reduced but the carrying cost increases and vice versa. A balance is to be stuck between these two factors and it is possible at economic order quantity where the total cost of managing the inventory is minimum. This technique is based on several assumption.
1.Demand is known, constant and independent.
2.Lead-time, that is the time between placement and receipt of the order is known and constant.
3.Receipts of inventory is instantaneous and complete. In other words, the inventory from an order arrives in are batch at one time.
4.Quantity discount are not possible.
5.The only variable costs are the cost of setting up or placing an order (ordering cost) and the cost of holding or storing inventory over time (carrying cost).
6.Stock outs (shortages) can be completely avoided if orders are placed at the right time.
It is possible to fix the economic order quantity with the help of a mathematical formula.
Let: Q be economic order quantity
A be annual requirement of material in units
O be cost of placing an order (which is assumed to remain constant irrespective of size of order
C be cost of carrying one unit per year
.i be carrying cost expressed as a percentage of unit purchase price.
‘A’ is the annual requirement and ‘Q’ is the size of one order, the total number of orders will be ‘A/Q’ and the total ordering cost will be: ‘A/Q x Q’.
Similarly, if the size of one order is ‘Q’ and if it is assumed that the inventory is reduced at a constant rate from order quantity to zero when it is replenished, the average inventory will be ‘Q/2’ and the cost of carrying one unit per year being ‘Ci’, the total carrying cost will be ‘Q/2 x Ci. Thus, Total cost = Ordering cost + carrying cost
= (AQ/Q) + Q/2Ci)
Optimal order quantity is found when ordering cost equals to carrying cost. Thus, economic order quantity could be mathematically presented as follows:-
A/QO = Q/2Ci
To solve for Q, we just simply cross-multiply and isolate ‘Q’ on the left of the equal sign.
= 2AO = Q2Ci
= Q2 = 2AO
Ci
Q = 2AO
Ci
Where Q = Order quantity
A = Annual demand
O = Ordering cost per order
C = Carrying cost per unit per year
.i = Carrying cost expressed as a percentage of a unit purchase price.
5.6. 2 ABC Analysis
ABC analysis divides on hand inventory into three classifications on the basis of annual dollar volume. ABC analysis is an inventory application of what is known as the pare to principle. The pare to principle states that a ‘vital few and trivial many’. The idea is to establish inventory policies that focus resources on the few critical inventory parts and not the many trivial ones. It is not realistic to monitor inexpensive items with the same intensity as very expensive items.
To determine annual dollar volume for ABC analysis, we measure the annual demand of each inventory item times the cost per unit.
A – Class items are these on which the annual dollar volume is high. Although such items may represent only about 15% of the total inventory items, they represent 70 to 80% of the total dollar usage.
B – Class items are those inventory items of medium annual dollar volume. These items may represent 30% of inventory items and 15 to 25% of the total value.
C – Class items are those with low annual dollar volume. These items may represent 5% of the annual dollar volume but about 55% of the total inventory items.
The importance of the various items may be decided on the basis of the following factors.
1.Amount of investment on inventories
2.Value of material consumption
3.Critical nature of inventory items
An example of ABC analysis can be given as below.
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No. of |
% of total |
Value |
% of Total Value |
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Class |
Item |
No. of items |
Consumption |
Consumption |
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A |
300 |
6 |
560,000 |
70 |
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B |
1500 |
30 |
160,000 |
20 |
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C |
3200 |
64 |
80,000 |
10 |
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5000 |
100 |
800,000 |
100 |
In order to exercise proper inventory control, A class items are watered very closely and control is exercised right from initial stages of estimating the requirements, fixing minimum level / lead time, following proper purchase / storage procedure etc. whereas in case of C items, only those inventory control measures may be implemented which are comparatively simple, elaborate and inexpensive in nature. Advantages Of Abc Analysis can be as illustrated below:
1.A close and strict control is facilitated on the most important items which constitutes a major portion of overall inventory valuation or overall material consumption and due to this the costs associated with inventories may be reduced.
2.The investment in inventory can be regulated in a proper manner and optimum utilization of the available funds can be assured.
3.A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio.
5.6. 3 Inventory Levels
Fixation of inventory levels facilitates initiating of proper action in respect of the movement of various materials in time so that the various materials may be controlled in a proper way. However, the following preposition should be remembered.
1.Only the fixation of inventory levels does not facilitate the inventory control. There has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in time.
2.The various levels fixed are not fixed as a permanent basis and are subject to revision regularly.
The various levels fixed are as below:-
1. Maximum level 2. Maximum level 3. Recorder Level 4. Danger level
A) Maximum level
It indicates the level above, which the actual stock should not exceed. If it exceeds, it may involve unnecessary blocking of funds in inventory while fixing this level following factors are considered.
1.Maximum usage
2.Lead-time
3.Storage facility available, cost of storage and insurance
4.Prices for the material
5.Availability of funds
6.Nature of material i.e. if certain type of material is subject to government regulations in respect of import of goods etc. maximum level may be fixed at a higher level.
Maximum level can be expressed in the following mathematical expression.
1.Maximum Level = Reorder level + EOQ – (Minimum usage x Minimum lead time)
B) Minimum Level
It indicates that level below which the actual stock should not reduce. If it reduces, it may involve the risk of non-availability of material whenever it is required while fixing this level, following factors are considered.
a) Lead time
b) Rate of consumption
Minimum level = Reorder level – (Normal usage x Normal lead time)
C) Reorder level
It indicates that level of material stock at which it is necessary to take the steps for procurement of further loss of material. This is the level falling in between the two existence of maximum level and minimum level and is fixed in such a way that the requirements of production are met properly till the new lot of material is received. Reorder level = Maximum usage x maximum lead time
D) Danger level
This is the level fixed below minimum level. If the stock reaches this level it indicates the need to take urgent action in respect of getting the supply. At this stage, the company may not be able to make the purchase in a systematic manner but may have to make rush purchases, which may involve higher purchases cost. Danger level = Normal usage x Lead time for emergency purchases
E) Average Level
This is the level, which has been held at an average during the period. It can be obtained as:
Average Level = Maximum level + Minimum Level
2
There may be one more way in which the various inventory levels may be fixed and for this, determination of safety stock (also called as minimum stock or buffer stock is essential).
Safety stock is that level of stock below which the actual should not be allowed to fall. The safety stock may be calculated as:-
Safety Stock = (maximum usage x minimum lead-time) – (Normal usage x Normal lead-time)
According to this method, the various inventory levels as discussed above may be fixed as below.
1.Minimum level equals to safety stock
2.Maximum level = Safety stock + EOQ
3.Reorder level = Safety stock + (Normal usage x Normal Lead-time)
4.Average stock level = Safety stock + EOQ/2
Example:- Components X and Y are used as follows
Normal usage – 50 units per week each
Minimum usage – 25 units per week each
Maximum usage – 75 units per week each
Reorder quantity X – 400 units
Y – 600 units
Reorder period X – 4 to 6 weeks
Y – 2 to 4 weeks
Calculate for each component
a) Reorder level b) Minimum level c) Maximum level d) Average stock level
Solution:-
a) Reorder level = Maximum usage x maximum lead – time
X = 75 units x 6 Y = 75 x 4
= 450 units = 300 units
b) Minimum level = Reorder level – (Normal usage x Normal lead-time)
X = 450 – (50 x 4+6/2) Y = 300 – (50 x 2+4/2)
= 200 units = 150 units
c) Maximum = Reorder level + Reorder quantity–(minimum usage x minimum lead time)
X = 450 + 400 – (25 x 4) Y = 300 + 600 – (25 x 2)
= 750 units = 850 units
d) Average stock level = Maximum level + minimum level 2
X = 750 + 200 Y = 850 + 150
2
= 475 units = 500 units
5.6. 4 Inventory Turnover Ratio (ITR)
Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as below:-
ITR = Value of material consumed
Average inventory held
Where value of material consumed can be calculated as:-
= Opening stock + purchases – Closing stock
Average inventory held can be calculated as
= Opening stock + Closing stock
2
Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be done by dividing 365 days by inventory turnover ratio.
A high inventory turnover ration or low inventory turnover period indicates that maximum material can be consumed by holding minimum amount of inventory of the same, this indicating fast moving item. Thus high inventory turnover ratio or lower inventory turnover period will always be preferred.
Thus, knowledge of inventory turnover ratio or inventory turnover period in case of various types of material will enable the organization to exercise proper control.
Example:-
Calculate the inventory turnover ratio for the year 1990 from the following information and determine which of the two materials is fast moving.
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Material A |
Material B |
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|
Birr |
Birr |
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|
|
|
|
Materials in hand 01.01.01 |
60,000 |
80,000 |
|
Materials in hand 31.12.01 |
20,000 |
60,000 |
|
Purchase during the year |
200,000 |
120,000 |
Solution:-
Material Consumed = Opening stock + purchases – Closing stock
A = 60,000 + 200,000 – 20,000 B = 80,000 + 120,000 – 60,000
= 240,000 = 140,000
Average Inventory = Opening stock + Closing stock
2
A = 60,000 + 20,000 ; B = 80,000 + 60,000
2
= 40,000 = 70,000
Inventory Turnover = Cost of material consumed
Average inventory held
A = 240,000 B = 140,000
40,000 70,000
= 6 times = 2 times
Inventory holding period = 365 days .
Inventory turnover
A = 365 B = 365
2
= 63.83 days = 182.5 days
» 64 days » 183 days
Therefore, material A is fast moving
5.6.5 Bill of Material
In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for production purposes whenever it is required. This aim can be achieved by preparing what is normally called as “Bill of Material”.
A bill of material is a list of material required for a job process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by production department or production planning department. The form in which bill of material is usually prepared is as below.
Bill of Material
No._______________
Date of Issue: ______________________ Production / Job Order No._______________
Department Authorized _______________________________
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For Department use only |
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Serial |
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Code |
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Material |
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Quantity |
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No. |
Description |
No. |
Quantity |
Reqn. No. |
Date |
Demanded |
Remark |
The function of bill of materials are as below:-
a) Bill of material gives an indication about the order to be executed to all the persons concerned.
b) Bill of material gives an indication about the materials to be purchased by the purchase department if the same is not available with the stores.
c) Bill of material may serve as a base for the production department for placing the material requisition slip.
d) Costing / Accounting department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as a base for quoting the price for the job or production.
5.6.6 Perpetual Inventory / Cycle Counting
In order to exercise proper inventory control, perpetual inventory system may be implemented. It aims basically at two facts.
1.Maintenance of bin cards and stores ledger in order to know about the stock in quantity and value at any point of time.
2.Continuous verification of physical stock to ensure that the physical balance and the book balance tallies.
The continuous stock taking may be advantageous from the following angles.
a) Physical balance and book balances can be compared and adjusted without waiting for the entire stocktaking to be done at the year-end. Further it is not necessary to close down the factory for annual stocktaking.
b) The figures of stock can be readily available for the purpose of periodic profit and loss account.
c) Discrepancies can be located and adjusted in time.
d) Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition of material.
e) Stock details are available correctly for getting the insurance of stock.
f) A systematic maintenance of perpetual inventory system enables to locate slow and non-moving item and to take remedial action for the same.
5.6.7 Fixed Period Systems
In a fixed period system, however, inventory is ordered at the end of a given period. Then, and only then, is on hand inventory counted. Only the amount necessary to bring total inventory up to a prespecified target level is ordered.
The advantage of the fixed period system is that there is no physical count of inventory item after an item is withdrawn – this occurs only when the time for the next review comes up. This procedure is also convenient administratively especially if inventory control is only one of several duties of an employee.
A fixed period system is appropriate when vendors make routine (that is at fixed – time interval) visit to customers to take fresh orders or when purchasers want to combine orders to save ordering and transportation costs (therefore, they will have the same review period for similar inventory items).
The disadvantages of this system is that because there is no tally of inventory during the review period, there is the possibility of a stock out during this time. This scenario is possible if a large order draws the inventory level down to zero right after an order is placed. Therefore, a higher level of safety stock (as compared to a fixed – quantity system) needs to be maintained to provide protection against stock out during both the time between reviews and lead-time.
5.6.8 Just In Time (JIT)
When properly implemented a JIT system results in the following supply chain benefits, reduced inventory, increased quality, reduced lead time, reduced scrap and rework and reduced equipment down time. The benefits of JIT protect and enhance the success of firms that embrace it. Unfortunately, too frequently a key prerequisite to successful implementation of such a system is ignored. JIT requires defect free incoming purchased material.
In addition, to requiring virtually defect free incoming materials, JIT requires a high degree of integration of the customer’s and production plan and schedules affect the suppliers’ schedules. Experience has demonstrated that dependable singly – source partnership are virtually essential if the required level of integration is to result.
A firm that is considering the adoption of JIT manufacturing must focus on its suppliers’ abilities and willingness to meet the stringent quality and schedule demand imposed by the system. The sourcing team must carefully investigate a potential suppliers capability as a JIT manufacturer.
5.7 Summary
Inventory control is a technique of maintaining a stock keeping item at a desired level, be it raw material, semi-finished goods, finished goods and maintenance repair and operating supplies (MRO). The firm may hold inventory at a desired level due to transaction motive, precautionary motive; and speculative motive. The main objectives of inventory is to maintain the optimal level of inventory in order to have a smooth running of production process and sustainable finished product supplying to customers.
The first step in inventory planning/control process is the classification of different types of inventory to determine the type and degree of control required for each. The ABC system is a widely used classification techniques for the purpose. Based on this value of investments, items of inventory are classified as A, B and C.
The second aspect repeats to the determination of size/quantity of inventory, which would be acquired. I.e., the order quantity. The economic order quantity or economic lot size (EOQ) is that level of inventory where the total cost of managing inventory will be at its minimum.
Yet another important question relating to inventory planning and control is: when should the order to procure inventory be place (Reorder point). The reorder point is that inventory level which is equal to the consumption during the lead time /Procurement true etc.
