Inventory Techniques

INTRODUCTION
Inventory is one of the major current assets to the organization. They are important input of final product. It is an area where significant cost savings can be made. Inventory decisions are high risk and high impact from the perspective of financial operation. Inventory, as current asset, differs from other current assets because only financial managers are not involved. Rather, all the functional areas, finance, marketing, production, and purchasing are involved. The job of the financial manager is to reconcile the conflicting viewpoints of the various functional areas regarding the appropriate inventory levels in order to fulfill the overall objective of maximizing the owners wealth. Raw materials shortages can shutdown a manufacturing line or modify a production schedule, which, in turn introduces added expenses and potential for finished goods shortages. Just as shortages can disrupt planned marketing and manufacturing operations, over stocked inventories also create problems. Overstocks increases cost and reduce profitability through added warehousing, working capital requirements, deterioration, insurance, tax and obsolescence.

Inventory Techniques

BENEFITS OF INVENTORY MANAGEMENT

Reduced stocking costs resulting from efficient matching of requirements to stock. Re-order recommendations highlight urgent needs. Help prevent stock-outs. Instant access to 24 month usage pattern aids decision-making, reveals trends. Old data easily purged. Automatic capture on audit trail of all stock movement details helps resolve queries. Instant month-end valuation of receipts, issues, adjustments etc. Rapid stock and work-in-progress evaluation. True multi-location without constraints. Easy monitoring of slow moving stocks. Automation of inventory checking cycles ensures that items are not forgotten, improves accuracy. Automatic tracking of scrap rates and recalculation of safety levels reduces effort, improves control. ABC analysis system focuses attention on high value stock holdings.

Inventory Techniques

CHARACTERISTICS
The holding of inventory is risky because of the capital investment

and the potential for obsolescence. Investments for inventory cannot be used to obtain other goods or assets that could improve enterprise performance. Funds supporting inventory investment must be borrowed, increasing the firms interest expense. A second form of risk is the possibility that the product will be pilfered or become obsolete. These factors and the relative magnitude of assets that are inventory related contribute substantially to the riskiness of most enterprises. It is important to understand that the nature and extent of risk vary depending on an enterprises position in the distribution channel.

Inventory Techniques

INVENTORY TECHNIQUES
ABC ANALYSIS ABC analysis underlines a very important principle Vital few: trivial many. Statistics reveal that only a handful of items account for bulk of the annual expenditure on materials. These few items called A items therefore hold the key to business. The other items known as B and C items are numerous in number but their contribution is less significant. ABC analysis thus tends to segregate all items into three categories: A, B and C on the basis of their annual usage. The categorization so made enables one to pay the right amount of attention as merited by the items. ABC CLASSIFICATION SYSTEM

Inventory Techniques

A B C Cla ssifica t io nS y st e m
D em an dv olu m e&v alu e of item sv ary Classifyin v en toryin to 3cat eg ories Class
A B C
2000 by Prentice -Hall Inc Russell/Taylor Oper Mgt 3/e

%of Un its
5- 1 5 3 0 5 0- 6 0

%of D ollars
7 0- 8 0 1 5 5- 1 0

Ch 12 - 8

A Items: It is hardly found that 5-15% of items account for 70-80% of the total money spent on materials. These items require detailed and rigid control and need to be stocked in smaller quantities. These items should be procured regularly, the quantity per occasion being small. A healthy approach would be to enter into contract with the manufacturers of these items and have their supply in staggered lots according to production program of the buyer. This, however, will be possible when the demand is steady. Alternatively, the inventory can be kept at minimum by frequent ordering. B Items: These items are generally 30% of all items and represent 15% of the total expenditure on the materials. These are intermediate items. The control on these items need not be as detailed and as rigid as applied to C items.
5

Inventory Techniques

C Items: There are numerous (as many as 5060% of the total items), inexpensive (represent hardly 510% of the total expenditure on materials) and hence insignificant (do not require close control) items. The procurement policy for these items is exactly the reverse of A items. C items should be procured infrequently and in sufficient quantities. This enables buyer to avail price discounts and reduce workload of the concerned departments.

Conducting ABC Analysis: To conduct ABC analysis, following seven steps are necessary: 1. Prepare the list of items and estimate their annual consumption (units). 2. Determine unit price (or cost) of each item. 3. Multiply each annual consumption by its unit price (or cost) to obtain its annual consumption in rupees (annual usage). 4. Arrange items in the descending order of their annual usage starting with the highest annual usage down to the smallest usage. 5. Calculate cumulative annual usages and express the same as cumulative usage percentages. Also express the number of items into cumulative item percentages.

Inventory Techniques

6. Graph cumulative usage percentages against cumulative item percentages and segregate the items into A, B and C categories. 7. To separate items into A, B and C categories, first few items which contribute between 70 75% of cumulative usage can be considered as A category, next few items which together with A category items segregated earlier contribute between 80 90% of cumulative usage can be considered B category, and left over items can be taken as C category. Example A firm has 7 different items in its inventory. The average number of each of these items held, along with their costs, is listed below. The firm wishes to introduce an ABC inventory systems. Suggests. Suggest a breakdown of the items of the items into A, B and C classification. Item number 1 2 3 4 5 6 7 Solution Item (1) 1 Units (2) 20000 Percent (3) 10 Unit cost (4) Rs. 60.80 Total cost Percent of total (5) (6) Rs1216000 38 Average number of Average cost per unit Rs. 60.80 102.40 11.00 10.28 3.40 3.00 1.3

units in inventory 20000 10000 32000 28000 60000 30000 20000

Inventory Techniques

2 3 4 5 6 7 TOTAL

10000 32000 28000 60000 30000 20000 200000

5 16 14 30 15 10 100

102.4 11.00 10.28 3.40 3.00 1.30

1024000 352000 288000 204000 90000 26000 3200000

32 11 9 6.38 2.80 0.82 100

The A B C system of classification should, however, be used with caution. For example, an item of inventory may be very inexpensive. Under the A B C system it should be classified as C category. But it may be very critical to the production process and may not be easily available. It deserves the special attention of management. But in terms of the A B C framework, it would be included in the category, which requires the least attention. This is a limitation of the A B C analysis.

Inventory Techniques

HML ANALYSIS H-M-L analysis is similar to ABC analysis except for the difference that instead of usage value, price criterion is used. The items under this analysis are classified into three groups, which are called High, Medium and Low. To classify, the items are listed in the descending order of their unit price. The cut-off-lines are then fixed by the management for deciding three categories. For example, the management may decide that all items of unit price above Rs. 1000 will be of H category, those with units price between Rs. 100 and Rs. 1000 will be of M category and those having unit price below Rs. 100 will be of L category. HML analysis helps to: Assess storage and security requirements (e.g. high priced items like bearings, worm shafts, worm wheels, etc. require to be kept in the cupboards).

Inventory Techniques

To keep control over consumption at the departmental head level (e.g. indents of high and medium priced items are authorized by the departmental head after careful scrutiny of the consumption figures). Determine the frequency of stock verification (e.g. high priced items are checked more frequently than low priced items). To evolve buying policies to control purchases (e.g. excess supply than the order quantity may not be accepted for H and M groups while it may be accepted for L group). To delegate authorities to different buyers to make petty cash purchase (H and M category of items may be purchased by senior buyers and L category of items by junior buyers).

10

Inventory Techniques

VED ANALYSIS VED analysis represents classification of items based on their criticality. The analysis classifies the items into three groups called Vital, Essential and Desirable. Vital category encompasses those items for want of which production would come to halt. Essential group includes items whose stock-outs cost is very high. And Desirable group comprises of items which do not cause any immediate loss of production or their stock-out entail nominal expenditure and cause minor disruptions for a short duration. VED (Vital Essential Desirable) analysis is carried out to identify critical items. An item, which usage-wise belongs to C-category, may be critical from production point of view if its stock-out cause heavy production loss. An item may be vital for a number of reasons, namely 1. If the non availability of the item can cause serious production losses. 2. Lead-time for the procurement is very large.

11

Inventory Techniques

3. It is non standard item and is procured to buyers design. 4. The sources of supply are only one and are located far off from the buyers plant.

Steps involved in making VED analysis are as under: Identify the factors to be considered for VED analysis: These commonly considered factors affect on production (i.e. stock out cost in the event of its non availability), lead-time, and nature of the item and sources of supply. Assign points/weightages to the factors according to their importance to the company. Typical examples of the weightages to the above four factors may be 30, 30, 20 and 20 points. Divide each factor into three degrees and allocate points to each degree . Usually, the first degree is assigned points equal to the weightage of its factor; second degree is allocated points equal to twice the weightage of the factor and third degree is assigned points equal to thrice the weightage of the factor. Prepare categorization plan (shown below), which provides the basis of classification of items into vital, essential and desirable categories. Evaluate items one by one against each factor and assign points to the item depending upon the extent of presence of the factor in the item

12

Inventory Techniques

Place the items into V, E and D categories depending upon the points scored by them (table below) and basis of classification set under step (iv).

Typical VED Analysis Categorization Plan FACTOR 1 FIRST SECOND THIRD

DEGREE Stock out cost Above Rs. X in the event of non availability (30) Lead time for 1 4 weeks procurement (30) (30) (30)

DEGREE DEGREE Between Rs. Above Rs. Y X to Y (60) (90)

4 8 weeks (60)

Over 8 weeks (90)

Nature of an Produced item (20) commercial standard, availability (20) of Local

to Produced suppliers or design (40)

to Produced

to

buyers design or proprietary items (60)

off the shelf

Sources

Outstation

Imported,
13

Inventory Techniques

supply (20)

(20) (40)

quota supply (60)

items

i.e. controlled

Typical Categorization Plan POINTS 100 160 161 230 231 300 CLASSIFICATION DESIRABLE ESSENTIAL VITAL

VED analysis is best suited for spares inventory. In fact, it is advantageous to use more than one method. E.g. ABC and VED analysis together would be helpful for inventory control of spares.

14

Inventory Techniques

S D E ANALYSIS S D E analysis is based on the problem of procurement namely: Non availability Scarcity Longer lead-time Geographical location of suppliers Reliability of suppliers, etc. S D E analysis classifies the items into three groups called Scarce, Difficult and Easy. The information so developed is then used to decide purchasing strategies. Scarce classification comprises of items, which are in short supply, imported or canalized through government agencies. Such items are best to procure limited number of times a year in lieu of effort and expenditure involved in the procedure for import. Difficult classification includes those items, which are available indigenously but are not easy to procure. Also items which come from long distance and for which reliable sources do not exist fall into this category. Even the items, which are difficult to manufacture and only one or two manufacturers are available belong to this group. Suppliers of such items require several weeks of advance notice.

15

Inventory Techniques

Easy classification covers those items, which are readily available. Items produced to commercial standards, items where supply exceeds demand and others, which are locally available, fall into this group. S D E analysis is employed by the purchase department: 1. To decide on the method of buying. E.g. Forward buying method may be followed for some of the items in the Scarce group; scheduled buying and contract buying for Easy group. 2.To fix responsibility of buyers. E.g. senior buyers may be given the responsibility of S and D groups while items in E group may be handled by junior buyers or even directly by the storekeeper.

16

Inventory Techniques

G NG LF ANALYSIS / GOLF ANALYSIS G NG LF analysis (or GOLF analysis) like S D E analysis based on the nature of the suppliers which determine quality, lead time, terms of payment, continuity or otherwise of supply and administrative work involved. The analysis classifies the items into four groups namely G NG L and F. G group covers items procured from Government suppliers such as the STC, the MMTC and the public sector undertakings. Transaction with this category of suppliers involve long lead time and payments in advance or against delivery NG (O in GOLF analysis) group comprises of items procured from Nongovernment (or Ordinary) suppliers. Transactions with this category of suppliers involve moderate delivery time and availability of credit, usually in the range of 30 to 60 days. L group contains items bought from Local suppliers. The items bought from local suppliers are those which are cash purchased on blanket orders. F group contains those items, which purchased from Foreign suppliers. The transactions with such suppliers:

17

Inventory Techniques

1. Involve a lot of administrative and procedural work. 2. Necessitate search of foreign suppliers. 3. Require opening of letter of credit. 4. Requiring making of arrangement for shipping and port clearance. S OS ANALYSIS S OS analysis is based on seasonality of the items and it classifies the items into two groups S (seasonal) and OS (Off Seasonal). The analysis identifies items, which are:

Seasonal and are available only for a limited period. Example: agriculture produce like raw mangoes, raw materials for cigarette and paper industries, etc. are available for a limited time and therefore such items are procured to last the full year.

Seasonal but are available throughout the year. Their prices, however, are lower during the harvest time. The quantity of such items requires to be fixed after comparing the cost savings due to lower prices if purchased during season against higher cost of carrying inventories if purchased throughout the year. Non seasonal items whose quantity is decided on different considerations.

18

Inventory Techniques

M N G ANALYSIS M N G analysis based on stock turn over rate and it classifies the items into M (Moving items), N (Non moving items) and G (Ghost items). M (moving items) are those items which are consumed from time to time. N (Non moving items) are those, which are not consumed in the last one year. G (Ghost items) are those items, which had nil balance, both in the beginning and at the end of the financial year, and there were no transactions (receipt or issues) during the year. Analysis mainly helps to identify non existing items for which the store keeps bin cards or waste computer stationary while preparing store ledger. Stores department even might have even ear marked space for these non existing items. All pending / open purchase orders (if any) of such items should be cancelled.

19

Inventory Techniques

F S N ANALYSIS F S N analysis is based on the consumption figures of the items. The items under this analysis are classified into three groups: F (fast moving) S (slow moving) N (Non moving) To conduct the analysis, the last date of receipt or the last date of issue whichever is later is taken into account and the period, usually in terms of number of months that has elapsed since the last movement is recorded. Such an analysis helps to identify: 1. Active items, which require to be reviewed regularly. 2. Surplus items whose stocks are not being consumed. The last two categories are reviewed further to decide on disposal action to deplete their stocks and thereby release companys productive capital 3. Non moving items which are not being consumed. The last two categories are reviewed further to decide on disposal action to deplete their stocks and thereby release companys productive capital.

20

Inventory Techniques

Further detailed analysis is made of the third category in regards to their year wise stocks and items can be sub classified as non moving for 2 years, non moving for 3 years, non moving for 5 years and so on.

X Y Z ANALYSIS X Y Z analysis is based of value of the stocks on hand (i.e. inventory investment). Items whose inventory values are high are called X items while those inventory values are low are called Z items. And Y items are those, which have moderate inventory stocks. Usually X Y Z analysis is used in conjunction with either ABC analysis or HML analysis. XYZ analysis when combined with ABC analysis is as used as under: Class of items X A Efforts made stocks Y B be Efforts Z them C be Steps to be taken Y surplus stocks. Control may be further tightened. Stock may levels * be

to to

to to

reduce made to convert to dispose off category. be * Z

category. Efforts to made these category. * to

convert

reviewed twice a

21

Inventory Techniques

year.

X Y Z analysis when combined with F S N analysis helps to formulate more specific strategies as under: Class of items X F Tighten control. S Deplete to Y * very level. Deplete a good price. * (to clerical N stocks Dispose low immediately

off at

optimum price. the Dispose off as as possible. Dispose off as early as possible even at a lower price.

stocks further at early Z Liberalize control reduce cost)

* Items are within control. No further action is necessary. XYZ, therefore, helps to identify a few items which account for large amount of money locked up in stock and take steps for their liquidation / reduction. XYZ when combined with FSN analysis helps to classify non moving items into XN, YN and ZN group and thereby identify a handful of non moving items, which account for bulk of non moving stock. These can be studied individually in details to take decision on their disposal or retention.

22

Inventory Techniques

ECONOMIC ORDER QUANTITY Under the fixed order quantity system of inventory management, an order for supplies is placed when the existing stock reaches re order point. EOQ is the technique, which solves the problem of the inventory management. EOQ is the order size at which the total cost; comprising ordering cost plus carrying cost, is the least. Graphical representation of EOQ

23

Inventory Techniques

Graphing the two costs, viz., holding costs and ordering costs show exactly, where the total cost curve is at its lowest point. An examination of the two curves reveals that the carrying cost curve is linear i.e., the more the inventory held in any period, greater will be the cost of holding it. Ordering cost curve, on the other hand, is different. Ordering in small quantities means more acquisition and higher ordering costs. The ordering costs decrease with increase in order sizes. A point where the holding cost curve and the ordering cost curve meet, represent the least total cost, which incidentally is the EOQ. EOQ technique is highly useful as it answers the question of how much to order and in doing so, establishes the frequency with which, orders are placed. EOQ is applicable to both to single items and to any group of stock items with similar holding and procurement costs. Its use causes the sum of the two costs to be lower than under any other system of replenishment.

24