Basic concepts of Inventory and Material management

Index

1 Definition of inventory.................................................................................................................1
2 Classification of inventory............................................................................................................1
3 Cost associated with inventory.....................................................................................................2
4 Inventory Control:.........................................................................................................................2
5 Inventory accounting principals....................................................................................................5
6 Order Quantity Methods...............................................................................................................8
7 Inventory flow in an Organization (From receipt till consumption and delivery)......................10
8 References...................................................................................................................................11

1 Definition of inventory
Inventory is usable but idle resources that have economic value for an organization. These resources
can be direct or indirect to the business operations. Inventory can be of any form raw material to
finished goods. Inventory status starts with raw material input which after being worked on and with
addition with other direct or indirect inventory get converted into WIP, if the conversion is not
complete. Once the final stage is reached the form of the WIP gets converted into finished goods.
The conversion cycle is as follows:

RAW FINISHED
WIP
MATERIAL GOODS

Inventory is stock kept in order for the following reasons:

 To meet the customer (internal & external) demand at the right time
 To avoid lost sales due to stock outs
 Economy of scale in production, purchase and logistics
 To protect against the rising prices of the material in the market
2 Classification of inventory
2.1 Category wise
 Raw materials - materials and components scheduled for use in making a product.
 Work in process, WIP - materials and components that have begun their transformation to
finished goods.
 Semi Finished assemblies
 Finished goods - goods ready for sale to customers.
 Goods for resale - returned goods that are salable.
 Maintenance and repair parts
2.2 Function wise
 Safety stock (buffer stock): It is used to protect against the possibility of stock-outs when
demand or supplies are subject to uncertainty or fluctuation.
 In transit stock (Pipeline stock): This represents material that is in transit, such as from a plant
to a distribution center or a customer. Pipeline stocks are most prevalent with distribution
inventories of finished goods
  Anticipation stock: Type of inventory buildups that are produced and accumulated based on
some strategy as preparing for peak season, planned sales promotional campaign, or to help
level the production rate to reduce the production rate changeover costs.
 Hedging stock: it’s similar to anticipation stock but is built-up in anticipation of some event
that may not actually come about, like labor strike at supplier side, unsettled government
trade dispute or any unjustifiable price peak.
 Lot size stock: The inventory ordered is lot form in order to take benefit of bulk discount, to
reduce ordering, shipping and other costs.
3 Cost associated with inventory
a) Item cost: The landing price paid for an item, this includes the actual price of item and other
indirect costs such as freight, handling, in transit insurance, taxes, custom duties etc,
b) Carrying costs: carrying cost includes various indirect cost associated with inventory, which
includes in-house transportation - handling charges, storage cost (space, worker’s salary and
handling equipment’s cost), opportunity cost and risk cost associated with damage,
obsolescence, deteriorations etc and also insurance
c) Ordering costs: costs associated in ordering an item. This includes purchase department’s
overhead charges, interests on the account payables, receiving and inspection etc.
d) Stock-out costs: The demand increases than available inventory levels in between order lead
time cause stock out situation to arise. This leads to loss of sales, loss of customer, back
ordering costs, damage to brand value and goodwill etc.
e) Capacity-related costs: Costs associated with capacity creation in order to suit the production
level. This will increase the carrying cost to be increased and also the related employment
costs.
4 Inventory Control:
Control of inventory is done by controlling individual items called Stock Keeping Units (SKUs).
Fours factors needs to considered in controlling inventory:
a) What is the importance of the inventory item?
b) How to control them?
c) How much should be ordered at one time?
d) When should an order be placed?
Inventory is classified using the following criteria under various control methods:
 Unit Cost
 Lead Time
 Annual Usage Quantity
 Cost of a Stock-out
 Storage requirements for an item
 Scarcity of resources, raw materials
 Shelf life, possibility of pilferage

Based on these factors many methods are developed, some of them are:
4.1 ABC Analysis:
ABC analysis determines importance of items and thus allowing different levels of control based on
the relative importance of items. In general organizations have plenty of SKUs. It is needed to
classify them in order to have better control at a reasonable cost.

ABC analysis is based on Pareto’s law. In this method, a relationship is found between the
percentage of items and the percentage of annual dollar usage:
A : About 15% of the items account for about 80% of the dollar usage
B : About 35% of the items account for about 15% of the dollar usage
C : About 50% of the items account for about 5% of the dollar usage

ABC Classification process

Inputs required:
 Annual usage in units for each item
 Unit cost of each item
Process Steps:
1 Calculate annual dollar usage for each item by multiplying Annual usage in units by the
unit cost.
2 Add the total annual usages of all items to determine the aggregate annual dollar usage.
3 Divide the annual dollar usage of each item by the aggregate annual usage to obtain
percentage of total usage by each item.

4 Rank items by percentage of total usage in descending order (from highest to lowest).
5 Calculate the cumulative percentage of total usage from top to bottom of the list.
6 Group the items into A, B and C groups based on cumulative percentage and the defined
rules.
Control Based on ABC Classification
ABC classification helps in instituting various levels of controls on inventory.
‘A’ items:
High priority: Tighter control, complete accurate records, regular and frequent reviews,
close follow-ups and expediting to reduce lead times. Allocate maximum resources and
efforts for tightest control.
‘B’ items:
 Medium priority: Normal controls, good records and normal processing with regular
attention.
‘C’ items:
Lowest priority: Simple and basic controls, Order large quantities, have plenty and carry
safety stock
Few common uses of ABC classifications are:
 Cycle-counting frequency
 Engineering priorities
 Procurement priorities
 Security
 Replenishment systems
 Investment decisions
 Method of calculation

4.2 XYZ Analysis’

XYZ analysis is more used in relation of the customer demand for FG (finished goods). X is high
demand, Y medium demand, Z very low or sporadic demand. Variance is calculated for demand of
all items. The items are arranged in increasing fashion of their Variation Coefficient and then
starting 20% (count wise) of total items will be classified as X next 30% as Y and rest 50% as Z.
X category items will have lower variation and their demand can be predicted with more accuracy,
then second 30% can be predicted with less accuracy and rest 50% item’s demand can not be
forecasted at all as their demand in sporadic in nature.
The results of the XYZ analysis provide information that helps evaluate how each inventory part
should be monitored and controlled. These controls are typically:

• X class items which are critically important and require close monitoring and tight control
while this may account for large value these will typically comprise a small percentage of the
overall inventory count.
• Y class is of lower criticality requiring standard controls and periodic reviews of usage.
• Z class require the least controls, are sometimes issues as “free stock” or forward
holding.
4.3 VED (Vital, Essential, Desirable) Analysis:
This classification is from the point view of operation particularly useful for spare parts control
Vital equipment is one, which feeds a battery of equipments downstream such as servers. Essential
is one which is necessary but is independent like desktop terminals and desirable item is like
speakers.

4.4 HML Analysis:

Items are classified according to the unit value as high, medium, and low. It is used to control the
purchase value of items.
4.5 FSN (Fast, Slow, Non moving) Analysis etc.
It is based upon frequency of consumption so their control will be designed as per consumption
pattern. This is specifically used for spare parts. Fast items can be nuts n bolts, slow can be brake
assembly and non-moving can be an outdated cassette based music player for a car in a motor
repair shop.
4.6 GOLF
Government-controlled, ordinarily available in the open market, locally available and foreign
imported purchase
4.7 SDE
Scarce item or single source item, Difficult to obtain or Easy to obtain as it is an off-the-shelf item.
4.8 SOS
Seasonal and Off-seasonal

5 Inventory accounting principals

5.1 Tracking of inventory:
It is the process of keeping records of available inventory which is further used for determining the
inventory value at a specified point of time.
5.1.1 Perpetual:
It is the tracking process in which records are maintained after each and every transaction,
receipt, withdrawal. Based on these on hand record is generated after each entry, so this system
provides us with up to date status on stock and quantity allocated on order for an item. The
process needs high accuracy and speed in recognition of transactions.
5.1.2 Periodic:
A periodic system does not keep track of each issue. Tracking or review is done at predefined
cycles that can be daily, weekly, or monthly, depending on the consumption speed for an item.
The recorded inventory level is used for periodic reporting and for cyclic replenishment. In this
system higher level of safety stock is needed for covering up variation in demands during cycle
time and lead time
Periodic systems are often used for MRO supply items or for other small, inexpensive parts.
5.1.3 Four-Wall Inventory Systems:
This system is used mainly for very fast moving items which do not require storage in warehouse.
The systems records inventory when it is received in factory or warehouse and is subtracted only
when it leaves premises in finished goods form. As this cycle is so small that inventory need not
to be stored in warehouse at any stage.

5.2 Deriving cost of inventory

5.2.1 LIFO:
This method assumes that the last unit coming into inventory is sold first. The older inventory,
therefore, is left over at the end of the accounting period.
5.2.2 FIFO:
This method assumes that the first unit coming into inventory is the first sold.
5.2.3 Average Costing System:
This method takes the weighted average of all units available for sale during the accounting
period and then uses that average cost to determine the value of COGS and ending inventory

Example:
Analyzing inventory of Orizon Company to understand various methods and how they affect the
financial analysis of a company.

Monthly Inventory Purchases*

Month Units Purchased Cost/unit Total Value

January 1,000 $10 $10,000

February 1,000 $12 $12,000

March 1,000 $15 $15,000

Total 3,000

Beginning Inventory = 1,000 units purchased at $8 each (a total of 4,000 units)

Income Statement (simplified): January-March*

Item LIFO FIFO Average

Sales = 3,000 units @ $20 each $60,000 $60,000 $60,000

 Beginning Inventory 8,000 8,000 8,000

Purchases 37,000 37,000 37,000

Ending Inventory (appears on B/S)

8,000 15,000 11,250
*See calculation below

COGS $37,000 $30,000 $33,750

Expenses 10,000 10,000 10,000

Net Income $13,000 $20,000 $16,250

*Note: All calculations assume that there are 1,000 units left for ending inventory:
(4,000 units - 3,000 units sold = 1,000 units left)
We are trying to find out COGS and inventory asset balance in various methods

Ending Inventory = Inventory in hand at the end of accounting period * Relevant Price
Cost of Goods Sold= Beginning Inventory + Net Purchases - Ending Inventory
LIFO Ending
Inventory Cost =1,000 units X $8 each = $8,000
COGS = 8000+37000-8000 = 37000

FIFO Ending
Inventory Cost =1,000 units X $15 each = $15,000
COGS = 8000+37000-15000 = 30000

Average Cost Ending Inventory =

[(1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = $11.25 per unit

Ending Inventory =1,000 units X $11.25 each = $11,250

COGS = 8000+37000-11250 = 33750

5.2.4 Standard Costing System:

In this method price (Standard) is assumed for an item based on the historical prices or on the
basis of some other measures. Inventory and COGS are valued using that price and variance is
reported from the standard cost.
5.2.5 Replacement Cost system:
This system values inventory based on the current price level at which it can be replenished. This
approach is very realistic for inventory valuation.

Apart from the methods discussed there are other various systems such as Actual Cost systems,
Value added costing etc.

5.3 Methods of Counting

5.3.1 Cycle counting:
It is a continuous system which is applied on limited fast moving items. Items are counted daily by
trained employees.
5.3.2 Periodic physical counting:
This is the most preferred method and is performed annually, where all items are counted in a
short period of time. Due to volume it often requires shutdown of operations. Its primary purpose
is to validate the aggregate inventory values used for financial accounting statements and it may
not have accurate Day-to Day status.

5.4 Replenishment systems

5.4.1 Time Based:
Time Phased Order Point: Time phasing is a technique that has been borrowed from Material
Requirement Planning (MRP) as a means to determine when replenishment orders must be
placed to ensure a continuous supply of goods. The prerequisites for this system include a
forecast of requirements, lead-time of the item and order quantity.
Based on the scheduled receipts, forecasted demand and the beginning balance in a particular
period the Project available for that period is calculated, once this value falls in safety stock level
or below then order must be placed to avoid interruption in supply.

Projected Available for Period n = Projected Available for Period (n-1)

+ Scheduled Receipts for Period n
– Forecast Demand for Period n

5.4.2 Quantity based –

Re-order Point: The reorder point method assumes that a perpetual method is employed to keep
track of inventory so that on-hand balances are always known to the control system.
As units are withdrawn from inventory to meet the demands, the inventory declines gradually until
it becomes zero (out of stock). However, if replenishment orders are placed at judicious times,
then an inventory receipt of same predetermined quantity should come at just about the time
inventory would be depleted. This inventory graph, referred as saw-toothed graph, is a classic
model of inventory behavior when usage is uniform and relatively continuous.

6 Order Quantity Methods

6.1 Demand Based Methods
All order quantity, or lot-size, choices are based on the principle of economy of scale. It is
usually less expensive to purchase (and transport) or produce a bunch of material at once
than to order it in small quantities. On other hand, larger lot sizes result in more inventories
and inventory is expensive to hold.

6.1.1 EOQ:
EOQ is the optimal quantity to order taking into consideration both the cost to carry inventory and
the cost to order the item. This Minimizes total inventory cost. EOQ can be used if annual usage
can be determined. It can be calculated by adding up all the demands over the planning horizon
and then “annualize” the demand by extending an average of the period demands to represent
the data for a full year.
Carrying cost is some fixed percentage of the item cost so total carrying cost varies with inventory
volume. Ordering cost is fixed cost per order irrespective or quantities added into it. So as the
quantity in an order increases the ordering cost per unit goes down.

Assumptions:
 Constant unit price, constant carrying and ordering costs
 Known & constant demand
 Known & constant lead time
 Instantaneous receipt of material
 Constant consumption rate
 No quantity discounts
 Only order (setup) cost & holding cost
 No stock outs

Calculation for Economic Order Quantity

D= Annual demand (units) Total cost = (Q/2) x I x C + S x (D/Q)+D*C

C= Cost per unit ($) carry cost order cost inv cost
Q= Order quantity (units) Take the 1st derivative:
S= Cost per order ($) d(TC)/d(Q) = (I x C) / 2 - (D x S) / Q²
I= Holding cost (%) To optimize: set d(TC)/d(Q) = 0
H= Holding cost ($) = I x C
 Number of Orders = D / Q
Ordering costs = S x (D / Q) DS/ Q² = IC / 2

Average inventory Q²/DS = 2 / IC

units = Q / 2
$ = (Q / 2) x C Q²= (DS x 2 )/ IC

Cost to carry Q = sqrt (2DS / IC)

average inventory = (Q / 2) x I x C
= (Q /2) x H
2 ⋅D ⋅S
O
ptim
al Order Q
uantity =Q* =
H
D D = Demand per year
E
xpected Nu
m b
er O
rders =N =
Q*
S = Setup (order) cost per order
Work
ing Days/Y
ear
E
xpected Tim
e Betw
een O
rders =T =
H = Holding (carrying) cost
N
D d = Demand per day
d =
W
ork
ing Days/Y
ear L = Lead time in days

R
O P =d ⋅L
Re-Order Point

6.1.2 Fixed order quantity

A form of independent demand item management model in which an order for a fixed quantity is
placed whenever stock on hand plus on order reaches a predetermined reorder level. The fixed
order quantity may be determined by the economic order quantity, by a fixed order quantity (such
as a carton or a truckload), or by another model yielding a fixed result. The reorder point in either
instance is large enough to cover the maximum expected demand during the replenishment lead
time.
6.2 Discrete Methods
6.2.1 Lot for lot (L4L):
Lot-for-lot ordering is the method of placing an order for each period that has requirements in the
exact amount of the requirement. The order quantity changes whenever requirements change.
This method requires time-phased information. This system creates no unused lot size inventory
and hence is best for ‘A’ class items and in a just-in-time environment.
6.2.2 Period Order Quantity (POQ):
The approach uses a formula based on the EOQ but is solved for optimum number of periods to
be covered by each order rather than for the optimum quantity. The number of orders per year is
same as EOQ, but the quantity ordered each time varies. Thus ordering cost remains same but
as the order quantities are determined by actual demand, the carrying cost is reduced.

7 Inventory flow in an Organization (From receipt till consumption and delivery)

 Warehouse:
Inventory Records

Allocate
Inventory Data
& Dispatch
Sales Department: Yes
Order receiving
Customer Material Inspecti NO
Order availabili Yes on
ty Cleared
NO
Discrepancy
Report
Inspections
Purchasing Dept:
Purchase Request
Order Item, Design Spec,
Data QC documents
Challan, Packing
Supplie list, Items Receiving
r Department

8 References

1. Basics of supply chain management: APICS-CPIM Certification Course: Study Guide

2. Fundamentals of Operation Management 4e: Tata Mc Graw-Hill Companies
3. Operation Management 8e by William J. Stevenson
4. Lecture: Industrial Logistics, ABC/XYZ Analysis as a basis of differentiated scheduling from
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