Management of Inventory

Dr. Teena Shivnani

WCM / Dr. Teena

Meaning of Inventory
Inventory is one of the most visible and tangible aspects of doing business. In simple words, inventory is defined as the sum total of value raw material, WIP and FG though it depends largely upon the type of business. Inventory works as link between production & consumption of goods.

WCM / Dr. Teena

Types of Inventory
Material Inventory Raw Material Work in Progress Finished goods Consumables Spares Liquidity Inventory Cash & marketable securities :- cash and marketable securities can be thought of as an inventory of liquidity that allows separation of collection from disbursement. Without this liquidity inventory payment of bills would be tied to collection of accounts, in some cases, with payment delayed until accounts receivable are collected.

Inventory Management
The techniques of maintaining stock, keeping items at desired level whether they are raw material, WIP or finished goods. Inventory management means efficient control and management of capital invested in raw materials and supplies, work in progress & finished goods for the purpose of obtaining maximum return from the investment.

WCM / Dr. Teena

Cont..
Inventory management is most important as it involves around 25% to 30% of the total investment. It is the role and responsibility of purchase and production function as also of the manufacturing and marketing functions.

WCM / Dr. Teena

Objectives
Operating objectives
1. Regular flow of material 2. Risk minimization 3. Avoiding over stocking and under stocking

Financial objectives
1. Making possible a minimum level of investment 2. Ensure no losses 3. No duplication of purchases so maintaining the stocks likewise

Purpose and Benefits of maintaining Inventory

To facilitate uninterrupted production and smooth running of business
The transaction motive The precautionary motive The speculative motive

Risk associated with inventory

The risk in inventory management signifies the chance that inventories cannot be turned over into cash through normal sale without a loss. These risks are due to three factors:1. Price decline :- it may result from an increase in the market supply of products, introduction of new competitive product and price reduction by competitors. 2. Product deterioration :- it may result due to holding a product too long or it may occur when inventories are held under improper conditions of light, heat, humidity and pressure. 3. Obsolescence :-it is due to changes in customer taste, new production techniques, improvement in product design, specifications etc.

Cost of holding Inventory

The optimum level of inventory depends on the following costs:1. Material Cost 2. Ordering cost 3. Carrying cost 4. Stock out cost/ shortage cost

WCM / Dr. Teena

Material Costs
These are the cost of purchasing the goods plus transportation and handling charges. It may be calculated by adding the purchase price (less any discount), the delivery charges and sales tax, if any. Purchase Price + Delivery charges + sales tax Discount.

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Ordering cost

1. 2. 3. 4. 5.

Every time of an order is placed for stock replenishment, certain costs are involved. The ordering cost may vary dependent upon the type of item. Ordering cost pertain to placing an order for the purchase of certain items of raw materials. This cost includes:Cost of preparation of purchase order. (typing, dispatch, postage, etc.) Cost of sending reminders to get the dispatch of the items Cost of transportation of goods Cost of receiving and verifying the goods Cost of unloading of the item.

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Cont..
A large organization can fixed the ordering cost regardless the number of order can change. Ordering costs are inversely related to the level of inventory.

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Carrying cost
Carrying cost constitute all the costs of holding items in inventory for a given period of time. They can expressed either in rupees per unit per period or as a % of the inventory value per period. It includes: Storage & handling costs Interest on capital Taxes, depreciation and insurance. The cost of fund invested in inventories Product deterioriation and obsolescence.
WCM / Dr. Teena 13

Cont..
The level of inventory and carrying cost are positively related and move in the same direction. Like ordering cost inventory carrying cost contain both fixed & variable components. Mostly carrying cost vary with the inventory level but a certain portion of them such as warehouse rent and depreciation on inventory handling equipment are relatively fixed over the short run.

WCM / Dr. Teena

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Shortage cost (costs of stock out)

Shortage costs or costs of stock out are such costs which the company would incur in case of shortage of certain items of raw material required for production or the shortage of certain items of finished goods to meet the immediate demands of the customers. Shortage of inventories of raw materials may affect the company in one or more of the following ways:1. the company may have to pay some what higher price, connected with immediate procurements. 2. The company may have to compulsorily resort to some different production schedules, which may not be as efficient and economical. Stock out of finished goods, however may result in the dissatisfaction of the customers and the resultant loss of sales.
WCM / Dr. Teena 15

Relationship between OC, CC & TC

The order quantity that minimize total annual inventory costs, can be determined graphically by plotting inventory cost. TC = OC + CC + Pur. Price As no. of orders ordering cost As no. of orders carrying cost Total cost initial decrease till OC & CC are not equal. When OC = CC, total cost start increasing.
WCM / Dr. Teena 16

Example
O 1 2 3 4 5 6 OC 100 80 70 50 30 20 CC 20 30 40 50 90 110 TC 120 110 110 100 120 130

TC

CC

OC

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Techniques
Modern Technique
Traditional

Technique

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Modern Techniques
EOQ ROL Stock Levels Selective Techniques

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Traditional Techniques
Perpetual Inv. System Periodic order system

Two Bin System

Inventory Ratio

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EOQ / OOQ Model

If a firm order for its total annual requirement of material in one lot and keeps it in stock, its ordering costs will be low but carrying cost will rise. On the other hand in case the firm orders small quantities at different times in more than one order, its carrying costs would be low but ordering cost will increase. Therefore, a firm should place an order for that quantity where there is a trade-off between ordering cost and carrying costs becoz at this point the total cost of inventory would be minimum. EOQ or OOQ is that size of the order where total inventory costs ( OC + CC ) are minimized.
WCM / Dr. Teena 21

Assumptions
1. The usage demand of the various items of inventory is equal through out the period. 2. There is no lead time involved 3. There only two distinct costs involved in computing the total costs:- (a) ordering cost (b) carrying cost 4. The cost of every order remains uniformly the same, irrespective of the size of the order. 5. The inventory carrying cost is a fixed % of the average value of inventory.

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Methods of EOQ
1. Formula Method 2. Graphic Method 3. Trail & Error Method

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Formula Method
It is also known as Square Root Formula or Wilson Formula method. The EOQ is three steps :Step 1 = calculation of EOQ EOQ = (2AO) / PC
O = Cost per Order (it is assumed to be fixed or constant) A = Annual Usage or Sales P = Price per Unit C = Carrying cost % or PC = carrying cost in amount

Step 2:- No. of order = Sales or usage / EOQ

Step 3:-Time gap between two orders= 365 / no of orders
WCM / Dr. Teena 24

Example 1
The annual sales of friends electrical limited is estimated at 1800 units, the cost price per unit is Rs. 80/-. The ordering cost per order is (fixed) Rs. 60/- and the inventory carrying cost per unit is Rs. 2/-.

EOQ =

(2AO) / PC

Eoq= (2x 60x 1800) / 2 Q= 328.63 or 329/No. of order = 1800 / 329 = 5.47 orders or 6 orders Time gap between two orders = 365 / 6 = 60.83 days
WCM / Dr. Teena 25

Calculation of Total Cost of Inventory

Total Cost of Inventory = Cost of Purchases + Ordering Cost + Carrying cost
Cost of Purchase = Annual Consumption x purchase price Ordering cost= No of order x ordering cost Carrying Cost = EOQ / 2 x carrying cost

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Example
A Ltd uses an average of 1000 bags of cement each year. They have an ordering cost per order of Rs. 60/-, order in quantities of 350 bags and have carrying costs of Rs. 10 per bag each year. Calculate total cost. Total Cost of Inventory = Cost of Purchases + Ordering Cost + Carrying cost = 1000x 60 + 1000 / 350 x 60 + 350/2 x 10 = 61921/- .

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Calculation of TC in case of Discount

Reduced the cost price by discount amount Calculate new carrying cost becoz as purchase price is changed CC will also change. Consider the minimum quantity of discount as new EOQ. Calculate the total cost according to formula.

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Example of Discount
In Maheshwari company the annual consumption of a particular item is 4000 units. The purchase price per unit is Rs. 10. ordering cost is 60/- per order. Carrying cost is 30% of the value of inventory. The supplier is offering a bulk discount of 1% on lots of 800 units. Advice whether the EOQ should be raised to 800 units.
WCM / Dr. Teena 29

Graphic Method
The EOQ can also be determined with the help of graph. Under this method OC, CC and TC according to different lot sizes are plotted on the graph. The point at which the line of inventory carrying cost and the line of ordering cost intersect each other is the EOQ. At this point the total cost line is also minimum.

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Example
O 1 2 3 4 5 6 OC 100 80 70 50 30 20 CC 20 30 40 50 90 110 TC 120 110 110 100 120 130

TC

CC

OC

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Trial & Error Method

Under this method, annual consumption of goods are divided into imaginary different lot sizes and total inventory cost (CC & OC) for each lot size is calculated. The lot size , where TC is minimum is chosen as EOQ or most profitable quantity to be purchased.

WCM / Dr. Teena

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Re-Order Point / ROL

It is a level of inventory at which an order should be placed for replenishing of current stock of inventory. This can well done by ensuring that the order is placed when sufficient balance of stock is still left to take care of the lead time. But for this we may have to know the rate of usage of material & lead time exactly.

WCM / Dr. Teena

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Lead Time
Lead time is the time lag that takes place between the placement of an order and the actual supply / delivery made in the company godown. As we have seen earlier the standard EOQ model presumes as if there is no lead time involved. It means the order can place when inventory level comes to zero. It is not possible. Therefore we should directly take account the lead time too while calculating EOQ. This can be done by introducing a slight modification in the standard EOQ analysis.

WCM / Dr. Teena

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Usage Rate
This is the rate per day at which the item is consumed in production or sold to customers. It is expressed in units. It is calculated by dividing the total consumption by no of days in a year or 360.

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Safety stock
Safety stock as the minimum quantity of inventory which a firm decides to keep always protect itself against the risk & losses. In actual practice one can neither estimate the lead time nor the daily usage so accurately and exactly. Accordingly we should always keep some safety stock with us to meet such uncertainty.

WCM / Dr. Teena

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Uncertainty & Inventory Management

Inventory is related to consumption of material or selling of FG. But on both the aspect may have uncertainty. To face the uncertainty, always maintain safety stock in the organization. As the level of uncertainty is high, it require more safety stock and viva versa. Uncertainty safety stock Uncertainty safety stock

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ROL Formula
Re- Order point can computed as in case safety stock is not given = Re-Order point = Lead time X Daily usage = 5 X 20 kg. = 100 kg. is order point.

Re- Order point can computed as in case safety stock is given =

Re- Order point = ( lead time X daily usage ) + safety stock

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Stock Level
For avoiding the under stocking and over stocking most of the large companies adopt a scientific approach of fixing stock levels. These levels are :Maximum Level Minimum Level Re-order Level Re-order Quantity / EOQ

1. 2. 3. 4.

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Maximum stock Level

This is the level above which stock level should not normally be allowed to rise. The maximum level is fixed after taking into account such factors as:1. Rate of consumption of material 2. Space availability 3. Cost of storing above normal stock 4. Amount of capital needed and available for purchasing of stock 5. Re-order quantity
WCM / Dr. Teena 40

Formula
Max. stock =
ROL + ROQ (Min consumption x Min re-order period) ROL = Re-order level ROQ = Re order quantity If safety stock is given than formula will be = Max. stock = EOQ + Safety Stock

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Minimum Level / safety stock

It is that level below which stock should not normally be allowed to fall. This is essential safety stock and is not normally touched. In case of stock falling below this level there is a risk of stoppage in production. Min level = ROL ( Normal consumption X Normal re-order period) If safety stock is given than Min. stock will be = safety stock
WCM / Dr. Teena 42

Re-order Level
When to place a order is also an important question requiring a suitable answer. The optimum order point or order level is the level of inventory at which the EOQ of stock (it means EOQ is ordering second, third time etc) should be ordered again. ROL = Max. daily usage X Max. lead time
OR

ROL = Max consumption X Max re-order period If safety stock is given than add safety stock in above formula.
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Average stock
It represent the stock which is maintained in the stores. This level is above the minimum level and below the maximum level. AS = Min stock + Max. stock / 2 AS = Min stock + Re-order quantity

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Re-order Quantity
It is known as EOQ. Formula for calculating EOQ will be same.

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Danger level
Sometimes purchase material are not received in time and stock level goes below the minimum level. In order to meet such type of situation a danger level is fixed. Danger level is a level at which normal issue are stop and material are issued for important job only. Danger level means less than minimum stock. At this level the minimum required raw material is purchased at any price , the raw material at this level is arranged at war level.

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Formula
There are two opinion based formulas for calculation of danger level: 1st opinion= It being emergency period, these purchases are costly and hence to be bought minimum of quantity. DL =Minimum rate of consumption X Emergency delivery period 2nd opinion = emergency has no definite limit, so maximum quantity to be bought to tide over further arising problems. DL=Maximum rate of consumption X Emergency delivery period
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Example
Two material A & B are used as follows:Min = 50 units per week each Max. = 150 unit per week each Normal uses = 100 units per week each Re-order quantity = A = 600 unit B = 1000 unit Delivery period = A = 4 6 week B = 2 4 week

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Solution
ROL = Max. cons. X Max re-order time A = 150 x 6 = 900 unit B = 150 x 4 = 600 unit
Min Level = ROL (NC X Normal del. Period) = A = 900 ( 100 X 5) = 400 unit = B = 600 (100 x 3) = 300 Unit Normal Delivery Period = A = 4 + 6 / 2 = 5 days B = 2 + 4 / 2 = 3 days

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Cont..
Max. Level = ROL + ROQ ( Min consumption X Min delivery Period) A = 900+600 (50 x 4) = 1300 unit B = 600+1000 (50 x 2) = 1500 Unit Average Stock = Min st. + max. st./ 2 A = 400 + 1300 / 2 = 850 units B = 300 + 1500 / 2 = 900 Units
WCM / Dr. Teena 50

Example
A company uses annually 50,000 units of an item each costing 1.20/- each. Each order cost 45/-. And inventory carrying cost 15% of the annual average inventory value. Find out = EOQ = if the company operates 250 days a year the procurement time is 10days and safety stock is 500 units find ROL, max. & Min. inventory and average stock

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Solution
EOQ = 5000 units (Calculate) Consumption per day = 50,000 / 250 days = 200 units ROL = safety stock + (Lead time x consumption per day) = 500 + (10 x 200) = 500 + 2000 = 2500 units Max. inventory = ROL + EOQ (Min consumption during lead time) 2500 + 5000 ( 10X200) = 5500 units Min inventory = ROL (Normal consumption in lead time) = 2500 (10 x 200) = 500 units Average stock = 500 + 5500 / 2 = 3000 units

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Inventory Control Models

ABC Analysis VED Analysis SED Analysis FSN Analysis.

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ABC Analysis
Always Better Control (ABC) is an application of the principle of Management by Exception to the field of inventory control. Under this technique all the items of inventory are classified in the following three categories i.e. A, B, C on the basis of usage rate. The A, B, & C category value will be decided by company. The value is vary according to company. Different company may have different value of A, B, & C category. This value may be change as per time also.
WCM / Dr. Teena 54

ABC Analysis
ABC analysis may be defined as a technique where inventories are analyzed according to their value so that costly items are given greater attention and care by management. Classification can be done on the basis of value of stock not on the basis of quantity of stock. A Category items are of high value . B category items are of moderate value C category items are of low.
Category
A B C

% of Total Value
70 80 % 20 25 % 5 10%
WCM / Dr. Teena

% of Total Quantity
5 -10 % 20 30 % 60 70 %
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Objective of ABC
The main purpose of ABC analysis is to indicate the degree of control required for inventory items of each category. A category items will require tight control. B category items will require less control. C category items require general control.

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80 -20 rule in ABC Model

Maximum value is contribute by very few items. Managers should focused on this A category. Same way calculate B & C category. In C category item will many but contributing to very small value of stock. So the management can ignore C category.
WCM / Dr. Teena 57

Process of ABC Calculation

1. Calculate TC of all the products 2. Arrange total cost in descending order. 3. Cumulative total cost 4. Calculate % of value on total cost as per A,B,C 5. Now break up the cumulative TC as per ABC

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Example
No of units were = 100 Value of total 100 unit were = 100000 no of item value A 20 80,000 B 30 15000 C 50 5000

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e.g. of calculation ABC Category

Dinesh limited is considering a selective control for its inventories. Prepare ABC Plan.:Items A B C D E F G Units 8000 15000 5000 7500 5000 7000 2500 Unit Cost 5.50 1.70 30.40 1.50 0.65 5.14 51.20

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1
Ite Units m (1) s
A B C 8000 15000 5000

2
Unit Cost (2)
5.50 1.70 30.40

Total Cost ( 1 X 2)
44,000 25,500 1,52,000

Ite TC in m Descending s order C G A F B D E 1,52,000 1,28,000 44,000 36,000 25,500 11,250 3,250

Cumulative Cate. TC 1,52,000 2,80,000 3,24,000 3,60,000 3,85,500 3,96,750 4,00,000 C B A

D E F G

7500 5000 7000 2500

1.50 0.65 5.14 51.20

11,250 3,250 36,000 1,28,000 4,00,000

TOTAL COST

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VED Analysis
Virtual , Essential, Desirable items. In this model item will be divided in V, E, D category according to their importance. The organization may focus more on virtual and less focus on desirable items.

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VED & ABC Matrix

V A B C
It require no attention due to D & C category.
It require more attention, Becoz A & V both are here. Value is high as well as importance is more.

E
Require average attention in all three category.

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SDE Analysis
SDE ( Scarce, Difficult and Easy) analysis evaluates the importance of the inventory items on the basis of availability. Scarce (S) items are those items which are in short supply and mostly such items constitute important items. Difficult (D) items refer to such items which cannot be procured easily. Easy (E) items are the items which are easily available in the market.
WCM / Dr. Teena 64

FSN Analysis
FSN (Fast, Slow, Non moving) in this technique inventory are grouped according to the movement into the following categories. Fast (F) moving = these are stored in large quantities and a close watch on the movement of such items is kept. E.g Raw Material Slow (S) =these are not frequently require by the production dept. E.g. production equipments Non-moving (N) =these are rarely required by the production dept. A smaller number of items are kept in stores.
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Inventory systems
Records pertaining to quantity and value of inventory in hand can be maintained according to any of the following systems:1. Periodic inventory system 2. Perpetual inventory system 3. Just in Time Inventory System

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Periodic inventory system

In case of this system the quantity and value of inventory is found out only at the end of the accounting period after having a physical verification of the units in hand. The system does not provide the information regarding the quantity and value of material in hand on a continuous basis. In this system following formula will be followed:-

opening stock + purchases closing stock

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Perpetual inventory system

It is also known as an automatic inventory system It is a method of recording inventory balances after every receipt and issue to facilitate regular checking and to obviate closing down for stocktaking. In case of this system the stores ledgers give balance of goods on a continuous basis. The basic objective of this system is to make available the details about the quantity and value of stock of each item at all times.
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Perpetual Inventory Techniques

1. 2. 3. 4. 5. FIFO Method LIFO Method Average price Method Weighted Price Method Base Stock Method

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 First in First out (FIFO) :- under this method, it is assumed that the materials / goods first received are the first to be issued/ sold. Last in first out (LIFO) :- this method is based on the assumption that last item of material / goods purchased are first to be issued / sold. IMPORTANT:- In both method if opening balance of stock is there then this balance qty & its price always shown in balance column only.
WCM / Dr. Teena 70

 Receipt Jan. 1 Balance 50 units @ 4/Jan. 5 Job no. 10, 40 units @ 3/Jan. 8 job no. 12, 30 units @ 4/Jan. 15 job no. 11, 20 units @ 5/Jan. 26 job no 13, 40 units @ 3/ISSUE:- Jan. 10 , 70 units Jan. 12, 10 units Jan. 20, 20 units Jan. 24, 10 units
24 April 2013 Material Control / Dr. Teena 71

FIFO Method
Date 1st Jan 5th Jan 8th Jan Qty -40 30 P --3 4 Amt --120 120 Qty ------P ------Amt -------Qty 50 50 40 50 40 30 20 30 10 30 10 30 20 20 20 10 20 70 (total) P 4 4 3 4 3 4 3 4 3 4 3 4 5 4 5 5 5 --Amt 200 200 120 200 120 120 60 120 30 120 30 120 100 80 100 50 100 270 (total)
72

10th Jan 12th Ja 15th Ja

------20

------5

-----100

50 20 10 ---

4 3 3 ----

200 60 30 ----

20th Ja

---

---

----

10 10 10 ---

3 4 4 ---

30 40 40 ---

24th Jan 26th Jan

--40

--3

--120

24 April 2013

Material Control / Dr. Teena

Average Price Method

The average price is calculated by adding all the different prices of material in stock and divided by the number of prices used in that total. In this method Ave. price is calculated for only issue. In the balance column ave. price is not written, in it amt and qty. is calculated on the basis of previous qty & amt issue qty & issue amt. this method can be combination of FIFO & Ave. method. Ave. Price = Prices of the stock / 2
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Average Method
Qty P Amt Qty P Amt Qty P Amt 200 2.00 400 300 2.40 720 250 2.20
(Ave. P)

200 --- 400 500 -550 250 -1120 570

250 2.60 650

200 2.5
(A.P.)

500 -500 300 --

1220
720

24 April 2013

Material Control / Dr. Teena

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Weighted Average Price Method

This method is based on the presumption that once the material or goods are put into a common bin, they lose their identity. Hence, the inventory consists of no specific batch of goods. The inventory is thus priced on the basis of average prices paid for the goods, weighted according to the quantity purchased at each price. In this method once stock is received then we have to calculated weighted price. On this calculated price we have to show balance price and further issue till we are not receive any other quantity of stock. It means as we receive stock we have to calculated Weighted price.
24 April 2013 Material Control / Dr. Teena 75

Weighted Average Method

Qty 200 P 2.00 Amt 400 Qty P Amt Qty 200 P 2/(w.a.p.) = 200 /400

Amt 400

300

2.40

720
250 2.24

500
560 250

2.24
(w.a.p.) = 1120 /500

1120
560

2.24

250

2.60

650

500

2.42
(w.a.p) = 1210 / 500

1210

200

2.42

484 300 300

2.42 2.42

726 726
76

24 April 2013

Material Control / Dr. Teena

Base Stock Method

This method is based on the contention that each enterprise maintain at all times a minimum quantity of materials or FG in its stock. This quantity is termed as base stock. The base stock is deemed to have been created out of the first lot purchased and therefore, it is always valued at this price and is carried forward as a fixed assets.
WCM / Dr. Teena 77

Just in Time (JIT) Inventory System

JIT inventory system as its name suggests means at the extreme there is zero inventory and goods are produced or ordered only when they are needed. In other words, RM are received just in time to go into production, manufactured parts are completed just in time to be assembled into products and products are completed Just in Time to be shipped to customers.
WCM / Dr. Teena 78

Two Bin System

Under this method all inventory items are stored in two separate bins. In the first bin, a sufficient supply is kept to meet the current requirement over a designated period of time. In the second bin a safety stock is maintained for use during lead time. When the stock of first bin is used an order for further stock is immediately placed. The material in second bin is then consumed to meet stock needs un till the new order is received.
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Stock Turnover Ratio

This ratio establishes a relationship between cost of goods sold and average stock. Cost of goods sold= O/S + purchases + direct Expenses C/S OR Net sales G/P Average stock = O/S + C/S / 2 Stock ratio = cost of goods sold / average stock If cost of goods sold and average stock is not given, then sales and closing stock are used. Stock ratio = net sales / Average stock or C/S
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