Introduction to Inventory Management

The dictionary meaning of inventory is ‘stock of goods, or a list of goods’. The word ‘Inventory’ is
understood differently by various authors. In accounting language it may mean stock of finished
goods only. In a manufacturing concern, it may include raw materials, work in process and stores, etc.
to understand the exact meaning of the work ‘inventory’ we study it from the usage side of from the
‘side of point of entry’ in the operations.

The American Institute of Certified Public Account (AICPA) defines:

“Inventory in the sense of tangible goods, which are held for sale, in process of Production and
available for ready consumption”.

According to Bolten S.E., “Inventory refers to stock-pile of product, a firm is offering for sale and
components that make up the product”,

According to Philip Kotler, “Inventory management refers to all the activities involved in developing
and managing the inventory levels of raw materials, semi-finished materials (work-in-progress) and
finished good so that adequate supplies are available and the costs of over or under stocks are low”.

Inventory is stock or store of goods. The storage of these goods “is done near the location of the
business to meet the demands of the customers. Inventory is very important for retailers because if
goods are not available the customers will immediately buy the product from other retailer.
Generally the retailer has to keep the inventory of finished goods in order to meet the demand of the
customers. Inventories are held for various reasons like meeting the seasonal demands, physical
necessities functional purposes, etc.

Sometimes a firm may keep larger inventory than is necessary to meet cons demand and keep the
factory running under current conditions of demand, pack If the firm exists in a volatile environment
where demand is dynamic, an on hand inventory could be maintained as buffer against unexpected
changes in demand. This buffer inventory also can serve to protect the firm if a supplier fails to
deliver at the required time, or if the supplier’s quality is found to be substandard upon inspection,
either of which would otherwise leave the firm without the necessary raw materials. Other reasons for
maintaining an unnecessarily large inventory include buying to take advantage of quantity discounts
(i.e., the firm saves by buying in bulk), or ordering more in to avoid any future price increase.

Types of inventory

Types of inventories are classified according to the type of business. There are mainly three types of
organization namely, manufacturing Organization, trading organization (retail or wholesale) and
service

1. Raw Materials:
Raw materials are the materials a company uses to create and finish products. When the
product is completed, the raw materials are typically unrecognizable from their original form,
such as oil used to create shampoo.

2. Components:
Components are similar to raw materials in that they are the materials a company uses to
create and finish products, except that they remain recognizable when the product is
completed, such as a screw. Eg: A company that makes T-shirts has components that include
fabric, thread, dyes and print designs.

3. Work In Progress (WIP):

WIP inventory refers to items in production and includes raw materials or components,
 labour, overhead and even packing materials. Eg: A cell phone consists of a case, a printed
circuit board, and components. The process of assembling the pieces at a dedicated
workstation is WIP.

4. Finished Goods:
Finished goods are items that are ready to sell.
Eg: A jewellery manufacturer makes charm necklaces. Staff attaches a necklace to a pre-
printed card and slips it into cellophane envelopes to create a finished good ready for sale.
The cost of goods (COGS) of the finished good includes the packaging it comes in as well as
the labour to make the item.

5. Maintenance, Repair and Operations (MRO) Goods:

MRO is inventory—often in the form of supplies—that supports making a product or the
maintenance of a business.

6. Packing and Packaging Materials:

There are three types of packing materials. Primary packing protects the product and makes it
usable. Secondary packing is the packaging of the finished good and can include labels or
SKU information. The tertiary type of packing is bulk packaging for transport.

7. Buffer inventory or Safety Stock and Anticipation inventory:

Safety stock is the extra inventory a company buys and stores to cover unexpected events.
Safety stock has carrying costs, but it supports customer satisfaction. Similarly, anticipation
stock comprises raw materials or finished items a business purchases based on sales and
production trends. If a raw materials price is rising or peak sales time is approaching, a
business may purchase safety stock.

8. Decoupling Inventory:
Decoupling inventory is the term used for extra items or WIP kept at each production line
station to prevent work stoppages. It is useful if parts of the line work at different speeds and
only applies to companies that manufacture goods. Whereas all companies may have safety
stock.

9. Cycle Inventory:
Companies order cycle inventory in lots to get the right amount of stock for the lowest storage
cost.

10. Service Inventory:

A management accounting concept, service inventory refers to how much service a business
can provide in a given period.

11. Transit Inventory:

Also known as pipeline inventory, transit inventory is stock that’s moving between the
manufacturer, warehouses and distribution centres. Transit inventory may take weeks to move
between facilities.

12. Theoretical Inventory:

Also called book inventory, theoretical inventory is the least amount of stock a company
needs to complete a process without waiting. Theoretical inventory is used mostly in
production and the food industry. It’s measured using the actual versus theoretical formula.
 13. Excess Inventory:
Also known as obsolete inventory, excess inventory is unsold or unused goods or raw
materials. A company doesn’t expect to use or sell this stock but must pay to store it.

14. Obsolete inventory:

When any facility becomes unserviceable , and it is to be replaced by new one, after replacing
, the old machine/facility is to disposed. Such machines, which have become useless are
terms as obsolete inventory.

Inventory Management
Effective inventory management is all about knowing what is on hand, where it is in use & how much
finished product results. In short activities employed in maintaining optimum number or amount of
each inventory item.

Inventory management is the process of efficiently overseeing the constant flow of units and out of an
existing inventory. This process usually involves controlling the transferring of units in order to
prevent the inventory from becoming too high, or dwindling to levels that could put the operation of
the company into jeopardy. Competent inventory management also seeks to control the costs
associated with the inventory, both from the perspective of the total value of the goods included and
the tax burden generated by the cumulative value of the inventory.

Balancing the various tasks of inventory management means paying attention to three key aspects of
any inventory. The first aspect has to do with time. In terms of materials acquired for inclusion in the
total inventory, this means understanding how long it takes for suppliers to process an order and
execute a delivery. Inventory management also demands that a solid understanding of how long it will
take for those materials to transfer out of the inventory be established. Knowing these two important
lead times makes it possible to know when to place on order and how many units must be ordered to
keep production running smoothly.

Calculating what is known as buffer stock is also key to effective inventory management. Essentially,
buffer stock is additional units above and beyond the minimum number required for maintain
production levels. For example, the manager may determine that it would be a good idea to keep one
or two extra units of a given machine part on hand, just in case an emergency situation arises or one of
the units proves to be defective once installed. Creating this cushion or buffer helps to minimize the
chance for production to be interrupted due to a lack of essential parts in the operation supply
inventory.

Inventory management is not limited to documenting the delivery of raw materials and the movement
of those materials into operational process. The movement of those materials as they go through the
various stages of the operation is also important. Typically known as a goods or work in progress
inventory, tracking materials as they are used to create finished : goods also helps to identify the need
to adjust ordering amounts before the raw materials inventory gets dangerously low or is inflated to an
unfavourable level.

Finally, inventory management has to do with keeping accurate records of finished goods that are
ready for shipment. This often means posting the production of newly completed goods to the
inventory totals as well as subtracting the most recent shipments of finished goods to buyers. When
the company has a return policy in place, there is usually a sub-category contained in the finished
goods inventory to account for any returned goods that are reclassified as refurbished or
second grade quality. Accurately maintaining figures on finished goods inventory makes it possible to
quickly convey information to sales person as to what is available and ready for shipment at any given
time.
Inventory management is the management of inventory and stock. As an element of supply chain
management, it includes aspects such as controlling and overseeing ordering inventory, storage of
inventory, and controlling the amount of product for sale.
The definition of Inventory Management is easy to understand. Simply, “inventory
management is all about having the right inventory at the right quantity, in the right place, at the right
time, and at the right cost.” But how do you implement the best inventory management techniques to
ensure the best results?

Objectives of Inventory Management

Objectives of an effective inventory Management system :

1. A controlled level of marked downs

2. Minimum investment in unnecessary inventory
3. Proper inventory turnovers (not too high and not too low).
4. Minimum expenses associated with the store of merchandise.
5. Balancing of inventory against sales i.e. inventory should peak prior to sale speak, subside as
demand subsides and sold out (or close to it) when demand ceases.
6. Minimal carry-over of prior season merchandise.
7. Maintenance of sufficient breadth and depth of inventory to satisfy customer needs.
8. Minimal merchandise shrinkage (shortage).

Inventory Valuation in Retail

Inventory is normally valued at cost. The method of valuation of inventory, depends on the type of the
product. There are three methods for Valuation of inventory.

1. First-in-First-out (FIFO): This method is used for perishable goods, and goods with expiry date.
Under this method the closing inventory is valued on the basis of the cost of goods purchased later. In
case of Perishable, goods like fruits vegetables and food items, the goods purchased first are sold first.
i.e, First-in-First out. Therefore, the unsold goods are valued at the latest price.

For example, a retail store purchases 20 kg of apples on Monday at a price of Rs. 100 per kg. On
Tuesday 10 kg of apples are purchased at a price of 110 per kg and 22 kg of apples were sold @ 125
per kg. The valuation of remaining stock (30 - 22) 8 kg will be done at the latest purchase i.e., Rs.110
per kg.

Value of inventory = unsold goods * latest purchased price = 8 kg x 110 = 880

2. Last-in First-out (LIFO): This method is used for non-perishable goods. Under this method the
goods which are purchased later are sold first. The categories of goods which do not have any
immediate expiry date are valued on this basis.

Example : when bags of cement are purchased by the retailer, they are stored one above the other, at
the time of sale the bag purchased last is issued first as it is kept on the top. This is Last-in-first-out.
Under this method the closing inventory is valued on the basis of the cost of goods purchased earlier.

3. Weighted Average method: Under this method weighted average approach, both inventory and the
cost of goods sold are based upon the average cost of all units bought during the period.

Stock Recording: There are two different methods of recording of inventory in the accounting
systems:
1. Perpetual inventory system updates inventory accounts after each purchase or sale. Inventory
subsidiary ledger is updated after each transaction. Inventory quantities are updated continuously.

2. Periodic inventory system records inventory purchase or sale in “Purchases” account. Purchases”
account is updated continuously; however “Inventory” account is updated on a periodic basis, at the
end of each accounting period (e.g., monthly, quarterly). Inventory subsidiary ledger is not updated
after each purchase or sale of inventory. Inventory quantities are not updated continuously. Inventory
quantities are updated on a periodic basis.

Within Retail industry, periodic inventory method used for inventory valuation at the stores, whereas
distributer follows perpetual inventory method to track inventory in their distribution centres. As a
best practice, some of the retail companies are using perpetual accounting method to track inventory
available in warehouses and distribution centres. In an idealistic world, perpetual inventory method
can provide the true and real time inventory information, however due to complexities in
consolidating all the purchases, sales, shrinkages and other market factors, it is advisable retail
companies to follow periodic accounting method to analyze and review the results before presenting
the inventory valuation results to internal gd external agencies like Shareholders, Income Tax
Authorities etc.

Important Terminologies used in Inventory management

1. SKU (Stock Keeping Unit)

Every product available at the store has a unique code. This code which helps in the
identification and tracking of the products at the retail store is called as stock keeping unit or
SKU.The retailer feeds each and every SKU in the master computer and can easily track the
product in the stock just by entering the SKU Number. Assigning a unique code to the products
avoids unnecessary searching.

2. New Old Stock (Abbreviated as NOS)

The stock which is never been sold by the retailer and now not even being manufactured
comprises the new old stock. Such products do not have takers and may not be produced
anymore.

3. Stock out

Stock out refers to a situation when the retailer fails to fulfill the customer’s requirement due to
lack of merchandise. The merchandise is not available in the current inventory and thus the
customer has to return home empty handed.

Benefits of Inventory Maintenance

1. Reduced Inventory: This is the most obvious benefit of inventory maintenance. The supplier is
able to control the lead-time component of order point better than a customer with thousands of
suppliers they have to deal with. Additionally, the supplier takes on a greater responsibility to have
the product available when needed, thereby lowering the need for safety stock. Also, the supplier
reviews the information on a more frequent basis, lowering the safety stock component. These factors
contribute to significantly lower inventories.

2. Reduced stock-outs: The supplier keeps track of inventory movement and takes over responsibility
of product availability resulting in a reduction of stock outs, thereby increasing customer satisfaction.
3. Increase in sales: Due to less stock-out situations, customers will find the right product at right
time. The customers may frequently visit such store, thus it may lead to increase in sales.

4. Detection of damages, breakages and spoilages: The proper maintenance of inventory allows
quick detection of damages and spoilages.

5. Reduces clerical carelessness: Computerized recording of inventory by the chances of clerical

errors. It prevents errors during valuation of physical stocktaking.