UNIT – IV INVENTORY MANAGEMENT

INTRODUCTION:
The investment in inventories constitute the most significant part of
working capital in most of undertakings. On an average, inventories are
approx. 60 percent of current assets in companies in India.

Because of the large size of inventories maintained by the firms, a

considerable amount of funds is required to be committed to them. It is
therefore, absolutely imperative to manage inventories efficiently and
effectively in order to avoid unnecessary investment.

Meaning and types of inventories:

The inventory means and includes the goods being sold by the
firm and the raw materials or other components being used in the
manufacturing of such goods.
A retail Shopkeeper keeps an inventory of finished goods to be
offered to customers whenever demanded by them. On the other
hand, a manufacturing concern has to keep a stock of not only of
finished goods, but also of all physical ingredients being used in
the production process.
The various forms in which a manufacturing concern may carry
inventory are:
i) Raw Materials: These represent inputs purchased and stored
to be converted into finished products in future by making
certain manufacturing process on the same.
ii) Work jn progress: These represent semi manufactured
products which need further processing before they can be
treated as finished products.

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 iii) Finished Goods: These represents the finished products ready
for sale in the market.
iv) Stores and Supplies: These represent that part of the 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.

MOTIVES FOR HOLDING INVENTORY

OR
NEED TO HOLD INVENTORIES
Every firm big or small, trading or manufacturing has to maintain
some minimum level of inventories. Maintaining inventories
involves tying up of the company’s funds and incurrence of
storage and handling costs.
If it is expensive to maintain inventory, why do business firms hold
inventories? There are different motives for maintaining
inventories, and these are more or less the same as the motives
for holding cash. The motives for holding inventory may be
enumerated as follows:
1) Transactionary Motive: Every firm has to maintain some level
of inventory to meet the day to day requirements of sales,
production process, customer demand etc. This motive makes
the firms to keep the inventory of finished goods as well as raw
materials.
2) Precautionary Motive: In addition to the requirement to hold
the inventories for routine transactions, the company may like
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 to hold them to safe guard against risk of unpredictable
changes in demand and supply forces. For example, supply of
raw material may get delayed due to the factors like strike,
transport disruption, short supply, lengthy process involved in
import of the raw material etc.
Similarly the demand of the finished goods may suddenly
increase and if the company is unable to supply them , it means
the loss of sale. Hence, the company will like to maintain
sufficient stock of finished goods.
3) Speculative Motive: The company may like to purchase and
the stock the inventory in the quantity which is more than
needed for the 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.

RISK AND COSTS OF HOLDING INVENTORIES

The holding of inventories involves blocking of a firm’s funds

and incurrence of capital and other costs. It also exposes the
firm to certain risks. The various types of costs and risks
involved in holding inventories are as below:
i) Capital costs: Maintaining of inventories results in blocking of
the firm’s financial resources. The firm has, therefore, to
arrange for additional funds to meet the cost of holding
inventories.
ii) Storage and Handling costs: Holding of inventories also
involves costs on storage as well as on handling of materials.

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 The storage costs include the rent of the godown, insurance
charges, etc.
iii) Risk of Price Decline: There is always a risk of reduction in the
prices of inventories by the suppliers in holding inventories.
iv) Risk of Obsolescence: The inventories may become obsolete
due to improved technology, changes in requirements etc.
v) Risk of Deterioration in quality: The quality of the materials
may also deteriorate while the inventories kept in stores.

INVENTORY MANAGEMENT

➢ Like Cash management, inventory management too is

guided by the objective of counter balancing the two
conflicting aims.
➢ One, to reduce cost of holding stock so that investment in
stock remains minimal and second, to reduce the risk of
stock outs so that production cycle operates smoothly.
➢ The first aim persuades the business to reduce the level
of inventory whereas second one prompts it to increase
the same. The business has to strike the balance.
➢ On the different perspective the first aim represents the
cost of holding stock and second aim reflects the benefits
accruing from holding stock.
➢ So, the act of counter balancing is done through trade-off
between the costs and benefits so that quantity of stock
held is optimal and investment therein is minimum.

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Objects of inventory management

The main objectives of inventory management are

operational and financial.
The operational objectives mean that the materials and
spares should be available in the sufficient quantity so
that work is not disrupted for want of inventory.
The financial objective means that investments in
inventories should not remain idle and minimum working
capital should be locked in it.
The following are the main objectives of inventory
management:
i) To ensure continuous supply of materials, spares
and finished goods so that production should not
suffer at any time and the customers demand
should also be met.
ii) To avoid both over-stocking and under-stocking of
inventory.
iii) To maintain investments in inventories at the
optimum level as required by the operational and
sales activities.
iv) To keep the material cost under control so that they
contribute in reducing cost of production and
overall costs.

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TECHNIQUES OF INVENTORY MANAGEMENT

Effective inventory management requires an effective control

over inventories. Inventory control refers to a system which
ensures supply of required quantity and quality of inventories
at the required time and at the same time prevents
unnecessary investments in inventories. The techniques of
inventory control / inventory management are as follows:
1) ABC Analysis
2) Determination of Economic order Quantity.
3) Determination of Stock levels.
4) VED Analysis
5) Inventory Turnover Ratio.

1) ABC ANALYSIS:
➢ It is neither feasible nor desirable for the management to pay equal
attention towards all the items of inventory. Hence selective inventory
techniques are being followed. One of such techniques is ABC (Always
Better Control) technique. It is valued based technique.
➢ This technique is based on the principle of management by exception.
Under this technique, items of inventory are classified is three categories
on the basis of their value (consumption value in a given period).
➢ In ‘A’ category we take a few most valuable items, in ‘B’ category we take a
number of average value items and in ‘C ’ category we take a large No. of
least value items.
➢ There is no definite rule about percentage of value and percentage of
items. Generally we try to take such 10% items in A category, the value of
which is about 70%, such 20% items in B category the value of which is
about 20% and such 70% items in C category the value of which is 10%.
➢ We try to achieve these targets as much as we can with more emphasis
(not sole emphasis) on Value.

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 ➢ The management controls the A category items regularly by using different
techniques such as fixation of different levels, proper review systems,
continuous stock records etc. The management exercises moderate control
over the B category items and least control is exercised over C category
items.

Advantages of ABC Analysis:

i) it ensures that, without there being any danger of interruption
of production for the want of materials, minimum investment
will be made in inventories of stocks of materials.
ii) The cost of placing orders, receiving goods and maintaining
stock is minimized if the system is coupled with determination
of proper economic order quantity.
iii) Management time is saved since attention need be paid only
to some of the items rather than all the items.
iv) With the introduction of the ABC system, much of the work
connected with the purchase can be systemized on a routine
basis to be handled by the subordinate staff.

Problem No.1. The following table contains information about usage and price for
10 items used by a firm.

Item Price(Rs.) Annual usage(units) Amount(Rs.)

1 34 100 3400

2 10 7000 70000

3 3 4000 12000

4 4 250 1000

5 3 500 1500

6 1 2000 2000

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7 20 20 400

8 25 10 250

9 8 1000 8000

10 14.5 100 1450

Make ABC plan.

1) ECONOMIC ORDER QUANTITY

Inventory related costs:

There are two inventory related costs

(i) Cost to carry- insurance, interest, storage, obsolescence etc.

(ii) Cost to Order- fixed transportation cost per order, cost of placing an order ,
cost of inspection etc.
➢ For the concept of EOQ cost to carry are assumed as variable cost,
i.e., such cost vary with quantity carried in stock and cost to order
are assumed to be fixed per order, i.e., cost to order is not
influenced by order size, it is assumed to be fixed per order.
➢ Cost to carry have positive correlation with order size, i.e. if order
size increases, quantity carried in the stock increases, hence cost to
carry increases. If order size decreases, quantity carried in stock
decreases, hence cost to carry decreases.
For the purpose of EOQ , average quantity in the stock is taken as half of
the order size on the assumption of uniform consumption rate.
Thus average quantity carried in the stock = ½ of order size.
Carrying cost = average quantity * Carrying cost per unit per period
➢ Cost to order has negative correlation with order size, i.e., if order
size increases, No. of orders decreases, hence cost to order
decreases. If the order size decreases, No. of orders increases, hence
cost of order increases.

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 No. of orders= Demand / order size
Ordering cost= No. of orders * Ordering cost per order.

EOQ is that order size at which total inventory related cost ie. Carrying cost and
ordering cost is minimum.

At this point, cost to carry is equal to cost to order.

Assumptions underlying EOQ :

i) Ordering cost per order is fixed.

ii) Carrying cost per unit per annum is fixed. Ie. It varies with the No. of
units.
iii) Estimated use is Known.
iv) Cost per unit of material is constant and there is no quantity discount.
v) The goods are received immediately after placing the order.

Problem 2. The annual demand of the product is 6400 units. Inventory carrying
cost is 1.50 per unit per annum. If the cost of one procurement is Rs.75 ,
determine

(a) EOQ
(b) No. of orders per year
(c) The time between two consecutive orders.

Problem:3 : An engineering company consumes 50,000 units of a component per

year. The ordering, receiving and handling costs are RS.3 per order while the
trucking costs are Rs. 12 per order. Further details are as under-

Interest Re.0.06 per unit per year. Deterioration cost Re. 0.004 per unit p.a.
Storage cost Rs. 1000 per annum for 5000 units, calculate EOQ.

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Note:

In the examinations two types of questions have been asked-

i) Where there is no discount offer on purchases--- In this type of

questions the above formula is applicable.
ii) Where discount on purchase is available --- in this type of questions the
above formula cannot be applied as the formula is based on the
assumption of no discount on purchases. In such type of questions we
Calculate the purchasing cost plus inventory related cost at various
levels and the level at which the total cost is minimum the Economic
Order Quantity.

Problem:4: Economic enterprises require 90,000 units of a particular

every year. Cost per unit is Rs.3 . Ordering cost per order is Rs.300.
carrying cost Rs.6 per unit per annum. What is optimum order size if
supplier offers discount as below:
Order quantity Discount %
4500-5999 2
6000 or above 3

Problem:5: Let the annual usage –1000 units , ordering cost Rs. 5 per
order. Cost Rs. 2.50 per unit.
Carrying cost 16%. The manufacturer offers discount of 5% when 100
units bought at a time and 10% if 300 units are bought at a time.
Suggest the order size.

2) DETERMINATION OF STOCK LEVELS:

Carrying of too much and too little of inventories is detrimental to the firm.
If the inventory level is too little, the firm will face frequent stock-outs
involving heavy ordering cost and if the inventory level is too high it will be
unnecessary tie-up of capital. Therefore, an efficient inventory
management requires that a firm should maintain an optimum level of
inventory where inventory costs are the minimum and of the same time
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 there is no stock-out which may result in loss of sale or stoppage of
production. Various stock levels are discussed as such.
i) Re-order Level:
Having determined the economic order quantity or optimum
production quantity, it is also an important to decide when to order
for the new stock. This problem is solved by determining the re-order
level.
Re-order level is that level of material stock at which it is necessary to
take the steps for procurement of further lots of material.
Formula for computation of Re-order level:
a) When maximum usage and maximum lead time is given:
Re-order level = maximum con. * maximum Lead time

b) When Safety stock, average consumption and average lead time is

given:
Re-order level = Safety Stock + ( Average con. * Average LT)
Or
Re-order level = Safety Stock + normal lead time demand

ii) Minimum Stock level( Safety Stock / Buffer Stock):

Minimum Stock level is the lower limit below which the stock of any
inventory item should not normally be allowed to fall. This level is also called
safety stock or buffer stock level. The main object of establishing this level is to
protect against stock out of a particular stock item.

Minimum Stock level= Re-order level - ( Av. Con. * Av. LT)

iii) Maximum Stock Level:

Maximum Stock level indicates the maximum figure of inventory held in
stock at any time.
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 Formula =
ROL – (min Con. * Min. LT) + EOQ / ROQ

iv) Average stock level:

Formula
Minimum Stock level + Maximum Stock Level
2

Or

Minimum stock level + ROQ/EOQ

2

v) 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.

Danger Level = Average Con. * Lead Time for emergency purchase

Problem 6: From the following information, determine the reorder point,

minimum stock level and maximum stock level:

i) Minimum Con. = 100 Units per day

ii) Maximum Con. = 175 Units per day
iii) Normal Con. = 125 Units per day
iv) Re- Order quantity = 1,500 Units
v) Minimum LT = 7 days
vi) Maximum LT = 15 days
vii) Normal LT = 10 days

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 3) VED Analysis:
The VED analysis is used generally for spare parts. The requirements and
urgency of spare parts is different from that of materials. ABC analysis may
not be properly used for spare parts. The demand for spares depends upon
the performance of the plant and machinery.
➢ In this analysis, the items are classified on the basis of their criticality
to the production process or other services.
➢ In the VED , V stands for Vital items without which the production
process would come to a standstill. E in the system denotes
Essential items whose stock out would adversely affect the
efficiency of the production system. Although the system would not
altogether stop for want of these items, yet their non availability
might cause temporary losses in, or dislocation of, production. The D
are the Desirable items which are required but do not immediately
cause a loss of production.
➢ The classification of spares parts should be left to the technical staff
because they know the need, urgency an use of these spares.

4) Inventory Turnover Ratios:

Inventory Turnover Ratios are calculated to indicate whether inventories have

been used efficiently or not. The purpose is to ensure the blocking of only
required minimum funds in the inventory. This ratio establishes the relationship
between the value of material consumed during the given period and the average
amount of inventory carried during the period.

Inventory Turnover Ratio = Value of Material consumed during the period

Average inventory held during the period

Where

Value of material consumed = opening stock

+ purchases

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 + Direct Exps

-- Closing Stock

Average inventory = Opening Stock + Closing Stock

Inventory conversion period may also be calculated to find the average time
taken for clearing the stocks. In other words, inventory turnover can be indicated
in terms of number of days in which average inventory is consumed.

Inventory conversion period == Days in a period

Inventory Turnover Ratio

A high inventory turnover ratio or low inventory turnover period indicates that
maximum material can be consumed by holding minimum amount of inventory
for the same, thus indicating fast moving items. Thus high inventory turnover
ratio will always preferred.

Thus, Knowledge of inventory turnover ratio in the case of various types of

material will enable to reduce the blocked up capital in undesirable types of
stocks and will enable the organization to exercise proper inventory control.

Problem 7: The following figures are taken from the records of Swati ltd. for the
year 2009-2010. The value of inventory is Rs.10 per lg.

Opening Stock purchases Cl. Stock

Inventory A 700 kg 11,500 kg 200 kg

Inventory B 200 kg 11,000 kg 1,200 kg

Inventory C 1,000 kg 1,800 kg 1,200 kg.

Calculate the inventory turnover ratio of the above inventories and express in
number of days the average inventory held.

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Assignment – II
5 Questions – PDF already forwarded
Qno.6. A manufacture buys certain equipment from outside suppliers at Rs. 30
per unit. Total annual needs are 800 units. The following data are available.
Annual return on investment 10% Rent , takes ,insurance per unit per year Rs. 1
Cost of placing an order Rs.100 Determine the EOQ.

Q.no.7. From the details given below , calculate:

(1) Re- ordering level

(2) Maximum level

(3) Minimum level

(4) Danger level

Recording quantity is to be calculated on the basis of following information:

Cost of placing a purchase order is Rs. 20

Number of units to be purchased during the year is 5000

Purchase price per unit inclusive of transportation cost is Rs.50

Annual cost of storage per units is Rs. 5.

Details of lead time : Average 10 days, Maximum 15 days, Minimum 6 days . For

Emergency purchases 4 days.

Rate of consumption : Average : 15 units per day,

Maximum : 20 units per day.

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Q.no.8.. A company is reviewing its stock policy and has the following
alternatives available for the purchase of stock number 12789

(a) Purchase stock twice monthly, 100 units

(b) Purchase stock monthly ,200 units

(c) Purchase every three months , 600 units

(d) Purchase six ,monthly ,1200 units

(e) Purchase annually , 2400 units

It is as certained that the purchase price per unit is Rs. 0.80 for deliveries up to
500 units. A 5% Discount is offered by the supplier where deliveries are 501 and
up to 1000 and 10% deduction on the total order for deliveries in excess of 1000.

Each purchase order incurs administration costs of Rs. 5.

Storage, interest on capital and other costs are Rs. 0.25p.u. p.a. of average stock
quantity held.

You are required to advise management on the optimum order size.

Q.no.9.Annual consumption -12000 units. Cost per unit – Rs.1. Ordering cost
Rs.12 per order. Inventory carrying charges – 24% , normal lead time – 15 days.
Safety stock – 30 days consumption. EOQ? ROL? (Assume 360 days in a year)

Q.no.10. After inviting tenders , two quotations are received as under:

Supplier A- Rs. 2.20 per unit

Supplier B – Rs. 2.10 per unit + Rs. 2000 fixed charges

(1) Calculate the order quantity for which the purchase price per unit will be
the same.

(2) Select the supplier if the purchase officer wants to place an order for
15000 units

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