CHAPTER 5: INVENTORY MANAGEMENT

5.1 Introduction
Inventories constitute the most significant part of current assets of the business concern.
It is also essential for smooth running of the business activities.
A proper planning of purchasing of raw material, handling, storing and recording is to be considered
as a part of inventory management.
Inventory management means, management of raw materials and related items.
Inventory management considers what to purchase, how to purchase, how much to purchase, from
where to purchase, where to store and when to use for production etc.
4.2 Meaning
The dictionary meaning of the inventory is stock of goods or a list of goods.
In accounting language, inventory means stock of finished goods.
In a manufacturing point of view, inventory includes, raw material, work in process, stores, etc.
4.3 Kinds of Inventories
Inventories can be classified into three major categories.
A. Raw Material
It is basic and important part of inventories.
These are goods which have not yet been committed to production in a manufacturing business
concern.
B. Work in Progress
These include those materials which have been committed to production process but have not yet
been completed.
C. Finished Goods
These are the final output of the production process of the business concern. It is ready for
consumers.
4.4 Objectives of Inventory Management
Inventories occupy 30–80% of the total current assets of the business concern.
It is also very essential part not only in the field of Financial Management but also it is closely
associated with production management.
Hence, in any working capital decision regarding the inventories, it will affect both financial and
production function of the concern.
Hence, efficient management of inventories is an essential part of any kind of manufacturing
process concern.
The major objectives of the inventory management are as follows:
To efficient and smooth production process.
To maintain optimum inventory to maximize the profitability.
To meet the seasonal demand of the products.
To avoid price increase in future.
To ensure the level and site of inventories required.
To plan when to purchase and where to purchase
To avoid both over stock and under stock of inventory.

4.5 Techniques of Inventory Management

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 Inventory management consists of effective control and administration of 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 investment in inventories.
It needs the following important techniques.
Inventory management techniques may be classified into various types:

4.5.1 Techniques based on the order quantity of Inventories

Order quantity of inventories can be determined with the help of the following techniques:
Stock Level
The level of stock which is maintained by the business concern at all times.
Therefore, the business concern must maintain optimum level of stock to smooth running of the
business process.
Different level of stock can be determined based on the volume of the stock.
a) Minimum Level
The business concern must maintain minimum level of stock at all times.
If the stocks are less than the minimum level, then the work will stop due to shortage of material.
b) Re-order Level
Re-ordering level is fixed between minimum level and maximum level.
Re-order level is the level when the business concern makes fresh order at this level.
Re-order level = maximum consumption × maximum Re-order period
c) Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must maintain.
If the quantity exceeds maximum level limit then it will be overstocking.

Maximum level = Re-order level + Re-order quantity– (Minimum consumption × Minimum delivery period)
d) Danger Level
It is the level below the minimum level. It leads to stoppage of the production process.
Danger level = Average consumption × Maximum re-order period for emergency purchase

e) Average Stock Level

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It is calculated such as,
Average stock level= Minimum stock level + ½ of re-order quantity maximum level or
Maximum level + Minimum level
2
f) Lead Time
Lead time is the time normally taken in receiving delivery after placing orders with suppliers.
The time taken in processing the order and then executing it is known as lead time.
g) Safety Stock
Safety stock implies extra inventories that can be drawn down when actual lead time and/ or usage
rates are greater than expected.
Safety stocks are determined by opportunity cost and carrying cost of inventories.
If the business concerns maintain low level of safety stock, it will lead to larger opportunity cost and
the larger quantity of safety stock involves higher carrying costs.
Economic Order Quantity (EOQ)
EOQ refers to the level of inventory at which the total cost of inventory comprising ordering cost and
carrying cost.
Determining an optimum level involves two types of cost such as ordering cost and carrying cost.
The EOQ is that inventory level that minimizes the total of ordering of carrying cost.
Carrying costs represent all of the direct and opportunity costs of keeping inventory on hand. These
include:
Storage and tracking costs.
Insurance and taxes.
Losses due to obsolescence, deterioration, or theft.
The opportunity cost of capital on the invested amount.
The other type of costs associated with inventory is shortage costs.
Shortage costs are costs associated with having inadequate inventory on hand.
The two components of shortage costs are restocking costs and costs related to safety reserves.
Depending on the firm’s business, restocking or order costs are either the costs of placing an order
with suppliers or the costs of setting up a production run.
EOQ can be calculated with the help of the mathematical formula:

Where,
a = Annual usage of inventories (units)
b = Buying cost per order
c = Carrying cost per unit
Exercise 1
Find out the economic order quantity and the number of orders per year from the following information:
Annual consumption: 36,000 units
Purchase price per units: $ 54
Ordering cost per order: $ 150
Inventory carrying cost is 20% of the average inventory.

Solution

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A = 36,000 units
O = $ 150
C = 20% of 54 = 10.80
EOQ = 2×36,000×150 = 1,000 units
10.8
Exercise 2
From the following information calculate, (1) Re-order level (2) Maximum level (3) Minimum
level (4) Average level
Normal usage: 100 units per week
Maximum usage: 150 units per week
Minimum usage: 50 units per week
Re-order quantity (EOQ) 500: units
Log in time: 5 to 7 weeks
Solution
(1) Re-order Level
= Maximum consumption × Maximum Re-order period
= 150×7 = 1050 units
(2) Maximum Level
= Re-order level + Re-order quantity – (Minimum consumption × Minimum delivery period)
= 1050 + 500 – (50 × 5) = 1300 units
(3) Minimum Level
= Re-order level – (Normal consumption × Normal delivery period)
= 1050 – (100 × 6) = 450 units
(4) Average Level
= Maximum level + Minimum level
2
= 1300 + 450 = 875 units
2
TECHNIQUES BASED ON THE CLASSIFICATION OF INVENTORIES
A-B-C Analysis
It is the inventory management techniques that divide inventory into three categories based on the
value and volume of the inventories; 10% of the inventory’s item contribute to 70% of value of
consumption and this category is known as A category.
About 20% of the inventory item contributes about 20% of value of consumption and this category is
called category B and
70% of inventory item contributes only 10% of value of consumption and this category is called C
category.

Aging Schedule of Inventories

Where:

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 F = Fast moving inventories
N = Normal moving inventories
S = Slow moving inventories
D = Dead moving inventories
This analysis is mainly calculated for the purpose of taking disposal decision of the inventories.
VED Analysis
This technique is ideally suited for spare parts in the inventory management like ABC analysis.
Inventories are classified into three categories on the basis of usage of the inventories.
Where:
V = Vital item of inventories
E = Essential item of inventories
D = Desirable item of inventories
HML Analysis
Under this analysis, inventories are classified into three categories on the basis of the value of the
inventories.
H = High value of inventories
M = Medium value of inventories
L = Low value of inventories
TECHNIQUES ON THE BASIS OF RECORDS
A. Inventory Budget
It is a kind of functional budget which facilitates the estimated inventory required for the business
concern during a particular period.
This budget is prepared based on the past experience.
B. Inventory Reports
Preparation of periodical inventory reports provides information regarding the order level, quantity to
be procured and all other information related to inventories.
On the basis of these reports, Management takes necessary decision regarding inventory control and
Management in the business concern.

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