Chapter 26

INVENTORY MANAGEMENT

OUTLINE Introduction Need for inventories Order quantity EOQ model Order point Pricing of raw materials and valuation of stocks Monitoring and control of inventories Criteria for judging the inventory system Inventory management in practice

INTRODUCTION
There are three types of inventories: raw materials, work in process and finished goods that are held by manufacturing firms whereas only finished goods by distribution firms The proportion of inventories to total assets generally varies between 15 and 30 percent

NEED FOR INVENTORIES Process or movement inventories are required because it takes time to complete a process/operation and to move products from one stage to another.

Organisation inventories are maintained to widen the

latitude in planning and scheduling successive operations.

ECONOMIC ORDER QUANTITY

There are three kinds of cost with respect to EOQ model:

a. Ordering cost: Expenses on requisitioning, set up and receiving and placing in storage b. Carrying cost: Expenses on interest on capital locked in inventory, storage, insurance, obsolescence and taxes c. Shortage cost: Arise when inventories are short of requirements for meeting the needs of production or the demand of customers Minimization of overall costs of inventory management would require a consideration of trade offs among these costs

ASSUMPTIONS OF THE EOQ MODEL

a. b. c. d. The demand for a given period, usually one year, is known The demand is even throughout the period Inventory orders can be replenished immediately Two costs associated with inventories: cost of ordering and cost of carrying e. Cost per order is constant regardless of the size f. Cost of carrying is a fixed percentage of the average value of inventory

ORDER QUANTITY EOQ MODEL 2FU Q= PC Q = economic order quantity F = cost per order

U = annual usage/demand
F = cost per order

C = percent carrying cost

P = price per unit - Refer illustration on Page 765

BEHAVIOUR OF INVENTORY

RELATED COSTS

Costs

Total costs

Carrying costs

Ordering costs Quantity ordered

QUANTITY DISCOUNTS AND ORDER QUANTITY

The standard EOQ analysis is based on the assumption that the price per unit remains constant irrespective of the order size When quantity discounts are available, the price per unit is influenced by the order quantity Refer Page 765 & 766

ORDER POINT If the usage rate of materials and the lead time for procurement are known with certainty, then the

ordering level would simply be:

Lead time in days x Average daily usage for procurement When the usage rate and lead time are likely to vary, the reorder level should be: Normal consumption + Safety stock

PRICING OF RAW MATERIALS The important methods of pricing inventories used in production are: FIFO (First in First Out) Method The material which is issued first is priced on the basis of the cost of material

received earliest, so on and so forth.

Weighted Average Cost Method Material issued are priced at the weighted average cost of materials in stocks

TREATMENT OF FIXED MANUFACTURING COSTS Direct Costing Fixed manufacturing overhead costs are treated as period costs and not product costs. Hence, they are not reflected in inventory valuation. Absorption Costing Fixed manufacturing costs are treated as product (or inventoriable) costs.

GRAPH OF CUMULATIVE PERCENTAGE OF ITEMS

AND CUMULATIVE PERCENTAGE OF USAGE

Cumulative usage of items (percentage)

100 80 60 40

20

A 25

B 40 60

80

100

Cumulative percentage of items

JUST-IN-TIME (JIT) INVENTORY CONTROL The JIT control system implies that the firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components just-in-time to meet its assembly requirements. This may be contrasted with the traditional inventory management system which calls for maintaining a healthy level of safety stock to provide a reasonable protection against uncertainties of consumption and supply the traditional system may be referred to as a just-in-case system.

PROGRAMME OF INVENTORY MONITORING AND CONTROL

Exercise of vigilance against imbalances of raw materials and work-in-process which tends to limit the utility of stocks.

Vigorous efforts to expedite completion of unfinished production jobs to get them into saleable condition.
Active disposal of goods that are surplus, obsolete, or unusable. Shortening of the production cycle. Change in design to maximise the use of standard parts and components which are available off-the-shelf. Strict adherence to production schedules. Special pricing to dispose of unusually slow-moving items. Evening out of seasonal sales fluctuations to the extent possible.

INVENTORY MANAGEMENT IN INDIA The most commonly used tools of inventory management in India are ABC analysis, FSN (fast moving, slow moving, and nonmoving analysis), and inventory turnover analysis. Inventory management in India can be improved by effective computerisation, review of classifications, improved coordination, development of long-term relationships, and disposal of obsolete/surplus inventories, and adoption of challenging norms.

SUMMING UP
Inventories represent a very significant proportion of total assets.
A distinction may be drawn between process or movement inventories and organisation inventories.

According to EOQ model, the optimal order quantity is:

2 FU PC The reorder point may be determined by the following formula: Reorder Point = S (L) + S R(L) Q=
FIFO method and weighted average cost method are commonly used for pricing inventories.

ABC analysis advocates a selective approach to inventory control.

The most commonly used tools of inventory management in India are: ABC analysis, FSN analysis and inventory turnover analysis.