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THEORY OF INVENTORY MANAGEMENT

INTRODUCTION Material is a very important factor of production. It includes physical commodities use to manufacture the final end product. It is the starting point from which the first operation starts. It inventoriable and does not get waste and exhaust with the passage of time as labour is wasted with the passage of time whether in use or not. Another feature of material is that it can be purchased in varying quantities according to the requirements of the firm where as other element of costs like labour and other services can not be easily varied once they are established. From this it can be concluded that material is most flexible and controllable input. Thus, the importance of material control lies in the fact that any saving made in the cost of materials will go a long way in reducing the cost of production and improving the profitability of the concern. Proper control of material is necessary from the time orders for purchase of materials are placed with suppliers until they have been consumed. The object of material control is to attack the material cost on all fronts so that cost of material may be reduced. In other worlds, efforts are to be made to reduce the cost of material when it is purchased, stored and used. MEANING AND NATURE OF INVENTORY 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 material. Work-in-progress and stores etc. To understand the exact meaning of the word inventory we may study it from the usage side or from the side of point of entry in the operations. An Inventory would include items which are held for sale in the ordinary course of business or which are in the process of production for the purpose of sale, or which are to be used in the production of goods or services which is for sale. Accounting standard 2 (AS-2) of Institute of chartered Accountants of India, which deals with Inventory, has given the following definition of Inventory.

Inventories are assets:


Held for sale in the ordinary course of business;

In the process of production for such sale; or In the form of materials or supplies to be consumed in the production process or in the rendering of services. Inventory includes the following things: (a) Raw material:- Raw materials from a major input into the organization. They are required to carry out production activities uninterruptedly. The quantity of raw materials required will be determined by the rate of consumption and the time required for replenishing the supplies. The factors like the availability of raw materials and government regulations, etc.too affect the stock of raw materials. (b) Work-in-progress:-The work-in-progress is that stage of stocks which are in between raw material and finished goods. The raw materials enter the process of manufactures but they are yet to attain a final shape of finished goods. The quantum of work-inprogress depends upon the time taken in the manufacturing process. The greater the time taken in manufacturing, the more will be the amount of work-in-progress. Consumables:- These are the materials which are needed to smoothen the process of production. These materials do not directly enter production but they are as catalyst, etc. consumable stores do not create any supply problems and form a small part of production cost. There can be instance where these materials may account for much value than the raw materials. The fuel oil may form a substantial part of cost. (d) Finished goods:- These are the goods which are ready for the consumers. The stock of finished goods provides the buffer between production and market. The purpose of maintaining inventory is to ensure proper supply of goods to customers. In some concerns the production is undertaken on order basis, in these concerns there will not be a need for finished goods.The need for finished goods inventory will be more when production is undertaken in general without waiting for specific orders.

(e) Spares:- spares also form a part of inventory. The consumption pattern of raw materials, consumables, finished goods are different from that of Spares. The stocking policies of spares are different from industry to industry. Some industries like transport will require more spares then the other concerns. The costly spare parts like engines, maintenance spares etc. are not discarded after use, rather they are kept in ready position for further use. All decisions about spares are based on the financial cost of inventory on such spares and the cost that may arise due to their non-availability. PURPOSE/BENEFIT OF HOLDING INVENTORIES Although holding inventories involves blocking of a firms funds and the cost of storage and handling, every business enterprise has to maintain a certain level of inventories to facilitate uninterrupted production and smooth running of business. In the absence of inventories a firm will have to make purchases as soon as it receives orders. It will mean loss of time and delays in execution of orders which sometimes may cause loss of customers and business. A firm also needs to maintain inventories to reduce ordering costs and avail quantity discounts, etc. Generally speaking, there are three main purposes or motives of holding inventories. The transaction motive which facilitates continues production and timely execution of sales orders. The precautionary motive which necessitates the holding of inventories for meeting the unpredictable changes in demand and supplies of materials. The speculative motive which includes to keep inventories for taking advantages of price fluctuations, saving in re-ordering costs and quantity discounts, etc. RISK AND COSTS OF HOLDING INVENTORIES The holding of inventories blocking of a firms fund and incurrence of capital and other costs. It also exposes the firm to certain risks. The various costs and risks involved in holding inventories are as below:

i.

ii.

iii.

iv.

v.

Capital costs. Maintaining of inventories result in blocking of the firm financial resources. The firm has, there are for, to arrange for additional funds to meet the cost of inventories. The funds may be arranged from own resources or from outsiders. But in both the cases, the firm incurs a cost. In the former case; the firm has to pay interest to the outsiders. Storage and Handling costs. Holding of inventories also involves cost on storage as well as handling of materials. The storage cost includes the rental of the godown, insurance charge, etc. Risks of price Decline. There is always a risk of reduction of price of the inventories by the suppliers in holding inventories. This may be due to increased market supplies, competition or general depression in the market. Risk of Obsolescence. The inventories may become obsolete due to improved technology, changes in requirement, change in customers taste,etc. Risk deterioration in Quality. The quality of the materials may also deterioration while inventories are kept in store. INVENTORY MANAGEMENT

Inventory management is methods used for organize, store and replace inventory, to keep an adequate supply of goods while minimizing costs. The main objective of inventory management is to maintain inventory at appropriate level so that it is neither excessive nor short of requirement. Objectives of Inventory Management:
a. To ensure that the supply of raw material and finished good

b. c.
d.

e. f.
g.

h.

will remain continuous so that production process is not halted and demands of customers are duly met. To minimize carrying cost of Inventory To keep Investment in inventory at optimum level To reduce the losses of theft, obsolescence & wastage etc. To minimize Inventory ordering cost To make arrangement for sale of slow moving items To design proper organization for inventory management, a clear cut Accountability should be fixed at various level of the organization. To avoid both over stock and under stock of Inventory

i. To ensure right quality goods at reasonable prices. Suitable

quality standard will ensure proper quality of stock the priceanalysis, the cost-analysis and value analysis will ensure payment of proper prices. j. To ensure perpetual Inventory control so that material shown in stock ledger should be actually lying in the stores.

BENEFITS OF INVENTORY MANAGEMENT:


1. Reduces costs and provides detailed reports for reference or 2. 3. 4.

5.

6. 7. 8.

checking purposes. Increase account saturation and maintenance Provide flexible to suit individual needs of customer Strengthen the relationship with the customer by becoming on-going partner in the customers profitability improvement and demonstrating that product price is only part of the cost of doing Inventory management can remove barriers between manufacturer and retailer and established a closer relationship between them. It gets the complete information about the value of inventory It gives complete knowledge of the exact size of merchandizing inventory Organization has full knowledge of its inventory

PROBLEMS OF INVENTORY MANAGEMENT: There are a number of problems that can cause havoc with inventory management. Some happen more frequently than others. Here are some of the more common problems with inventory systems.
1. Unqualified employees in charge of inventory. Too many

companies put people in charge of their inventory distribution who either dont have enough experience, are neglectful in their job, or dont have adequate training. No matter what kind of system is used, companies need to pay closer attention in overseeing their inventory management and making sure employees receive proper training.

2. Using a measure of performance for their business that

is too narrow. All too often companies will evaluate how well their business is doing. The processes they use are not wide enough and do not encompass all the aspects and factors in the company. Many areas get overlooked and can lead to either inventory shortages or inventory stockpiling.

3. A flawed or unrealistic business plan for a business for

the future. To predict how well a company may do in the future, you have to collect enough data and accurately analyze it. The downfall of many companies starting out is that they give an unrealistic assessment of a companys growth. This affects inventory management because if a company predicts more growth than they actually experience, it can lead to an overstock of inventory. The opposite is true if forecasters do not predict enough growth and are left with not enough inventory.

4. Not identifying shortages ahead of time. It happens all

the time. A business needs a number of products or materials but discover that they do not have enough in stock and must re-order. Waiting for the shipment to come in can slow down the supply chain process. Not having enough product in stock to meet customer demand can lead to bad customer relations. A supervisor in charge of inventory management should look over their inventory on a regular basis to make sure enough product is in stock.

5. Bottlenecks and weak points can interfere with on-time

product delivery. This means that if too many orders come in for outgoing shipments and do not get handled in an efficient manner, they can build up, or bottleneck. This slows down deliveries. The same is true for any weak points in an inventory management system. Weak points slow down the system and can stop it altogether.

6. Falling victim to the bullwhip effect. This is an over-

reaction by a company to changes in the market. As the demand of a market changes, a company may panic and order an overstock of inventory, thinking the new market conditions will move the inventory. Instead, the market stabilizes and the business is now left with a surplus of products that just sit in the warehouse, taking up space and not making money.

7. Too much distressed stock in inventory. Distressed stock

is products or materials in inventory that has or will soon pass the point where it can be sold at the normal price before it expires. This happens all the time in grocery stores. As a particular food product nears its expiration date, the business will discount the item in order to move it quickly before it expires.

8. Excessive inventory in stock and unable to move it

quickly enough. This is probably the most common problem for most businesses. Cash-flow comes from moving inventory. If a company buys an amount of product for their inventory and they do not move it, the company ends up losing money.

9. Computer assessment of inventory items for sale is

inaccurate. Nothing is more frustrating than going to a business that says it has a product but it turns out that they do not. The quantities are off and the actual items are not available. Too many people assume that the computer records are infallible. But the records have to be entered by a person and if the person responsible does not keep accurate records, it can turn into a real headache. Inaccurate inventory records can easily result in loss of money and strained customer service.

10. Computer inventory systems are too complicated. There

are many inventory software programs available for business use. The problem is that many of these programs are not userfriendly. Computer software developers do not take into

account that most of the people who will actually be using these systems are not tech savvy. A company does not always have the time and money to invest in training of personnel to use software effectively.

11. Items

in-stock get misplaced. Even if the computer accurately shows the item as in stock, it may have been misplaced somewhere at the warehouse, or in the wrong location within a store. This can lead to a decrease in profits due to lost sales and higher inventory costs because the item must be re-ordered. Plus, the company must spend the time for employees to track down the misplaced item.

12. Not keeping up with the rising price of raw materials.

This falls more into the accounting end of inventory management. By not keeping current with the rising price of raw materials, a company will lose profits because they are not adjusting the price of their finished products. Finished items in inventory must be relative to the cost of raw goods. TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT Effective inventory management requires an effective control system for inventories. A proper inventory control not only helps in solving the acute problem of liquidity but also increases profit and causes substantial reduction in the working capital of the concern. The following are the important tools and techniques of inventory management and control: 1. Determination of Stock Levels 2. Determination of Safety Stock 3. Selecting a proper system of Ordering for Inventory 4. Determination of Economic Quantity 5. A.B.C Analysis 6. V.E.D Analysis 7. Inventory Turnover Ratio 8. Aging Schedule of Inventory 9. Classification & codification of Inventories

10. 11. 12. 13.

Preparation of Inventory Report Lead Time Perpetually Inventory System JIT Control System

Determination of Stock Level An efficient inventory management is required so that a firm should maintain an optimum level of inventory where inventory costs are minimum and at same time there is no stock out which may result in loss of sale or stoppage of production. Various stock levels are discussed as such: (a) Minimum level: The minimum level or minimum stock is that level of stock below which stock should not be allowed to fall. In case of any item falling below this level, there is danger of stopping of production and, therefore, the management should give top priority to the acquisition of new supplies. Formula: Minimum level or minimum limit can be calculated by the following formula: [Minimum limit or level =Re-order level or ordering point Average or normal usage * normal re-order period] Or [Minimum limit or level =Re-order level or ordering point Average usage for normal period] (b) Maximum level: The maximum stock limit is upper level of the inventory and the quantity that must not be exceeded without specific authority from management. In other words, the maximum stock level is that quantity of material above which the stock of any item should not normally be allowed to go. This level is fixed after taking into account such factor as: capital, rate of consumption of materials, storage space available, insurance cost, risk of deterioration and obsolescence and economic order quantity.

Formula: Maximum level or maximum limit can be calculated by the help of following formula: [Maximum level or limit = Re-order level or ordering pointMinimum usage * Minimum re-order period + Economic order quantity] Re-ordering level: It is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels. Order points are based on usage during time necessary to requisition order, and receive materials, plus an allowance for protection against stock out. Formula: The following two formulas are used for the calculation of re-order level or point: [Re-order level = Maximum daily or weekly or monthly usage * Lead time] The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided. When safety stock is provided then the following formula will be applicable: [Re-order level = Maximum daily or weekly or monthly usage * Lead time + Safety stock] Determination of Safety stock: Safety stock is a buffer to meet some unanticipated increase in usage. The usage of Inventory cannot be perfectly forecasted. It fluctuates over a period of time. The demand for materials may fluctuate and delivery of inventory may also be delayed and in such a situation the firm can face a problem of stock out. The stock out can be proving costly by affecting the smooth working of the

concern. In order to protect against the stock-out arising out of usage fluctuating, firm usually maintain some margin of safety or safety stocks. The basic problem is to determine the level of quantity of safety stocks. Two costs are involved in the determination of this stock i.e opportunity cost of stock-outs and carrying costs. The stock-outs of raw materials cause production disruption resulting into higher cost of production, similarly, the stock-outs of finished goods results into the failure of the firm in competition as the firm cannot provide proper customer service. If a firm maintain low level of safety frequent stock-out will occur resulting into the larger opportunity costs. On the other hand, the larger quantity of safety stocks involved higher carrying costs. Ordering System of Inventory: The basic problem of inventory is to decide the re-order point. This point indicates when an order should be placed. The re-order point is determined with the help of these things: Average consumption rate ii. Duration of lead time iii. Economic order quantity When the inventory is depleted systems of ordering and concern can choose any one of these:
i. Fixed order quantity system generally known as Economic

order quantity(EOQ) system ; Fixed period order system or periodic re-ordering system or periodic review system; Single order and schedule part delivery system. Economic Order Quantity (EOQ): Economic order quantity is one of the techniques of inventory control which minimizes total holding and ordering costs for the year. The economic order quantity is the technique which solves the problem of the materials managers.

A decision about how much to order has great significance in inventory Management. The quantity to be purchased should neither be small or nor big because cost of buying and carrying materials are very high. Economic Order Quantity in the size of the lots to be purchased which is economically viable. This is the quantity of materials which can be purchased at minimum cost. Generally, Economic Order Quantity is the point at which inventory carrying costs are equal to order costs. In determining EOQ it is assumed that a cost of managing inventory is made of solely of two parts i.e ordering costs and carrying costs.
A. Ordering Costs. These are the costs which are associated with

the purchasing or ordering of materials. These costs include:


1) Cost of staff posted for ordering of goods. A purchase order is

processed and placed with the supplier. The labour spent on this process is included in ordering costs. 2) Expenses incurred on the transportation of goods purchased. 3) Inspection costs of incoming materials. 4) Cost of stationary, typing, postages, telephone charges etc. These costs are called buying costs and will arise only when these costs will be known as set-up costs. These costs will include costs of setting up machinery for manufacturing, time taken up in setting, cost of tools, etc.
B. Carrying costs. It is the cost of holding the materials in the

store and include,


1) Cost of storage space which could have been utilizing for some

other purpose. 2) Cost of bins and racks that have to be proved for the storage of materials. 3) Insurance costs 4) Clerical costs All these costs are taken together as carrying cost which is amount to near about 20-25% of the cost of materials per year.

ABC Analysis:
A.B.C analysis is a selective technique of controlling different items of inventory. In actual practice, thousands of items are included in business as inventories. But all these items are not equally important. According to this technique, only those items of inventory are paid more attention which is Significant for business. According to this technique, all items are classified into 3 categories A, B &C. In A category those items are taken which are very precious and their quantity or number is small. In B category those items are reserved which are less costly than the items of category A but their number is greater. In C category all those items are included which are low priced but their number highest. The rate of use of items of category A is the highest and that of category C is the lowest. In a manufacturing organization, the items of inventory can be classified as under:Example:Class A B C TOTAL Number of items in % as per terms of their % their value 15 70 30 55 100 20 10 100

Thus, the number of items of category A is 15% but their value is 70% of total inventory. Therefore, inventory management can be made more effective by concentrating control on this category.

Efforts are made to minimize investment item of this category. The % of number of items in category B is 30 but their value is 20%. Therefore this category will be paid less attention. The items in category C are 55% but their value is just 10% of total. Therefore, management need not spend much time for control of this class of inventory because very little investment is made in them. These items are purchased in bulk quantity once in 2-3 years. The management must be aware that these items may be less important in terms of value but their non-availability can break down the production process.

VED Analysis:
This analysis specially pertains to the classification of maintenance spares denoting the essentially of stocking spares according to their critically. V Stands for vital items when out of stock or when not readily available, completely brings the production to a halt. E Stands for Essential items without which temporary losses of production or dislocation of production work occurs. D- Stands for Desirable all other items which are necessary but do not cause any immediate effect on production.

Inventory Turnover Ratio:


Inventory turnover ratios are calculated to indicate whether inventories have been used efficiently or not. The inventory ratio is also known as stock velocity is normally calculated as sales/average inventory or cost of goods sold/average inventory cost. (a) [Inventory Turnover Ratio = cost of goods sold / average inventory at cost]

(b) [Inventory Turnover ration = Net sales / average inventory at cost]

Perpetual inventory system:


Perpetual inventory system may be defined as a method of recording stores balances after every receipt and issue to facilitate regular checking and to obviate closing down for stock taking. So perpetual inventory system implies continuous maintenance of stock records and in its broad sense it covers both continuous stock taking as well as up to date recording of stores books. The balance of the same item of store in bin card should correspond with that shown in the materials or store ledger card and a frequent checking of these two records should be made and compared with the actual or physical quality of materials in stock.

Just In Time:
It is a production and inventory control system in which materials are purchased and units are produced only as needed to meet actual customer demand. When companies use Just in Time (JIT) manufacturing and inventory control system, they purchase materials and produce units only as needed to meet actual customers demand. In just in time manufacturing system inventories are reduced to the minimum and in some cases is zero. JIT approach can be used in both manufacturing and merchandising companies. It has the most profound effects, however, on the operations of manufacturing companies which maintain three classes of Inventories raw material, Work-in-progress, and finished goods.

FINDINGS AND DATA INTERPRETATION PURCHASE PROCEDURE IN RSP : The inventories are occurred through a process of formal work. The purchase officer does not invite by auction for the purchase of material on his own accord. A purchase requisition is a form used as formal request (maintain about the type of material needed in the department) to the purchasing department. This form is prepared by the store keeper for the regular items and by the departmental head for special materials. The requisition is approved by the Head of the Department. The purchase requisitions/indent for the material is generally prepared in triplicate. The original copy is sent to the purchasing department. The duplicate is kept by the store keeper on the department, which initiates the requisition, and the triplicate is send to the authorizing executive. The purchase requisition for regular items of material is called regular purchase requisition. It is prepared by the department head for special material is known as special purchase requisition or occasional purchase requisition. Regular purchase requisitions are prepared when the items of material reach at the ordering level. This is done with a view to avoid the shortage of materials and make available an interrupted supply of material to department. According to the purchase requisition the purchase order is placed to the lowest bidder of the tender. No.

ROURKELA STEEL PLANT Purchase Requisition Date Date by which Materials are Required Quantity Remark required

Serial No.

Description of articles

Stores code no.

Requested by . For use in the purchase department Quotation invited on .. From 1.. 2 3.. Other Action.. Purchase officer

Besides the RSP as its own source for availing the R.M. The raw materials occurred by the following process. The departments are divided into small cost unit and the every department has its own planning section. These planning sections know the requirement of the departments. During the budgeting period these planning section put forward the annual requirement of material for producing the budgeted output for sale. According to the budgeted requirement the mines abstract raw material, like iron ore, lime stone, dolomite it is the continuous offices. But others are being purchases. EOQ Estimated Coking coal annual requirement : 2.257 million ton Purchasing cost per ton : Rs. 3611 Ordering cost (per order) : Rs. 500 Carrying cost per ton : Rs. 100 EOQ = {2*CO)/1 = 2*2257000*500/100 = 4751 tones RSP can buy the 2.257 million tones of cooking coal all the times or throughout the year. But the quantity order should be such that the carrying cost and the ordering cost must be minimum or equal, so that the investment in the material should be economical. Like the above some more material optimum size are given below. LEVEL SETTING The level setting is needed for better control over inventories. The reorder point is to be set to know when the order the lead time to replenish the materials are estimated by the official considering. The material is local or is to be imported from other countries and the way of transportation is also consider for local materials and the lead time 3 to 15 days. But for he imported material the lead time is 6 to 12 months.

Materials

Lead time

Usage of materials per day

Max. recorder period for emergency purchase

Safety stock level (tones)

Reord er point (tones )

Iron Ore

15-30 days Indigenou 15-30 s coal days Imported 6-12 coal months Coke Limeston e Dolomite 15-30 days 5-15 days 3-7 days

7000-8000 10 days 2500-3000 8 days 2000-2500 3 months/90 days 10-20 9 days 1100-1300 2 days 1200-1400 2 days

75,000 22,000 2,02,500 135 2400 2600

2,40,0 00 90,00 0 9,00,0 00 600 19,50 0 9.800

The safety stock is maintain incase the uncertainty like strike, delay in delivery of inventory, when the inventory reaches the recorder point the store keeper should initiate to replenish the inventory for smooth flow production like in case of iron ore stock reaches 2,40,000 tones. The store keeper should initiate for purchase of inventory. The safety stock of 75,000 ton is maintained in case any uncertainty occurs. JUST IN-TIME SYSTEM RSP follows the just-in-time system of purchase for the inventories which are easily available in the local market and the sources are enough to satisfy the current requirement. It is also mostly applicable for per coble goods. ABC Analysis RSP has categorized the materials in there group of inventory according to their total value of the inventory. A B C Imported coal Zinc Coke Indigenous coal Silicon manganese Copper Iron ore Naphtha Tin Intermediary Dolomite Other ferrous metals

product

Limestone Aluminum

Ferro Silicon Ferro Manganese Nickel Pig iron ore

In case of a material falling under A group, the control is the highest, B group is given more attention and the C group is controlled under simple control system. VED Analysis The VED control system is followed to the inventories according to their degree of essentially. The more essential inventories are given most of the attention and the less essential inventories are given simple attention. In RSP the inventory control system followed is the combination of ABC analysis, VED analysis and FNSD analysis.

Investment in Inventory : Items Sales Gross profit PBT Inventory Networking capital Rs. (in crore) 3100 600 300 690 183

The variable expenses (Selling expenses, general expenses and administrative expenses) are about 10% of sales. The inventory turnover ratio is 6% RSP has taken advantages of price fluctuation. RSP has invested about Rs. 50 crore in inventories in anticipation of price increase and makes profit about 1.4 crore, which is about 28% profit on investment. RSPs return on net asset employed is 8.1% PBT/Net assets = (300/3700)% = 8.1% Gross margin ratio is 19.35% RSPs investment in inventory is satisfactory and it is optimum to increase its profitability. It can also withstand the price fluctuation. LOCATION

Another most essential point to be considered in inventory management is the location of the store. RSP is maintaining centralized stores with sub-stores. In RSP the departments are situated at a distance from the central store, so in order to keep the transportation costs and handling charges minimum, sub-stores (near receiving departments) are situated near the production departments. The quantity required for the production for the period, the quantity is kept in the sub-stores. At the end of the period the storekeeper of each store let know the central store that how much quantity of material is required for the next period.