CONTENTS

1. INTRODUCTION

2. INVENTORY TYPES

*RAW MATERIALS

*WORK-IN-PROGRESS

*FINISHED GOODS

*TRANSIT INVENTORY

*BUFFER INVENTORY

*DECOUPLING INVENTORY

3. MOTIVE OF HOLDING INVENTORY

4. REASONS AND BENEFITS OF INVENTORY

5. INVENTORY MANAGEMENT

6. TECHNIQUES OF INVENTORY MANAGEMENT

INTRODUCTION

Inventories are assets of the firm and require investment

and hence involve the commitment of firm’s resources. The

inventories need not be viewed as an idle asset rather these

are an integral part of firm’s operations. If the inventories

are too big, they became a strain on the resources, however,

if they are too small the firm may loose the sales. Therefore,

the firm must have an optimum level of inventories.

INVENTORY TYPES

Inventory is defined as a stock or store of goods. These goods are

maintained on hand at or near a business's location so that the firm

may meet demand and fulfill its reason for existence. If the firm is a

retail establishment, a customer may look elsewhere to have his or her

needs satisfied if the firm does not have the required item in stock

when the customer arrives. If the firm is a manufacturer, it must

maintain some inventory of raw materials and work-in-process in order

to keep the factory running. In addition, it must maintain some supply

of finished goods in order to meet demand.

Sometimes, a firm may keep larger inventory than is necessary to

meet demand and keep the factory running under current conditions of

demand. If the firm exists in a volatile environment where demand is

dynamic (i.e., rises and falls quickly), an on-hand inventory could be

maintained as a 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 advance of an impending price increase.

Generally, inventory types can be grouped into four classifications: raw

material, work-in-process, finished goods, and MRO goods.

RAW MATERIALS

Raw materials are inventory items that are used in the manufacturer's

conversion process to produce components, subassemblies, or finished

products. These inventory items may be commodities or extracted

materials that the firm or its subsidiary has produced or extracted.

They also may be objects or elements that the firm has purchased

from outside the organization. Even if the item is partially assembled

or is considered a finished good to the supplier, the purchaser may

classify it as a raw material if his or her firm had no input into its

production. Typically, raw materials are commodities such as ore,

grain, minerals, petroleum, chemicals, paper, wood, paint, steel, and

food items. However, items such as nuts and bolts, ball bearings, key

stock, casters, seats, wheels, and even engines may be regarded as

raw materials if they are purchased from outside the firm.

The bill-of-materials file in a material requirements planning system

(MRP) or a manufacturing resource planning (MRP II) system utilizes a

tool known as a product structure tree to clarify the relationship among

its inventory items and provide a basis for filling out, or "exploding,"

the master production schedule. Consider an example of a rolling cart.

This cart consists of a top that is pressed from a sheet of steel, a frame

formed from four steel bars, and a leg assembly consisting of four legs,

rolled from sheet steel, each with a caster attached. An example of this

cart's product structure tree is presented in Figure 1.

Figure 1

Generally, raw materials are used in the manufacture of components.

These components are then incorporated into the final product or

become part of a subassembly. Subassemblies are then used to

manufacture or assemble the final product. A part that goes into

making another part is known as a component, while the part it goes

into is known as its parent. Any item that does not have a component

is regarded as a raw material or purchased item. From the product

structure tree it is apparent that the rolling cart's raw materials are

steel, bars, wheels, ball bearings, axles, and caster frames.

WORK-IN-PROCESS

Work-in-process (WIP) is made up of all the materials, parts

(components), assemblies, and subassemblies that are being

processed or are waiting to be processed within the system. This

generally includes all material raw materials that has been released for

initial processing up to material that has been completely processed

and is awaiting final inspection and acceptance before inclusion in

finished goods.

Any item that has a parent but is not a raw material is considered to be

work-in-process. A glance at the rolling cart product structure tree

example reveals that work-in-process in this situation consists of tops,

leg assemblies, frames, legs, and casters. Actually, the leg assembly

and casters are labeled as subassemblies because the leg assembly

consists of legs and casters and the casters are assembled from

wheels, ball bearings, axles, and caster frames.

FINISHED GOODS

A finished good is a completed part that is ready for a customer order.

Therefore, finished goods inventory is the stock of completed products.

These goods have been inspected and have passed final inspection

requirements so that they can be transferred out of work-in-process

and into finished goods inventory. From this point, finished goods can

be sold directly to their final user, sold to retailers, sold to wholesalers,

sent to distribution centers, or held in anticipation of a customer order.

Any item that does not have a parent can be classified as a finished

good. By looking at the rolling cart product structure tree example one

can determine that the finished good in this case is a cart.

Inventories can be further classified according to the purpose they

serve. These types include transit inventory, buffer inventory,

anticipation inventory, decoupling inventory, cycle inventory, and MRO

goods inventory. Some of these also are know by other names, such as

speculative inventory, safety inventory, and seasonal inventory. We

already have briefly discussed some of the implications of a few of

these inventory types, but will now discuss each in more detail.

TRANSIT INVENTORY

Transit inventories result from the need to transport items or material

from one location to another, and from the fact that there is some

transportation time involved in getting from one location to another.

Sometimes this is referred to as pipeline inventory. Merchandise

shipped by truck or rail can sometimes take days or even weeks to go

from a regional warehouse to a retail facility. Some large firms, such as

automobile manufacturers, employ freight consolidators to pool their

transit inventories coming from various locations into one shipping

source in order to take advantage of economies of scale. Of course,

this can greatly increase the transit time for these inventories, hence

an increase in the size of the inventory in transit.

BUFFER INVENTORY

As previously stated, inventory is sometimes used to protect against

the uncertainties of supply and demand, as well as unpredictable

events such as poor delivery reliability or poor quality of a supplier's

products. These inventory cushions are often referred to as safety

stock. Safety stock or buffer inventory is any amount held on hand that

is over and above that currently needed to meet demand. Generally,

the higher the level of buffer inventory, the better the firm's customer

service. This occurs because the firm suffers fewer "stock-outs" (when

a customer's order cannot be immediately filled from existing

inventory) and has less need to backorder the item, make the

customer wait until the next order cycle, or even worse, cause the

customer to leave empty-handed to find another supplier. Obviously,

the better the customer service the greater the likelihood of customer

satisfaction.

ANTICIPATION INVENTORY

Oftentimes, firms will purchase and hold inventory that is in excess of

their current need in anticipation of a possible future event. Such

events may include a price increase, a seasonal increase in demand, or

even an impending labor strike. This tactic is commonly used by

retailers, who routinely build up inventory months before the demand

for their products will be unusually high (i.e., at Halloween, Christmas,

or the back-to-school season). For manufacturers, anticipation

inventory allows them to build up inventory when demand is low (also

keeping workers busy during slack times) so that when demand picks

up the increased inventory will be slowly depleted and the firm does

not have to react by increasing production time (along with the

subsequent increase in hiring, training, and other associated labor

costs). Therefore, the firm has avoided both excessive overtime due to

increased demand and hiring costs due to increased demand. It also

has avoided layoff costs associated with production cut-backs, or

worse, the idling or shutting down of facilities. This process is

sometimes called "smoothing" because it smoothes the peaks and

valleys in demand, allowing the firm to maintain a constant level of

output and a stable workforce.

DECOUPLING INVENTORY

Very rarely, if ever, will one see a production facility where every

machine in the process produces at exactly the same rate. In fact, one

machine may process parts several times faster than the machines in

front of or behind it. Yet, if one walks through the plant it may seem

that all machines are running smoothly at the same time. It also could

be possible that while passing through the plant, one notices several

machines are under repair or are undergoing some form of preventive

maintenance. Even so, this does not seem to interrupt the flow of

work-in-process through the system. The reason for this is the

existence of an inventory of parts between machines, a decoupling

inventory that serves as a shock absorber, cushioning the system

against production irregularities. As such it "decouples" or disengages

the plant's dependence upon the sequential requirements of the

system (i.e., one machine feeds parts to the next machine).

The more inventory a firm carries as a decoupling inventory between

the various stages in its manufacturing system (or even distribution

system), the less coordination is needed to keep the system running

smoothly. Naturally, logic would dictate that an infinite amount of

decoupling inventory would not keep the system running in peak form.

A balance can be reached that will allow the plant to run relatively

smoothly without maintaining an absurd level of inventory. The cost of

efficiency must be weighed against the cost of carrying excess

inventory so that there is an optimum balance between inventory level

and coordination within the system.

CYCLE INVENTORY

Those who are familiar with the concept of economic order quantity

(EOQ) know that the EOQ is an attempt to balance inventory holding or

carrying costs with the costs incurred from ordering or setting up

machinery. When large quantities are ordered or produced, inventory

holding costs are increased, but ordering/setup costs decrease.

Conversely, when lot sizes decrease, inventory holding/carrying costs

decrease, but the cost of ordering/setup increases since more

orders/setups are required to meet demand. When the two costs are

equal (holding/carrying costs and ordering/setup costs) the total cost

(the sum of the two costs) is minimized. Cycle inventories, sometimes

called lot-size inventories, result from this process. Usually, excess

material is ordered and, consequently, held in inventory in an effort to

reach this minimization point. Hence, cycle inventory results from

ordering in batches or lot sizes rather than ordering material strictly as

needed.

MRO GOODS INVENTORY

Maintenance, repair, and operating supplies, or MRO goods, are items

that are used to support and maintain the production process and its

infrastructure. These goods are usually consumed as a result of the

production process but are not directly a part of the finished product.

Examples of MRO goods include oils, lubricants, coolants, janitorial

supplies, uniforms, gloves, packing material, tools, nuts, bolts, screws,

shim stock, and key stock. Even office supplies such as staples, pens

and pencils, copier paper, and toner are considered part of MRO goods

inventory.

THEORETICAL INVENTORY

In their book Managing Business Process Flows: Principles of

Operations Management, Anupindi, Chopra, Deshmukh, Van Mieghem,

and Zemel discuss a final type of inventory known as theoretical

inventory. They describe theoretical inventory as the average

inventory for a given throughput assuming that no WIP item had to

wait in a buffer. This would obviously be an ideal situation where

inflow, processing, and outflow rates were all equal at any point in

time. Unless one has a single process system, there always will be

some inventory within the system. Theoretical inventory is a measure

of this inventory (i.e., it represents the minimum inventory needed for

goods to flow through the system without waiting). The authors

formally define it as the minimum amount of inventory necessary to

maintain a process throughput of R, expressed as:

Theoretical Inventory = Throughput Theoretical Flow Time

Ith = R Tth

In this equation, theoretical flow time equals the sum of all activity

times (not wait time) required to process one unit. Therefore, WIP will

equal theoretical inventory whenever actual process flow time equals

theoretical flow time.

Inventory exists in various categories as a result of its position in the

production process (raw material, work-in-process, and finished goods)

and according to the function it serves within the system (transit

inventory, buffer inventory, anticipation inventory, decoupling

inventory, cycle inventory, and MRO goods inventory). As such, the

purpose of each seems to be that of maintaining a high level of

customer service or part of an attempt to minimize overall costs.

What is "Inventory Management"

Inventory management is the active control program which allows the

management of sales, purchases and payments.

Inventory management software helps create invoices, purchase

orders, receiving lists, payment receipts and can print bar coded

labels. An inventory management software system configured to your

warehouse, retail or product line will help to create revenue for your

company. The Inventory Management will control operating costs and

provide better understanding. We are your source for inventory

management information, inventory management software and tools.

A complete Inventory Management Control system contains the

following components:

Inventory Management Definition

Inventory Management Terms

Inventory Management Purposes

Definition and Objectives for Inventory Management

Organizational Hierarchy of Inventory Management

Inventory Management Planning

Inventory Management Controls for Inventory

Determining Inventory Management Stock Levels

MOTIVE OF HOLDING INVENTORY:-

Transaction Motive:- Every firm has to maintain some fuel of

inventory to meet the day to day requirements of sale

production process, customer demand etc.

Precautionary Motive:- The firm should keep some inventory for

unforeseen circumstances also. For eg. The fresh supply of raw

materials may not reach the factory due to strike by the

transports or due to natural calamities in a particular area.

Speculative Motive:- It may be required to keep some inventory

in order to capitalize an opportunity to make profits. Example,

sufficient level of inventory may help the firm to earn profit in

case of expected shortage in market.

REASONS AND BENEFITS OF

INVENTORY

 The inventory has cost as well as benefits associated with it. While

determining the optimum level of inventories, the financial manager

must consider the necessity of  holding inventory & cost thereof. The

optimum level of inventory is a subjective matter and depends upon

the features of  a firm. The following are some of the benefits or

reasons for holding inventories.

1) Trading firm:

If the firm has some stock of goods then the sale activity can be

undertaken even if the procurement as stopped due to one reason or

the other .  Otherwise ,if stock is not there , there is likelihood that the

ale will stop as soon as there is an interruption in procurement.

Moreover , it is not always possible to procure goods whenever there is

a sales opportunity , as there is always a time gap required  between

the purchase & sale of the goods. Thus , a trading concern should have

some stock of finished goods in order to undertake sales activities

independent of each other. A firm may have several incentives being

offered in terms of quantity discount or lower price etc. the inventory

so purchased, at a discount/lower cost, will result in lowering the total

cost resulting in higher to the firm. So , in case of trading concern, the

inventory helps in de-linking the sales activity from purchase activity 

and also to capitalize a profit of opportunity.

2) Manufacturing firm:

A manufacturing firm should have inventory of not only the finished

goods, but also, of raw material  and work-in-progress for obvious

reason as follows:

 

i) Uninterrupted production schedule:

Every firm must have sufficient stock of raw material in order to have

regular & uninterrupted production schedule. If there is stock-out of

raw material at any stage of production process , then the whole

production process may come to a halt. This may result in customer

satisfaction as the goods can not be delivered in time. The firm may

have to incur heavy cost to restart the production process.

Further, sufficient work-in-progress would let the production process to

run smoothly. The work-in-progress helps in fulfillment of sales orders

even if the supply of raw material has stopped. 

ii) Independent sales activity:

The production schedule is generally a time consuming process & in

most cases goods cannot be produced just after receiving orders.

Every manufacturing concern  therefore, maintains a minimum level of

finished goods in order to deliver the goods as soon as the order is

received.

COST OF INVENTORY: Every firm maintains some stock of raw

materials, work in progress and finished goods depending upon the

requirement and other features of the firm. It is benefited by holding

inventory no doubt, yet it must also consider various costs involved in

holding inventories. The cost of holding inventories may include the

following:

1. Carrying cost: This is the cost incurred in keeping or maintaining

an inventory of one unit of raw material or work in progress or

finished goods. Two basic costs are associated with holding a

unit in inventory. These are:

(a)Cost of storage- This means and includes the cost of

storing one unit of raw material by firm .This cost may be

in relation to rent of space occupied by the stock ,the cost

of people employed for the security of the stock , cost of

infrastructure required e.g., air conditioning ,etc ., cost of

insurance , cost of pilferage , warehousing cost , handling

cost ,etc..

(b)Cost of financing: This cost includes the cost of funds

invested in the inventories. The funds used in the purchase

/ production of inventories have an opportunity cost i.e. the

income which could have been earned by investing these

funds elsewhere. Moreover, if the firm has to pay interest

on borrowings made for the purchase of materials / goods,

then there is an explicit cost of financing in the form of

interest.

It may be noted that total carrying cost is entirely variable

and rise in direct proportion to the level of inventories carried.

The total carrying cost move in the same direction as the

annual average inventory.

2. Cost of Ordering: The cost include the cost of acquisition of

inventories .it is the cost of preparation and execution of an

order, including cost of paper work and communicating with

the supplier. There is always minimum cost involved

whenever an order for replenishment of goods is placed. The

total annual cost of ordering is equal to the cost per order

multiplied by the number of order placed in a year. The

number of orders determines the average inventory being

held by the firm. Therefore, the total order cost is inversely

related to the average inventory of the firm. The ordering cost

may have a fixed component which is not affected by the

order size; and a variable component which changes with the

order size. For example, transportation charges may be

payable per unit subject to a minimum charge per trip.

3.Cost of stock outs- A stock out is a situation where the firm is

not having units of an item in store but there is a demand for that

either from the customers or the production department. The stock

out refer to demand for an item whose inventory level has already

reduced to zero or insufficient level. It may be noted that the stock

out does not appear if the item is not demanded even if inventory

level is fallen to zero. The whole theory of inventory management

can be summarized as follows-

1. Maintaining sufficient stock of raw materials ensuring continuous

supply to production schedule.

2. Maintaining sufficient supply of finished goods for achieving

smooth sales operations, and

3. Minimizing the total annual cost of maintaining inventories.

TECHNIQUES OF INVENTORY MANAGEMENT

ABC ANALYSIS-ABC analysis is a type of analysis of material dividing in

three groups called A-group items, B-Group items and C-group items

For the purpose of exercising control over materials. Manufacturing

concerns find it useful to divide materials into three categories.

An analysis of the annual consumption of materials of any organisation

would indicate that a handful to top high value items (less than 10 per

cent of the total number) will account for a substantial portion of about

70 per cent of total consumption value.

Remember: 10% of total number of items carries 70% of value. - "A"

group items

Similarly, a large number bottom items (over 70 per cent of the total

number of items) account for only about 10 percent of the

consumption value.

Remember: 70% of total number of items account for only about 10%

of consumption value - "C"-group items.

Between these two extremes will fall those items the percentage

number of which is more or less equal to their consumption value.

Remember: 20% of total number of items account for only about 20%

consumption value - "B" group items.

Items in the top category are treated as "A" items, items in the bottom

category are called as "C" category items and the items that lie

between the top and the bottom are called "B" category items. Such an

analysis of materials is known as ABC analysis or Proportional

parts value analysis.

Classification of items into A, B and C

categories

The logic behind this kind of analysis is that the management should

study each item of stock in terms of its usage, lead time, technical or

other problems and its relative money value in the total investment in

inventories.

Critical items i.e., high value items deserve very close attention and

low value items need to be devoted minimum expense and effort in

the task of controlling inventories.

The Material Manager by concentrating on "A" class items is able to

control inventories and show visible results in a short span of time. By

controlling "A" items and doing a proper inventory analysis, obsolete

stocks are automatically pinpointed.

ABC analysis also helps in reducing the clerical costs and results in

better planning and improved inventory turnover. ABC analysis has to

be resorted to because equal attention to A, B and C items will not be

worthwhile and would be very expensive.

The following steps will explain to you the classification of items into A,

B and C categories.

The following steps will explain to you the classification of items into A,

B and C categories.

1. Find out the unit cost and and the usage of each material over a

given period.

2. Multiply the unit cost by the estimated annual usage to obtain the

net value.

3. List out all the items and arrange them in the descending value.

(Annual Value)

4. Accumulate value and add up number of items and calculate

percentage on total inventory in value and in number.

5. Draw a curve of percentage items and percentage value.

6. Mark off from the curve the rational limits of A, B and C categories.

Stock Levels

Maintenance of proper stock of each item of materials is one of the

main functions of stores department. Large quantity of material in

store lead to huge investments, deterioration in quality, large space

requirement etc. Less stock also leads to higher costs, frequent

purchases and loss of production etc. Therefore, it is important to

maintain stock level. One of the best way to maintain stock is to

determine the minimum and maximum stock levels as per the

necessity and maintain it regularly.

Store keepers usually use scientific technique of material management

to ensure optimum quantity of material in store and make purchases

accordingly. In order to do that following levels are fixed in advance:

1. Maximum Stock Level

2. Minimum Stock level

3. Re-ordering level

4. Danger level

Reordering Level

Re-ordering level is a level at which the storekeeper will initiate the

steps to purchase fresh supplies. This level is called re-ordering level or

ordering level. This level usually lies between minimum and maximum

stock level. This level will usually be higher than the minimum stock

level to cover unexpected delay in delivery of fresh supplies or

abnormal usage of materials. Following points need to be taken into

consideration while fixing the re-ordering level

1. Economic ordering quantity

2. Rate of consumption

3. Time required for the delivery of fresh supply.

Following formulas can be used for calculating the re-ordering level.

Reorder level = Maximum consumption x Maximum re-order period

or

Reorder level = Minimum level + consumption during the time

required to get fresh deliveries

Example 1

Calculate the reorder level from the following information:

Maximum Consumption = 100 units per week

Minimum Consumption = 50 units per week

Maximum reorder period = 4 weeks

Solution:

Reorder level = Maximum consumption x Maximum reorder period

= 100 x 4 = 400 units.

Example 2

Find out the order level from the following information:

Maximum Stock: 250 units

Minimum stock: 100 units

Time required for receiving fresh supplies: 10 days

Daily consumption of material : 5 units

Solution:

Reorder level = Minimum level + consumption during the time

required to get fresh deliveries

= 100 + (5 x 10)

= 150 units.

Minimum Stock Level

Minimum stock level is a level of stock which must be kept in store at

all times. This is a level of an item of material below which the stock in

hand is not allowed to fall. The objective of this limit is to avoid the

possibility of interruption of production due to shortage of material.

The following points needs to be taken into consideration while fixing

the minimum stock level.

1. Time required for the fresh supply of material - Lead time

2. Rate of consumption of material during the lead time.

3. Reorder level

Following formula can be used for determine the minimum stock level

Minimum stock level = Reorder level - (Normal consumption x

Normal reorder period)

Example:

Calculate the minimum stock level from the following data:

Net normal consumption = 500 units per day

Normal reorder period = 10 days

Reorder level = 8000 units

Solution:

Minimum stock level = Reorder level - (Normal consumption x Normal

reorder period)

= 8000 - (500 x 10)

= 3000 units

Maximum stock level

Maximum stock level is a quantity of material above which the stock of

any item should not be allowed. To avoid blocking of working capital

and making undue investments in stock, maximum stock level is to be

fixed. It also helps to maintain proper quality of raw materials.

Following points must be taken into consideration while fixing

maximum stock level:

1. Availability of storage space

2. Cost of carrying the inventory

3. Amount of working capital available

4. Economic ordering quantity

5. Possibility of change in market trend

6. Normal rate of consumption of material during the reordering

process.

7. Time necessary for fresh delivery of materials.

8. Possibility of loss due to deterioration/evaporation etc.

9. Price fluctuation.

10. Insurance costs if any.

Following formula is normally in use for calculating Maximum stock

level.

Maximum stock level = Reorder level + reorder quantity -

(maximum consumption X minimum re-order period)

Example:

Find out the Maximum stock level from the following information:

Reorder Level = 32000 units

Reorder quantity = 30000 units

Minimum Consumption = 3000 units per month

Minimum reorder period = 2 months.

Solution:

Maximum stock level = Reorder level + reorder quantity - (maximum

consumption X minimum re-order period)

Maximum stock level = 32000 + 30000 - (3000 x 2)

=62000 - 6000 = 56000 units.

Danger Level

Danger level is a level below the minimum level. This is a level at

which urgent action must be taken to procure new stock otherwise the

stock may exhaust and could affect the production. This level is

calculated by taking into account the time required to get the

materials by the shortest possible means. Generally following formula

is used to calculate the Danger level:

Danger level = average consumption x Maximum reorder period for

emergency purchase.

Average stock level

Average stock level can be determined by using the following formula:

Average Stock Level = 1/2 of (Maximum stock level + Minimum Stock

level)

or

Average Stock Level = Minimum stock level + half of reorder quantity)

Reorder Quantity or Economical order

Quantity

It is better to determine in advance how much is to be purchased when

the material reaches reorder level. This quantity is called reorder

quantity. It is the quantity when it received, it will not exceed the

maximum stock level. It is also called Economic Order Quantity

because purchase of this quantity of material is most economical as

well. Frequent purchase will result in increase in cost of transportation.

Too much of goods may block the working capital for a long time.

Following points needs to be taken into consideration while fixing the

reorder quantity.

1. Cost of transportation

2. cost of storage (warehouse rent, insurance, heating and lighting

expenses)

3. cost of ordering

4. Availability of working capital

5. Minimum and maximum consumption for the lead time.

6. Time necessary to obtain deliveries

7. Possibility of loss due to evaporation or deterioration

8. Changes in the fashion trend.

9. Interest on investment

10. Obsolescence losses,