Financial Management & Cost Accounting

Module 7. Inventory Management

Lesson 38
INTRODUCTION TO INVENTORY MANAGEMENT

38.1 Meaning and Definition of Inventory

Definition

“Inventory may be defined as the stock of any item or resources used by an Organization.”. A manufacturing unit may generally have the stocks of following items

· Raw Materials

· Work in Process

· Finished Goods

· Spares, Tools, Lubricants etc.

Based on the above, Inventory may be divided in to following types.

38.2 Types of Inventories

1) Raw Materials Inventory

It denotes the stock of all raw Materials, parts, components, assemblies which are used to manufacture the final product.

2) Work – in –Process Inventory or Semi-finished goods Inventory

It is the stock of semi-finished goods in the production department. These are the good which have entered the production process but have not reached completion stage.

3) Finished goods inventory

It is the stock of goods which are completely manufactured and are ready you sale.

4) Maintenance , Repairs & Operation inventories

It represents the stock of maintenance, repair and operating supplies, which are useful for production process but do not form a part of the product. e.g. lubrication oil, soaps, brooms, light bulbs, machine repair parts etc.

A manufacturing firm will generally have all kinds of inventory Raw materials, WIP, Finished goods and spares inventory, whereas a wholesale retail firm will generally have a large amount of finished goods inventory. The level of inventory also depends upon the production cycle of the firm. For example organization which have long production cycles, carry large amount of inventories and hence a lot of capital is tied up in inventory. Whereas, Organizations having shorten production cycles require less inventory and less capital is tied up in inventory.

38.3 Importance of Inventory Management

On an average inventories are around 60% of current assets and around is-30% of total assets. It is therefore necessary to devote attention to inventories and ensure that the level of inventory is optimum (Neither large inventories nor to low inventories) and they are efficiently and effectively managed.

Goal of inventory management:

 A firm has two conflicting choices regarding inventory:

a) Excessive Inventory: If the firm keeps large stocks of raw materials, finished goods, spares etc then it has an advantage that there is continuous and smooth production without any stoppage. Also the firm is always able to fulfill customer orders promptly and carry out marketing activities smoothly. But keeping excessive inventories has a big disadvantage that the investment in inventory is to huge.

b) Very Less Inventory (Inadequate Inventory): In this situation where a firm keeps very less stock of items then it has a benefit that very less capital is blocked in inventory. But in this case it is possible that the firm experience frequent production stoppage due to non availability of raw materials, spares etc.

It is possible that due to inadequate finished goods inventory the firm may loose sales. It may not be able to fulfilling customer orders in time. It may even result in permanent loss of customers and loss of good will. Both the extreme situations a) Excessive inventoried b) Inadequate inventories are not desirable and a good manager should try to avoid them. The aim of Inventory management should be to avoid both the danger points and try to determine the Optimum level of inventory and maintain the same.

38.4 Benefits of Holding Inventories

It is always beneficial for a firm to hold stocks of raw materials, work in process, finished goods, spares and tools. This is because inventories enable in decoupling of various activities, e.g. Raw materials Inventory decouple the purchasing activity and production activity. Hence stock of raw materials acts as a buffer between purchasing and production. The purchase department gets some flexibility and time to search for new suppliers, to negotiate for discounts, to order in bulk quantities etc.

Similarly Work-in–process inventory is useful in providing flexibility in providing scheduling. The stock of finished goods is kept in order to carry out smooth functioning of marketing and sales department. The marketing department functions somewhat independently and fulfills customer order promptly due to the stock of finished goods kept by the firm (Marketing department is not totally depended upon production for fulfillment of customer orders, due to the finished goods inventory).

38.5 Inventory Costs

There are three types of Inventory costs:

a) Ordering Costs

b) Holding Costs/Carrying Costs/Storage Costs

c) Shortage Costs

Ordering Cost

Ordering costs are those costs which are incurred in placing the orders. Various ordering costs incurred are

· Cost involved in requisitioning

· Preparation of purchase orders

· Cost of expediting and follow-up

· Transaction Cost

· Receiving and Inspection Cost

Hence, ordering cost include all the cost which are incurred right from the point of Requisitioning to the point of receiving the materials and placing it in stores.

Carrying cost/holding cost/storage costs

It is simply the cost incurred in storage of materials. The main costs involved in storing materials are-

· Rent of Warehouse, Insurance, Cost of spoilage, Cost due to pilferage

· Obsolescence Cost, Opportunity Cost of Capital blocked in inventory etc, Security cost of store house

· Cost of ventilation, utilities etc in the store house

So, It is clear from the above discussion that, two cost-ordering cost and storage Costs are involved when we purchase a material. Ordering Cost is the sum of all costs incurred up to the stage of receiving the material. Once the material has been received and placed in storehouse, all the costs which are incurred behind storing the material are called storage costs or holding costs.

Shortage costs

Shortage costs are those which the firm has to bear when there is a shortage of particular stock item. For example, the shortage of raw materials causes production stoppages, inefficient production, and delay in production schedules, customer dissatisfaction and loss of sales. It also includes the high costs associated with “Crash-procurement”. So from the above discussion it can be seen that there are only three kinds of inventory costs Ordering Cost, Holding Cost and Shortage Cost.