In inventory management, the inventories are assets of the firm, and as such, they represent an investment. Because such investment requires a commitment of funds, managers must ensure that the firm maintains inventories at the correct level. If they become too large, the firm loses the opportunity to employ those funds more effectively. Similarly, if they are too small, the firm may lose sales. Thus, there is an optimal level of inventories and there is an economic order quantity model for determining the correct level of inventory.
Inventories, like receivables, are a significant portion of most firms’ assets and, accordingly, require substantial investments. To keep these investments from becoming unnecessarily large, inventories must be managed efficiently. In this lesson, we shall discuss how to do that and how efficient management of inventory is related to financial management.
Types of Inventories
Inventories are goods held for eventual sale by the firm and the raw materials or other components being used in the manufacturing of such goods. A retailer keeps an inventory of finished goods to be offered to customers whenever demanded by them. On the other hand, a manufacturing concern has to keep a stockpile of not only the finished goods it is producing but also of all physical ingredients being used in the production process.
The common types of inventories for most business firms may be classified as finished goods, work-in-progress and raw materials.
Finished goods: These are completed products awaiting sale. They are the final output of the production process in a manufacturing firm. In the case of wholesalers and retailers, they are generally referred to as merchandise inventory.
Work-in-process: It refers to the raw materials engaged in various phases of the production schedule. The degree of completion may be varying for different units. The work-in-progress refers to partially produced goods. The value of work-in-process includes the raw material costs, the direct wages and expenses already incurred and the overheads, if any.
Raw materials: These are goods that have not yet been committed to the production process in a manufacturing concern. They may consist of basic raw materials or finished components.
The quantity and value of the above three kinds of inventories differ depending upon the nature of the business. For example, a manufacturer will have levels of all three kinds of inventories. While a retailer or a wholesaler will have a high level of inventories of finished goods but will have no inventories of raw materials or work-in-process. Moreover, depending upon the nature of the business, inventories may be durable or non-durable, valuable or inexpensive, perishable or non-perishable, etc.
Benefits of Holding Inventories
The holding of inventories has costs as well as benefits associated with it. While determining the optimal level of inventories, the financial manager must consider the necessity of holding inventory and costs thereof. The following are some of the benefits or reasons for holding inventories.
Quick Service: Customers desire a prompt fulfillment of orders. A firm will have to make the goods available for sale. In the event of its not being able to offer quick service to customers, the latter is likely to get their orders executed by competitors.
Uninterrupted production schedule: Every manufacturing firm must have sufficient stock of raw materials in order to have a regular and uninterrupted production schedule. If there is stock out of raw material at any stage of the production process, then the whole production process may come to a halt. This may result in customer dissatisfaction as the goods cannot be delivered on time. Moreover, the fixed costs will continue to be incurred even if there is no production.
Discounts: A firm is in a position to take advantage of trade discounts by placing bulk orders with suppliers. A proper proportion will have to be maintained between the cost of maintaining inventories and the discount that is likely to be gained.
Reduction in Order Costs: Each order of supply of goods or materials carries certain costs. If the number of orders is reduced, it is possible to economize on these costs as the procedure involving each order need not be repeated each time.
Protection against shortages: Adequate inventories protect a firm against the shortages that would result in production stoppages and considerable losses.
Risks and Costs Associated with Inventories
The costs of holding inventories can be put as follows:
Materials Cost: This includes the cost of purchasing the goods, transportation, and handling charges less any discount allowed by the supplier of goods.
Ordering cost: The cost of orders includes the cost of acquisition of inventories. It is the cost of preparation and execution of an order, including the cost of paperwork and communicating with the supplier. There is always a minimum cost involved whenever an order for the replenishment of goods is placed. The total annual cost of ordering is equal to the cost per order multiplied by the number of orders 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.
Carrying Costs: This includes the expenses for storing the goods. It comprises storage costs, insurance costs, spoilage costs, costs of funds tied up in inventories, etc. 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. The ordering cost may be referred to as the “cost of acquiring” while the inventory carrying cost is the “cost of holding” inventory. The cost of acquiring decreases while the cost of holding increases with every increase in the quantity of the purchased lot. A balance is therefore struck between the two opposing factors.
Costs of Stock-outs: A stock-out is a situation when 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 refers to the 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 the inventory level has fallen to zero. There is always a cost of stock-out in the sense that the firm faces a situation of lost sales or orders not honored. If the item demanded is not in stock, the customer may buy the item/good someone else. This results in a loss of goodwill too.
Objectives of Inventory Management
Inventory management covers a large number of issues including fixation of minimum and maximum levels; determining the size of the inventory to be carried; deciding about the issue price policy; setting up receipt and inspection procedure; determining the economic order quantity; and providing proper storage facilities. However, the firm is faced with the problem of meeting two conflicting needs while dealing with these issues.
- To maintain a large size of inventory for efficient and smooth production and sales operations.
- To maintain a minimum investment in inventories to maximize profitability.
Both ’excessive’ and ’inadequate’ inventories are not desirable. There are two danger points that the firm should operate. The objective of inventory management should be to determine and maintain the optimum level of inventory investment. This level of inventory will lie between two danger points of excessive and inadequate inventories. More specifically, the following are the objectives of inventory management.
- To have stocks available as and when they are required.
- To utilize available store space, but prevent stock levels from exceeding space availability.
- To meet a high percentage of demand without creating excess stock levels. In other words, “Neither to overstock nor to run out” is the best policy.
- To provide, on an item-by-item basis, for re-order points and order such quantity as would ensure that the aggregate results conform to the constraints and objectives of inventory control.
- To decide which item to stock and which item to procure on-demand.
- To ensure an adequate supply of materials, stores, spares, etc, minimize stock-outs and shortages; and avoid costly interruption in operations.
- To enable the management to make costs and consumption comparisons between operations and periods.
- Minimizing inventory carrying costs.
- To ensure investment in inventories at the optimum level.
Techniques of Inventory Management
Effective inventory management requires effective control over inventories. Inventory control refers to a system that ensures the supply of the required quantity and quality of inventories at the required time and prevents unnecessary investment in inventories. The techniques of inventory control/inventory management are as follows:
Determination of Economic Order Quantity: Determination of the quantity for which the order should be placed is one of the important problems concerned with efficient inventory management. If the firm is buying raw materials, it has to decide lots in which it has to be purchased on each replenishment. Determining an optimum inventory level involves two types of costs: (a) ordering costs and (b) carrying costs. The economic order quantity is that inventory level that minimizes the total of ordering and carrying costs.
Determination of Optimum Production Quantity: The use of the EOQ model can be extended to production runs to determine the optimum size of the manufacture. Two costs involved are ordering costs (set-up costs) and carrying costs. Production costs or set-up costs will reduce with bulk production runs, but carrying costs will increase as large stocks of manufactured inventories will be held. The economic production size will be the one where the total set-up and carrying costs are minimum.
ABC Classification: An ABC analysis offers an important solution to the problem of scientific planning and control of inventories, and is an important technique of inventory management. It is based upon the value of different items constituting an inventory. It may be concerned with several items – raw materials, purchases, and self-fabricated component parts, sub-assemblies, factory supplies, office supplies, tools, machinery, and handling equipment items. An inventory may be differentiated on the basis of bulk, size, weight, usage, value, durability, availability, etc.
The idea underlying an ABC analysis is in this recognition of the principle that some items of inventory are more important than others. Thus, items are classified under broad categories -A, B, and C. The ABC technique enables an enterprise to keep their investment low and avoid stock-outs of critical items. Its objective is to reduce the minimum stock as well as the working stock.
Items under category A constitute a small percentage of the total volume but account for a large percentage of the product value of a unit. A large glossary of items entering a bulk of the total volume and accounting for an insignificant product value is placed underclass C. Items under class B constitute a moderate class which is neither substantial nor insignificant in relation to the product value of a unit. Thus, the B group stands mid-way. It deserves less attention than A but more than C. It can be controlled by employing less sophisticated techniques.
The advantages of ABC analysis are as follows:
- It ensures closer control of costly items in which a large amount of capital has been invested.
- It helps in developing a scientific method of controlling inventories, clerical costs are reduced and stock is maintained at an optimum level.
- It helps in achieving the main objective of inventory control at minimum cost. The stock turnover rate can be maintained at a comparatively higher level through scientific control of inventories.
Problems in Inventory Management
The techniques of inventory management, discussed above, are very useful in determining the optimum level of inventory and finding the answer to the problems of the economic order quantity, the reorder point, and the safety stock. These techniques are very essential to economize the use of resources by minimizing the total inventory cost. Inventory management involves a number of problems. Some of these are given below:
- Knowledge of demand, certainty, risk, and uncertainty
- Method of obtaining a commodity
- The decision process
- Time lag in receiving on order, Constant time lag, or probability distribution.
Financial Manager and Inventory Management
Although the financial manager is not directly concerned with inventory policies, yet he cannot ignore them since they directly affect the financial needs of the firm to a significant extent. It is, therefore, necessary for the financial manager to get familiar with ways to control inventories effectively so that there can be an efficient allocation of funds. He should make all-out efforts to reduce lead time, regulate usage, and minimize the safety stock. In case he does so, he will be in a position to reduce investment in inventories to the optimum level and leave sufficient funds for more profitable channels which will ultimately result in maximization of the shareholders’ wealth.