Chapter 16 –

Inventory Management

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 Learning Objectives
• Discuss the tradeoffs between costs and benefits associated with the level of
inventory
• Describe the common techniques for managing inventory—ABC system, the
basic economic order quantity (EOQ) model, the recorder point and the safety
stock
• Discuss just-in time inventory/production

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 Introduction
• The term inventory refers to the stockpile of the products a firm is offering for
sale and the components that make up the product.
• In other words, inventory is composed of assets that will be sold in future in the
normal course of business operations.
• The assets which firms store as inventory in anticipation of need are (i) raw
materials, (ii) work-in-process (semi-finished goods) and (iii) finished goods.

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 Objectives
• The objective of inventory management consists of two counter-balancing parts:
(i) to minimise investments in inventory, and (ii) to meet a demand for the
product by efficiently organising the production and sales operations.
• These two conflicting objectives of inventory management can also be expressed
in terms of cost and benefit associated with inventory.

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 Costs of Holding Inventory
• One operating objective of inventory management is to minimise cost.
• Excluding the cost of merchandise, the costs associated with inventory fall into
two basic categories: (i) ordering or acquisition or set-up costs, and (ii) carrying
costs.
• These costs are an important element of the optimum level of inventory
decisions.

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 Ordering Costs
• Ordering cost is the fixed cost of placing and receiving an inventory order
• Included in the ordering costs are costs involved in (i) preparing a purchase order
or requisition form and (ii) receiving, inspecting, and recording the goods
received to ensure both quantity and quality.
• These costs are generally fixed per order placed, irrespective of the amount of
the order.

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 Carrying Costs
• The second broad category of costs associated with inventory are the carrying
costs.
• Carrying costs are the variable costs per unit of holding an item in inventory for a
specified time period.
• The cost of holding inventory may be divided into two categories:
 Those that Arise Due to the Storing of Inventory
 The Opportunity Cost of Funds

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 Those that Arise Due to the Storing of
Inventory
• The main components of this category of carrying costs are

storage cost, that is, tax, depreciation, insurance, maintenance of the building,
utilities and janitorial services;
insurance of inventory against fire and theft;
deterioration in inventory because of pilferage, fire, technical obsolescence, style
obsolescence and price decline;
serving costs, such as, labour for handling inventory, clerical and accounting cost.

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 The Opportunity Cost of Funds
• This consists of expenses in raising funds (interest on capital) to finance the
acquisition of inventory.
• If funds were not locked up in inventory, they would have earned a return.
• This is the opportunity cost of funds or the financial cost component of the cost.
• The carrying costs and the inventory size are positively related and move in the
same direction.
• If the level of inventory increases, the carrying costs also increase and vice-versa.
• Total cost is the sum of the ordering costs and carrying costs of inventory.
• Total cost is compared with the benefits arising out of inventory to determine the
optimum level of inventory.

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 Benefits of Holding Inventory
• The major benefits of holding inventory are the basic functions of inventory.
• In other words, inventories perform certain basic functions which are of crucial
importance in the firm’s production and marketing strategies.
• Inventories enable firms in the short run to produce at a rate greater than purchase of
raw materials and vice-versa, or to sell at a rate greater than production and vice-versa.
• Inventory enables uncoupling of the key activities of a firm, each of them can be
operated at the most efficient rate.
• This has several beneficial effects on the firm’s operations.
• The effect of uncoupling (maintaining inventory) are as follows.
 Benefits in Purchasing
 Benefits in Production
 Benefits in Work-in-Process
 Benefits in Sales
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Benefits in Purchasing
• If the purchasing of raw materials and other goods is not tied to production/sales,
that is, a firm can purchase independently to ensure the most efficient purchase,
several advantages would become available.
Benefits in Production
• Finished goods inventory serves to uncouple production and sale.
• This enables production at a rate different from that of sales.
• That is, production can be carried on at a rate higher or lower than the sales rate.
Benefits in Work-in-Process
• The inventory of work-in-process performs two functions.
• In the first place, it is necessary because production processes are not instantaneous.
• In a multi-stage production process, the work-in-process inventory serves a second
purpose also.
Benefits in Sales
• The maintenance of inventory also helps a firm to enhance its sales efforts.
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 Techniques
• The financial managers should aim at an optimum level of inventory on the basis
of the trade-off between cost and benefit to maximise the owner’s wealth.
• Many sophisticated mathematical techniques are available to handle inventory
management problems.
• They involve in-built financial costs.
• The major problem areas that comprise the heart of inventory control are
 the classification problem to determine the type of control required,
 the order quantity problem,
 the order point problem, and
 safety stocks.

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 Classification Problem: A B C System
• The first step in the inventory control process is classification of different types of
inventories to determine the type and degree of control required for each.
• A B C system is an inventory management technique that divides inventory into
three categories of descending importance based on the rupee investment in each.
• On the basis of the cost involved, the various inventory items are categorised into
three classes:
 A
 B
 C.
• The items included in group A involve the largest Investment.
• The C group consists of items of inventory which involve relatively small investment.
• The B group stands midway.

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 Order Quantity Problem: Economic Order
Quantity (EOQ) Model

• While purchasing raw materials or finished goods, the questions to be addressed are:
How much inventory should be bought in one lot under one order on each
replenishment?
Should the quantity to be purchased be large or small?
Or, should the requirement of materials during a given period of time (say, six months or
one year) be acquired in one lot or should it be acquired in instalments or in several
small lots?
Such inventory problems are called order quantity problems.

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• On the basis of a trade-off between benefits derived from the availability of inventory
and the cost of carrying that level of inventory, the appropriate or optimum level of
the order to be placed should be determined.
• The optimum level of inventory is popularly referred to as the economic order
quantity(EOQ).
• It is also known as the economic lot size.
• Economic order quantity (EOQ) model is the inventory management technique for
determining optimum order quantity which is the one that minimises the total of its
order and carrying costs; it balances fixed ordering costs against variable ordering
costs.
Approaches
• The EOQ model can be illustrated by
 the long analytical approach or trial and error approach, and
 the short cut or simple mathematical approach.

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 Trial and Error (Analytical) Approach
• It uses different permutations and combinations of lots of inventory purchases so
as to find out the least ordering and carrying cost combination.
• The carrying and acquisition costs for different sizes of orders to purchase
inventories are computed and the order size with the lowest total cost of
inventory is the economic order quantity.

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 Mathematical (Short cut) Approach
• The economic order quantity can, using a short-cut method, be calculated by the
following equation:

Where A = Annual usage of inventory (units);

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 Order Point Problem
• An important question pertaining to efficient inventory management is: when should
the order to procure inventory be placed?
• This aspect of inventory management is covered under the reorder point problem.
• Reorder point is the point at which to order inventory expressed equationally as: lead
time in days  daily usage.
• Lead time is time normally taken in receiving delivery after placing orders with suppliers.

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 Safety Stock
• Safety stock implies extra inventories that can be drawn down when actual lead
time and/or
usage rates are greater than expected.
• The safety stock is defined as the minimum additional inventory to serve as a safety
margin or buffer or cushion to meet an unanticipated increase in usage resulting
from an unusually high demand and or an uncontrollable late receipt of incoming
inventory.
• The safety stock involves two types of costs:
stock-out, and
carrying costs.
• The term stock-out costs refers to the cost associated with the shortage (stock-out)
of inventory.
• The larger the safety stock, the larger would be the carrying costs and vice-versa.
• Conversely, the larger is the safety stock, the smaller would be the stock-out costs.
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 Just-In Time Inventory/Production
• The JIT is an innovative manufacturing system.
• Just-in-time refers to acquiring materials and manufacturing goods only as needed to fill
customer orders.
• The JIT production, also called lean production, is a demand-pull.
• It is a widely used system.
• The JIT production systems aim to simultaneously
 meet customer demand in a timely way,
 with high quality products and
 at the lowest possible total cost.
• It is a philosophy of eliminating non-value-added activities and increasing product
quality throughout the manufacturing process.

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Non-value added activities
• Non-value added activities refers to those functions that do not directly increase
the worth of a product to a customer.
Value added activities
• Value added activities do increase the value of a product to the customers.

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 Financial Benefits of JIT and Relevant
Costs
• In addition to lower carrying costs of inventory, other benefits of lower inventory are:
greater transparency of the production process,
heightened emphasis on eliminating the specific causes of rework, scrap and
waste, and
lower manufacturing to lead times.

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 Performance Measure
Personal Observation
• The production layout in a JIT plant is streamlined and operations are not obscured by
piles of inventory/rework.
• For this reason, personal observation is more effective in JIT plants compared to
traditional plants.
Financial Performance Measure
• The financial measure that is widely used is inventory turnover ratio, that is, cost of goods
sold ÷ inventory.
• This ratio would increase in a JIT system

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 Non-financial Performance Measures
• Included in this category of measures are:
 Decrease in manufacturing lead time
 Increase in units produced per hour
 Decrease in number of days inventory on hand
 Decrease in total setup time for machines ÷ total manufacturing time
 Decrease in number of units requiring rework or scrap ÷ total number of units
started and completed.

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 Effect on Costing System
• JIT reduces overhead costs.
• It facilitates direct tracing of some costs usually classified as indirect.
• The use of multi-skilled workers allows the costs of setup, maintenance and
quality inspection to be traced as direct costs.

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