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Definition Inventory cost Types of inventory Zero inventory and its Advantages Advantages and disadvantages of inventory Accounting techniques of recording inventory Determinants of financial stock levels ABC analysis VED analysis FNSD analysis Inventory turnover ratio Just in time
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Stock of items kept to meet future demand Purpose of inventory management

how many units to order when to order

Definition - A physical resource that a firm holds in stock with the intent of selling it or transforming it into a more valuable state. Raw Materials Works-in-Process Finished Goods

Inventory System- A set of policies and

controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be Inventory management-Inventory Management Explained A focus on Forecasting, Lot Sizing, Safety Stock, and Ordering Systems.
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Inventory forecasting- It all starts with the forecast. Forecasting is all about turning unknowns into known (or reasonable approximations). The more unknowns you can make known, the easier it is to make inventory management decisions. But more importantly, as you increase your accuracy at estimating future demand, you are able to increase the performance of your inventory. In other words, you are able to increase your service levels while at the same time reducing your inventory investment and risk of obsolescence.
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Carrying costs - Capital (opportunity) cost - Inventory risk cost - Space cost - Inventory service cost Ordering cost - Ordering processing cost - Shipping cost - Handling cost Storage cost - Temporary or permanent loss of sales when demand cannot be met
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Inventories can be of following 3 type : 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
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Works-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 materialrom raw material 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.

 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.

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Zero inventory in the state of inventory where company does not keep any raw material ,purchased parts or subassemblies stock. They directly purchase at time of production using the concept of JUST IN TIME. This can be facilitated good relations with the suppliers.

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Reducing amounts of raw materials and purchased parts and subassemblies by having suppliers deliver them directly. Reducing the amount of works-in process by using just-in-time production. Reducing the amount of finished goods by shipping to markets as soon as possible.

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Improve customer service Economies of purchasing Economies of production Transportation savings Hedge against future Unplanned shocks (labor strikes, natural disasters, surges in demand, etc.) To maintain independence of supply chain

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Non-value added costs Opportunity cost Complacency Inventory deteriorates, becomes obsolete, lost, stolen, etc.

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There are 3 methods of calculating accounting inventory 1. The First-In-First-Out Method (FIFO) This method assumes that the first inventories bought are the first ones to be sold, and that inventories bought later are sold later.

2. The Last-In-First-Out Method (LIFO) This method assumes that the last inventories bought are the first ones to be sold, and that inventories bought first are sold last.
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3. The Weighted Average Cost Method This method assumes that we sell all our inventories simultaneously. The weighted average cost method is most commonly used in manufacturing businesses where inventories are piled or mixed together and cannot be differentiated, such as chemicals, oils, etc. Chemicals bought two months ago cannot be differentiated from those bought yesterday, as they are all mixed together. So we work out an average cost for all chemicals that we have in our possession. The method specifically involves working out an average cost per unit at each point in time

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1) Re order level it is the level of inventory in the store room at which an order should be placed with the supplier. It is usually fixed in a manner that shortages / stock outs are avoided. Formula of Re-Order level re-order level = Maximum daily or weekly or monthly usage Lead time
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Example : Two types of materials are used as follows: Minimum usage each Maximum usage each Normal usage each Re-order period or Lead time Material A: Material B:

20 units per week 40 units per week

60 units per week

3 to 5 weeks 2 to 4 weeks

Calculate re order point for two types of materials. Calculation: Ordering point or re-order level = Maximum daily or weekly or monthly usage Maximum reorder period A: 60 5 = 300 units B: 60 4 = 240 units
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2) Maximum level it is the level of inventory in the store room beyond which the inventory level can never cross during the year. Formula of Maximum level Maximum limit or level = Re-order level or ordering point + re-order quantity (minimum usage minimum delivery period)

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Example: Normal usage day Maximum usage Minimum usage Re-order period Economic order quantity

100 units per 130 units per day 70 units per day 25 to 30 days 5,000 units

Calculate maximum limit or level. In order to calculate maximum limit of stock we must calculate re-order point or re-order level first. Ordering point or re-order level = Maximum daily or weekly or monthly usage Maximum re-order = 130 30 = 39,000 units Calculation: Maximum limit or level = Re-order level or ordering point Minimum quantity used in re-order period usage + Economic order quantity = 3900 (70 25) + 5,000 = 7150 units

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3) Minimum stock level / Buffer stock / safety stock level it is the ideal inventory level at which the ordered material should be received.
Formula of Minimum stock level Minimum limit or level = Re-order level or ordering point Average or normal usage Normal reorder period

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Example Re-order Period = 8 to 12 days Daily consumption = 400 to 600 units Minimum Level = ? Calculation Minimum Level = Re-order Level - (Normal Consumption x Normal Re-order Point) = 7200 - (500 x 10) = 2200 units. Working Notes: 1. Re-order Level = Maximum consumption x Maximum Reorder Point = 600 x 12 = 7200 units 2. Normal consumption = (Maximum Consumption + Minimum Consumption)/2 = (600+400)/2 = 1000/2= 500 units 3. Normal Re-order Period = (Maximum Re-order Period + Minimum Re-order Period)/2 = (12+8)/2 = 10 days.
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4) Danger level it is the level beyond which material should not fall in any case. IF danger level arises immediate steps should be taken to replenish the stock even if more cost is incurred in arranging the material. IF material are not arranged immediately there is possibility of stoppage of work. Formula of Danger level Danger level = Average daily requirement Time required to get emergency supply
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Example Normal usage or average requirement 700 units per day Maximum usage 800 units per day Minimum usage 600 units per day Re-order period 25 to 30 days Time required to receive emergency supplies 4 Days Calculate danger level. Calculation Danger level = Average daily requirement Time required to get emergency supply = 700 4 = 2,800 units

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6) Economic order quantity - Economic order quantity (EOQ) is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the materials at the optimum level and at the minimum cost. In other words, the economic order quantity (EOQ) is the amount of inventory to be ordered at one time for purposes of minimizing annual inventory cost. The quantity to order at a given time must be determined by balancing two factors: (1) the cost of possessing or carrying materials and (2) the cost of acquiring or ordering materials. Purchasing larger quantities may decrease the unit cost of acquisition, but this saving may not be more than offset by the cost of carrying materials in stock for a longer period of time. The carrying cost of inventory may include:
Interest on investment of working capital Property tax and insurance Storage cost, handling cost Deterioration and shrinkage of stocks Obsolescence of stocks.

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Formula of Economic Order Quantity (EOQ):

A = Demand for the year Cp = Cost to place a single order Ch = Cost to hold one unit inventory for a year *=

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The ordering cost is constant. The rate of demand is constant The lead time is fixed The purchase price of the item is constant i.e no discount is available The replenishment is made instantaneously, the whole batch is delivered at once.

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Example

Pam runs a mail-order business for gym equipment. Annual demand for the Trico Flexers is 16,000. The annual holding cost per unit is $2.50 and the cost to place an order is $50. Calculate economic order quantity (EOQ)

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Calculation

A = 16000 Cp = $50 Ch = $2.50

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5) Average stock level The level of inventory held on an average during the year is termed as average stock level.

Formula of Average stock level Average Stock Level = Minimum Stock Level + of EOQ

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Example Re-order quantity = 2000 units Minimum Level = 500 units Average stock level = ? Calculation Average stock level = Minimum level + 1/2 x Re-order quantity = 500 + 1/2 x 2000 = 500+ 1000 = 1500 units.

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An analysis of a range of items that have different levels of significance and should be handled or controlled differently. It is a form of Pareto analysis in which the items (such as activities, customers, documents, inventory items, sales territories) are grouped into three categories (A, B, and C) in order of their estimated importance. 'A' items are very important, 'B' items are important, 'C' items are marginally important. For example, the best customers who yield highest revenue are given the 'A' rating, are usually serviced by the sales manager, and receive most attention. 'B' and 'C' customers warrant progressively less attention and are serviced accordingly.
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VED analysis divides items into three categories in the descending order of their critically as follows:

V stands for vital items and their stock analysis requires more attention, because out-of-stock situation will result in stoppage of production. Thus, 'V items must be stored adequately to ensure smooth operation of the plant.
'E' means essential items. Such items are considered essential for efficient running but without these items the system would not fail. Care must be taken to see that they are always in stock. 'D stands for desirable items which do not affect the production immediately but availability of such items will lead to more efficiency and less fatigue.VED analysis can be very useful to capital intensive process industries. As it analyses items based on their critically, it can be used for those special raw materials which are difficult to procure.

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Age of inventory indicates duration of inventory in organisation. It shows moving position of inventory during the year. If age of inventory is minimum it means, the turnover position of that particular item of inventory is satisfactory. If the age of any particular item of inventory, it indicates the slow moving of stock which may be due to lower demand for the product, inefficiency in shocking policy, excessive stocking etc. The excessive investment in stocks means, high investment is locked-up in inventory leads to lower profitability of the firm due to excess carrying costs. FNSD analysis divides the items into four categories in the descending order of their usage rate as follows:

'F' stands for fast moving items and stocks of such items are consumed in a short span of time. Stocks of fast moving items must be observed constantly and replenishment orders be placed in time to avoid stock-out situations.
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'N' means normal moving items and such items are exhausted over a period of a war or so. The order levels and quantities for such items should be on the basis of a new estimate of future demand to minimize the risks of a surplus stock.
'S' indicates slow moving items, existing stock of which would last for two years or more at the current rate of usage but it is still expected to be used up. Slow moving stock must be reviewed very carefully before any replenishment orders are placed. 'D' stands for dead stock and for its existing stock no further demand can be foreseen. Dead stock figures in the inventory represents money spent that cannot be realized but it occupies useful space. Hence, once such items are identified, efforts must be made to find all alternative uses for it.
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Inventory turnover is the ratio of cost of goods sold to average inventory. It is an activity / efficiency ratio and it measures how many times per period, a business sells and replaces its inventory again Formula of ITR: Inventory turnover ratio is calculated using the following formula: Inventory Turnover = Cost of Goods Sold Average Inventory Average Inventory is calculated as the sum of the inventory at the beginning and at the end of the period divided by 2. Cost of goods sold comes from income statement and inventory figures are obtained from the balance sheets at the beginning and at the ending of the accounting period.
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Just In Time (JIT) is a production and inventory control system in which materials are purchased and units are produced only as needed to meet actual customer demand. In just in time manufacturing system inventories are reduced to the minimum and in some cases are zero. While inventories provide buffers against unforeseen events, they have a cost. In addition to the money tied up in the inventories, expert argue that the presence of inventories encourages inefficient and sloppy work, results in too many defects, and dramatically increase the amount of time required to complete a product.
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The main benefits of just in time manufacturing system are the following: 1) Funds that were tied up in inventories can be used elsewhere. 2) Areas previously used, to store inventories can be used for other more productive uses. 3) Throughput time is reduced, resulting in greater potential output and quicker response to customers. 4) Defect rates are reduced, resulting in less waste and greater customer satisfaction.
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Harley Davidson Toyota Motor Company General Motors Ford Motor Company Manufacturing Magic Hawthorne Management Consulting Strategy Manufacturing Inc.

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