608

Financial Management
Inventory inventory management occupies the most significant position in the structureture of
of workino .
Management:
sum of
The Management of inventory may be defined as the sum of total of those activities necessar capital working
total of for the
those activities acquisition, storage, disposal or use of [Link] is one of the important
necessary for the current assets.
Inventory management is an important area of working capital management h
componer componen
acquisition; plays a crucial role in economic operation of the firm. Maintenance of
large size of inuan
storage disposal requires a considerabte amount of funds to be invested on them. Efficient and
or use of
effective inven
materials. management is necessary in order to avoid unnecessary investment and inadequate investmenttory
A considerable amount
of funds is required to be committed in inventories. It
is absolutel
imperative to manage inventories efficiently and effectively in order to
optimise investment in
management is one of the challenging tasks of the financial manager. the
Prudent inventory
management of inventory reduces the cost of production and Eficient
of the consequently increases the profitability
enterprise by minimising the different types of costs assOciated with
undertaking, neglecting the management of inventories, will be holding inventory. An
and may fail jeopardising its long-term
ultimately. It is possible for a firm to reduce its level of inventories to a profitability
degree, i.e., 10 to 20 per cent of current assets without adverse
effects
considerable
using simple inventory planning and control production and sales by on

may succeed even in attaining the "Zero [Link] business planning can be
perfect, a firm
to suggest, is not too inventory") norm which the
unrealistic a goal. The reduction in inventories Japanese management seems
the company's carries a favourable
profitability. The efficiency of inventory management in impact on
inventory management practices adopted by it. any firm depends on the
MEANING AND DEFINITION OF
Inventory: The INVENTORY
aggregate of raw The term "Inventory" has originated from the French
materials; work- Inventariom" which implies a list word "Inventaire" and the Latin word
in-process; American Institute of of things found. The term inventory has been defined by the
finisned goods Accountants) as
which (a) are held for sale in the ordinarythe aggregate of those items of
of business, (b) are in thetangible personal property
and stores and
Spares. such sales, or (c) are to course
be currently consumed in the process of production tor
for sale. The term
inventory refers to the production of goods or services to be availadie
stockpile of the
components product. Inventories are products
that make up the a firm is
the stocks of the
offering for sales and ne
manufacturing for sale and the components that make up the product of a company
inventories exist in a manufacturing product. The various forms in wnl
company are: (i) raw materials,
goods, and (iv) stores & spares. However, in (ii) work-in process. (ii) finisi
raw materials, work-in-process and finishedcommercial
goods. Theparlance,
term inventory includes
inventory usuallyraw maicores
includes S
work-in-process, finished goods packaging, spares and
demand or distribution in the future. others stocked in order to meet an
unexP
Components of
COMPONENTS OF INVENTORY
Inventory: Raw From the above definitions,
can draw the we
materials, work- which inventories exist in a components of inventory. The
in-process, and stores and spares. manufacturing firm are, raw
materials, work-in process,various
finished goods, Figure 22.I gives the finis
goods,

and stores & 1. Raw Materials: Raw materials components.

spares. are those
throughthe manufacturing process. These
inputs that are converted into
Tn
goods

In other words, they form a major input for roducd

2
are
very much needed for manufacturs
uninterrupted production
Work-in-Process:
andfinished goods. Work-in-process is that stage of stocks that are
t h e p r o d u c t s t h a t n e e d t o u n d e r g o s o m e o t h e r p r o c e s s t o b e c o m e f i n i s
c h
t s
e d T
ghoW e ymreaptreersie
a n
ls

Work-in-process inventories
are'semi-finished betweel producS ds
 v e nt o r y M a n a g e m e n t 609
Inve
Componentsof Inventory
Figure 22.1
Components of

Inventory

Raw Materials
Work-in-Process Finished Products Stores & Spares
Products: nished products are those products, which are ready for sale. The
Finished
4 stock offinished goods provides a buffer between production and market.

Stores & Spares: spares inventory (include office and plant cleaning materials
Stores &

Oil, fuel, light, bulbs, etc.) are those purchased and stored for the
ike, soap, brooms,
maintenance of machinery.
purpose of
INVENTORY MANAGEMENT MOTIVES

involve block of funds and inventory holding costs. Maintenance of Speculative

inventories Motive: Holding9
Managing motives for
then why do firm hold inventories?. There are three general inventory to take
ventory
nve
is expensive, the advantage of
holdinginventories changes in prices
production
includes of goods and sale of goods. and getting
1. Transaction Motive: Transaction motive
and delivery of order at given time (right time).
a
quantity
It facilitates uninterrupted production
discounts.

inventories for unexpected

motive necessitates the holding of
2. Precautionary Motive: This
demand and supply factors.
changes in
inventories to take the advantage of
to hold some
3. Speculative Motive: This compels discounts.
quantity
changes in prices and getting
MANAGEMENT
INVENTORY
OBJECTIVES OF
are operational
and Objective of
management may
be viewed in two they Inventory:
ne objectives of inventory to meet demands for product
maintain sufficient inventory,
Management is to
The operational objective is to view is to minimise maintain sufficient
NCal. and sales operations and financial
firm's production inventory and
Ently organising the costs. reduce inventory
ICIent inventory and reduce inventory carrying of carrying costs.
be expressed in termscan also
management
objectives of inventory investments in inventory
CSe two conflicting The firm should maintain
lower the carrying
associated with inventory.
imal benefits such that smaller the inventory,
involves cost, production. An
aintaining an inventory the smooth functioning ofthe
Costand facilitates (benefits)
efVce versa. But inventory
efective inventory management should:
supplies to facilitate uninterrupted
materials and
Sure a continuous supply of raw

production; periods of
short supply and anticipate
price
materials in
of raw
intain sufficient stocks
and efficient
changes; inventory for smooth
sales operation,

finished goods
insufficient

customer service;
ana
mise the carrying costs and time; level.
an optimum
i n v e n t o r i e s and
keep it at
rol investment in
 613
ory Management
nventory Manag

OLS AND TECHNIQUES OF INVENTORY cONTROL

TOOL

hould aim at optimum inventory level formaximising shareholders' wealth.

Financialmanager

mination and
determination and maintenance of optimum inventory level, helps maximise owner's
n o t h e rw o r d s ,
ana gement problems can be handled by sophisticated/refined mathematical
t h .I nventory
orproblematic areas of inventory management are (a) classification problem to
problem.

major
The required. (b) the order quantity problem,(c) the order point problem, and
ues. control requi.
e offety stocks. But these are more suitable areas of production and operations
enethe ypE
ydeterminationof needs to be familiar with these
scope of this book. Financial manager
off tthe
involves financial costs. Use of a particular technique
out
and

inventory management
ement
manager ase the firm the ultimate
oftthe company. Whatever techniques are used by
becau:

techniques venience
of
minimum
service at a
the c o n is to provide maximum customer
on
d e p e n d so r
control programme discussed.
been
inventory control techniques have
ventory

ective ofin some ofthe

th
various items of inventory
following,
the used techniques to identify ABC analysis:
one of the widely
Cost
[Link] is: This is
Analysis: and useful tool for
classifying, Inventory control

control. In other words,

it is a very effective the
of control on all
tool t h a t

nose of inventory should not keep s a m e degree

inventories. The firm
categories
Control.
h ep u r p o
of as Selective
Inventory inventory into
tari and control Law. It is also known
A,
on P a r e t o ' s with the comparison three groups
ventory. It is based items whose
value is the highest, and C, in
n in
items
of maximum
c o n t r o l on
those
items and is also
known as
Control B,
descending order
important
The firm should put
items. The
technique
concentrates on
to maintain
several types ofinventories, of importance of

two a firm has their relative control.

other Usually instance of
inventories in the
afthe |CEJ,0
and Exception have to classify this technique.
h nportance control of
them, firm should
Value Analysis
(PVA). According to
three categories
Proportional items into
for proper known a s inventory
it is also of
classification all shown in
Table 22.1.
value. Hence is the proper items is end
management
c a t e g o r i s a t i o n of
inventory control. At
the other
the task ofinventory The ideal be under tight
and C category. and would afford e x p e n s e s
'A items' firm c a n n o t
namelyA, B are
c l a s s i f i e d as
this types ofin
ventory Thus.
amounts.

value items ' C i t e m s ' , on value o r low

Thehigher find category
classification we
because of
order m o r e
the low months of supply,
of the and expending, stocks, and require
ordering safety
s o m e w h a t higher
and'Citems

frequent 'A item'

ngid controls, w e may m a i n t a i n
07 items' fall in between
WIN the "C items', s e r v i c e . 'B
customer
levels of
prct lower
attention of
management. of Inventory
Teasonable Categorisation Item Value (%)
Table 22.1
Items (%) 70
No. of
20
Category
30 10
55
100
cent of the
100 for 70 per
a c c o u n t

cent of items
i t e m s may 55 per
Total of the less
whereas

cent required, will be paid

15 p e r is items),
only of inventory
Theabove table indicatee s that
attention
category
value
which
greater
inventory
(C of
total
the two
otal value on of
cent between

[A categor ltems],
total
value for 20 per value
lies
of the
account

Y account for p
10 e
perr cent

ofin
ventory
as
this,
category

22.2.
te e r cent
Figure
The remaining
ng
30
3 per
0p
cent
le attention
r e a s o n a b l e
attention

the
following

oherategory
c items) "
De paid a shown by
can
be
legories. The above
8

Value ofitems (%)

ItemA
-

Item B

Item C

-----

8
 ntory Management

615

2AO
EOOCC
Where:
A
=Annual usage
O-Ordering cost per order
carrying cost per unit CC = Price
rice per unit
CC Annual. x
Carrying cost per unit in percentage
simple formula will not be
sufficient to determine E0Q when more complex cost
The
e q u a t i o n sa r e i n v o l v e d .

annlicable
EOQi sapplicableiboth to single items and to any group of stock items with similar holding and
the sum of the two costs to be lower than under
costs. lts
uses

ordering
any other
of system
replenishment.

Limitations of EOQ

from th
Apart from the above application it has its own limitations, which are mainly due to the restrictive Constant usage is
on which it is based.
of theassumptions the main
nature
limitation of EOQ
Constant Usage: It may not be possible to predict, if usage varies unpredictably, as it tool.
formula will work well.
often does, no

Faulty Basic Information: Ordering and carrying costs are the base for calculation
EOQ. It assumes that ordering cost is constant per order, but actually varies from
commodity to commodity. Carrying cost can also vary with the company's opportunity
cost of capital
Costly Calculations: In many cases, the cost estimation, cost of possession and acquisition
and calculating EOQ exceeds the savings made by buying that quantity.

then at what level of inventory should

[Link] Point Problem: After determination of EOQ,
level is too high it will unnecessarily block the capital, and if the
the order be placed?. If the inventory
stock-out and also involves high ordering cost.
level is too low, it will disturb production by frequent
maintain optimum inventory level, where
Hence, efficient management of inventory needs to
an
The different stock levels are (a) Minimum level,
there is no stock out and the costs are minimum.
stock level, and (e) Danger level.
(6) Re-order level, (c) Maximum level, (d) Average
for smooth
that level that must be maintained always
(a) Minimum Level: Minimum stock is stock level,
While determination minimum of
flow How to fix minimum level?
production.
material nature must be considered.
ead time, consumption rate,
date of
to receive the inventory from the
Lead-time is the number of days required time of inventory.
called as procurement
placing order. Lead time is also rate is
consumed daily. The consumption
r a w materials
The average quantity of
and production plan.
calculated based on the past experience
regular production
or special order
normal or
Kequirement of materials for order production, then
theminimum
is required for special
Ifthe material
production.
stock level need not be maintained.
level-[Average Usage * Average delivery time]
Re-order
Minimum stock level
=

at which an order should be

inventory Re-order Level:
(6 that level of level lies
Level: Re-order level is Generally, the
re-order The level of
rder current stock of inventory. inventory at which
Or replenishing the stock level.
hat an order should
and maximum
minimum stock level be placed.
cen usage
x Average Daily

Re-order oint Lead time (in days)

616 Financial Management
assumption that
consistent usage, and Fixed lead
The above formula is based on the ime.
and lead-time is difficult. Raw mat
Safety Stock: Prediction of average daily usage it is the case for lead-i
d-time also. Lea erials
from week to week,
may vary from day to day or faces problem af
increases, then the company
time may be delayed if the usage stock
to maintain sarety stock. Formula (und.
out. To avoid stock out, a firm may require nder
uncertainty of usage and lead time).
stock
Re-order point = (Lead time(in Average usage) + Safety
days) x

Maximum Level: Maximum level of stock, is that level of stock beyond which a fir
(c) should not maintain the stock. If the firm stocks inventory beyond the maximum stoel.
level it is called as overstocking. Excess inventory (overstock) involves heavy costof
inventory, because it blocks firms funds in inventory, excess carrying cost, wastape
obsolescence, and theft cost. Hence, firm should not stock above the maximum stock
level. Safety stock is that minimum additional inventory to serve as a safety margin or
better or buffer or cushion to meet an unanticipated and increase in usage resulting from
an unusually high demand and or an uncontrollable late receipt of incoming inventory,

Maximum Stock Level Reorder Level +Reorder Quantity (Minimum Usage x

Minimum Delivery Time)

(d) Average Stock Level:

Average Stock Level = Minimum level + [Reorder Quantity + 2

(e) Danger Stock Level: Danger level is that level of materials beyond which materials
should not fall in any situation. When it falls in danger level it will disturb production.
Hence, the firm should not allow the stock level to go to danger level if at all it falls in that
level then immediately stock should be arranged even if it is costly.
Danger Level = Average Usage x Minimum Deliver Time [for emergency purchase]
Two-Bin
Technique: 4. Two-Bin Technique: It is one of the oldest techniques of inventory control. Generally, it is
Inventory control used to control C' category inventories. According to this technique, stock of each item is separated
tool in which
order for
into two pipes, bins or groups. irst bin contains stock, just enough to last from the date a new order
inventory is is placed until it is received in inventory. The second bin contains stock, which is enough to meet
placed current demand over the period of replenishment. First stock is issued when the first bin stock is
immediately after
the first bin is completed. then an order for replenishment is placed, and the stock in the second is utilised until the
empty. ordered material is received.

Classification: According to this classification inventories are grouped based on

5. VED
u
effect on production and inventories are grouped into three, they are Vital, Essential and Desirable
inventories. Itisspecially used for classification of spare parts. If a part is vital, in production. thenit
is classified as V', if it is essential, then it is assigned 'E' and if it is not so essential, desirable that is
given 'D. V category item are stocked high and category 'D' items are maintained at m

level
minna

HML Techniques: 6. HML Classification: Here the materials are classified based the unit value and not the
It classifies
annual usage value. The inventory is
on u
materials into classified into three categories such
three groups H , Low, it is adopted in selective inventory control
as
as High, Medl e
M and L in
(ABC) technique. The inventory items shou
listed in the descending order of unit value and it is up to the hree
descending management to fix limits torlevels.
u
annual usage categories. This classification 1s useful for keeping control over consumption at departmental ic
value. for deciding the frequency of physical verilication, and for controlling
purchases.