MANAGEMENT OF INVENTORIES - Accounts and Finance for Managers

Meaning of Inventory

The inventory includes the following :

  • Stock of raw materials: It means that the value of the raw materials stored for the purpose of production in the storage yard. The stock of raw materials can be classified normally into two categories viz opening stock and closing stock of raw materials.
  • Stock of work in progress: During the production process, the firm usually stores the semi finished goods which are neither a raw materials nor finished goods. The purpose of the storage of work in progress in order to shorten the time duration to manufacture the finished goods. The value of the semi finished / work in progress stored in the storage house may be classified into two categories viz opening stock and closing stock. The finalizing the value of the stock of the work in progress is inevitable process in transfer pricing. The value of the work in progress normally expressed in two different ways viz on the basis of prime cost and works cost.
  • Stock of finished goods: This is the stage at which the goods are readily available for selling in the market. The value of the stock of the goods is computed on the basis of cost of production.
  • Stock of Stores supplies, components and accessories.
    stock-of-suppliers

Why inventory is to be controlled ?

The ultimate purpose of controlling the inventory arises only due to the conflicting and heterogeneous objectives of the various functional departments of the organizations. How inventory influences the various department of the organization ? Normally, the inventory influences on the following departments viz Production Purchase, Finance and Sales department How it influences the various departments at a time together.

On/of the Production department: The manager production frequently insists the organisation to maintain the continuous and uninterrupted supply to have smooth flow production. This requires the production manager to build ample stock of raw materials. This is routed through the purchase requisition by the manager production to the purchase manager.

Less the stock of raw materials and accessories - Risk of Lock out due to insufficient quantities and vice versa

On/of the Purchase department: Due to the influence from the production manager, the purchase department is demanded to procure the requirements. As per the requisition of the production department, meeting the requirements is not tough task but the department should know about the financial intricacies of the organisation through the finance department which is especially meant for the purpose.

Lesser the quantum of purchase will lead to lesser financial commitment but expected to loose the benefits out of the bulk procurement. Not advisable for the materials which are in scarcity.

Lesser the quantum of purchase - Greater will be cost of procurement and lesser will the economic benefits and vice versa

On/of the Sales department: Due to the market pressure/greater demand of the products require the sales department to supply the goods in time as well as to meet the needs and demands of the intermediaries and consumers. To supply them in time, the sales manager need not wait for the production cycle to be completed to produce the finished goods. To save time, the sales manager must be given ample facility to store the finished goods in the depot not only to meet the needs but also traps and drags the existing customers and consumers.

More the stock of the finished goods - Better the position for the firm to meet the needs of the biz environment and more the cost of storage and investment on the current assets and vice versa

On/of the Finance department: Due to influence from the department of the production, purchase and sales departments, the finance department is required to concentrate on the various angles.
It is the only department bearing a difference of opinion in maintaining more volume of inventory in the firm; which certainly slashes the earning capacity of the firm due to least volume of assets deploy on the productive purpose.

Lesser the inventory - Higher the risk in meeting the needs of production, purchase and sales - but better the return of the firm.

For e.g. The famous MNC Jindal Corporation Ltd. has wound up its operations at industrial site in Bangalore due to the cost of raw materials cost. The transportation cost, acquisition cost of copper ore gone up due to escalated cost in the biz market. They were neither to store nor to transport more and more which led to the winding up of operations of the enterprise at Bangalore.

The following diagram will obviously facilitate the Inventory Control:

Inventory Control

Inventory control: Inventory control means that maintenance of desired level of inventory by way of taking into the economic interest of the firm.

The economic interest of the firm differs from one functional dept. to another due to the heterogeneous objectives. The economic desired benefits of the dept. are illustrated to the tune of the preceding illustrated diagrams.

Production department: Benefits towards less production cost through mass production.

Purchase department: Benefits towards discounts, carrying cost and so on.

Sales department: Timely supply of the goods to the requirements, facilitates the firm to earn greater volume of earning. To reduce the operating cycle in duration in order to realize the economic benefits as early as possible.

Finance department: Benefits towards the carrying cost, storage cost of the entire inventory.

Major Benefits of Inventory Control

  • It leads to effective utilization of funds only through an appropriate investment on inventory
  • It facilitates to obtain the economic supply of raw materials
  • It possess the firm comfortably to meet the needs and wants of the consumers in time
  • It neither allows the firm to undergo the practices of overstocking nor understocking.
  • It leads to effectiveness in the material handing which reduces the wastage, pilferage and so on.

Before discussing the methods of inventory control, every one must obviously understand the organization of the stores department. The stores department is the only department which applies all the techniques of inventory control.

The organization of the inventory control are various in dimensions . The organization of differs from one industry to another industry, one firm to another within the same industry, from one nature to another, from volume to another. They are as follows:

Centralised stores
Decentralised stores
Central and Sub stores

Centralised Stores

Under this type, the materials are received by and issued at one central place by the department to the requirements of the other functional departments.

The following diagram will facilitate to understand the organisation structure of the centralized stores of the manufacturing department. The materials are continuously received by the stores dept. through the purchase department and the received material are distributed to the various assisting departments.

Centralised Stores

This type of organization of stores control has its own advantages and disadvantages in application
The major advantages are following:

  • It requires less space
  • It facilitates to minimize the stock investment
  • The centralization leads to lower administrative and maintenance cost of stores

In addition to the advantages, the present organization suffers with its own limitation while in applications; which are following:

  • The centralization of stores leads to enhance the cost of transportation as well as handling cost of materials.
  • The centralized system leads to lot of inconvenience and delay to other department due to distance
  • There is a greater risk of calamity loss of materials which are stored under one roof
  • The success is subject to the effectiveness of the transportation

Decentralised Stores

Under this method, the separate stores are maintained by the departments on their own as well as run by the exclusive store keeper. It ensures the smooth flow material to the tune of requirements and reduces the time involved in the transit of materials from the stores to the respective departments. The following diagram will facilitate to have an insight on the organization of the stores.

Decentralised Stores

Central stores and Sub stores

This is a method which attempts to discard the bottlenecks of the above mentioned as well as brings forth unique organization of stores. Under this method, each department is given separate sub store which is within easier access and shorter in distance to supply the material requirements through the store keeper. The sub store keeper should have to make requisition to central stores where all the materials are centrally procured and supplied then and there to the tune of the individual departments.

Central stores and Sub stores

The role of the store keeper is most inevitable in controlling the stores. While controlling the stores, the store keeper should neither disturb the production process nor undergo the practices of overstocking. By earmarking the above enlisted objectives, every store keeper is led by the various methods of inventory valuation in addition to various methods of requisitioning of material.

First we will discuss, the various methods of requisitioning of materials.

Reordering Level

This is the level at which the firm should go for fresh purchase requisition of material through the store keeper to meet the requirements. The reordering level which takes into consideration of minimum level of consumption of raw material during the course of production process as well as the amount material required by the firm during period of purchase and goods in transit immediately after the order.

Reordering Level

Reordering level=Minimum level of stock for uninterrupted flow of production process
+
Amount of materials required during the periods of consumption
Or
Lead time stock level
Alternate method is available by using the maximum consumption and maximum reorder period
Re ordering level= Maximum consumption × Maximum Re- order period

This method registers the maximum consumption of the firm during the production as well as the maximum time period required for the supply of required materials.

Under this alternate approach, the firm at any moment will not face any difficulties due to short supply or insufficient amount of materials.

Minimum Level/Safety level

The firm should at always maintain minimum amount of material in its hands to facilitate the flow of production process as unaffected .due to short fall in the quantum of materials.

The following points are most important in designing the minimum level of stock:

  • Lead time should be predominantly considered to determine the time lag in between the materials ordered and received. The firm should find out the practical difficulty of the vendor in supplying the material for the determination for minimum level of stock.
  • Amount of consumption of the material during the lead time

Minimum stock level=Reordering level- (Normal level consumption × Normal Reorder period)
Minimum level = Reorder level + (Average level of consumption × Average Reorder period)
Average and normal level of consumption are synonymous with each other. If normal or average consumption is not given, the formula is as follows

Average consumption=

Minimum level consumption + Maximum level consumption
2

Maximum Level

This is the level at which the firm holds maximum quantity of materials as stock during the process. The ultimate aim of fixing the level of maximum level is that to avoid the overstocking. If the stock level of the firm exceeds the maximum level already fixed is known as overstocking level of the firm, more than the requirement.

Why over stocking is considered not advisable ?

  • It leads to excessive investment on inventory more than the requirement
  • It leads to unnecessary wastage of the materials due to excessive stock
  • The excessive storage of materials may certainly affect the price of the product

Maximum stock level= Reordering level+ Reordering quantity -(Minimum consumption × Minimum Reordering period)

Danger level

At this level, the firm should not further issue any materials to the various functional departments .At the danger level, the purchase department is vested with greater responsibility to immediately arrange the supply of raw materials in order to maintain the flow of production as uninterrupted.

The consumption level of the materials is getting varied from one time period to another. During the specified period, there may be maximum consumption and minimum consumption, which should be averaged to find the mid point in between the two, in order to either fulfill the minimum consumption or maximum consumption to the extent possible.
Why the maximum reorder period is taken into consideration?
The purpose of considering is that the greater period taken by the supplier to supply the required materials
Danger Level= Average consumption × Maximum reorder period

Average Stock Level

Average stock level =Minimum stock level + ½ of the reorder quantity

Economic Ordering Quantity

The ordering of materials usually tagged with three different component of costs viz:

  • Acquisition cost of materials
  • Ordering cost of materials
  • Carrying cost of materials

The ordering quantity of materials may be either larger or meager in volume, which carries its own advantages and disadvantages.
If the quantity ordered is larger in volume, the following are some of the important advantages:

  • The bulk purchase order reduces the ordering cost of the materials. The greater the size of the order which leads to reduce the number of the orders in procuring the materials.
  • Quantity discounts: The discount can be classified into two categories viz Trade discount and Cash discount .
  • What is trade discount ?

Trade discount is the discount granted by the supplier to the buyer of materials at the moment of bulk purchase. This % of discount is greatly possible only during the periods of greater volume of purchase; which reduces the over all cost of the acquisition.

If the quantity is procured in meager volume, the following are construed as advantages:

  • The carrying cost will come down in the case of lesser inventories
  • The cost of storage is lesser as far as the meager quantities of materials
  • Loss due to deterioration, obsolescence, wastage will be minimum
  • Insurance cost is less due to meager volume of materials

Economic Ordering Quantity

2AO
1

A = Annual requirement in units
O = Ordering cost
I = Cost of storing per year or cost of carrying the inventory

Economic Ordering Quantity

Illustration :

Annual Requirement =20,000 units
Ordering cost= Rs.100 per order
Cost per unit =Rs.4
Carrying cost =16%
Determine the EOQ of the firm and finally justify the EOQ

Economic Ordering Quantity=

2AO
1

=

2 *20,000 *Rs.100
0.16% on Rs.4

= 2,500 units

Annual requirement of 20,000 units

Illustration :

Calculate EOQ
Annual Requirement -1600 units
Cost of materials per unit Rs.40
Cost placing and receiving -Rs.50
Annual carrying cost of inventory -10% on value

Economic Ordering Quantity=

2AO
1

=

2 *1600 *Rs.50
10% on Rs.40

= 200 units

Illustration :

Consumption during the year -600 units
Ordering cost Rs. 12 per order
Carrying cost 20%
Price per unit Rs. 20

Economic Ordering Quantity=

2AO
1

=

2 *600 *Rs.12
20% on Rs.20

= 60 units

Illustration :

A manufacturer purchases certain machinery from outside suppliers Rs.60 per unit. Total annual needs are 800 units. The following are the additional information
Annual return on investments 10%

Rent, insurance, taxes per unit per year Rs 2 Working Capital Management
Cost of placing an order Rs.200
Determine the economic order unit
First step to find out the earnings= 10% Rs.60= Rs.6 to be earned from the investment
The amount of rent , insurance , taxes per unit year =Rs 2
I= 10% on Rs.60 + Rs.2= Rs.8

Economic Ordering Quantity=

2AO
1

=

2 *800 *Rs.200
10% on Rs.60+2

= 200 units

Illustration :

Given the annual consumption of material is 1,800 units, ordering costs are Rs.2 per order, price per order price per unit of material is 32 paise and storage costs are 25% per annum of stock value, find the economic order quantity.

Economic Ordering Quantity=

2AO
1

=

2 *1,800 *Rs.2
25% on 32paise

= 300 units

Illustration :

Find out the Re ordering level from the following information
a) Minimum stock 1000 units b) Maximum stock 2000 units c) Time required for receiving the material 20
days d) Daily consumption of material 100 units
Reordering level = Minimum level + Lead time stock level
The first step is to find out the Lead time stock level

Lead time stock level is nothing but the amount of stock level required by the firm, till the next fresh receipt of goods, subject to the time normally taken by the supplier to supply.
Lead time stock level= Time required for receiving the material × Daily consumption
Lead time stock level= 20 days * 100 units per day= 2000 units
Reordering level= 1,000 + 2,000 units= 3,000 units

Illustration :

Calculate maximum level, minimum level and reordering level from the following data

Reorder quantity 2,000 units
Reorder period 8 to 12 weeks
Maximum consumption 800 units per week
consumption 600 units per week
Minimum consumption 500 units per week
Reordering level = Minimum level + Lead time stock level
Or
= Maximum consumption * Maximum lead time
Minimum level= Reordering level – (Average consumption * Average lead time )
Maximum level= Reorder level + Reorder quantity – (Mini consumption * Mini Leadtime)
First step is to find out the Re ordering level
Reordering level = 800 units per week * 12 weeks= 9,600 units
The next step is to find out the Maximum level
Maximum level = 9,600 units + 2,000 units - (500 units * 8 weeks)
= 11,600 units- 4,000 units =7,600 units

The next step is to find out the minimum level. For that Average consumption has to be found out. The average consumption is nothing but normal consumption. The normal lead time period is the average of minimum and maximum re order period of the firm in getting the supply of the materials from the suppliers
Minimum level = 9,600 units – (600 units * 20/2)
= 9,600 units – 6,000 units= 3,600 units

Illustration :

Two components A and B are used as follows
Normal usage 50 units per week each
Minimum usage 25 units per week each
Maximum usage 75 units per week each
Re order quantity A: 300 units
B: 500 units
Re order period A: 4 to 6 weeks
B: 2 to 4 weeks
Calculate for each component
(a) Re order level (b) Minimum level (c) Maximum level and (d) Average stock level
First step is to find out the Reorder level for both A and B components

The maximum usage is common for both A and B components but the reorder period are different from each other
Reorder level = Maximum consumption /usage * Maximum Reorder period
(A)=75 units * 6 weeks= 450 units
(B)=75 units * 4 weeks= 300 units
The next step is to determine the Maximum level of both Components A and B
Maximum level = Reordering level + Reordering quantity – (Mini Consumption * Mini Lead time)

Minimum level

Illustration :

The following information is available in respect of components of R * 100
Maximum stock level 10,000 units
Budgeted consumption Maximum 3,000 units per month
Minimum 1,600 units per month
Estimated delivery period Maximum 4 months
Minimum 2 months
You are required to calculate
Re-order level
Re-order quantity
Re order level = Maximum consumption * maximum lead time
= 3,000 units * 4 months=1,200 Units
The Reordering quantity could be found out with the help of Maximum level equation
Let us assume Re ordering quantity =X
Maximum level = Re-ordering level + Re-ordering quantity - (Minimum consumption * Mini Re order period)
= 1,200 units+ (X)-(1,600 units ´ 2 months)
(-X) = 1,200 units-3,200 Units
= –2000 units
X = 2,000 units

In the stores control, there are two important documents viz Bin card system and stores ledger.

Bin Card: Bin card is a record prepared by the store keeper at the moment of issuing and receiving the materials. It is maintained by the store keeper for physical verification with accuracy and effectiveness. The inventory control can be accessed through physical verification then and there, whenever the situation warrants.

The bin card system is adopted by many firms for their inventory control either in the form of bin tag or stock card hanging outside the rack in order to portray the information immediately to facilitate the store keeper to understand the stock position of the store room. The bin card system is available in two major categories viz:

Two Bin card system: Under this system two different bins are used. As soon as the goods or materials received by the store keeper, that should be recorded in terms of quantities. One among the two should be maintained for Re order level and minimum level another for Maximum stock level.

To alarm the firm neither to store more than the maximum level nor to issue less than the minimum level of the stock. If the firm once reaches the maximum level, it should immediately caution the implications due to the overstocking. The same firm, if reaches the minimum level of stock, it should not go for further issue of materials to functional department or otherwise, the firm's production may be disturbed due to the poor stocking.

Three-Bin-Card-system

Three Bin Card system: It is an extension of the early method, which incorporates the lead time stock level in addition to the other level viz Maximum, Reorder and Minimum level of the stock. Among the three, two cards are exclusively used by the firm in order to maintain the appropriate stock level, i.e., for maximum stock level and minimum stock level. The firm should neither to store beyond the maximum level nor to issue less than the Minimum level. In between, a separate bin card is used only for the Reorder level and Lead time stock level at which the firm should go for the placement of an order to get fresh delivery of materials and facilitate the firm to undergo production without any interruption by considering the time taken by the supplier to supply the ordered materials.

Three Bin Card system

Some other methods of the inventory control
There are few models exercise the inventory control, which facilitates the firm to avoid either under or over stocking.

  • ABC Analysis
  • VED Analysis

ABC analysis

Normally the materials are classified on the basis of the following covenants viz:

  • Volume and
  • Value

Based on the basis the materials are classified into three categories:

  • Lesser percentage in volume and Greater percentage in Value- Category A
  • Greater percentage in volume and Lesser percentage in Value - Category B and
  • Percentage in volume and Percentage in value are more or less - Category C

This will be explained with the help of following example for insight.
A store has 4,000 items of consumption and a monthly consumption of Rs 20,00,000. 320 items will have a consumption of Rs.15,00,000. 500 items will account for Rs 4,00,000 and 2,680 items consume material worth Rs.1,00,000 only.

Table-of-Items-and-value

How the control of the inventory is being exercised ?

  • Group A items are high valued items among the other items of the enterprise, require greater monitoring and controlling.
  • Group B items are comparatively lesser in value among the three items given next to the Group A, require less rigid control and monitoring.
  • Group C items are the major volume of items among the 4000 items of the enterprise which are least in value, need very little control and monitoring.

The following of control of inventory on A, B and C items of the enterprise:

control of inventory on A, B and C

From the above table, it is obviously understood that the items which have greater % (75%) in the total value requires rigid control than any other quantity of materials. The Group C items are bearing 67% of total consumption amounted which 5% of total value of the items procured by the enterprise.

The-Unique-features-of-the-ABC-analysis

Advantages

  1. It guides the management to exercise the control based on the value of goods to the total composition.
  2. Systematic inventory control can be exercised through this analysis on the basis of value of the materials. The high value materials of Group A are rigidly controlled which finally led to lesser investments.
  3. Scientific system facilitates to lessen the storage cost of the inventory.

VED analysis

VED analysis is applied for the inventory control of the manufacturing enterprise.
V-Vital
E-Essential and
D-Desirable
The spare parts are classified into vital, essential and desirable to the crucially to the production.


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