Essentials of Inventory Management – Types | Cost | Techniques

Inventory Management is the process of ordering, storing, using, and selling a company's inventory. This includes the management of raw materials, components, and finished products, as well as warehousing and processing of such items. Effective inventory management helps businesses minimize the costs associated with holding inventory while maximizing sales and profits. It's a crucial component for any business that handles physical goods, helping ensure that the right amount of inventory is available at the right time and in the right place to meet customer demand.

Table of Contents

1. Introduction
2. Types of Inventories
3. Inventory Management
4. Reasons and Benefits of Inventories
5. Costs of Inventory
6. Techniques of Inventory Management

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1. Introduction

“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 are assets of the firm and require investment and hence involve the commitment of firm’s resources. The inventories need not be viewed as an idle asset rather these are an integral part of firm’s operations. But the question usually is as to how much inventories be maintained by a firm? If the inventories are too big, they become a strain on the resources, however, if they are too small, the firm may lose the sales. Therefore, the firm must have an optimum level of inventories. Managing the level of inventories is like maintaining the level of water in a bathtub with an open drain. The water is flowing out continuously. If water is let in too slowly, the tub is soon empty, it water is let in too fast, the tub over flows. Like the water in the tub, the particular item in the inventory keeps changing, but the level may remain the same. The basic financial problem is to determine the proper level of investment in the inventories and to decide how much inventory must be acquired during each period to maintain that level. The present chapter attempts to discuss different aspects of inventory management.

2. Types of Inventories

The inventory means and includes the goods and services being sold by the firm and the raw materials or other components being used in the manufacturing of such goods and services. A retail shopkeeper 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 of the business firms may be classified as finished goods, work-in-progress and raw materials.

2.1 Finished Goods

These are the goods which are either being purchased by the firm or are being produced or processed in the firm. These are just ready for sale to customers. Inventories of finished goods arise because of the time involved in production process and the need to meet customer’s demand promptly. If the firms do not maintain a sufficient finished goods inventory, they run the risk of losing sales, as the customers who are unwilling to wait may turn to competitors. The purpose of finished goods inventory is to uncouple the production and sales function so that it is not necessary to produce the goods before a sales can occur and therefore sales can be made directly out of inventory.

2.2 Work-in-Progress

It refers to the raw materials engaged in various phases of production schedule. The degree of completion may be varying for different units. Some units might have been just introduced, while some others may be 40% complete or others may be 90% complete. The work-in-progress refers to partially produced goods. The value of work-in-progress includes the raw material costs, the direct wages and expenses already incurred and the overheads, if any. So, the work-in-progress inventory contains partially produced/completed goods.

The quantity and the value of work-in-progress depend on the length of the production cycle. In the case of a shorter production cycle, the work-in-progress may be small, but if the production cycle is lengthy, the firm will have a large work-in-progress. The more complex and lengthy the production process, the larger the investment in work-in-progress inventory. The purpose of work-in-progress inventory is to un-couple the various operations in the production process so that machine failures and stoppages in one operation will not affect the other operations.

2.3 Raw Materials

The raw materials include the materials which are used in the production process, and every manufacturing firm has to carry certain stock of raw materials in stores. These units of raw materials are regularly issued/transferred to production department. Inventories of raw materials are held to ensure that the production process is not interrupted by a shortage of these materials. The amount of raw materials to be kept by a firm depends on a number of factors, including the speed with which raw materials can be ordered and procured (the greater the speed, the lower the required inventory for raw material) and the uncertainty in the supply of these raw materials (the larger the uncertainty, the greater the need for raw materials inventory). Its purpose is to uncouple the production function from the purchasing function i.e., to make these two functions independent of each other so that delay in procurement of raw materials do not cause production delays and the firm can satisfy its need for raw materials out of the inventory lying in the stores.

The classification of a particular item as a finished goods or raw material depends on the kind of business being discussed. For a coal mining firm, coal is a finished good but it is a raw material for a steel mill as the coal is used in the production of steel. Similarly, steel is a finished good for a steel mill but it is a raw material for an automobile firm.

3. Inventory Management

It is already noted that the purpose of carrying inventory is to uncouple the operations of the firm i.e., to make each function of the firm independent of other functions so that delays in one area do not affect the production and sales activities. As the production shutdown results in increased costs and because the delays in delivery can result in losing the customers, the management and control of inventory is an important dimension of the duties of the financial manager. Inventory management assumes significance in any firm and it is of great concern to any financial manager. Though the inventory is more directly related to production and marketing departments, still the financial managers has to play an active role in the management of inventory. He, in fact, is the decision-maker in the whole process of inventory management.

Any firm will like to hold higher levels of inventory. This will enable the firm to be more flexible in supplying to the customers and will find ease in its production schedule. Most of the customers may require immediate delivery and higher inventories may help meeting their demands, and hence there would be less and less chances of sales being disrupted. But there is always a cost involved in the inventories. This cost includes the capital cost of the stock and the costs of storing and carrying, etc. On the other hand, holding lower level of stock than required may result in stock-outs. The cost of stock-out may be sales loss or customer’s dissatisfaction. The stock-outs may also result in delays or hold-ups in the production process.

Given the benefits of holding inventories and costs of stock-outs, a firm will be tempted to hold maximum possible inventories. But this is costly too, because the funds blocked in inventory always have an opportunity cost. So, every firm is required to manage the inventories in such a way as to get the best return thereof. It must weigh the benefits of holding inventory against its opportunity costs. While achieving the objective of an optimum level of inventory, a financial manager has to reconcile the differing viewpoints of the production department, marketing department, and finance department. No doubt, most of the decisions relating to inventories are taken by purchase department in consultation with the production department, still the financial manager should ensure that the inventories are properly controlled and he should stress the need for the consideration of financial implications of inventory management.

Thus, the objective of inventory management is to determine the optimum level of inventory i.e., the level at which the interest of all the departments are taken care of. The inventory management seeks to maximize the wealth of the shareholders by designing and implementing such policies which attempt to minimize the cost of procuring and maintaining the inventories.

Business firms keep inventories for different purposes. Every firm, big or small, trading or manufacturing has to maintain some minimum level of inventories. There are different motives for maintaining inventories, and these are more or less the same as the motives for holding cash. The motives for holding inventory may be enumerated as follows:

1. TransactionaryMotive – Every firm has to maintain some level of inventory to meet the day to day requirements of sales, production process, customer demand etc. This motive makes the firm to keep the inventory of finished goods as well as raw materials. The inventory level will provide a smoothness to the operations of the firm. A business firm exists for business transactions which require stock of goods and raw materials.
2. Precautionary Motive – A firm should keep some inventory for unforeseen circumstances also. For example, the fresh supply of raw material may not reach the factory due to a strikes by the transporters or due to natural calamities in a particular There may be labour problems in the factory, and the production process may halt. So, the firm must have inventories of raw materials as well as finished goods for meeting such emergencies.
3. Speculative Motive  – The firm may be tempted to keep some inventory in order to capitalize an opportunity to make profit e.g. sufficient level of inventory may help the firm to earn extra profit in case of expected shortage in the market.

4. Reasons and Benefits of Inventories

The motives discussed above make the firm to hold the inventory. However, as already said, the inventory has costs as well as benefits associated with it. While determining the optimal level of inventory, the financial manager must consider the necessity of holding inventory and the costs thereof. The optimum level of inventory is a subjective matter and depends upon the features of a particular firm. The following are some of the benefits or reasons for holding inventories:

4.1 TradingFirm

In case of a trading firm, there may be several reasons why it will maintain inventory. If the firm has some stock of goods then the sales activity can be undertaken even if the procurement has stopped due to one reason or Otherwise, if stock is not there, there is a likelihood that the sales will stop as soon as there is an interruption in procurement. Moreover, it is not always possible to procure the goods whenever there is a sales opportunity, as there is always a time gap required between the purchase and sale of goods. Thus, a trading concern should have some stock of finished goods in order to undertake sales activities independent of the procurement schedule.

Similarly, a firm may have several incentives being offered in terms of quantity discount or lower price, etc., by the supplier of goods. The benefits can be availed and goods may be purchased even if there is no immediate sales order. The inventory so purchased, at a discount/lower cost, will result in lowering the total cost resulting in higher profit for the firm. So, in case of trading concern, the inventory helps in de-linking the sales activities from purchase activity and also to capitalize a profit of opportunity.

4.2 ManufacturingFirm

A manufacturing firm should have inventory of not only the finished goods, but also of raw materials and work-in-progress for obvious reasons as follows:

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 a stock-out of raw material at any stage of production process, then the whole production process may come to a halt. This may result in customer dissatisfaction as the goods cannot be delivered in time. Moreover, the fixed costs will continue to be incurred even if there is not production. The firm may also have to incur heavy cost to restart the production schedule.

Further, sufficient work-in-progress would let the production process run smoothly. In most of the manufacturing concerns, the work-in-progress is a natural outcome of the production schedule. The work-in-progress helps in fulfilment of some sales orders even if the supply of raw material has stopped.

IndependentSales Activity – Inventory of finished goods is required not only in a trading concern, but manufacturing firms should also have sufficient stock of finished. The production schedule is generally a time-consuming process, and in most cases, goods cannot be produced just after receiving orders. Every manufacturing concern therefore, maintains a minimum level of finished goods in order to deliver the goods as soon as the order is received.

5. Costs of Inventory

Every firm maintains some stock of raw materials, work-in-progress and finished goods depending upon the requirement and other features of the firm. It is benefited by holding inventory, no doubt, yet it must also consider various costs involved in holding inventories. Had these costs not there, there would not have been any problem of inventory management and every firm would have maintained a higher and higher level of inventories. The cost of holding inventories may include the followings:

5.1 Carrying Cost

This is the cost incurred in keeping or maintaining an inventory of one unit of raw material or work-in-progress or finished goods. Two basic costs are associated with holding a unit in inventory. These are:

Cost of storage – This means and includes the cost of storing one unit of raw material by the firm. This cost maybe in relation to rent of space occupied by the stock, the cost of people employed for the security of the stock, cost of infrastructure required g., air conditioning, etc., cost of insurance, cost of pilferage, warehousing cost, handling cost, etc.

Cost of financing– This cost includes the cost of funds invested in the inventories. The funds used in the purchase/production of inventories have an opportunity cost e., the income which could have been earned by investing these funds elsewhere. Moreover, if the firm has to pay interest on borrowings made for the purchase of materials/goods, then there is an explicit cost of financing in the form of interest.

It may be noted that the total carrying cost is entirely variable and rise in direct proportion to the level of inventories carried. The total carrying cost move in the same direction as the annual average inventory.

5.2 Cost of Ordering

The cost of ordering include the cost of acquisition of inventories. It is the cost of preparation and execution of an order, including cost of paperwork and communicating with the supplier. There is always minimum cost involved whenever an order for replenishment of goods is placed. The total annual cost of ordering is equal to the cost per order multiplied by the number of order 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. The ordering cost may have a fixed component which is not affected by the order size; and a variable component which changes with the order  For example, transportation charges may be payable per unit subject to a minimum charge per trip.

The carrying cost and the cost of ordering are the opposite forces and collectively they determine the level of inventories in any firm. The carrying cost considerations require that the firms should maintain the inventories at the lowest level and should be replenished as frequently as possible. This will result in lowering of the total carrying cost. But this also requires frequent order to be replaced and therefore, results in increasing the total cost of ordering. A financial manager has to achieve a trade-off between the carrying cost and the cost of ordering.

• Cost of Stock-outs (A hidden cost) – 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-outs refer to 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 back  Further stock-out of some item may result in lost sales of not only that out of stock item, but also for other related items.

Stock-outs are quite often expensive. If the inventory item is a finished goods, the customer may buy the goods from someone else. This will result in profit lost on such lost sales. Even if the customer is willing to wait until the goods arrive, some goodwill is definitely lost. If the firm is often not able to supply goods when the customers demand, its reputation suffers and it will lose business. Stock-out of raw materials or work-in-progress can cause the production process to stop. This will be expensive because employees will be paid for the time not spent in producing goods. Some production processes are so expensive to shut down that the management will go to great lengths to avoid to running out of materials.

So, the trade-off on inventory is fairly clear. On the one hand, having too high an investment in inventory results in large carrying costs which, will drag down the value of the firm. On the other hand, having too small an inventory results in either lost sales or higher ordering costs for the firm. On the basis of the above discussion, the whole theory of inventory management can be summarized as follows:

1. Maintaining sufficient stock of raw materials ensuring continuous supply to production process for uninterrupted production schedule,
2. Maintaining sufficient supply of finished goods for achieving smooth sales operations, and
3. Minimizing the total annual cost of maintaining in-

In order to ensure the above, various steps are required. In the following section, some of the techniques of inventory management are discussed.

6. Techniques of Inventory Management

As in the case of other current assets, the decision making in investment in inventory involves a basic trade-off between risk and return. The risk is that if the level of inventory is too low, the various functions of the business do not operate independently. The return results because lower level of inventory saves money. As the size of the inventory increases, the storage and other costs also rise. Therefore, as the level of inventory increases, the risk of running out of inventory decreases but the cost of carrying inventory increases. Out of different current assets being maintained by the firm, inventory is one which requires to be monitored and managed not only in terms of money value but also in terms of number of physical units. The financial manager must see that the inventory does not become unnecessarily large when compared with the requirements; and for this, close control over the size and composition of inventories must be maintained. Moreover, since the investment in inventories is the least liquid of all the current assets, any error in its management cannot be readily rectified and hence may be costly to the firm. The goal of inventory management should therefore, be established a level of each item of the inventory.

There should be a systematic approach to inventory management that attempts to balance out the expected costs and benefits of maintaining inventories. In order to ensure efficient management of inventories, the finance manager may be required to answer the following questions:

1. Are all items of inventories equally important, or some of the items are to be given more attention?
2. That should be the size of each order or each replenishment?
3. At what level should the order for replenishment be placed?

Various techniques has been suggested to deal with these problems. Some of these has been discussed as follows:

ABC Analysis – The ABC analysis is based on the propositions that

1. managerial time and efforts are scare and limited, and
2. some items of inventory are more important than others. The ABC analysis classifies various inventory items into three sets or groups of priority and allocates managerial efforts in proportion of the priority. The most important items are classified as class A, those of intermediate importance are classified as class B and the remaining items are classified as class C. The financial manager should monitor different items belonging to different groups in that order of priority. Utmost attention is required for class A item, followed by items in class B and then items in class C.

Under ABC analysis, the different items may be placed in different groups as follows:

1. Different items are given priority order on the basis of total value of annual consumption. Item with the highest valueis given top priority and so  The annual consumption value of all the items, already arranged in priority order, are then shown in cumulative terms for each and every item.
2. Thereafter,the running cumulative totals of annual value of consumption are expressed as a percentage of total value of consumption.
3. Then these cumulative percentage of consumption values are divided into three categories e., A, B and C. Usually, group A is consisting of items having cumulative percentage value of 60% to 70%; group B is consisting of next 20% to 25% and the remaining items are placed in group C. The ABC analysis of inventory management