HOW TO MANAGE INVENTORY
WHAT IS INVENTORY MANAGEMENT?
Inventory management refers to the process of ordering, storing, and using a company’s inventories. This includes the management of raw materials, components, and finished products as well as the warehousing and processing of such items.
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| Inventory Storing |
Since the inventory is the most important component of any inventory-intensive sector, special efforts are put in to ensure that:
• There is a sufficient inventory of raw materials available to produce the number of finished goods to meet the sale forecast,
• There is a sufficient inventory of finished goods available to meet the immediate sales requirement (both expected and unexpected) to avoid stock-out situations,
• The quantity so available is not in excess of the market needs to avoid any obsolescence, damage, or blockage of finance and
• The costs associated with inventory are minimized.
Why do companies hold stocks?
There are three general reasons:
1. Transaction motive
2. Precautionary motive and
3. Speculative motive.
The transaction motive occurs when there is a need to hold stocks to meet production and sales requirements instantaneously. The stock is maintained in order to operate the production smoothly without stoppage of work due to mishandling of material.
The firm might also decide to hold additional amounts of stock to cover the possibility that it may have underestimated its future production and sales requirements or that the supply of raw materials may be unreliable because of uncertain events affecting the supply of materials. This represents a precautionary motive that applies only when future demand is uncertain and fluctuating.
When it is expected that future input prices may change, a firm might maintain higher or lower stock levels to speculate on the expected increase or decrease in future prices. This is called speculative motive.
Costs Associated with Inventories:
Inventory management is quite critical for companies as it includes substantial costs, especially in material-intensive manufacturing concerns. Following are the costs that are associated with inventories:
1. Cost of purchasing the inventory – the price that is settled with the supplier, after deducting the trade discounts and rebates.
2. Cost of ordering the inventory – such as clerical costs of preparing the material requisition, purchase order, receiving and handling shipments and preparing to receive the report, communicating in case of quantity/ quality errors or delay in receipt of shipment, and accounting for the shipment and the payment.
3. Cost of holding the inventory – such as interest cost on borrowings for purchase of inventory, insurance cost, warehouse, and storage cost, handling cost and cost of obsolescence, deterioration of inventory, and the opportunity cost of holding the stocks.
All these costs are financed either through the company’s own funding or borrowings from banks.
a) If inventories are financed using the company’s own funds, the company would have to bear the opportunity cost in a way had these funds were not invested in the inventories and could be used in investing in any other avenues to earn a fixed return. The gain so forgone shall be treated as the opportunity cost.
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| Inventory Management |
WHAT IS ECONOMIC ORDER QUANTITY?
There are models which incorporate transaction motives for holding the optimum level of stocks. This is possible where a company is able to predict the demand for its inputs and outputs with perfect certainty and where it knows with certainty that prices of inputs, will remain constant for some reasonable length of time.
In such a situation, the optimum order will be determined by those costs that are affected by either:
• the number of stocks held or • the number of orders placed.
If more units are ordered at one time, fewer orders will be required per year. This will result in a reduction in ordering costs.
As seen in the above example, if the order size is 10,000 units, the number of orders will be 200,000 / 10,000 = 20 orders which will reduce the ordering cost to Rs. 220,000
However, when fewer orders are placed, larger average stocks must be maintained which leads to an increase in holding costs that is (10,000 / 2) x 270.95 = 1,354,750. Hence the total relevant cost (ordering cost + holding cost) shall become Rs. 1,574,750 which is Rs. 457,375 higher than the one calculated at 5,000 units (i.e. 440,000+677,375=1,117,375).
Therefore, an optimum level must be determined at which the total relevant cost is minimized. This optimum level is called Economic Order Quantity (EOQ).
The EOQ can be determined by using the following methods:
1. Tabular Method
2. Graphical Method
3. Formula Method
Limitations of the Economic Order Quantity Model:
a) It is assumed that the annual demand for material is known and constant, which in fact not. The demand will be based on sales which may vary.
b) It is also assumed that per-order cost and holding cost per unit shall not change. In practice, it is not possible as some of these costs are not controllable. For example, an increase in the price of petrol by the Government will enhance transportation costs.
c) Another limitation of the EOQ model is its assumption in connection to the non-availability of discounts which is not possible in practice.
d) In seasonal variation situations, the demand will be higher during the season while it will be declined in the off-season. Therefore, it will not justify the assumption that demand can be predicted with perfect certainty
WHAT ARE INVENTORY LEVELS AND BUFFER STOCK?
A business entity shall always maintain certain levels of inventories. These levels are: a) Re-order Level
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| Buffer Stock |
b) Safety Stock / Buffer Stock
c) Maximum Inventory Level
d) Minimum Inventory Level
So far, it has been assumed that when an item of materials is purchased from a supplier, the delivery from the supplier will happen immediately. In practice, however, there is likely to be some uncertainty about when to make a new order for inventory in order to avoid the risk of running out of inventory before the new order arrives from the supplier. The period of time between placing a new order with a supplier and receiving the delivery of the same is called “Lead Time”. This lead time could be in days, weeks, or months.
On the basis of this lead time, the companies determine the level of stock at which new orders should be placed to avoid a stock-out situation. The level at which a new order is placed is called the “Re-order Level”. It depends upon two factors, one is the lead time and the other is used. If any of these factors is higher, then the re-order level should be higher to avoid any stock out.
Such re-order level is determined using the average consumption during lead time. However, sometimes the demand during lead time exceeds expectations, in such cases, if the demand is not fulfilled, the customers may move to competitors and resulting in a loss of profit and goodwill. Also, the delivery may delay the expected time due to which the company may fail to produce the expected demand which again results in a loss of profits. To avoid such risk, the company also maintains a level of stock which is called “Safety Stock or Buffer Stock”
The re-order level is determined in two ways:
- Under certain circumstances = Average consumption during lead time =Average Lead Time (days / week / month) x Average Consumption per day / week / month. This is also called Minimum Inventory
Level
- Under uncertain circumstances = maximum lead time (days / weeks / month) x maximum demand per day / week / month
The Safety Stock is determined as:
Re-order level at uncertain circumstances – Re-order level at certain circumstances
(Maximum Demand x Maximum Lead Time) – (Average consumption x Average Lead Time)
Due to safety stock, the average inventory shall become:
This way, the entity carries safety stock on the basis of maximum demand as well as maximum delivery time. However, the probability of both events occurring at the same time is very low. Thereby, the management is incurring excessive holding costs on safety stocks.
If the cost of holding safety stocks is greater than the cost of stock-out, the business would be incurring more losses. Therefore, a level should be set where the cost of stock-out plus the cost of holding the safety stock is minimized.
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