INVENTORY

MANAGEMENT
AND CONTROL
 INTRODUCTION
 The need for inventory. It also
provides a cushion for future price
fluctuations. The purpose of inventory
management is to ensure availability of
materials in sufficient quantity as and
when required and also to minimise
investment in inventories.
 MEANING AND NATURE OF
INVENTORY
 The dictionary meaning of inventory is ‘stock of
goods, or a list of goods’. The work ‘Inventory’ is
understood differently by various authors, in
accounting language it may mean stock of finished
goods only. In a manufacturing concerns, it may
include raw materials, work in process and stores, etc.
a. Raw Material: The quantity of raw materials
required will be determined by the rate of
consumption and the time required for replenishing
the supplies. The factors like the availability of raw
materials and government regulations, etc. too affect
the stock of raw materials.
b. Work-in-Progress: The work-in-progress is that stage of
stocks which are in between raw materials and finished goods.
The greater the time taken in manufacturing, the more will be
the amount of work in progress.
c. Consumables: These materials do not directly enter
production but they act as catalyst, etc. There can be instances
where these materials may account for much value than the
raw materials. The fuel oil may form a substantial part of cost.
d. Finished Goods: These are the goods which are ready for the
consumers. The stock of finished goods provides a buffer
between production and market. The purpose of maintaining
inventory is to ensure proper supply of goods to consumers. In
some concerns the production is undertaken on order basis, in
these concerns there will not be a need for finished goods. The
need for finished goods inventory will be more when
production is undertaken in general without waiting for
specific orders.
e. Spares: Spares also form a part of inventory.
Some industries like transport will require
more spares than the other concerns. The
costly spare parts like engines, maintenance
spares etc. are not discarded after use, rather
they are kept in ready position for further
use. All decision about spares are based on
the financial cost of inventory on such spares
and the costs that may arise due to their non-
availability.
 PURPOSE / BENEFITS OF HOLDING
INVENTORIES
 Although holding inventories involves blocking of a firm’s
funds and the cost of storage and handling, every business
enterprise has to maintain a certain level of inventories to
facilitate uninterrupted production and smooth running of
business. There are three main purpose or motives of holding
inventories.
i. The Transaction Motive which facilitates continuous
production and timely execution of sales orders.
ii. The Precaution Motive which necessitates the holding of
inventories for meeting the unpredictable changes in demand
and supplies of materials.
iii. The Speculative Motive which induces to keep inventories
for taking advantage of price fluctuations, saving in re-
ordering cost and quantity discount, etc.
 RISK AND COSTS OF HOLDING
INVENTORIES
 The various costs and risks involved in
holding inventories are as below:
i. Capital Costs: Maintaining of inventories
results in blocking of the firm’s financial
resources. The funds may be arranged from
own resources or from outsides. In the
former case, there is an opportunity cost of
investment while in the later case, the firm
has to pay interest to the outsides.
ii. Storage and Handling costs: The storage costs
include the rental of the godown, insurance charges,
etc.
iii. Risk of Price Decline: This may be due to increased
market supplies, competition or general depression in
the market.
iv. Risk of Obsolescence: The inventories may become
obsolete due to improved technology, changes in
requirements, change in customer’s tastes, etc.
v. Risk Deterioration in Quality: The quality of the
materials may also deteriorate while the inventories
are kept in store.
INVENTORY MANAGEMENT
 It is necessary for every management to give proper attention
to inventory management. A proper planning of purchasing,
handling, storing and accounting should form a part of
inventory management. An efficient system of inventory
management will determine (a) what to purchase (b) how
much to purchase (c) from where to purchase (d) where to
store, etc.
There are conflicting interests of different departmental heads
over the issue of inventory. The finance manger, production
manager. The purpose of inventory management is to keep the
stocks in such a way that neither there is over-stocking nor
under-stocking. The investments in inventory should be kept
in reasonable limits.
 OBJECTS OF INVENTORY
MANAGEMENT
 Themain objectives of inventory management
are operational and financial. The operational
objective mean that the materials and spares
should be available in sufficient quantity so that
work is not disrupted for want of inventory.
The financial objective means that investments
in inventories should not remain idle and
minimum working capital should be locked in
it.
1. To ensure continuous supply of materials, spares and finished
goods so that production should not suffer at any time and the
customers demand should also be met.
2. To avoid both over-stocking and under-stocking of inventory.
3. To maintain investments in inventories at the optimum level as
required by the operational and sales activities.
4. To keep material cost under control so that they contribute in
reducing cost of production and overall costs.
5. To eliminate duplication in ordering or replenishing stocks.
This is possible with the help of centralising purchases.
6. To minimise losses through deterioration, pilferage, wastages
and damages.
7. To ensure perpetual inventory control so that materials shown
in stock ledgers should be actually laying in the stores.
8. To ensure right quality goods at reasonable prices.
9. To facilitate furnishing of date for short-term and long-term
planning and control of inventory.
 TOOLS AND TECHNIQUES OF INVENTORY
MANAGEMENT AND CONTROL

 The following are the important tools and technique of

inventory management and control.
1. Determination of stock levels.
2. Determination of safety stocks.
3. Selecting a proper system of ordering for inventory.
4. Determination of economic order quantity.
5. A.B.C. Analysis.
6. V.E.D. Analysis.
7. Inventory turnover ratios.
8. Aging schedule of inventories
9. Classification and codification of inventories
10. Preparation of inventory reports.
1. Determination of stock levels: Carrying of too much and
too little of inventories is detrimental to the firm. If the
inventory level is too little, the firm will face frequent stock-
outs involving heavy ordering cost and if the inventory level
is too high it will be unnecessary tie-up of capital.
Therefore, an affective inventory management requires that
a firm should maintain an optimum level of inventory where
inventory costs are the minimum and at the same time there
is no stock-out which may result in lost of sale or stoppage
of production. Various stock levels are discussed as such.
b. Minimum Level: This represents the quality which must be
maintained in hand at all times. If stocks are less than the
minimum level then the work will stop due to shortage of
materials. Following factors are taken into account while
fixing minimum stock level:
 Lead Time: The time taken in processing the order and then
executing it is known as lead time. It is essential to maintain
some inventory during the period.
 Rate of Consumption: It is the average consumption of
material in the factory.
 Nature of Material: If a material is required only against
special orders of the customer than minimum stock will not
be required for such materials. Minimum stock level can be
calculated with the help of following formula:
Minimum stock level = Re-ordering level – (Normal
consumption) × Normal Re-order period)
b. Re-ordering Level: Re-ordering level or ordering level is
fixed between minimum level and maximum level. Re-
ordering level is fixed with the following formula:
Re-ordering Level = Maximum Consumption
× Maximum Re-order period.
c. Maximum Level: It is the quantity of material
beyond which a firm should not exceed its stocks. If
the quantity exceeds maximum level limit then it
will be overstocking. A firm should avoid
overstocking because it will result in high material
costs. Overstocking will mean blocking of more
working capital, more space for storing the
materials, more wastage of materials and more
chances of losses from obsolescene.
Maximum Stock Level = Re-ordering Level + Re-
ordering Quantity – (Minimum Consumption
× Minimum Re-ordering period).
d. Danger Level: It is the level beyond which materials should not
fall in any case. If danger level arises then immediate steps
should be taken to replenish the stocks even if more cost is
incurred in arranging the materials. If materials are not arranged
immediately there is a possibility of stoppage of work. Danger
level is determined with the following formula:

Danger Level = Average Consumption × Maximum re-

order period for emergency purchases.

e. Average Stocks Level: The average stock level is calculated as

such:

Average Stock Level = Minimum Stock Level + ½ of re-

order quantity.
 2. Determination of Safety Stocks
 Safety stock is a buffer to meet some unanticipated increase in
usage. The usage of inventory cannot be perfectly forecasted. It
fluctuates over a period of time. The demand for materials may
fluctuate and delivery of inventory may also be delayed and in such
a situation the firm can face a problem of stock-out. The stock-out
can prove costly by affecting the smooth working of the concern.
In order to protect against the stock out arising out of usage
fluctuations, firms usually maintain some margin of safety or safety
stocks. The basic problem is to determine the level of quantity of
safety stocks. Two costs are involved in the determination of this
stock i.e. opportunity cost of stock-outs and the carrying costs. The
stock outs of raw materials cause production distruption resulting
into higher cost of production. Similarly, the stock-out of finished
goods result into the failure of the firm in competition as the firm
cannot provide customer service. If a firm maintain low level of
safety frequent stock-outs will occur resulting into the large
opportunity costs. On the other hand, the larger quantity of safety
stocks involve higher carrying costs.
 3. Ordering systems of Inventory
 The basic problem of inventory is to decide the re-order
point. This point indicates when an order should be placed.
The re-order point is determined with the help of these
things: (a) average consumption rate, (b) duration of lead
time, (c) economic order quantity, when the inventory is
depleted to lead time consumption, the order should be
placed. There are three prevalent system of ordering and a
concern can choose any one of these:
a. Fixed order quantity system generally known as economic
order quantity (EOQ) system;
b. Fixed period order system or periodic re-ordering system or
periodic review system;
c. Single order and schedule part delivery system.
 4. Economic Order Quantity (EOG)
 Economic order quantity is the size of the lot to be purchased
which is economically viable. This is the quantity of materials
which can be purchased at minimum costs. Generally, economic
order quantity is the point at which inventory carrying costs are
equal to order costs. In determining economic order quantity it is
assumed that cost of managing inventory is made up solely of two
parts i.e., ordering costs and carrying costs.
 Ordering costs: These are the costs which are associated with the
purchasing or ordering of materials. These costs include:
1. Costs of staff posted for ordering of goods. A purchase order is
processed and then placed with suppliers. The labour spent on this
process is included in ordering costs.
2. Expenses incurred on transportation of goods purchased.
3. Inspection costs of incoming materials.
4. Cost of stationery, typing, postage, telephone charges, etc.
 These costs are also known as buying costs
and will arise only when some purchases are
made. When materials are manufactured in
the concern then these costs will be known as
set-up costs. These costs will include costs of
setting up machinery for manufacturing
materials, time taken up in setting, cost of
tools, etc.
 The ordering costs are totalled up for the year
and then divided by the number of orders
placed each year.
B. Carrying Costs: These are the costs of holding the
inventories. These costs will not be incurred if
inventories are not carried. These costs include:
1. The cost of capital invested in inventories. An interest
will be paid on the amount of capital locked-up in
inventories.
2. Cost of storage which could have been used for other
purpose.
3. The lost of materials due to deterioration and
obsolescence. The materials may deteriorate with
passage of time. The loss of absolescence arises when
the materials in stock are not usable because of change
in process or product.
4. Insurance cost.
5. Cost of spoilage in handling of materials.
 The longer the materials kept in stocks, the costlier it
becomes by 20 percent every year. The ordering and
carrying costs have a reverse relationship. The
ordering cost goes up with the increase in number of
orders placed. On with the increase in number of
units, purchased and stored. It can be shown in the
diagram shown.
 The ordering and carrying costs of materials being
high, an effort should be made to minimise these
costs. The quantity to be ordered should be large so
that economy may be made in transport costs and
discounts may also be earned. On the other hand,
storing facilities, capital to be locked up, insurance
costs should also be taken into account.
 Assumptions of EOQ: While calculating EOQ the
following assumptions are made.
1. The supply of goods is satisfactory. The goods can be
purchased whenever these are needed.
2. The quantity to be purchased by the concern is certain.
3. The prices of goods are stable. It results in stabilising
carrying costs.
4. When above-mentioned conditions are satisfied, economic
order quantity can be calculated with the help of the
following formula:
2AS
EOQ =
I
Where A = Annual consumption in rupees.
S = Cost of placing an order.
I = Inventory carrying costs of one unit.
 EOQ and Quality Discount: Customer is offered
some discount for bulk purchase or if the size of a
single order is large. Thus, the price per unit of an
item may decrease for buying larger quantities. The
quantity discount affect inventory cost in three
ways:
i. As the price per unit is reduced, the total price for
the lot is reduced.
ii. The lot size is increased, the number of offers is
reduced and as a result the total ordering cost is
reduced.
iii. The average inventory holding increase and as a
result the storage cost will increase.
 Thus, to decide whether to avail the
quantity discount or not, first of all EOQ
is determined and then its total cost
without quantity discount and with
quantity discount is determined. In case,
the total cost is less due to quantity
discount the offer is accepted, other wise
it is rejected. The following example
illustrates the point.
 Illustration 4. Economic Enterprises require 90,000
units of a certain item annually. The cost per unit is
Rs.3, the cost per purchase order Rs. 300 and the
inventory carrying cost Rs. 6 per unit per year.
i. What is the Economics Order Quantity?
ii. What Should the firm do if the suppliers offer
discount as below:

Order Discount

4500-5999 2%

6000 and above 3%

 2AS
 Solution. (i) EOQ =
I

Where, A = Annual Usage in units = 90,000

S = Cost of placing an order = Rs. 300
I = Inventory carrying costs of one unit. = Rs. 6

2 × 90,000 × 300
∴ EOQ = = 90,000 = 3,000 units
6
 As the supplier offers discount on order quantity, we
shall calculate the total cost of 3000 units, 4500 units
and 6000 units as below:
Order Size Average Annual No. of orders Price per unit Cost of Carrying cost Total ordering Total Cost (6
Inventory requirements (3 divided 1) purchase at Rs. 6 per cost at Rs. 300 + 7 + 8) (Rs.)
(units) (3) X (5) Rs. unit (Rs.) per order (Rs.)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

3,000 1,500 90,000 30 3.00 2,70,000 9,000 9,000 2,88,000

45,00 2,250 90,000 20 2.94 2,64,600 13,500 6,000 2,48,100
6,000 3,000 90,000 15 2.91 2,61,900 18,000 4,500 2,48,400

 Since the total cost at order of 4500 units is the

lowest, the firm should place order for 4500 units
and obtain 2% discount.
 5. A-B.C Analysis
 The materials are divided into a number of categories for
adopting a selective approach for material control. Under
A-B-C analysis, the materials are divided into three
categories viz, A, B and C. Past experience has shown that
almost 10 percent of the items contribute to 70 percent of
value of consumption and this category is called ‘A’
Category. About 20 percent of the items contribute about
20 percent of value of consumption and this is known as
category ‘B’ materials. Category ‘C’ covers about 70
percent of items of materials which contribute only 10
percent of value of consumption. There may be some
variation in different organisations and an adjustment can
be made in these percentages.
The information is shown in the
following diagram:

Class No. of Items Value of

% Items %
A 10 70
B 20 20
C 70 10
 A-B-C analysis helps to concentrate more efforts on
category A since greatest monetary advantage will
come by controlling these items. An intention should
be paid in estimating requirements, purchasing,
maintaining safety stocks and properly storing of ‘A’
category materials. These items are kept under a
constant review so that a substantial material cost may
be controlled. The control ‘C’ items may be relaxed
and these stocks may be purchased for the year. A
little more attention should be given towards ‘B’
category items and their purchase should be
undertaken at quarterly or half-yearly intervals.
The following example will explain the advantage of
A-B-C analysis:
Suppose three items P,Q,R have been used their
consumption is Rs. 2,40,00, Rs. 24,000 and Rs.
2,400 respectively. Let us presume that A-B-C
classification is not done and annual orders are 12 in
number. Each item will be ordered 4 times and
average inventory will be:
Item Annual No. of orders Average working
consumption inventory (Rs.)
P 2,40,000 4 60,000
Q 24,000 4 6,000
R 2,400 4 600
Total 2,66,400 12 66,600
 Suppose A-B-C analysis is followed and the number
of orders will be according to the importance of the
items. If the number of orders are 8, 3 and 1, for items
P, Q and R respectively then the average inventory
will be as follows:

Item Annual No. of Average working

consumption orders inventory (Rs.)

P 2,40,000 4 30,000
Q 24,000 4 8,000
R 2,400 4 2,400

Total 2,66,400 12 40,400

 When A-B-C analysis was not followed the
average inventory was Rs. 66,600 and after
following A-B-C analysis inventory came
down to Rs. 40,400. Average value of
inventory is nearly 1½ times in the earlier
situation, than as compared to the second
situation.
 6. VED Analysis
 The VED analysis is used generally for spare parts.
Spare parts are classified as Vital (V), Essential (E)
and Desirable (D). The vital spares are a must for
running the concern smoothly and these must be
stored adequately. The non-availability of vital spare
will cause havoc in the concern. The E type of spares
are also necessary but their stocks may be kept at low
figures. The stocking of D type of spares may be
avoided at times. If the lead time of these spares is
less, then stocking of these spares can be avoided.
The classification of spares under three categories is
an important decision. The classification of spares
should be left to the technical staff because they
know the need urgency and use of these spares.
 7. Inventory Turnover Ratios
 Inventory turnover ratios are calculated to indicate whether
inventories have been used efficiently or not. The purpose is to
ensure the blocking of only required minimum funds in
inventory. The inventory turnover ratio also known as stock
velocity is normally calculated as sales/average inventory or
cost of goods sold/average inventory cost. Inventory
conversion period may also be calculated to find the average
time taken for clearing the stocks.
Symbolically,
Cost of Good Sold
Inventory Turnover Ratio =
Average Inventory at Cost

Net Sales
=
(Average) Inventory
8. Aging Schedule of Inventories

 Classificationof inventories according to

the period (age) of their holdings also
helps in identifying show moving
inventories thereby helping in effective
control and management of inventories.
The following table shown aging of
inventories of a firm.
Item Name / Age Classification Date of Acquisition Amount (Rs.) % age to Total
Code

001 0-15 days June 25, 2000 30,000 15

002 16-13 days June 10, 2000 60,000 30

003 31-45 days May 20, 2000 50,000 25

004 46-60 days May 5, 2000 40,000 20

005 61 and above April 12, 2000 20,000 10

2,00,000 100
 9. Classification and Codification of
Inventories
 The inventories of a manufacturing concern may
consist of raw materials, work in process, finished
goods, spares, consumable stocks, etc. All these
categories may have their sub-divisions. The raw
materials used may be of 3-4 types, finished goods
may also be of more than one type, spares may be of
a number of types and so on. For a proper recording
and control of inventory, a proper classification of
various types of items is essential. The inventories
should first be classified and then code numbers
should be assigned for their identification.
 The identification of short names are useful for inventory
management not only for large concerns but also for small
concerns. Lack of proper classification may also lead to
reduction in production. Generally, material are classified
according to their nature such as construction materials,
consumable stocks, spares, lubricants, etc. The coding
class of materials is assigned two digits and then two or
three digits are assigned to the category of materials in that
class. The third distinction is needed for the quality of
goods and decimals are used to note this factor.
 10. Inventory Reports
 From effective control, the management should be
kept informed with the latest stock position of
different items. This is usually done by preparing
periodical inventory reports. These reports should
contain all information necessary for managerial
action. On the basis of these reports management
takes corrective action wherever necessary. The more
frequently these reports are prepared the less will be
the chances of lapse in the administration of
inventories.
 LEAD TIME
 Lead time is the period that elapses between the recognition of
a need and its fulfilment. There is a direct relationship
between lead time and inventories. The level of inventory of
an item depends upon the length of its lead time. Suppose,
lead time is one month. Any action taken now will have an
effect only one month later. So inventory for the current
month must be in hand. During lead time there will be no
delivery of materials and consuming departments will have to
be served from the inventories held.
 Lead time has two components: Lead time for company
(administrative lead time and the lead time for the producer
know as delivery lead time from the placing of an order until
the delivery of the ordered material.
 Administrative lead time is in the hands of those who
are dealing with material procurement. Delivery lead
time has to be negotiated at the time of preparing
purchase contract.
 It is often seen that bulk of the lead times is taken up
by administrative lead time. This is the time over
which company has control but still too much time is
taken up in receiving and inspecting of goods. Stock
control or purchase section of the organisation should
maintain lead time schedules for all groups of
materials
PREPETUAL INVENTOYR SYSTEM
 The stock taking may either be done anually or
continuously. In the latter method, the stock taking
continues throughout the year. A schedule is prepared
for stock taking of various bins (store rooms). One
bin is selected at random and the goods are checked
as per shown in the bin card. Then some other bin is
selected at random and so on. The institute of cost
and management Accountants, London define
perpetual inventory system as “a system of records
maintained by the controlling departments, which
reflects the physical movements of stocks and their
current balance.”
 Procedure of Perpetual
Inventory System
1. The upto date position in stores ledger and bin cards
should be made to know the current balance of
stores.
2. The programme is planned in such a way that in a
year every item is checked 3-4 times.
3. The stores which have not been inspected as yet
should not be mixed with other stores because no
entries are made for such items.
4. There is a surprise checking every time.
5. The physical stock available in the store after
counting, weighing etc. is recorded on sheets
provided for this purpose.
 Advantages of Perpetual
Inventory System
1. Quick Calculation of Closing Stock: Under
perpetual inventory system, the stock is checked
regularly throughout the year. It helps in preparing
Profit and Loss A/c and Balance Sheet without loss
of time.
2. Helpful in Formulating Purchase Polices: This
system of stock taking is also helpful formulating
purchase policies. The store-keeper is in know of the
requirements of various departments. He can also
tell the time, quantity and quality of materials
needed by production departments. Such
information is very useful in preparing purchase
policies.
 Check on Stores Personnel: The system of
continuous stock taking acts a check on personnel in-
charge of stores. They are not told of checking
programme in advance. This system also prevents
pilferage of stores.
 Helpful in Production Planning: Production
planning can be done according to the availability of
materials in stores because management is constantly
kept informed of stores position.
 Investments Under Check: There are minimum and
maximum stock levels within which stock limits are
maintained. This system helps in avoiding under
stocking and over stocking of stores and investments
in inventory are kept under check.
 Errors and Shortages Easily Detected: The
regular checking of stocks helps in detecting
errors and shortages in stores. There are may
be a wrong entry in either stores ledger or in
bin card. Such mistakes will be detected while
stocks are checked.
 Increasing Efficiency of Organisation: The
regular supply at proper time will enhance the
efficiency of the whole organisation.
 JUST IN TIME (JIT) INVENTORY
CONTROL SYSTEM
 The term JIT refers to a management tool that helps to produce only
the needed quantities at the needed time. According to the official
terminology of C.I.M.A., JIT is “a technique for the organisation of
workflows, to allow rapid, high quality, flexible production whilst
minimizing manufacturing work and stock level.” There are broadly
two aspects of JIT (i) just in time production, and (ii) just in time
purchasing.
 Just in time inventory control system involves the purchase of
materials in such a way that delivery of purchased material is assured
just before their use or demand. The philospohy of JIT control
system implies that the firm should maintain a minimum (zero level)
of inventory and rely on suppliers to provide materials just in time to
meet the requirements. The traditional inventory control system, on
the other hand, requires maintaining a healthy level of safety stock to
provide protection against uncertainties of production and supplies.
 Objective of JIt
 The ultimate goal of JIT is to reduce wastage and
enhance productivity. The important objectives of
JIT include:
1. Minimum / zero inventory and its associated costs.
2. Elimination of non-value added activities and all
wastes.
3. Minimum batch / lot size.
4. Zero breakdowns and continuous flow of
production.
5. Ensure timely delivery schedules both inside and
outside the firm.
6. Manufacturing the right product at right time.
 Features of JIT
a. It emphasises that firms following traditions inventory
control system overestimate ordering cost and
underestimate carrying costs associated with holding of
inventories.
b. It advocates maintaining good relations with suppliers so
as to enable purchase of right quantity of material at
right time.
c. It involves frequent production / order runs because of
smaller batch/lot sizes.
d. It requires reduction in set up time as well as processing
time.
e. Purchase of produce in response to need rather than as
per the plans and forecasts.
 Advantages of JIT Inventory
Control System
i. The right quantities of materials are purchased or
produced at the right time.
ii. Investment in inventory is reduces.
iii. Wastes are eliminated.
iv. Carrying or holding cost of inventory is also
reduced because of reduced inventory.
v. Reduction in costs of quality such as inspection,
costs of delayed delivery, early delivery, processing
documents etc. resulting into overall reduction in
cost.