Inventory Management

T L Gunaruwan
Department of Economics
University of Colombo
 What is Inventory ?
The word inventory simply means the
goods and services that businesses
hold in stock.
(
http://www.nationalbarcode.com/articles/what
-is-inventory.html
)

Inventory is the raw materials, component

parts, work-in-process, or finished products
that are held at a location in the supply chain
 What is Inventory
Management ?
Inventory management is a science,
primarily about specifying the stock level
(including safety stocks), order quantities
and the time of stock replenishment
Questions asked :
What should be the order quantity (Q)?
When should an order be placed (ROP)?
How much should be the safety stock (SS)
?
 The scope is much wider .
The scope of inventory management concerns the fine lines
between :
Replenishment and replenishment lead time,
Carrying costs of inventory,
Asset management,
Inventory forecasting,
Inventory valuation,
Inventory visibility,
Future inventory price forecasting,
Physical inventory,
Available physical space for inventory,
Quality management,
Returns of defective goods, and
Demand forecasting.
Balancing these competing requirements leads to optimal
inventory levels, which is an on-going process as the
business needs shift and react to the wider environment.
Why Inventory management ?
At the macro
level:
Inventory is one of the biggest corporate ass

In the US, for example, Investment in

inventory is currently around 25% of
GNP.

Controlling inventories could result in

significant cost reductions and efficiency
gains.
Why Inventory Management ?
At the firm
level:
Right inventory at the right place at the
right time
Smooth production process
No stock-out situations
No excess stocks
Cost reduction; less money tied up
and Reduced Obsolescence

Greater Profits
 How do you manage your
inventory?
How much do you buy? When?
Rice
Vegetables
Bread
Milk
Paper Plates
Gas
Cereal
Exercise books
What Do you Consider?

Cost of not having it.

Cost of going to the grocery or gas
station (time, money), cost of drawing
money.
Cost of holding and storing, lost interest.
Price discounts.
How much you consume.
Some safety against uncertainty.
 Costs of Inventory
Physical holding costs:
out of pocket expenses for storing inventory
(insurance, security, warehouse rental, cooling)
All costs that may be entailed before you sell it
(obsolescence, spoilage, rework...)

Opportunity cost of inventory: foregone

return on the funds invested.

Operational costs:
Delay in detection of quality problems.
Delay the introduction of new products.
Increase throughput times.
Benefits of Inventory

Hedge against uncertain demand

Hedge against uncertain supply
Economise on ordering costs
Smoothing

Therefore, inventory should be build and

managed in order to match supply and
demand in the most cost effective way.
 Aggregate Inventory
Performance Measures
In general, companies that can
operate with less inventory are the
ones that operate more efficiently.
Several aggregate performance
measures can be used to judge how well
a company is utilizing its inventory
resources :
(1) Average Inventory Investment
(2) Inventory Turnover Ratio
(3) Days of Inventory
 Average Inventory
Investment
The value of a companys average
level of inventory
Disadvantage:
Difficult to compare
(large companies will generally have
more inventory than smaller
companies; different types of operation
need different stock levels, etc)
Inventory Turnover Ratio
Ratio of Companys sales to its average
Inventory Investment
Inventory Turnover Ratio
= Annual costs of goods sold / average
inventory investment

The inventory turnover ratio indicates how

many times during a year the inventory turns
over (or, sold).

Thus, in general, a company with a higher

turnover ratio will be using its inventory
more efficiently.
 Days of Inventory
(A measure closely related to inventory
turnover )

Days of Inventory
= Days per year / Inventory turnover
ratio

The days of inventory indicate approximately

how many days of sales can be supplied
solely from inventory.

Thus, the lower this value, the more

efficient would be the inventory usage.
Different types of inventory
models
1.Single period models
Single selling season,
single order

2.Multi-period model
Repeat business, multiple
orders
Inventory Accounting Systems

Perpetual Inventory Systems

A perpetual inventory system monitors
changes in inventory levels on a continues
basis.
Under such a system, inventory
transactions are recorded as they occur.
Example: Grocery stores - Point-of-Sale
systems bar code scanner / ATM machines
Universal Bar Code - Bar code
printed on a label that has
information about the item 0
to which it is attached 214800 232087768
Inventory Accounting Systems
(ctd)
Periodic Inventory Systems
Many smaller organizations do not have
the resources to maintain perpetual
inventory systems.
For example, small retailers often perform
periodic counts of the inventory on hand of
each item, then place an order based on
that inventory and the level of demand
expected.
Eg: Two-Bin System - Two containers of
inventory; reorder when the first is empty
 Effective Inventory
Management REQUIRES
A system to keep track of inventory
A classification system
A reliable forecast of demand
Knowledge of lead times
Reasonable estimates of
Purchase Costs
Holding Costs
Ordering Costs
Shortage Costs
 ABC Classification
As it turns out, companies often need not keep
extremely accurate track of all inventory items. For
instance, certain parts may have a high-value and
high usage. Such items must be tracked carefully
and continuously, compared to those items with
relatively low value and used infrequently.
To determine which inventory items should receive
the highest level of control, a scheme called ABC
Analysis has been developed.
Typically, only 20 percent of all the items account
for 80 percent of the total rupee usage (Annual
Demand x Unit Cost), while remaining 80 percent
of the items typically accounts for only 20 percent
of the rupee usage.
 A B C Classification (ctd)
After calculating the rupee usage for each
inventory item, they are ranked from highest to
lowest based on rupee usage.
The first 20% of the items are classified under
Class A.
Class A accurate inventory controls needed
control and monitoring through a Perpetual
Inventory System would be better
The next 30% of the items are classified as Class
B. Class B deserve less attention than items in
Class A
Finally, the last 50% of items are C items. Could
be monitored through periodic inventory
management systems 20
 Graphic Representation of ABC
Analysis
Percent of Annual Dollar

A -
80 Items
70
60
50
40
30
20 B-
Usage

10 Items C-
0 Items
10 20 30 40 50 60 70 80 90
100 Percent of Inventory Items

21
Multi- period models :
The Economic Order Quantity (EOQ)
Model
Economic order quantity (EOQ) :
The order size that minimises total
annual cost
Assumptions :
Only one product is involved
Annual demand (D) known, and
deterministic
Demand is even throughout the
year
Lead time does not vary
The Inventory Cycle
(based on the EOQ Model Assumptions)
Profile of Inventory Level Over Tim
Q Usage
Quantit rate
y
on
hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
 Variables in the EOQ Model

Demand : D units/year
Ordering cost (assumed known)/Order :
Rs S
Annual Holding Cost of average
inventory is H per unit
Purchasing cost/Unit : Rs C
Approach : Minimisation of Total Cost

Total Cost = Purchasing Cost

+ Ordering Cost
+ Inventory Cost
Where :
Purchasing Cost = (D) x (C)
Ordering Cost = (D/Q) x (S)
Stock Holding Cost = (Q/2) x (H)
Economic Order Quantity
EOQ = Order Quantity when TC is
minimum

TC = (D*C) + [(D/Q)*S] + [(Q/2)*H]

At Minimum, d(TC)/d(Q) =0
- [S(D)/(Q^2)] + (H/2) = 0
(D,C,S and H are assumed Constants)
Q^2 = 2 D*S/H 2SD
Therefore, EOQ H
=

and, at EOQ : HC = OC
 Overall Cost Minimisation
There is a trade-off between holding costs and ordering
costs

Q D
TC H S
2 Q
Annual
Cost

ld ing
Ho st
Co

Ordering
Ordering Costs
Costs

Order Quantity
QO = Optimal order
quantity = EOQ) (Q)
 EOQ Computation
Example

Assume that a computer dealer faces

a demand for 5,000 computers per
year, and that it costs $15,000 to
have an order shipped. Stock Holding
cost is estimated at $500 per
computer per year. How many times
should the dealer order, and what
should be the order size?
 Answer :

2SD
EOQ
H
=

2(15,000)(5,000)
EOQ 548
500

Therefore, it is optimum for the dealer to

order 548 computers at a time.
 If delivery is not instantaneous, but there is a
lead time L:
When to order? How much to order?
Order
Quantity
Q
Inventory

Receive
order

Lead Time
Time
 If demand is known exactly, place an order
when inventory equals demand during lead
time.

Order Q: When shall we order

Quantity
Q A: When inventory =
Q: How much shall we o
Inventory

A: Q = EOQ

Re-order Receive
Level order
(ROL)
ROL = L x
d
Lead Time
Time
d : demand per periodPlace
L: Lead time in periodsorder
Example (continued)
What if the lead time to receive computers
is 10 days? (when should you place your
order?)
Since D is given in years, first convert: 10 days
= 10/365 yrs
10 (5000
ROL =
36 )
= 137
5
So, every time when the number of
computers on the stock reaches 137,
order a new consignment of 548
computers.
ROL = ???

Place Receive
order Lead Time order
If Actual Demand > Expected Stock-out s
Order
Quantity

Stockout
Point
Inventory

Time

Lead Time Unfilled demand

Place Receive
order order
 To reduce stock-outs, safety stock is add
Inventory
Level

Order Quantity
ROL = Q = EOQ
Safety
Stock + Expected
Expected LT Demand
LT
Demand Safety Stock
Lead Time Time

Place Receive
order order
Decide what Service Level is desired
(Service level = probability of NOT stocking ou

Service level Probability

of stock-out

Safety
Stock
 Safety stock =
(safety factor z)(std deviation in Lead Time
demand)

Service level Probability

of stock-out

Safety
Stock

Read z from Normal table for a given service level

How to find ROL & Order Quantity with
Stochastic Demand during Lead Time ?
2SD
EOQ
H
 Average Inventory =
(Order Qty)/2 + Safety Stock
Inventory
Level

Order
Quantity

EOQ/2
Average
Inventory

Safety Stock (SS)

Lead Time Time

Place Receive
order order
Example (continued)
Back to the computer consignment
Recall that the lead time was 10 days and the
expected yearly demand was 5000. Assume you
estimated the standard deviation of daily demand to
be d = 6. When should you re-order if you want to
be 95% sure you dont run out of computers ????
 Inventory Valuation
Inventory valuation and matching principle
Matching principle :
Expenses during an accounting period should match the
income earned during the accounting period.
Thus, finding out value of goods sold to match against
sales is important to determine profits.
Cost of Goods sold = Opening stock + Purchases
Closing stock
Effect of errors in valuation of inventories.
Any error in valuation of inventory will lead to incorrect
estimation of the current years profits. Next years profits
also will be erroneous because the closing stock of a
current year is the opening stock of the coming year.
 Principle : Cost-based Valuation
Cost means cost of acquisition + cost of
conversion, if any
Raw materials, spare parts, consumables etc : Value at cost of
acquisition That is, purchase costs including duties and taxes,
freight and other expenses directly related to such purchases.
Similarly any discounts , rebates on such purchases should be
deducted.

Finished goods (manufacturing activity) : Value at Converted Cost

This means, cost of raw materials plus cost of conversion of raw
materials into finished goods .
[Consists of direct expenses like labour costs as well as indirect
manufacturing costs like power, water , fuel, factory rent , factory
insurance etc, which are directly attributable to production /
manufacturing. Indirect expenses like salaries, office expenses etc.
are not included since they are periodic costs]

Work in process : Valued at cost as above, depending on the stage

of completion [ cost of labour and overheads which are determined
by the production department, and the appropriate share
attributable to the level of completion in the process]
 Inventory Valuation Methods
Why ? Costs keep changing, and thus, not always possible to
assume cost of closing stock as cost of current purchases

FIFO ( First-In-First-Out ) :
Basis : Stock received first is consumed/sold first.
Therefore, the closing stock at hand is from the latest
purchases.
In case of rising prices, this may lead to over-valuation of
stocks in hand and over-estimation of profits. Under falling
prices, under-statement of stocks in hand and profits would
result.

LIFO ( Last-In-First-Out ) :
Basis : Last units purchased are consumed /sold first .
Therefore, the closing stock at hand is from the earliest
purchases.
In case of falling prices, this may lead to over-statement of
stocks in hand and profits. Under rising prices, under-statement
of stocks in hand and profits would result.
Inventory Valuation Methods (ctd)

Weighted Average Cost (WAC) :

Basis : The average cost is applied
An average cost is computed after every purchase,
using the cost of new purchases and the cost of
existing stock. This method tries to even out the
effects of price fluctuations.

Specific Identification method :

Basis : Specific costs for each unit in stock.
This method is suitable when the stock is not
homogenous, less in quantity and high in value.
 Which is the best method ?
Inventory valuation has influence over the Income
Statement and Balance Sheet

FIFO more realistic inventory value but unrealistic profit

LIFO - more realistic profit but outdated inventory value
WAC - the average of the two

Accounting Standards, in general, do not allow the use of

LIFO.

Under Income Tax laws in many countries, any method

may be adopted but it should be followed consistently.
 Other bases than Costs

Cost or Net Realisable value, whichever is

lower :

At times, it might be necessary to value inventories

below their costs (Ex : Inventory has suffered a
reduction in value due to damage , deterioration,
reduction in selling prices, or obsolescence )

Such loss is recognised by valuing inventory at the

cost or net realisable value, whichever is lower.

Such method may be applied to all items of

inventory or similar group of items.
 Necessity of Consistency and
Comprehension of the Company Policy
in Interpretation
A change in method of inventory valuation from year
to year will result incomparability between the two
periods.
Hinder the perception of the true and fair view of the
financial statements.
However if a change in method is warrented for
some reason (ex: necessary for better presentation
of financial results), a company may do so.
Thus, properly understanding a companys policy of
inventory valuation is extremely important when
interpreting its financial results.
Physical Verification of Inventory

Regardless of the valuation method used, it is

necessary to carry out a physical stock
verification at the end of an accounting period.
For better internal control, this is generally done by
staff other than those involved in inventory
management.
Actual stock is compared against the book stock and
differences analysed. Any adverse difference may
indicate theft or pilferage.