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- Inventory Management involves the control of assets being produced for the purposes of sale in the normal course of the company's operations.
- Inventories include raw material inventory, work-in-process inventory and finished goods inventory.
- The goal of effective inventory management is to minimize the total costs i.e., the direct and indirect cost that are associated with holding inventories.
- Liquidity Lag: Inventories are tied to the firm's pool of working capital in a process that involves three specific lags, namely, Creation Lag, Storage Lag and Sale Lag.
- Creation Lag: In most cases, inventories are purchased on credit, creating an account payable. This liquidity lag offers a benefit to the firm.
- Storage Lag: Once goods are available for resale, they will not be immediately converted into cash. First, the item must be sold. Even when sales are very active, a firm will hold inventory as a back-up. Thus, the firm will usually pay suppliers, workers, and overhead expenses before the goods are actually sold. This lag represents a cost to the firm.
- Sale Lag: Once goods have been sold, they normally do not create cash immediately. Most sales occur on credit and become accounts receivable. The firm must wait to collect its receivables. This lag also represents a cost to the firm.
- Shelf stock refers to items that are stored by the firm and sold with little or no modification to customers. An automobile is an item of shelf stock.
- Raw Materials Inventory: This consists of basic materials that have not yet been committed to production in a manufacturing firm. The purpose of maintaining raw material inventory is to uncouple the production function from the purchasing function so that delays in shipment of raw materials do not cause production delays.
- Stores and Spares: This category includes those products which are accessories to the main products produced for the purpose of sale.
- Work-in-Process Inventory: This category includes those materials that have been committed to the production process but have not been completed. The more complex and lengthy the production process, the larger will be the investment in work-in-process inventory.
- Finished Goods Inventory: These are completed products awaiting sale. The purpose of a finished goods inventory is to uncouple the productions and sales functions so that it no longer is necessary to produce the goods before a sale can occur.
- Material Costs: These are the costs of purchasing the goods including transportation and handling costs.
- The ordering costs refer to the costs associated with the preparation of purchase requisition by the user department, preparation of purchase order and follow-up measures taken by the purchase department, transportation of materials ordered for, inspection and handling at the warehouse for storing.
- Carrying Costs: These are the expenses incurred in storing goods. Once the goods have been accepted, they become part of the firm's inventories. These costs include insurance, rent/depreciation of warehouse, salaries of storekeeper, his assistants and security personnel, financing cost of money locked-up in inventories, obsolescence, spoilage and taxes.
- Cost of Funds Tied-up with Inventory: Whenever a firm commits its resources to inventory, it is using funds that otherwise might be available for other purposes. The firm has lost the use of funds for other profit making purposes. This is its opportunity cost. Whatever be the source of funds inventory has a cost in terms of financial resources. Excess inventory represents unnecessary cost.
- Cost of Running out of Goods: These are costs associated with the inability to provide materials to the production department and/or inability to provide finished goods to the marketing department as the requisite inventories are not available.
- The Economic Order Quantity (EOQ) refers to the optimal order size that will result in reduction of total ordering and carrying costs for an item of inventory given its expected usage, carrying costs and ordering cost. By calculating an economic order quantity, the firm attempts to determine the order size that will minimize the total inventory costs.
- As order Quantity (Q) increases the total ordering costs will decrease while the total carrying costs increase.
- Inflation affects the EOQ model through increased carrying costs. As inflation pushes interest rates up, the cost of carrying inventory increases.
- The EOQ Model can be extended to production runs to determine the optimum production quantity. The two costs involved in this process are: (i) set-up cost and (ii) inventory carrying cost.
- The set-up cost is of the nature of fixed cost and is to be incurred at the time of commencement of each production run. The larger the size of the production run, the lower will be the set-up cost per unit.
- The carrying cost will increase with increase in the size of the production run.
- There is an inverse relationship between the set-up cost and inventory carrying cost.
- The reorder point for replacement of stock occurs when the level of inventory drops down to zero.
- The two factors that determine the appropriate order point are the procurement or delivery time stock which is the inventory needed during the lead time (i.e., the difference between the order date and the receipt of the inventory ordered) and the safety stock which is the minimum level of inventory that is held as a protection against shortages.
- The stock level subsystem keeps track of the goods held by the firm, the issuance of goods, and the arrival or orders. It maintains records of the current level of inventory. For any period of time, the current level is calculated by taking the beginning inventory, adding the inventory received, and subtracting the cost of goods sold. Whenever this subsystem reports that an item is at or below the reorder-point level, the firm will begin to place an order for the item.
- A firm using the ABC system segregates its inventory into three groups: A, B and C. The A items are those in which it has the largest rupee investment. These are the most costly or the slower turning items of inventory. The B group consists of the items accounting for the next largest investment. The 'C' group consists of least rupee investment.
- There are different ways of valuing the inventories and a knowledge of these methods of valuing stocks is essential for an efficient inventory management process.
- First-In-First-Out (FIFO): When a firm adopts the FIFO method to price its raw material, the issue of material from the stores will be in the order in which it was received. Thus, the pricing will be based on the cost of material that was obtained first.
- Last-In-First-Out (LIFO): In the LIFO method, the material issued will be priced based on the cost of the material that has been purchased recently.
- Weighted Average Cost Method: The pricing of materials will be on a weighted average basis (weights will be given based on the quantity).
- Standard Price Method: Material is priced based on a standard cost which is predetermined. When the material is purchased the stock account will be debited with the standard price. The difference between the purchase price and the standard price will be carried into a variance account.
- Replacement/Current Price Method: In this method, material is priced at the value that is realizable at the time of the issue.