What is inventory? What are its varieties? Inventory is the buffer between two related sequential activities. Between purchase and production, between the beginning and completion of production, and between production and marketing, buffers are needed. Buffer means a cushion to fall back on. Production should not suffer due to some difficulty in purchase of raw materials. Marketing should not suffer due to some difficulty in production. If the business has some stock of raw materials, a temporary difficulty in purchase will not effect production since the stock of raw materials can be used. If there is a stock of finished goods marketing will not be effected due to any temporary hurdle in production. The stocks of raw materials and finished goods, therefore serve as buffers absorbing the difficulties in purchase and production respectively. So, inventory takes different forms. Stocks of raw materials, work-in-process and finished goods are prime inventory. Stocks of consumable stores (like cotton waste, lubricants, etc) maintenance materials (tools, jigs, etc), and packing materials are some secondary inventory. A business has to carry certain amount of inventory. Carrying too much or too little of inventory is bad. Inventory management is concerned with deciding of right quantity.
Inventory management refers to the planning and control of the size of individual items of materials that is carried on by a business. Take any business firm-trading or manufacturing. Many and diverse materials are dealt with/used by the firm. Quite a lot of money is locked up in these materials carried as stock. Several factors account for this. The nature of the business, the size of the business, the seasonality of production/consumption of the production, the seasonality of raw material availability, the terms of purchase/sale, the length of the production cycle, the dependability of transport facilities, the inventory policy of the business, the costs of emergency action courses, the lead time and the lead time consumption needs and the probabilities associated therewith etc, influence the size of inventory. To elaborate a little, trading and most manufacturing businesses, large businesses, seasonal businesses (like those in the manufacture of umbrellas, rain-coats, etc), businesses using raw materials which are available only during certain seasons (like flour mills, edible oil mills, etc), businesses which buy on cash and sell or credit terms, businesses with longer production cycle (where the time gap between beginning of production process and its completion is more), businesses with uncertain transport infrastructure, businesses pursuing cautious inventory policy (which carry more stock relative to their level of operation), businesses where emergency purchases cost heavily, and businesses with large/ fluctuating lead time and lead time requirements carry a lot more inventory than other businesses.
Well, coming back to determination of the optimum size of inventory, due regard given to all the above said factors, different questions arise. There are i) How much to order every time? ii) When to order or what is the re-order level? What should be the safety stock? What stock-out probabilities and levels are acceptable? Inventory management has to find optimal/satisfying answers to these and the size of inventory is thus determined.
The quantum of inventory carried depends on the motives of the organization. There are principally three motives, namely, transaction motive, precautionary motive, and speculative motive. Inventory carried in order to facilitate smooth running of day-to-day operations (production and sales) comes under the first category. Inventory held to avoid stock-outs due to unforeseen contingencies (like spurt in demand, increase in rate of usage, delay in arrival of ordered inventory, etc) comes in the second category. When excessive inventory is held taking advantage of favorable price trends in the market, such excessive inventory is called inventory held for speculative motives.
Inventory requirements for meeting the transactional and precautionary needs can be planned with fair degree of accuracy given the rate of usage, lead time, the level of insurance against stock-out that is considered prudent and other relevant information. With the help of these information the maximum, minimum and reorder level of stock and the optimum quantity of stock to be ordered each time can be ascertained, the stock level and optimum order quantity plans help achieving the objective of inventory management.
Importance of Inventory Management
Inventory forms a significant segment of current assets. For manufacturing businesses a chunk of their current asset is in inventory. For durable goods manufacturers work-in-process constitutes a good portion of their current assets. For trading businesses finished goods account for a good portion of current assets. In manufacturing businesses roughly 30% to 70% of current assets is in inventory of one form or the other. In trading businesses the maximum range can even approach 100% and the maximum may never fall below 50% or so. So large funds are kept invested in inventory. As these funds are not free of costs and invested funds are limited, every business has to see that it carries only just enough inventory which must ensure that:
- The increasing demand of the customers is met,
- There is no lost sales (i.e., sales that could have been made but for stock availability) and there is no loss of consumer goodwill,
- The production operations go smoothly,
- There is no pile-up of stock of any item and consequent loss due to obsolescence, theft, etc, and
- There is no lock-up of more than adequate capital inventory.
These objectives are conflicting. The first three objectives call for more investment in inventory, while the rest pull in the opposite. Herein the management has to play its role and balance these divergent objectives and set the optimal level of investment in inventory.
Inventory Costs
There are three types of costs. These are: Ordering costs (costs associated with placing orders), cost of materials and carrying costs.
- Ordering costs include cost of stationery, postage, telegram, etc in placing an order, and cost of administration of the purchase organization. Ordering costs are generally assumed to be fixed per order and directly proportional with the number of orders.
- Cost of materials is the purchase price, plus transport and insurance during transit.
- Carrying costs include space cost, storage costs, insurance, taxes, obsolescence, theft and pilferage, wastage and loss, the interest on capital locked-up, etc.
If you carry more inventory all the above costs will be increasing, though not proportionally and vice versa. Besides, if you carry less inventory there are also costs like high unit price for the inherent smaller order sizes, contribution on sales lost, cost of lost consumer patronage, and so on. For any given level of inventory, these three components of carrying costs are present in some proportional-mix.
Inventory management aims at reducing both the ordering cost and carrying cost. As these move in opposite directions, minimizing the total of both these costs is the crux of the whole of inventory management exercises. Economic order quantity technique of inventory management is based on this minimization effect.
Inventory Levels
Better inventory management is possible by setting inventory levels, like maximum level, reorder level and minimum level.
Maximum stock level represents the quantity of inventory beyond which the stock should never move up. Reorder level refers to the level of stock at which an order for replenishing the inventory has to be placed. Minimum level or safety level is the stock level below which the size of inventory should not normally fall. Lead time, lead time consumption and the economic order quantity (EOQ) determine these inventory levels. Lead time refers to the time lapse between order placement and receipt of goods. Lead time consumption refers to the requirement/demand during the lead time. Lead time is not a constant factor, neither lead time consumption is. So, minimum, average and maximum lead times and minimum, average and maximum lead time usage rates (per period) are found from experience. EOQ is a fixed quantity which the square root of twice the period (say a year) requirement of material times ordering cost per order divided by carrying cost of a unit of material per period (a year).
The different inventory levels are given by:
- Reorder stock level = Maximum lead time x maximum usage rate or Minimum stock + (Average lead time X average usage rate)
- Maximum stock level = Reorder level + EOQ – (Minimum lead time X Minimum Usage rate)
- Minimum stock level = Reorder level – (Average lead time X Average Usage rate)
- Average stock level = Minimum level + ½ of EOQ or (Minimum level + Maximum level)/2
- Danger stock level = Minimum usage rate X Emergency lead time.
Read More: Safety Stock Analysis in Inventory Management