AFM

M0d-4 INVENTORY MANAGEMENT

Inventory manangement
Introduction: there are three types of inventories: raw materials, work in process (WIP) and finished goods. Raw materials are materials and components that are inputs in making the final product. Work in process, also called stock in process, refers to goods in the intermediate stages of production. Finished goods consist of final products that are ready for sale. While manufacturing firms generally hold all the three types of inventories, distribution firms hold mostly finished goods.

 Inventories represent the second largest asset category for manufacturing companies, next only to plant and equipment. The proportion of inventories to total assets generally varies between 15 to 30%. Given substantial investment in inventories, the importance of inventory management cannot be over emphasized.

 Decision relating to inventories are taken primarily by executives in production, purchasing and marketing departments. Usually raw material policies are shaped by purchasing and production executives, WIP inventory is influenced by the decisions of production executives, and finished goods inventory policy is evolved by production and marketing executives. Yet as inventory management has important financial implications, the financial manager has the responsibility to ensure that inventories are properly monitored and controlled.

 He has to emphasize the financial point of view and initiate programs with the participation and involvement of others for effective management of inventories. There are seven sections in this chapter viz. 1. need for inventories 2. order quantity EOQ model 3. order point 4. pricing of raw materials and valuation of stocks 5 . monitoring and control of inventories. 6.criterion for judging the inventory systems. 7. inventory management in practice

 Need for inventories: there are two types of inventories viz; process or movement inventories and organization inventories. Process inventories or movement inventories are required because it takes time to complete a process / operation and to move products from one stage to another. The average quantity of such inventories would be equal to: Average output of the process (or average usage at the end of the movement) X time required for the process (or time required in movement)

 For ex. 1. If the average output of a process is 500 unit per day and the process time is 5 days, the average process inventory would be 2500 units, 2. if the average sales at the warehouse are 100 units a week and the transit (movement) time required to ship goods from the plant to the ware house is 3 weeks, the average movement inventory would be 300 units.

 Organization inventories are maintained to widen the latitude in planning and scheduling successive operations. Raw material inventory enables a firm to decouple its purchasing and production activities to some extent. It provides flexibility in purchasing and production. The firm can wait for an opportune buying movement without affecting its production schedule. Likewise, the production schedule need not be influenced by immediate purchasing activity.

 In-process inventory provides flexibility in production scheduling so that an efficient schedule and high utilization of capacity may be attained. Without in process inventory, a bottle neck at any stage in the production process renders idle, the machines and facilities at subsequent stages. This results in delay and idle facilities.

 Finished goods inventory enables a firm to decouple its production program and marketing activities so that desirable results can be achieved on both the fronts. If adequate finished goods inventory is available, the marketing department can meet the needs of customers promptly, irrespective of the composition of goods flowing out of the production line currently. By the same token, the volume and composition of current output from the production line may be determined some what independently of the volume and composition of the current off take in the market.

 Order quantity EOQ model: Two basic questions 1.what should be the size of the order ? 2. at what level should the order be placed? To answer the first question the basic economic order quantity (EOQ) model is helpful. There are three types of costs in the context of inventory management: ordering costs, carrying costs, and shortage costs.

 Ordering costs: ordering costs relating to the purchased items would include expenses on the following: requisitioning, preparation of purchase order, expediting , transport, and receiving and placing in storage. Carrying cost: include expenses on the following: interest on capital locked up in inventory, storage, insurance, obsolescence, and taxes. Carrying cost are about 25% of the value of inventories held.

 Shortage costs: arise when inventories are short of requirement for meeting the needs of production or the demand of customers. Inventory shortages may result in one or more of the following: high costs concomitant with crash procurement, less efficient and uneconomic production schedule, and customer dissatisfaction and loss of sales. Measurement of shortage costs when shortage results in failure to meet customers demand is relatively difficult because the effects are both long term and short term and some what intangible in nature.

 When a firm order large quantities in a bid to reduce the total ordering costs, the average inventory, other things being equal, tends to be high thereby increasing the carrying costs. Also when a firm carries a long safety stock to reduce shortage cost , its carrying costs tend to be high. In view of such relationships, minimization of overall costs of inventory management would require a consideration of trade off among these costs.

 Assumptions of EOQ model.: the basic EOQ model is based on the following assumptions: 1. the forecasts usage/ demand for a given period, usually one year, is known. 2. the usage / demand is even through out the period 3. inventory orders can be replenished immediately. 4. there are two distinguishable costs associated with inventories: cost of ordering and costs of carrying 5. the cost per order is constant regardless of the size of the order 6. the cost of carrying is fixed percentage of the average value of inventory

 EOQ formula: U = annual usage/ demand; Q = quantity ordered , F = cost per order, C =percent carrying cost., P = price per unit , Tc = total costs of ordering and carrying: Tc =U/Q x F + Q/2 x P x C In the above equation the first term on the RHS is the ordering costs, obtained as the product of the number of orders (U/Q) and the cost per order (F), and the second term is the carrying cost, obtained as the product of the average value of inventory holding (QP/2) and the percentage carrying cost (C).

 The graph illustrating the behavior of the carrying cost, the ordering cost and sum of these two costs.
Cost

Behaviour of inventory related cost

Total cost

Carrying cost Ordering cost

Quantity ordered

 The carrying cost varies directly with the order size ( since the average level of inventory is one half of the order size), whereas the ordering cost varies inversely with the order size. The total cost of ordering and carrying is minimized when : Q = (2FU/PC) This formula is EOQ formula.

 This formula is useful for inventory management. It tells us what should be the order size for purchased items and what should be the size of production run for manufactured items. Ex. U= annual sales =20000units, F= fixed cost per order = Rs.2000, P = purchase price per unit = Rs12, C= carrying cost =25% of inventory value. Q = (2 x 2000 x 20000)/(12x0.25) = 5164

 Quantity discounts and order quantity: the standard EOQ analysis is based on the assumption that the prices per unit remains constant irrespective of the order size. When quantity discounts are available, which is often the case , the price per unit is influenced by the order quantity. This violates the applicability of the EOQ formula. However the EOQ frame work can still be used as a starting point for analyzing the problem. To determine the optimal order size when quantity discount are available the following procedure may be used.

 1. determine the order quantity using the standard EOQ formula assuming no quantity discounts .Call it Q*. 2. if Q* enables the firm to get quantity discount then it represents the optimal order size. 3. if Q* is less than the minimum order size required for quantity discount (call it Q), compute the change in profit as a result of increasing the order quantity for Q* to Q as follows: = U D + (U/Q* - U/Q) F [ Q(P-D)C/2Q*PC/2]

 Where = change in profit ; U = annual usage / demand; D= discount per unit when quantity discount is available ; Q* = economic order quantity assuming no quantity discount, Q = minimum order size required for quantity discount., C = inventory carrying cost expressed as a percentage. The RHS first term in the above formula represents savings in price, the second term represents the saving in ordering cost, and the third term represents the increase in the carrying cost.

 4. if change in profit is +ve , Q represents the optimal order quantity. If the change in profit is ve, Q* represents the optimal order quantity. Ex. U = annual usage = 10000units, F=fixed cost per order= Rs.150, P = purchase price per unit = Rs.20, C= carrying cost =25% of inventory value, Q = minimum order size required for quantity discount = 1000 units, D= discount per unit = Re. 1 EOQ assuming no quantity discount Q* = 2FU/PC = 2 X150 X10000/20/0.25=775 units.

 Since Q* is less than Q (1000) the change in profit as a result of increasing the order quantity from Q* to Qis UD+ [U/Q* -U/Q]F-[Q(P-D)C/2 Q*PC/2] =10000 x1 +[10000/775 10000/1000]150 1000(20-1)0.25/2 -775 x20x 0.25/2 = 10000 + 435 (2375 -1938) = Rs 9998 Since the change in profit is +ve , Q =1000 represents the optimal order quantity.

 Note that the above procedure is based on the principle of marginal analysis. This involves comparing incremental benefits with incremental costs in going from one level of inventory to another. The principle may be used to compare a proposed order quantity with the present order quantity and more generally for comparing any set of alternatives.

 Inflation and order quantity: an implicit assumption of EOQ analysis is that the purchase price per unit is constant. In an inflationary period this assumption is not valid. If the rate of inflation is predictable, the EOQ formula can be applied with one simple modification; deduct the rate of inflation from C; the annual carrying cost expressed as a percentage. Why is the deduction to be made? The reason is that the rise in inventory values in the wake of inflation offsets to some extent the carrying cost associated with inventory holding.

 The above adjustment might suggest that the average inventory (and EOQ) increases during an inflationary period. This may not be true because the carrying cost also tends to increase during an inflationary period, thus lowering the EOQ and average inventories. The net effect of inflation on the EOQ and a average inventory holding may be negligible. However, the factor of inflation should be considered explicitly.

 Ordering point: the standard EOQ model assumes that materials can be procured instantaneously and hence implies that the firm may place an order for replenishment when inventory level drops to zero. In the real world, however, procurement of materials takes time and hence the order level must be such that the inventory at the time of ordering suffices to the needs of production during the procurement period.

 If the usage rate of material and lead time for procurement are known with certainty, then the ordering level would be : Lead time in days for procurement x average daily usage. When the usage rate and lead time are likely to vary, the reorder level should be higher than the normal consumption period requirement during the procurement period to provide a measure of safety in case of variability of usage and lead time. Put differently the reorder level should be =: normal consumption + safety stock.

 Safety stock: what should be the level of safety stock? In simple situation, where only the usage rate is variable and the maximum usage rate can be specified, the safety stock required to seek total protection against stock out is simply= (maximum usage rate average usage rate) x lead time.

 When both the lead time and usage rate vary, which is often the case, and the range of variation is wide, complete protection against stock out may require an excessively large safety stock. For ex. If the lead time varies between 60days and 180 days with an average value of 90 days, and the usage rate varies between 75units and 125 units per day with an average value of 100 units per day a safety stock of 13500 units is required for complete protection against stock out.

 This has been worked out as follows; Maximum possible usage normal usage (Maximum daily usage x max. lead time) - (av. Daily usage x av. Lead time) 125 x 180 100 x 90 = 13500 Since inventory carrying costs are proportional to the level of inventories carried, it rarely makes sense to seek total protection against stock out. In view of the trade off between stock out cost and inventory carrying cost, the optimal level of safety stock is usually much less than the level of safety stock required to achieve total protection against stock out.

EX. ABC co. manufactures cables using aluminum rods. The probability distributions of the daily usage rate and the lead time for procurement are as follows- these distributions are independent

Daily Probability usage rate in tons 10 0.2

20 30 0.6 0.2

Lead time in days 20

30 40

Probability

0.25
0.50 0.25

 The normal usage during the normal procurement period is 600 tons. This is the product of the average daily usage of 20 tons and the average lead time of 30 days (0.2 x 10 + 0.6 x 20 + 0.2 x 30) =20 and (0.25 x 20 +0.5 x 30 + 0.25 x 40)= 30 The maximum usage is 30 tons x 40days = 1200 tons The probability for the same is 0.2 x 0.25= 0.05

 The stock out cost is estimated to Rs. 10,000 per ton The carrying cost is Rs.1400 per ton per year The cost of various safety stocks are shown in the table. (next slide) Looking at the total cost column it is seen the optimal level of safety stock is 300 tons At this level of safety stock the sum of expected stock out cost and carrying cost is minimal Given the safety stock of 300 tons and normal consumption of 600 tons during lead time the reorder level is 900 tons

Inventory management
Cost associated with various levels of safety stock Safety stock tons 600 Stock outs Stock out cost probabili Expecte ty d stock outs cost Rs. 0 0 Carrying Total cost Rs. cost Rs.

840,000 280,000

840,000 580,000

300
200

300
100 400

3,000,000
1,000,000 4,000,000 2,000,000 3,000,000 6,000,000

0.05
0.10 0.05 0.15 0.10 0.05

150,000
100,000 200,000 300,000 300,000 300,000 300,000 900,000

420,000 570,000

200 300 600

900,000

 Other factors: In the real world some additional considerations ought to be taken into account. These may relate to one or more of the following. anticipated scarcity: when a certain raw material or product is likely to become scarce in future, it may make sense to carry a larger inventory than what is required otherwise to protect against scarcity or nonavailability in future. Expected price change: if a price change is in the offing, the level of inventory carried may be adjusted according to the direction of the expected price change an expected increase in price may warrant an increase in the level of inventory carried and an expected fall in price may justify a decrease in the level of inventory carried.

Obsolescence risk: the presence of obsolescence risk suggest a reduction in the level of inventory carried the degree of reduction would, of course , depend on how serious the obsolescence risk is Government restrictions: if the government imposes restriction on the level of inventory that can be maintained directly or indirectly (through the policies of commercial banks) , then this becomes a constraint in inventory management. Marketing considerations; some times the compulsions of the market dictate the levels of inventory maintained by the firm. If the market is highly competitive and the behavior of consumers unpredictable, a large inventory may have to be carried to ensure that selling opportunities are fully exploited.

 Pricing of raw materials and valuation of stocks: Pricing of raw material: several methods are used for pricing inventories used in production.The important ones are: FIFO method: this method assumes that the order in which the materials are received in the stores is in the order in which they are issued from the stores. Hence the materials which is issued first is priced on the basis of the cost of materials received earliest so on and so forth. Weighted average cost method: under this method, material issues are priced at the weighted average cost of materials in the stock.

 Valuation of stock: there are three important types of inventories carried by a manufacturing organization: 1. raw material inventory 2. work in process 3. finished goods inventory The valuation of WIP and finished goods inventory depends on 1. the method used for pricing the materials and 2. the manner in which fixed manufacturing overhead costs are treated.

 The treatment of fixed manufacturing costs are discussed in two systems of costing viz., direct costing and absorption costing. Under direct costing fixed manufacturing overhead costs are treated as period costs and not as product costs. Put differently, they are charged directly to the income statement and hence not reflected in the valuation of inventories. Under absorption costing, fixed manufacturing overhead costs are treated as product ( inventoriable) costs and period costs. Hence inventory valuation reflects an allocated share of fixed manufacturing overhead costs.

 Therefore, the valuation of WIP and finished goods inventory is lower, under direct costing and higher absorption costing. Further when the inventory level increases, the reported profit under direct costing is lower than the reported profit under absorption costing by the same token, when the inventory level decreases, the reported profit under direct costing is higher than what it is under absorption costing.

MONITORING & CONTROL OF INVENTORIES

ABC analysis Just-in-time analysis

MONITORING & CONTROL OF INVENTORIES

ABC ANALYSIS:
Small portion (items) accounts for very substantial usage (value) ABC analysis based on empirical reality advocates selective approach to inventory control Classify inventory as A, B, and C, Category A- 15-25% no. Of items accounting for 60-75% annual usage value

MONITORING & CONTROL OF INVENTORIES

Category B: 20-30% no.of items accounting to 20 30 % annual usage value Category C: 40-60% no. of items accounting to 10 15 % of annual uasage value Pl.See graph

 Graph of cumulative percentage of items and cumulative percentage of usage

Cumulative usage Of items(%) value
100
80 60 40

20

20

40

60

80

100

Cumulative percentage of items

MONITORING & CONTROL OF INVENTORIES

Just-in-time inventory control:
Developed by Taichi Okno of japan Implies that firm should maintain minimum inventory Should rely on suppliers to provide parts & components just in time to meet the requirement Contrast to traditional inventory system, which calls for safety stock

MONITORING & CONTROL OF INVENTORIES

J-I-T, Though appealing, difficult to implement as it needs change in total production & management system JIT requires:
Strong dependable relationship with suppliers with geographical nearness Reliable transport system Easy physical access to the goods, to the shop floor and conveniently located storage areas.

MONITORING & CONTROL OF INVENTORIES

Influence of JIT: Average inventory= 2FU/PC + safety stock Under JIT, F (ordering cost) is lowest, and no need for safety stock, enabled by forging strong supplier relationship. Hence lower inventory level

Monitoring & control of inventories

Elements of inventory programme:
1. Exercise vigilance against imbalance of RM & WIP 2. Expedite completion of unfinished production to saleable product 3. Dispose surplus, obsolete or unusable items 4. Shorten production cycle 5. Change design to maximise use of standard parts which are available of-the-shelf 6. Special pricing to dispose of slow moving items Evening out seasonal fluctuations

 Criteria for judging the inventory system Objective is to minimise cost to the firm at acceptable level of risk Criteria
Comprehensibility Adaptability Timeliness

CRITERIA FOR JUDGING THE INVENTORY SYSTEM

Comprhensibility:
Inventory system range from simple to weirdly complex Should be understood by the concerned irrespective of automated or manual Concerned should know the logic & rationale, Should be transparent, else, it will be considered as a black box of dubious value

CRITERIA FOR JUDGING THE INVENTORY SYSTEM

Adaptability:
System should respond to the changes Versatile to accept new products Need not take all products as it becomes cumbersome Atleast 90% to be covered and 10 % can be manually dealt with.

CRITERIA FOR JUDGING THE INVENTORY SYSTEM

Timeliness:
Losses in inventories are due to :
Obsolescence due to technology change Physical deterioration over time Price fluctuations because of inherent volatility Inventory system should be capable of inducing timely action and trigger appropriate corrective steps.

INVENTORY MANAGEMENT IN INDIA

Inventory management practices: Inventories are high in India due to:
Purchase executives punished for shortage costs not for carrying over inventory Lengthy & cumbersome import procedure Inventory pays during price rise due to inflation

INVENTORY MANAGEMENT IN INDIA

Unreliable delivery schedules Lack of standardisation Commonly used tools are: ABC analysis, which are not reviewed periodically FSN Analysis (fast, slow & non moving) Unfortunately non moving are not disposed off. Inventory turnover analysis done at aggregate level

INVENTORY MANAGEMENT IN INDIA

Areas of improvement:
Effective computerisation Review of ABC classification Improved coordination among production, purchase, finance & marketing Long term relationship with vendors Disposal of obsolete /surplus inventory Adoption of challenging norms such as JIT and global standards.