INVENTORY MANAGEMENT

INVENTORIES

“Inventories are assets held for sale in the ordinary course of business, in the process of
production for such sale or in the form of materials or supplies to be consumed in the production
process or in the rendering of services.”

Inventories encompass goods purchased and held for resale;

Classes of inventories

Inventories are broadly classified into two, namely inventories of a trading concern and
inventories of manufacturing concern.

A trading concern is one that buys and sells goods in the same form purchased. The term
merchandise inventory is generally applied to goods held by a trading concern.

A manufacturing concern is one that buys goods which are altered or converted into another form
before they are made available for sale.

Inventories of manufacturing concern

Finished goods – are completed products ready for sale. Finished goods have been assigned their
full share of manufacturing costs.

Goods in process or work in process – partially completed products which require further process
or work before they can be sold.

Raw materials – are goods that are to be used in the production process. No work or process has
been done on them. Broadly raw materials cover all materials used in manufacturing operations
but frequently this is restricted to materials that will be physically incorporated in the production
of other goods and which can be traced directly to the end product of the production process.

Factory or manufacturing supplies – are similar to raw materials but their relationship to the end
product is indirect. Factory supplies embraced in the term inventories because they are currently
consumed in the production of goods to be sold in the ordinary course of business.

Goods includible in the inventory

As a rule, all goods to which the company has TITLE should be included in the inventory,
regardless of location. There the title has already passed from seller to the buyer, the goods form
part of the inventory of the latter.

The phase passing of title is a legal language which means “the point of time at which the
ownership changes.”

Who is the owner of the goods in transit?

This will depend of the terms FOB Destination of FOB Shipping Point, FOB means FREE ON
BOARD.

Under FOB Destination, ownership of goods purchased is transferred only upon receipt of goods
by the buyer at the point of destination. Under this the goods in transit are still the property of
the seller.

Under FOB shipping point, ownership of goods purchased is transferred upon shipment of goods
at shipping point. Under this the goods in transit are the property of the buyer.

SINGLE-PERIOD AND MULTIPLE PERIOD INVENTORIES

Single-period inventory involves items that will be stocked only once, with no intention of
restocking them after they are consumed.

Multiple-period inventory involves items that will be maintained in inventory long enough that
units which have been consumed may be replenished. The amount and timing of future
replenishments can be varied to adjust the inventory level in response to demand. Multiple-
period inventories are kept for most finished products and their components and are much more
common than single-period inventories.

Types of Demand

1. Dependent demand – , as the name implies, is directly related to the demand for
another item or other items. It is the requirement for any of the parts or materials
necessary to make some other item. Items are typically subassemblies or component
parts that will be used in the production of a final or finished goods.
2. Independent demand – is the demand for an item in its current form. The item may
be a finished good, sold for use as is; a repair or service part;

INVENTORY TYPES

CYCLE INVENTORY

Cycle inventory varies in proportion to order quantity – larger orders result in higher cycle
inventory, while smaller orders result in lower cycle inventory.

SAFETY STOCK INVENTORY

Safety Stock is excess inventory that a company hold to guard against uncertainty in demand,
lead time and supply. Safety stock is used to improve customer service and reduce stock out
resulting from unpredictable changes in demand , lead time or supply.

ANTICIPATION INVENTORY

Inventory that is held for future use at a time when demand will exceed available capacity.
PIPELINE INVENTORY/ IN TRANSIT INVENTORY

Inventory that is in the process of moving form one location in the supply chain to another.
Inventory moves from suppliers to manufacturers, from manufacturers to retailers and from
distribution centers to customers or retailers. Pipeline inventory consists of orders that have been
placed but not yet received.

WORK IN PROCESS INVENTORY

Inventory that is in the process of being transformed from one state to another. It cannot be sold
to a customers since it is not yet finished.

REMANUFACTURED / RECONDITIONED INVENTORY

Inventory consists of products that had been used by a customer and then reacquired by a
company and either remanufactured or reconditioned for resale.

Functions of Inventory

1. to meet anticipated demand

2. to smooth production requirements
3. to protect against stock outs
4. to take advantage of order cycles
5. to hedge against price increase
6. to permit operations

Stock is both good and bad

The problem with inventory management is that keeping stock has both advantages and
disadvantages.

The advantages of inventory include,

1. Inventory allows customers to be served quickly and conveniently (otherwise you would
have to make everything as the customer requested it).
2. Inventory can be used so a company can buy in bulk, which is usually cheaper.
3. Inventory allows operations to meet unexpected surges in demand.
4. Inventory is an insurance if there is an unexpected interruption in supply from outside
the operation or within the operation.
5. Inventory allows different parts of the operation to be ‘decoupled’. This means that they
can operate independently to suit their own constraints and convenience while the stock
of items between them absorbs short-term differences between supply and demand

The disadvantages of inventory include

1. It is expensive. Keeping inventory means the company has to fund the gap between paying
for the stock to be produced and getting revenue in by selling it. This is known as working
capital. There is also the cost of keeping the stock in warehouses or containers.
2. Items can deteriorate while they are being kept. Clearly this is significant for the food
industry whose products have a limited life. However, it is also an issue for any other
company because stock could be accidentally damaged while it is being stored.
3. Products can become obsolete while they are being stored. Fashion may change or
commercial rivals may introduce better products.
4. Stock is confusing. Large piles of inventory around the place need to be managed. They need
to be counted, looked after and so on.

INVENTORY COSTS

Different Types of Inventory Costs

1. Holding/Carrying cost

This is the cost a business incurs over a certain period of time, to hold and store its
inventory They are expenses such as storage, handling, insurance, taxes, obsolescence,
and interest on funds financing the goods.  These charges increase as inventory levels
rise. To minimize carrying costs, management makes frequent orders of small quantities

2. Ordering costs

Ordering costs are those fees associated with placing an order, including expenses related
to personnel in purchasing department, communications, and the handling of related
paper work. Lowering these costs would be accomplished by placing small number of
orders, each for a large quantity. Unlike carrying costs, ordering expenses are generally
expressed as a monetary value per order.

3. Shortage cost

When the stock of the item is depleted, an order for that item must wait until the stock is
replenished or be cancelled. It happens when demand exceeds supply

4. Setup/production change costs

To make each different product involves obtaining the necessary material, arranging
specific equipment setup, filling out the required papers, appropriately charging time and
materials, and moving out the previous stock of material
Pressures for SMALL / LARGE Inventory

Reasons to carry less inventory Reasons to carry more inventory

Gain quantity

discounts

Increase Labor
Reduce interest Reduce property Reduce
and Equipment
Transportation
Taxes and utilization
Cost
insurance cost
Reduce Set up Improve customer
Reduce storage Reduce shrinkage
/Ordering Cost service and adapt
and handling cost and spoilage
to variation in
demand

INVENTORY MANAGEMENT

* The overseeing and controlling of the ordering, storage and use of components that a
company will use in the production of the items it will sell as well as the overseeing and
controlling of quantities of finished products for sale.

* Successful inventory management involves creating a purchasing plan that will ensure that
items are available when they are needed (but that neither too much nor too little is purchased)
and keeping track of existing inventory and its use.

*Activities employed in maintaining the optimum number or amount of each inventory item.
The objective of inventory management is to provide uninterrupted production, sales,
and/or customer-service levels at the minimum cost. Since for many companies inventory is the
largest item in the current assets category, inventory problems can and do contribute to losses or
even business failures. Also called inventory control.

Requirements for effective inventory management

Management has two basic functions with respect to inventory. One is to establish a
system of accounting for items in inventory, and the other is to make decisions regarding how
much to order and when to order. To be effective management, must have the following:

1. A system to keep track of inventory on hand and on order.

2. A reliable forecast of demand that includes an indication of possible forecast error.
 3. Knowledge of lead times and lead time variability
4. Reasonable estimates of inventory holding costs, ordering costs and shortage costs.
5. A classification system for inventory items.

INVENTORY SYSTEMS, JIT, KANBAN, EOQ, TWO BIN SYSTEM ABC ANALYSIS

Inventory System

A set of policies and controls that monitors levels of inventory and determines what levels
should be maintained, when stock should be replenished, and how large orders should
be.

An inventory system provides the structure and operating policies for maintaining and
controlling goods to be stocked in inventory. The system is responsible for ordering,
tracking and receiving goods. The two essential policies for every item that a company
stocks in inventory or uses in its processes are

1. How much or what quantity of an item to order?

2. When should an order for that item be placed?

Two General Types of Systems

1. Continuous Review Systems / Economic Order Quantity Systems / Q Systems/ Fixed-

order quantity models

Always order same quantity of items but differ in periods of time between orders

2. Periodic review systems / Fixed Period Systems or P- Systems/ Fixed- time periods models

Always have same time between orders but may have different order quantities from
order to order . It is used when the item should be in-stock and ready to use.

In this case, rather than monitoring the inventory level and ordering when the level gets
down to a critical quantity, the item is ordered at certain intervals of time, for example, every
Friday morning. This is often convenient when a group of items is ordered together. An
example is the delivery of different types of bread to a grocery store. The bakery supplier may
have 10 or more products stocked in a store, and rather than delivering each product
individually at different times, it is much more efficient to deliver all 10 together at the same
time and on the same schedule.
 Differences between inventory systems

Q System / Continuous Review P- Systems/ Periodic

System review system
Order quantity Q = constant Q = variable
Order timing R (orders when inventory position Order at the end of the
drops to or below the pre-determined period P (can be daily,
reorder point weekly, monthly or some
other time)
Database update Every time a withdrawal or addition is Only at the end of the
made period
Inventory size Lower Slightly higher because of
need to hold more safety
stock

Just-in-Time Inventory Management (JIT)

Many managers have come to realize that keeping a large inventory on hand can be costly.
With a Just-in-TIme inventory strategy, orders are placed only as needed to fill customer orders.
Money is saved by reducing inventory holding costs. Small quantities of inventory are ordered
as needed to produce products. A close eye must be kept on inventory levels at all times to avoid
inventory shortages which would result in an inability to fill customer orders.

Some facets of the management practice Toyota developed are ideologically related to Japan’s
unique customs, culture, and labor-management relations. Nevertheless most of the philosophy
and many elements of the Toyota production system have been adapted to other companies and
cultures. The concepts have been successful in many companies throughout the world.
Adaptations of the general philosophy in the US gave been called Just- In-Time Manufacturing,
Manufacturing excellence, world class manufacturing because the most noticeable characteristic
is operating with a very low work in process inventory and often low finished goods inventory.

Products are assembled just before they are sold, subassemblies are made just before the products are
assembled and components are fabricated just before the subassemblies are made so WIP inventory is low
and production lead times are short. To operate with these low inventories, the companies must be
excellent in other areas. They must have consistently high quality product throughout the
organization. To achieve this quality and coordination, they must have the participation
continuous improvement that includes mutually supportive components.

THE KANBAN SYSTEM

The kanban system is simple information system used by a work center (WC) to signal its
supplier WC to send a container of an item and to authorized the supplier WC to make another
container of that particular item. The word comes from the Japanese word kanban which means
card or sign. Originally card was used to signal the supplying WC. A WC can be used any a
variety of methods to trigger re-supply by its supplier. For example a flashing light the empty
container itself, message on a computer terminal can communicate a request for more material.

TWO - BIN SYSTEM.

One inventory system with a very simple way to signal that more material should be ordered is
the two-bin system. This system is useful for inexpensive items that cost more to count and monitor
that it costs simply to use some approximate reorder level. A two-bin system has a designated
location such a physically separate bin, a hold area with a painted outline on the floor, or a portion
of the larger bin below a painted line. To hold stock for use during the order lead time. The
reorder level is signaled, and a replenishment order is placed when the normal working stock is
exhausted and the company begins using stock from this “second bin”. When the order arrives,
the second bin is refilled, and the remainder of the order is placed in working stock.

VALUE ANALYSIS

Value analysis is an organized effort to reduce the costs of purchased parts and materials. It
involves a study of items or services that are to be purchased in sufficient quantities to justify
study. Value analysis seeks to answer such questions as: What is the function of the item? Is the
function necessary? Can a standard part that will serve the function to be found? What does the
item cost? The concept is sometimes is applied by a team or task force that may involve
engineering, production, and purchasing in a review of existing and new products to ensure that
expenditures result in the receipt of appropriate value.

ABC Classification

We have seen that there are a variety of types of inventory systems that a company may use to
manage its inventories of independent-demand items. More than one type of system may be used
within the same company- a fixed-quantity system for some items, a fixed interval system for
others. The interval between orders may be relatively short for some items and much longer for
others. Selection of the type of independent-demand inventory system to use may be influenced
by several systems, the unit cost of the item, or the seriousness of the problem if the item is not
available.
ABC analysis (Inventory)

ABC analysis is an inventory categorization method which consists in dividing items into three
categories, A, B and C: A being the most valuable items, C being the least valuable ones. This
method aims to draw managers’ attention on the critical few (A-items) and not on the trivial many
(C-items).

The ABC approach states that, when reviewing inventory, a company should rate items
from A to C, basing its ratings on the following rules:

A-items are goods which annual consumption value is the highest. The top 70-80% of the
annual consumption value of the company typically accounts for only 10-20% of total
inventory items.

B-items are the interclass items, with a medium consumption value. Those 15-25% of
annual consumption value typically accounts for 30% of total inventory items.

C-items are, on the contrary, items with the lowest consumption value. The lower 5% of
the annual consumption value typically accounts for 50% of total inventory items.

BUDGET ALLOCATION

A budget allocation inventory system is more of general guideline that a precise set of opening rules.
Systems of this general nature are used to control inventories in retail establishments-gift shops,
furniture stores, department stores, and the like. The budget allocation method relies on the
discretion of a buyer or department manager to determine how many of which items should be
in stock. General allocations of a total budget to various categories of merchandise may be made
to keep a balanced selection available to customers. Within these allowable investment amounts,
the company’s buyers observe what is selling and order replenishments from vendors. Buyers
also may decide to purchase items that currently are not stocked if they believe the products will
sell. Some companies have agreements with suppliers whereby the suppliers’ representatives
periodically visit the store, check the inventory on hand, and replenish the stock to some target
level. Budget allocation methods are useful when customers have some latitude in selecting
products.

Economic Order Quantity (EOQ)

The Economic Order Quantity inventory strategy assumes that demand for a product will
remain at a constant or near constant level. The goal is to minimize costs, including holding and
ordering costs. This strategy also assumes that lead time for the receipt of orders will remain
constant. No shortages are allowed with economic order quantity. They key to EOQ is selecting
an order quantity that minimizes average inventory management cost and time, thus avoiding
shortages or overages of inventory.
The Economic Order Quantity Model

EOQ models identify the optimal order in quantity in terms of minimizing the sum of
certain annual costs, which vary in order size.
Basic cost incurred

1. Holding costs or Carrying Costs – depreciation, warehousing, interest , rent, utilities, inventory
taxes, obsolescence, record keeping costs and other cost incurred while the inventory is in the
possession of the company.
2. Ordering costs or order costs – costs and expenses incurred in preparing and giving orders.
Cost involved in requisition, purchase order, receipt of goods, placing of goods in inventory and
processing of payment to suppliers.

Assumptions of the basic EOQ Model

1. there is only one product involved

2.annual usage ( demand) requirements are known)

3. usage is spread evenly throughout the years so that the usage rate is reasonable and constant
4. lead time does not vary
5. each order is received in a single delivery
6. there is no quantity discounts
EOQ Formulas:

EOQ or Q = 2DS
H

Annual Carrying Cost = Q H

2

Annual Ordering Cost = D S

Q

Total cost = Total carrying cost + Ordering costs

Where: D = demand in units per year

Q = Order quantity in units
S = Order cost in peso
H = Carrying cost in peso per unit

At EOQ Annual carrying cost = Annual ordering costs