30 Purpose of inventory and inventory cost

Sudhanshu Joshi

Learning Objectives:

The Learning objectives of the module are to address the following questions:

1. To understand why do firms carry inventory? What are the various types of inventory carried by an organization?

2. To increase awareness about various concepts of process management

3. Enhance understanding of the learner about different tools and types of process management.

1. Introduction

Inventory management, in the context of an industry, typically refers to the act of managing the material resources of an organization that can help the organization earn revenue in the future. Operations Manager is responsible for the managing part.

For example, a retail store that sells multiple goods (packed food items, groceries, clothes, and electronics goods, etc.) does not usually store all the goods in the store. In other words, a part of the entire stock of goods is kept at a warehouse. The sum of the goods in the store and at the warehouse at any particular point in time is known as the inventory.

2. Significance of Inventory Management

Organizations that are specifically into the production of goods or products heavily depend on a well-managed inventory for a number of reasons. The bottom-line is that an organization heavily into goods and products cannot really survive without a good inventory management system. Reasons for having a good inventory management system:

a) Meeting demands steadily: Demands for specific goods and services will not be the same throughout the season. For example, the sale of air-conditioners usually peaks during the summer and goes down during the winter. A well planned inventory of goods will enable an enterprise to fulfill the demands- and it is well known that the key to earning revenue is the optimum capitalization of demands.

b) Continuity of operations: Sound inventory management will enable an enterprise to run its operations smoothly. For example, if an organization manufactures goods that are heavily dependent on raw materials, then the enterprise needs a good inventory of raw materials so that the operations are unhindered.

c) Economy of operations: A well managed inventory management system enables an enterprise to cut costs. For example, when the festive season is round the corner and the enterprise foresees a surge in demand for goods, it can procure goods in bulk and store them for the season. The main benefits of this exercise are that the enterprise can keep up with the demand and when it buys in bulk, and it will be eligible for discounts too.

3. Principles of Inventory Management

The following practices can help an enterprise have a sound inventory:

a. Demand projection: This is a specialized skill. An enterprise must be able to project demands for specific goods and products at a specific time of the year. The enterprise must design its inventory system based on the demands.

b. Monitoring system: An inventory must have the mechanism of monitoring the amount of stock of goods at any point in time. The enterprise must be able to exactly find out the amount of inventory at any particular point in time.

c. Quality of warehouse: The warehouse must be able to keep the stock in good condition. Wasted materials amount to lost revenue opportunities.

Inventory management is therefore a challenge with most enterprises. In fact, much before an enterprise even begins its selling, the profit and loss can be partially determined by how well it is managing its entire inventory.

4. Decoupling Stocks

To simplify the decision making process. The entire supply chain is usually divided into various decision-making units. Usually, the demarcation of decision-making units takes place both at organizational and departmental boundaries. It is not uncommon for organizations to hold large inventories at organizational as well as departmental boundaries. This decoupling inventory provides the flexibility needed by each decision- making unit to manage its operations independently and to optimize its performance. Improving coordination across various decision making units across various operations can reduce decoupling inventory significantly. In most organizations, internal supply chain is divided into three decision units, materials, manufacturing and distribution, which take care of the buy, make and deliver functions, respectively.

5. Anticipated Inventory:

Anticipation inventory consists of stock accumulated in advance of expected peak in sales or that which takes care of some special event that does not occur on a regular basis. Anticipation stock may further fall into two categories:

a) Seasonal Stock;

b) Speculation Stock

6. Seasonal Stock

When the requirements of an item varies with time (e.g. paints and consumer durables exhibit high demand during festival seasons; refrigerators and air conditioners exhibit peak demand during the summer season), it may be economical for the firm to build the inventory during the low-demand season to take care of peak-season demand. The firm can build enough capacity so as to produce and supply the goods during the peak season, but this means surplus capacity for the firm during the lean season. Though the firm may have enough physical capacity in terms of plants and equipments, it may not like to work with varying production rates because of certain adverse implications for labour and supplier relationships. So for such predictable seasonal variability in demand, firms prefer to plan in advance.

7. Speculation Stock

If certain events like labour or transport strike, which one result in a temporary price or supply stock , are anticipated, a firm may carry certain stocks to take care of eventuality. For example, due to some disturbance in the Middle east, an oil price increase may be expected. Therefore, an excess quality of diesel oil may be carried to take care of this eventuality. Similarity, a high finished goods inventory may be held if a supply problem with some of the major competitors is anticipated. As the name suggests, this inventory is meant to be a preventive measure against an event that may never happen. Many firms hold high inventory in anticipation of price increase. Instead of holding higher physical inventory, firms may like to use ideas like hedging and forward contracts rather than holding physical inventory. Of course, speculation inventory or hedging has certain risk-related implication for the firm also. Even if firms decides to hold speculation inventory, as speculation is for a specific eventuality, after the temporary phase one should not hold any inventory on this account.

8. Pipeline Inventory

Since Production and Transportation activities take certain finite time, firms need to carry pipeline or in-transit stock. Pipeline inventory consists of materials actually being worked on (work-in-process inventory) or being moved from one location to another in the chain (in-transit inventory). The pipeline inventory of an item between two adjacent locations is the product of the process time or transport time and the usage rate of the item. Thus the pipeline inventory may be affected by choosing alternative modes of production or transportation. For example, pipeline inventory may be reduced by transporting goods by air rather than the sea. Similarly, by reducing manufacturing lead time, work-in –process inventory in the system can be reduced.

9. Dead Stock

Dead Stock refers to that part of the non-moving inventory that is unlikely to be of any further use in operations. Dead stock essentially includes items that have become obsolete because of changes in customer taste, design or production processes. Unfortunately, in many firms, dead stock is allowed to accumulate. Ideally, firms should dispose off dead stock on a periodic basis, even if it means incurring a loss in the disposal process. However, firms refrain from disposing off the dead stock as its disposal shows up in the account books as a financial loss. Instead, they choose to show these items as assets in their balance sheet, despite the fact that these items have very little market value. Currently, many companies need companies need inventory write-off decisions be approved at the broad level. This makes it almost impossible to dispose off dead stock because the broad has too many things to deal with and consequently dead stock keeps accumulating. The higher the accumulation of dead stock, the tougher it is to dispose it off, as this will have an adverse impact on the financial results of the firm in that specific year.

In the developed world, in the fashion goods business, obsolescence is quite a common phenomenon. To take care of this, firms in the business identify slow-moving items and offer huge discounts so as to dispose them off by the end of the season. The important thing is to put a process in place where periodically non moving items are analyzed and those that are unlikely to be used or demanded are classified as dead stock and disposed off.

10. Inventory-related costs

A company say monitor all finished goods inventory, and for items that have not moved for more than six months, the marketing department may be asked to identify customers for that item on a priority basis. Some companies with multiple units share information about non-moving items with other units to see if they can be used meaningfully by another units within the company. In the developed world, in the fashion goods business, obsolescence is quite a common phenomenon. To take care of this, firms in the business identify slow-moving items and offer huge discounts so as to dispose them off by the end of the season. The important thing is to put a process in place where periodically non moving items are analyzed and those that are unlikely to be used or demanded are classified as dead stock and disposed off.

11. Ordering Cost

a) Administration cost involved in placing an order: Preparing the purchase order with involve documentation, getting the necessary approval and other formalities. Electronic ordering can reduce the time required by the buyer and thus reduce this component of cost.The ordering cost includes all fixed costs (components of costs that do not vary with the size of the order) associated with placing an order. The main components of the ordering cost include the following:

b) Transportation cost: A fixed transportation cost is often incurred regardless of the size of the order.

c) Receiving cost: This refers to the cost incurred on account of the administrative work that has to be undertaken on receiving the order. For example, at the time of receipt, the receiver will have to prepare the goods receipt note, update inventory records, and make necessary checks against the respective purchase order.

All fixed costs (components of cost that do not vary with order quantity) that are associated with ordering should be included in ordering costs, and all those costs that vary with order size should be included in the cost of the item. A significant part of the ordering cost in a purchase situation is information intensive. By using electronic ordering one will be in a position to reduce ordering cost substantially. In a production environment, the ordering cost is the fixed cost of the set-up. Unlike the ordering cost in a purchase situation. Set up costs are less information intensive and a significant component of cost is the time lost in set-up activity so in a production environment, the focus is on set-up time reduction.

12. inventory-carrying costs

Carrying cost tries to capture all the actual and opportunity costs that are incurred because of holding inventory. The main components of carrying cost include the following:

a) Financing cost: The inventory represents the assets and the working capital of a firm. Usually, this represents a major and possibly an important part of cost of carrying and some firms estimate this to the cost of borrowing. Ideally, this should represent cost of opportunity as the funds can be deployed for alternative use. The best estimate of this is the weighted average cost of the capital that is used in capital budgeting. This component of cost is directly proportional to the value of the firm.

b) Storage and handling cost: Space costs are charges that the company incurs because of storage of inventory, and it will be a function of the size of the item and not the value. Of course, space costs are not relevant while calculating pipeline inventory.

c) Inventory risk: Cost associated with deterioration, obsolescence, shrinkage, theft or damage. This will depend on the nature of the item. For example, fashion goods, perishable goods and high-technology products are likely to have much higher risks.

13. tock out costs

Stock out cost captures the economical consequences of running out of stock. There are two possible scenarios- in one case the customer is willing to wait and items are back-ordered, and in the other, stock out costs are incurred when the customer places an order but it cannot be filled from the inventory. There are two kinds of stock out costs:

1. Lost sales costs;

2. Backorder cost

These costs are intangible and therefore difficult to measure.

14. Lost sale cost

In a situation when a company loses potential sales because of the non –availability of finished goods, it is treated as a lost sales case, and the cost incurred is the opportunity of making profit on that transaction. Apart from being a lost opportunity, it may affect the goodwill of the firm and hence the future sales.

15. Backorder cost

Backorder cost is incurred in a situation where the customer is willing to wait for his or her order to be fulfilled. Backorder result s in additional administrative costs and may involve an additional transportation and handling cost when the material is rushed through to meet this situation. Some of these cost are tangible, but it is also includes other intangible cost such firm goodwill and future sales.

Figure1-1 : Inventory and Operations Management

16. Forms of Demand

Figure 1-1 exhibit relationship between inventory and operations management. Broadly, There exist two types of Demand:

a) Dependent: Demand for items used to produce final products. Example,Tires stored at a Goodyear plant are an example of a dependent demand item

b) Independent: Demand for items used by external customers. Example, Cars, appliances, computers, and houses are examples of independent demand inventory

17. Inventory and Quality Management

• Customers usually perceive quality service as availability of goods they want when they want them

• Inventory must be sufficient to provide high-quality customer service in TQM

18. Types of Inventory Costs

Inventory cost can be classified as:

a. Carrying Cost: Cost of Holding an item in inventory

b. Ordering Cost: cost of replenishing inventory

c. Shortage Cost: Temporary or Permanent loss of sales when demand cannot be met.

19. Inventory Control System

• Continuous system (fixed-order-quantity): constant amount ordered when inventory declines to predetermined level

• Periodic system (fixed-time-period): Order placed for variable amount after fixed passage of time.

20. Economic Order Quantity

The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventory—such as holding costs, order costs, and shortage costs. The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventory—such as holding costs, order costs, and shortage costs. The Total Cost can be calculated using the following formula.

The relationship is TC = PD + HQ/2 + SD/Q, where

TC= is the total annual inventory cost—to be calculated.
P = is the price per unit paid—assume Rs. 5 per unit.
D = is the total number of units purchased in a year—assume 3,500 units.
H= is the holding cost per unit per year—assume Rs. 3 per unit per annum.
Q is the quantity ordered each time an order is placed—initially assume 350 gallons per order.
S is the fixed cost of each order—assumes Rs. 15 per order.

20.1 Assumption of EOQ Model

Demand is known with certainty and is constant over time
No shortages are allowed
Lead time for the receipt of orders is constant
Order quantity is received all at once

Suggested Readings:

(a) Piasecki (2009): Inventory Management Explained: A focus on Forecasting, Lot sizing, Safety Stock and Ordering Systems. Ops Publishing.

(b) Muller (2011): Essentials of Inventory Management. AMACOM.

(d) Waller and Esper (2014): The Definition Guide to Inventory Management: Principles and Strategies for the Efficient Flow of Inventory across the Supply Chain. Pearson FT Press.

(e) Piasecki (2003): Inventory Accuracy: People, Processes & Technology. OPS Publishing

(f) Subramanian (2014): Inventory Management: Principles and Practices. Excel Books

(g) Waters (2003): Inventory Control and Management. Wiley.