Working Capital Management - Inventory Management

INVENTORY MANAGEMENT

Inventory management refers to management of raw materials and related items and considers what to purchase, how to purchase, from where to purchase, when to purchase, where to store, when to use for production, etc. Inventories are stock of the product of a company manufacturing for sale and components that makeup the product. The following are the various forms in which inventories exist in manufacturing concern:

• Raw materials – Those units which have been purchased and stored for future productions
• Work in Process – Those units which are semi manufactured products
• Finished Goods – Those units which are completely manufactured and are ready for sale
• Supplies or stores – Those units which are needed for smooth running of production process
• Spares – Includes small spares and parts

Inventory Holding Motives:

« Transactions motive – To facilitate smooth production and sales operations

« Precautionary motive – To guard against the risk of unpredictable changes in demand and supply of forces and other factors

« Speculative motive – To take advantage of price fluctuations

Objectives of Inventory Management:

« To facilitate smoother and uninterrupted production process

« To maintain sufficient stock of raw materials in periods of short supply and anticipate price changes

« To maintain optimum inventory to maximize profitability

« To meet the seasonal demands of the products

« To maintain sufficient finished goods inventory for smooth sales operation and efficient customer service

Over investment in inventory causes

« Unnecessary tie-up of the firm’s funds and loss of profit

« Excessive carrying costs

« Risk of Liquidity

Inadequate level of inventory causes

« Production hold-ups

« Failure to meet delivery commitments, in turn loss of profit

Inventory Management Techniques:

1.     Techniques based on order quantity:

A.  Economic Order Quantity Method - EOQ:

EOQ refers to the level of inventory at which the total cost of inventory comprising ordering cost and carrying cost is at minimum.

Ordering cost: This includes entire cost of acquiring raw materials such as requisitioning, purchase ordering, transporting, receiving, inspecting and storing. Ordering costs increases with increase in number of orders and decreases with increasing size of inventory.

Carrying cost: This includes the costs incurred for maintaining a given level of inventory such as storage (warehousing), insurance and taxes, handling costs, administrative costs, deterioration and obsolescence. Carrying costs increases with increasing size of inventory and decreases with increase in number of orders.

The optimum inventory is determined at a level where the ordering costs and carrying costs is at minimum.

Formula:

EOQ= √(2*A*O/C)

Where

A = Annual demand in units

O = Ordering cost per unit

C = Carrying cost per unit

A.  Determination of stock level:

Stock level refers to the level of stocks maintained by the business concern at all times. Different level of stock can be determined based on the volume of the stock.

Minimum level: The level at which the stock needs to be maintained at all times. Below this level, the work will stop due to shortage of material.

Minimum level of Stock = Reorder level – (Average rate of consumption *                                                       Average reorder period)

Maximum level: The maximum limit of quantity of inventories the business concern needs to be maintained above which it will become overstocking.

Maximum level of Stock = (Reorder level + Reorder Qty) – (Minimum rate                                                      of consumption * Minimum reorder period)

            (OR)                            = EOQ = Safety Stock + Order Qty

Lead time: The time normally taken on receiving delivery after placing orders with suppliers.

Re-order level: The level when business makes fresh order, usually between maximum and minimum level of stock.

Reorder level or Ordering level = Maximum rate of consumption *                                                                                     Maximum reorder period  

          (OR)                                                     = Safety stock + Lead time consumption

Danger level: The level below the minimum level which leads to stoppage of production process.

Danger level = Average consumption * Maximum reorder period for emergency purchase

Safety stock: Extra inventories that can be drawn down when actual lead time and usage rates are greater than expected.

Safety Stock = (Annual Demand/365) *(Maximum Reorder period –                                                                     Average reorder period)

Average stock level = Minimum stock level + ½ of re-order quantity                                                             maximum level   

1.     Techniques based on the classification of inventories:

i.               ABC Analysis:

It is the inventory management techniques that divide inventory into three categories based on the value and the volume of the inventories.

Category	Volume (%)	Value (%)
A	10	70
B	20	20
C	70	10

 

ii.            FNSD Analysis:

                    F – Fast moving inventories; N – Normal moving inventories

                    S – Slow moving inventories; D – Dead moving inventories

It is the inventory management technique in which inventories are classified according to their period of holding and this method helps to identify the movement of the inventories (aging schedule of inventories).

iii.          VED Analysis:

          V – Vital items; E – Essential items; D – Desirable items

This technique ideally suited for spare parts in the inventory management which is classified based on the usage of the inventories.

iv.           HML Analysis:

          H – High Value; M – Medium Value; L – Low Value

This technique is based on the value of the inventories

Gross Operating and Cash Conversion Cycles:

Gross Operating Cycle: The total length of time from the purchase of raw materials until the final payment from the customer is termed as operating cycle.

Gross Operating Cycle = Inventory conversion period + Accounts    Receivable conversion period

GOC= ICP + RCP

Inventory Conversion Period (ICP): The delay between the initial investment in inventories and the final sale date.

ICP = Raw Materials Conversion Period + Work-In Process Conversion Period + Finished Goods Conversion Period

RMCP = (Raw materials inventory * 360)/ Raw materials consumption

WIPCP = (Work-in process inventory *360)/ Cost of Production

FGCP = (Fixed goods inventory*360)/ Cost of Goods Sold

Accounts Receivables Conversion Period (RCP): The delay between the time that the goods are sold and when the customers finally pay their bills.

RCP = (Account Receivables * 360)/ Credit Sales

Cash Conversion Cycle: The interval between the firm’s payment for its raw materials and the collection of payment from the customer is known as the firm’s Cash Conversion Cycle or Net Operating Cycle (NOC).

Net Operating Cycle = Gross Operating Cycle – Payment Deferral Period

NOC = GOC – PDP = ICP + RCP - PDP

Payment Deferral Period (PDP): The average time taken by the firm in paying its suppliers (creditors).

PDP = (Accounts Payables*360)/Credit Purchases

A company spends cash to buy inventory, then processes and it sells to create a revenue stream. The greater the quantity of inventory the company purchases, the less cash it has to pay bills. Consequently, the company may delay bill payment until the end of the cash conversion cycle. The more the days a company’s money is tied up in inventory, the longer the cash conversion cycle and the greater the number of days creditors must wait for their money. Consequently, the company will be less likely to obtain credit when needed and less likely to continue its operations. Therefore, it’s better to have a short rather than a long cash conversion cycle.