Finished Goods, Are An Essential Part of Virtually All Business Operations. Optimal Inventory Levels

INVENTORY MANAGEMENT
Inventories, which can include (1) supplies, (2) raw materials, (3) work in process, and (4)
finished goods, are an essential part of virtually all business operations. Optimal inventory levels
depend on sales, so sales must be forecasted before target inventories can be established.
Inventory constitutes an important item in the working capital of many business
concerns.Net working capital is the difference between current assets and current liabilities.
Inventory is a major item of current assets. The term inventory refers to the stocks of the product
of a firm is offering for sale and the components that make up the product Inventory is stores of
goods and stocks. This includes raw materials, work-in-process and finished goods. Raw
materials consist of those units or input which are used to manufactured goods that require
further processing to become finished goods. Finished goods are products ready for sale. The
classification of inventories and the levels of the components vary from organization to
organization depending upon the nature of business. For example steel is a finished product for
a steel industry, but raw material for an automobile manufacturer. Thus, inventory may be
defined as “Stock of goods that is held for future use”. Since inventories constitute about 50 to 60
percent of current assets, the management of inventories is crucial to successful working capital
management. Working capital requirements are influenced by inventory holding. Hence, the
need for effective and efficient management of inventories.
A good inventory management is important to the successful operations of most
organizations, unfortunately the importance of inventory is not always appreciated by top
management. This may be due to a failure to recognise the link between inventories and
achievement of organisational goals or due to ignorance of the impact that inventories can have
on costs and profits.
The inventory includes the following:
Stock of raw materials: It means that the value of the raw materials stored for the purpose of
production in the storage yard. The stock of raw materials can be classified normally into two
categories, opening stock and closing stock of raw materials.
Stock of work in progress: During the production process, the firm usually stores the semi-
finished goods which are neither a raw materials nor finished goods. The purpose of the storage
of work in progress in order to shorten the time duration to manufacture the finished goods. The
value of the semi-finished / work in progress stored in the storage house may be classified into
two categories, opening stock and closing stock. The finalizing the value of the stock of the work
in progress is inevitable process in transfer pricing. The value of the work in progress normally
expressed in two different ways, on the basis of prime cost and works cost.
Stock of finished goods: This is the stage at which the goods are readily available for selling in
the market. The value of the stock of the goods is computed on the basis of cost of production.
Stock of Stores supplies, components and accessories.
TECHNIQUES OF INVENTORY CONTROL
1. ECONOMIC ORDERING QUANTITY (EOQ)

It is important to note that only the correct quantity of materials is to be purchased. For
this purpose, the factors such as maximum level, minimum level, and danger level, re-ordering
level and quantity already on order, quantity reserved, availability of funds, quantity discount
and interest on capital, average consumption and availability of storage accommodation are to
be kept in view. There should not be any over stock vis-à-vis no question of non-stock. Balance
should be made between the cost of carrying and cost of non-carrying i.e. cost of stock-out. Cost
of carrying includes the cost of storage, insurance, obsolescence, interest on capital invested. Cost
of not carrying includes the costly purchase, loss of production and sales and loss of customer’s
goodwill.
Economic Ordering Quantity (EOQ) is the quantity fixed at the point where the total cost
of ordering and the cost of carrying the inventory will be the minimum. If the quantity of
purchases is increased, the cost of ordering decreases while the cost of carrying increases. If the
quantity of purchases is decreased, the cost of ordering increases while the cost of carrying
decreases. But in this case, the total of both the costs should be kept at minimum. Thus, EOQ may
be arrived at by Tabular method by preparing purchase order quantity tables showing the
ordering cost, carrying cost and total cost of various sizes of purchase orders.
Where:
Q = EOQ units
D = demand in units (typically on annual basis)
S = order cost (per purchase order)
H = holding costs (per unit, per year)
2. FIXING LEVELS (QUANTITY CONTROL)

For fixing the various levels such as maximum, minimum, etc., average consumption and
lead time i.e. the average time taken between the initiation of purchase order and the receipt of
materials from suppliers are to be estimated for each item of materials.
a. Maximum Stock Level

The maximum stock level is that quantity above which stocks should not normally be
allowed to exceed. The following factors are taken into consideration while fixing the maximum
stock level
1. Average rate of consumption of material.
2. Lead time.
3. Re-order level.
4. Maximum requirement of materials for production at any time.
 Total Cost
 Carrying Costs
 Ordering Cost
 Quantity per order Cost
5. Storage space available cost of storage and insurance.
6. Financial consideration such as price fluctuations, availability of capital, discounts due to
seasonal and bulk purchases, etc.
7. Keeping qualities e.g. risk of deterioration, obsolescence, evaporation, depletion and natural
waste, etc.
8. Any restrictions imposed by local or national authority in regard to materials i.e. purchasing
from small scale industries and public sector undertakings, price preference clauses, import
policy, explosion in case of explosive materials, risk of fire, etc.; and
9. Economic ordering quantity is also considered.
Formula:
Maximum Level = Re-order level— (Minimum consumption) × (Minimum lead times) +
Reordering quantity
b. Minimum Stock Level

The minimum stock level is that quantity below which stocks should not normally be
allowed to fall. If stocks go below this level, there will be danger of stoppage of production due
to shortage of supplies. The following factors are taken into account while fixing the minimum
stock level:
1. Average rate of consumption of material.
2. Average lead time. The shorter the lead time, the lower is the minimum level.
3. Re-order level.
4. Nature of the item.
5. Stock out cost.
Formula:
Minimum Level =Re-order level – (Average usage × Average lead time)
c. Re-order Level
This is the point fixed between the maximum and minimum stock levels and at this time,
it is essential to initiate purchase action for fresh supplies of the material. In order to cover the
abnormal usage of material or unexpected delay in delivery of fresh supplies, this point will
usually be fixed slightly higher than the minimum stock level. The following factors are taken
into account while fixing the re-order level:
1. Maximum usage of materials
2. Maximum lead time
3. Maximum stock level
4. Minimum stock level
Formula:
Re-order level = Maximum usage x Maximum lead time or Minimum level +
Consumption during lead time.
d. Danger Level
This is the level below the minimum stock level. When the stock reaches this level,
immediate action is needed for replenishment of stock. As the normal lead time is not available,
regular purchase procedure cannot be adopted resulting in higher purchase cost. Hence, this level
is useful for taking corrective action only. If this is fixed below the re-order level and above the
minimum level, it will be possible to take preventive action.
3. Just in Time (JIT)
Normally, inventory costs are high and controlling inventory is complex because of
uncertainties in supply, dispatching, transportation etc. Lack of coordination between suppliers
and ordering firms is causing severe irregularities, ultimately the firm ends-up in inventory
problems. Toyota Motors has first time suggested just – in – time approach in 1950s. This means
the material will reach the points of production process directly form the suppliers as per the time
schedule. It is possible in the case of companies with respective process. Since, it requires close
coordination between suppliers and the ordering firms, and therefore, only units with systematic
approach will be able to implement it.
4. Inventory Turnover Ratio

 Inventory Turnover Ratio: Cost of goods sold / average total inventories. The higher
the ratio, more the efficiency of the firm
 Work in process turnover ratio =Cost of goods sold /Average inventory of finished goods
at costs. Here, in this ratio also higher the ratio, more the efficiency of the firm.
 Weeks inventory of finished goods on hand → Finished Goods /Weekly sales of finished
goods.
The ratio reveals that the lower the ratio, the higher the efficiency of the firm
 Week raw material on order → Raw material on order / Weekly consumption of raw
material.
This ratio indicates that the lower the ratio, the higher the efficiency of the firm.
 Average age of raw material inventory → Average raw material inventory at cost /
Average daily purchases of raw material.
This ratio says that the lower the ratio the higher the efficiency of the firm.
 Average age of finished goods inventory → Average finished goods inventory at cost /
Average cost of finished goods manufactured per day.
This ratio indicates that the lower the ratio the higher the efficiency of the firm.
1. Out of stock index → No. of times out of stock /No. of items requisitioned
This ratio indicates the lower the ratio higher the efficiency of the firm.
2. Spare parts index → Value of spare parts inventory /Value of capital equipment.
This ratio reveals that the higher the ratio the more the efficiency of the firm.

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INVENTORY MANAGEMENT

The inventory includes the following:

TECHNIQUES OF INVENTORY CONTROL

1. ECONOMIC ORDERING QUANTITY (EOQ)

2. FIXING LEVELS (QUANTITY CONTROL)

a. Maximum Stock Level

b. Minimum Stock Level

4. Inventory Turnover Ratio

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