Inventory

 Management (Concept):
Inventory Management is a big part of profit planning for manufacturing and merchandizing
companied. Material costs often accounts for more than 40% of total costs of manufacturing
companies and more than 70% of total costs in merchandizing companies. Inventory
management is the planning and coordinating and controlling activities related to the flow of
inventories into through and out of an organization.
Inventory constitutes the most significant part of current assts of a large majority of companies.
On an average inventories are approximately 60% of current assts in public limited companies.
Because of the large size of inventories are maintained by firms a considerable amount of funds
is required be committed to them. It is, therefore absolutely imperative to manage efficiently and
effectively in order to avoid unnecessary investment. Inventory is stock of the product a
company is manufacturing for sale and components that make up the product. There are main
three type of inventory: Raw Material, Work-in-process, and Finished Goods.
Raw Materials are those basic inputs that are converted into finished products through the
manufacturing process. Raw materials inventories are those units, which have been purchased
and stored for future productions.
Work-in-Process
 inventories are semi-manufactured products. They represent products that
need more work before they become finished products for sale.
Finished
 Goods inventories are those completely manufactured products, which are ready for
sale. Stock of raw materials and work-in-process facilitates production while stock of finished
goods is required for smooth marketing operations. Thus inventories serve as a link between the
production and sale of a product.
Firms also maintain a fourth kind of inventory, supplies or stores and spares. Supplies include
office and plant cleaning materials like soap, brooms, oil, fuels, light bulbs etc. These materials
do not directly enter production, but are necessary for production process. Usually these supplies
are small parts of the total inventories and do not involve significant investment.
The levels of three kinds of inventory for a firm depends n the nature of its business. A
manufacturing firm will have substantially high levels of all three kinds of inventories, while a
retail or wholesale firm will have a very high level of finished goods and no raw materials and
work-in-process inventories.
Need  to Hold Inventory:
Maintaining inventories involves tying up of the company’s funds and incurrence of storage and
handling costs. There are three general motives for holding inventories.
1. Transactional motive:
It emphasizes the need to maintain inventories to facilitate smooth production and sales
operations.
2. Precautionary motive:
It necessitates holding of inventories to guard against the risk of unpredictable changes in
demand and supply forces and other factors.
3. Speculative motive:
It influences the decision to increase or decrease inventory levels to take advantage of price
fluctuations.
It is not possible for the company procure raw materials whenever it is needed. A time lag exists
between demands for material and its supply. Also there exists uncertainty in procuring raw
materials in time on many occasions. The procurement of materials may be delayed because of
such factors as strike, transport disruption or short supply. Therefore, the firm should maintain
sufficient stock of raw material at a given time to streamline production. Other factors, which
may necessitate purchasing and holding of raw materials are quantity discounts and anticipated
price increase. The firm may purchase large quantities of raw materials than needed for the
desired production and sales levels to obtain quantity discounts of bulk purchasing. At times, the
firm would like to accumulate raw materials in anticipation of price rise. Work-in-process
inventory builds up because of the production-cycle. Production-cycle is the time span between
introduction of raw material in to production and emergence of finished goods at the completion
of production-cycle. Till production-cycle completes stock of work-in-process has to be
maintained.
Stock of finished goods has to be held because production and sales are not instantaneous. A
firm cannot produce immediately when the customer demand goods on a regular basis, their
stock has to be maintained. Stock of finished goods has to be maintained for sudden demand
from customers. In case the firm’s sales are seasonal in nature, substantial finished goods
inventories should be kept to meet the peak demand. The level of finished goods inventories
would depend upon the coordination between sales and production as well as on production time.
Cost
 Associated with Inventory
Managing inventories to increase net income requires effectively managing costs that fall into
the following five categories:
1. Purchasing Costs:
The cost of goods acquired from suppliers, including incoming freight or transportation costs.
These costs usually make up the largest cost category of inventories
2. Ordering Costs:
The cost of preparing and issuing purchase orders, receiving and inspecting the items included in
th4e orders and matching invoices received, purchase orders and delivery records to make
payments.
Ordering costs include the coast of obtaining purchase approvals, as well as other special
processing costs.
3. Carrying Costs:
These are the costs that arise, while holding inventory. Carrying costs include the opportunity
cost of the investment tied up in inventory and the cost associated with storage; such as space
rental, insurance, obsolescence and spoilage.

4. Stock Out Costs:

These are costs that result when a company runs out of a particular item for which there is
customer demand. A company may respond to a stock out by expediting an order from a
supplier. Expediting costs of a stock out include the additional ordering costs plus any associated
transportation coasts. Ort the company may lose sales due to the stock out. In this case, the
opportunity cost of the stock out includes the lost contribution margin on sales not make due to
the items not being in the stock, plus any contribution margin lost on future sales due to customer
ill will caused by the stock out.
Objective
 of Inventory Management:
In the context of inventory management the firm is faced with the problem of meeting two
conflicting needs.
 T o maintain a large size of inventories of raw material and work inprocess for efficient and
smooth production and of finished goods for uninterrupted sales operations.
To maintain a minimum level of investment in inventories to maximize profitability.
The objective of inventory management should be to determine and maintain optimum level of
inventory investment. Te optimum level of inventory will lie between the two danger points of
excessive and inadequate inventories. The firm should always avoid a situation of over
investment or under investment in inventories.
The major dangers of over investment are:
a) Unnecessary tie up of the firm’s funds and loss of profit and opportunity costs.
b) Excessive carrying costs, and
c) Risk of liquidity.
The consequences of under investment in inventories are:
a) Production hold ups, and
b) Failure to meet delivery commitments.

Thus, efforts should be made to place an order at right time with the right source to acquire the
right quantity at the right price and quantity. An effective inventory management should
• Ensure a continuous supply of raw material to facilitate uninterrupted production,
• Maintain sufficient stocks of raw materials in periods of short supply and anticipated
price changes,
• Maintain sufficient finished goods inventory for smooth sales operations and efficient
customer services,
• Minimize the carrying costs and time, and
• Control investment in inventories and keep it at an optimum level.

• Inventory
 Management Techniques:
There are two basic questions relating to inventory management.
• What  should be the size of the order?
• At  what level should the order be placed?
The first question relates to the problem of ordering economic order quantity (EOQ) and is
answered with an analysis of costs of maintaining certain level of inventories. The second
question arises because of uncertainty and is a problem of determining the reorder point.
The ordering costs increase with the number of orders, thus the more frequently inventory is
acquired; the higher the firm’s ordering costs. On the other hand if the firm maintains large
inventory laves, there will be few orders placed and ordering costs will be relatively small but
the carrying costs of inventories increases heavily. The economic size of inventory would thus
depend on trade-off between carrying costs and ordering costs.
ABC Method of Inventory Control
Method which controls expensive inventory items more closely than less expensive items.
• Review “A” items most frequently
• Review “B” and “C” items less rigorously and/or less frequently.
 Cumul100

Invent
Perce

Value
ntage
ative

ory
90

of
C
70 B

A
0 15 45 100
Cumulative Percentage
of Items in Inventory

How Much to Order?

The optimal quantity to order depends on:
Forecast usage
Ordering cost
Carrying cost
Ordering can mean either the purchase or production of the item.

EOQ
 Model:
The basic assumptions of EOQ model are following:
• The forecast usage/demand for a given period usually one year, is known.
• The usage/demand is even throughout the period.
• Inventory orders can be replenished immediately, there is no delay in placing and
receiving orders
• There are only two distinguishable costs associated with inventory costs, ordering costs
and carrying costs.
• The cost per order is constant regardless of the size of the order placed.
• The cost of carrying inventory is fixed percentage of the average value of inventory.
 • Given these assumptions, EOQ model ignores purchasing costs and stock out costs. For
determining the EOQ formula we shall use the following symbols:
A = annual demand/usage,
Q = quantity ordered,
O = cost per order,
C = carrying costs per unit,
Given the above assumptions and symbols, the total costs of ordering and carrying inventories
are equal to

In the equation, the first term on the right hand side is the carrying cost, obtained as the product
of average value of inventory holding and the carrying cost per unit. The second term on the
right hand side is the ordering costs, obtained as the product of the number of orders and the cost
per order.
The total cost of ordering and carrying is minimized when
The formula may be illustrated with the help of the following data relating to Ace Company.
A = annual demand/usage/sales = 20,000 units
O = ordering cost per order = Rs. 2,000
C = carrying costs per unit = 25% of inventory value
P = purchase price/unit = Rs. 12
Here carrying cost/unit in is = Rs. 12 X 25% = Rs. 3

Graphical Approach of EOQ Model

The economic order quantity can also be found graphically. Figure illustrates the EOQ function.
In figure costs –carrying costs and ordering costs and total costs – are plotted on vertical axis and
horizontal axis is used to represent the order size. We note that total carrying cost increases as
the order size increases, because on an average a larger inventory level will be maintained and
ordering costs decline with increase in order size because larger order size means a less number
of orders. The behavior of total costs line is noticeable since it is a sum of the two types of costs,
which behave differently with order size. The total costs decline in first instance, but they start
rising when the decrease in average ordering cost is more than offset by the increase in carrying
costs
The EOQ occurs at the point Q* where the total cost is minimum. Thus the firm’s operating
profit is maximized at point Q*
It should be noted that the total costs of inventory are fairly intensive to moderate changes in
order size. It may be appropriate to say, therefore, that there is an economic order range, not a
point. To determine this range, the order size may be changed by some percentage and the
impact on total costs may be studied. If the total costs do not change very significantly, the firm
can change EOQ within the range without any loss.
Quantity
 Discount & Order Quantity
Many suppliers encourage their customers to place large orders by offering them quantity
discount. With quantity discount, the firm will save on the per unit purchase price. However, the
firm will have to increase its order size more than the EOQ level to avail the quantity discount.
This will reduce the number of orders and increase the average inventory holdings. Thus, in
addition to discount savings, the firm will save on ordering costs, but will incur additional
carrying costs. The net return is the difference between the resultant savings and additional
carrying costs. If the net rerun is positive, the firm’s order size should equal the quantity
necessary to avail the discount; if negative its order size would be equal to EOQ level.
Let’s assume the following data for a firm:
A = estimated annual demand 1200 units
P = purchasing cost per unit Rs. 50
O = ordering cost per order Rs. 37.50
C = carrying cost per unit Rs. 1
The firm is offered 0.5% (0.0005) or Rs. 0.05 per unit quantity discount on order of 400 units or
more. First we will calculate EOQ, assuming that the quantity discount does not exist

Now, the net return should be calculated for deciding whether the order size should be increased
from 300 to 400 units
The net return is given by the flowing equation:
= Discount savings + savings on ordering costs – additional carrying costs
= [d X p X a] + O [A/Q* - A/Q’] – [C/2 (Q’ - Q*)]
= [0.005 X 50 X 1200] + 37.50[1200/300 – 1200/400] – [1/2 (400-300)]
= 300 + 37.50 – 50
= 287.50 Rs.
Since the net return is positive, the firm should have an order quantity of 400 units.

When to Order?
Yet the answer should be sought to the second question, when to order?
This is a problem of determining the reorder point. The reorder point is tat inventory level at
which an order should be placed to replenish the inventory. To determine the reorder point under
certainty, we should know:
a) Lead time
b) Average usage and
c) EOQ
Lead Time -- The length of time between the placement of an order for an inventory item
and when the item is received in inventory.
Order Point -- The quantity to which inventory must fall in order to signal that an order
must be placed to replenish an item.
Order Point (OP) = Lead time X Daily usage
Example of When to Order
Julie Miller of Basket Wonders has determined that it takes only 2 days to receive the order
of fabric after the placement of the order.
When should Julie order more fabric?
Lead time = 2 days
Daily usage = 10,000 yards / 100 days = 100 yards per day
Order Point = 2 days x 100 yards per day = 200 yards

Economic Order Quantity (Q*)

2000
UNITS

Order
Point

200

0 18 20 38 40

Safety Stock
Safety Stock -- Inventory stock held in reserve as a cushion against uncertain demand (or
usage) and replenishment lead time.
Our previous example assumed certain demand and lead time. When demand and/or lead
time are uncertain, then the order point is:
Order Point =
(Avg. lead time x Avg. daily usage) + Safety stock
Order Point
with Safety Stock

2200

2000
UNITS

Order
Point

400
200
Safety Stock
0 18 20 38

2200

2000
Actual lead
time is 3 days!
UNITS

(at day 21)

Order The firm “dips”

Point into the safety stock

400

200
Safety Stock
0 18 21

How Much Safety Stock?

Depends on the:
 u Amount of uncertainty in inventory demand
u Amount of uncertainty in the lead time
u Cost of running out of inventory
u Cost of carrying inventory
Just-in-Time
Just-in-Time -- An approach to inventory management and control in which inventories
are acquired and inserted in production at the exact times they are needed.
Requirements of applying this approach:
u A very accurate production and inventory information system
u Highly efficient purchasing
u Reliable suppliers
u Efficient inventory-handling system

INVENTORY MANAGEMENT

COMPARISON BETWEEN AHMAD HASSAN TEXTILE MILLS LIMITED AND MERH DASTGIR TEXTILE

MILLS.

1. BASIC RAW MATERIAL INVENTORY

The basic raw material inventory for both mills is the same i.e. cotton.

3. INVENTORY MANAGEMENT SYSTEM

There are two types of inventory management system which are

i) Perpetual inventory system, and

ii) Periodical inventory system

Ahmad Hassan Textile Mills Limited use perpetual inventory system.

Mehr Dastgir Textile Mills Limited also uses perpetual inventory system.

3 .COSTING SYSTEM

There are two types of costing system

i) Job order costing system, and

ii) Process costing

Ahmad Hassan Textile Mills Limited use process costing.

Mehr Dastgir Textile Mills Limited also uses process costing.

4. PRODUCTION CAPACITY

Ahmad Hassan Textile Mills Limited’s production capacity is .

Mehr Dastgir Textile Mills Limited’s production capacity is .

5. INVENTORY CARRYING COST

Ahmad Hassan Textile Mills Limited has no carrying cost they have their own GODAMS but they pay in

term of insurance.

Mehr Dastgir Textile Mills Limited also no carrying cost they also have their own GODAMS but they pay in

term of insurance.

6. ON HAND STOCK

Ahmad Hassan Textile Mills Limited has 1800 bales. Mehr Dastgir Textile Mills Limited has 1000 bales as

on hand stock.

7. SAFETY STOCK

Ahmad Hassan Textile Mills Limited has safety stock of 200 bales.

Mehr Dastgir Textile Mills Limited has safety stock of 320 bales.

8. AVERAGE DAILY REQUIREMENT

Average daily requirement of cotton bales which are converted into spindles are 180 bales for Ahmad

Hassan Textile Mills Limited and 80 for Mehr Dastgir Textile Mills Limited.

9. TIME REQUIRED FOR RECEIPT

Time required for receipt is 10 days for both mills.

10. MAXIMUM DAILY REQUIREMENT

Maximum daily requirement for Ahmad Hassan Textile Mills Limited is 200 units and for Mehr Dastgir

Textile Mills Limited is 100 units.

11. MINIMUM DAILY REQUIREMENT

Minimum daily requirement for Ahmad Hassan Textile Mills Limited is 150 bales which are converted into

400 bags of spindles and for Mehr Dastgir Textile Mills Limited is 70 which are converted in to 190 bags

of spindles in to the next department.

12. ORDER POINT

 Order point for Ahmad Hassan Textile Mills Limited is 2000 but for Mehr Dastgir Textile Mills Limited is

1000.

13. MINIMUM LIMIT

Minimum limit for Ahmad Hassan Textile Mills Limited is 1800 bales and for Mehr Dastgir Textile Mills

Limited is 800 bale of cotton.

14. DANGER LEVEL

Danger level for Ahmad Hassan Textile Mills Limited is 540 and for Mehr Dastgir Textile Mills Limited is

270.

15. COSTING OF ISSUANCE METHOD

Both Ahmad Hassan Textile Mills Limited and Mehr Dastgir Textile Mills Limited uses LIFO method for

issuance and return of material from department to department.

15. BASIC SIGNIFICANT ACCOUNTING POLICIES

Both Ahmad Hassan Textile Mills Limited and Mehr Dastgir Textile Mills Limited prepared accounting

policies in accordance with the requirement of the companies Ordinance, 1984 and International

Accounting Standards as applicable in Pakistan.

16. ACCOUNTING CONVENTION

These accounts have been prepared under the historical cost convention modified by exchange rate

adjustments.

17. SPOILAGE

Both Ahmad Hassan Textile Mills Limited and Mehr Dastgir Textile Mills Limited treat spoilage as loss in

accounts.

18. VARIABILITY SEASONALITY

both Ahmad Hassan Textile Mills Limited and Mehr Dastgir Textile Mills Limited has demand variation

according to seasonal variability.

19. DEMAND ORDER PATTERN

Both Ahmad Hassan Textile Mills Limited and Mehr Dastgir Textile Mills Limited has no complicated

pattern for order demand it is just a telephonic order which is given by the Mill Manager and Chairman.
20. TRANSPORTATION

In case of imported inventory both Ahmad Hassan Textile Mills Limited and Mehr Dastgir Textile Mills

Limited uses transportation by ship. But in country purchase they use tucks.

21. INSURANCE OF STOCK

Ahmad Hassan Textile Mills Limited and Mehr Dastgir Textile Mills Limited has insured stock in every

aspect.

CONCLUSION

From the information given, it is concluded the Ahmad Hassan Textile Mills Limited has higher inventory

and demand than that of Mehr Dastgir Textile Mills Limited. Both have the similar pattern for inventory

management but the difference is in quantity. Both are the follower of ISO 9002 for their product quality.