Chapter 14 Inventory

Fundamentals of Financial Management
Chapter 14: Inventory Management
Introduction or Concept
Inventory is the goods or materials that are required for the production and sales. Basically, inventories can be in the
form of raw materials, work in progress or semi-finished goods and finished goods. For example, raw materials and
work in progress are required for production of finished goods while finished goods are used for sales. Inventories
are significant part of current asset which calls for effective and efficient management of inventories. So, inventory
management is concerned with making optimum investment (neither too less nor too more) in inventory that
minimizes the total cost of inventory.
Types of Inventories
 Raw materials: Raw materials are basic inputs for production process. Raw materials are processed
goods to convert it into semi finished goods and finally the finished goods. Raw materials are purchased by
the firm from its suppliers.
 Work in progress: Work in progress consists of all items that are currently used in the production
process. They are also called semi finished or partly manufactured goods.
 Finished Goods: It contains those items that are completely produced and are ready for use and
consumption.
Significance or Importance of Inventory Management

As mentioned earlier, investment in inventory should neither be less nor excessive. Excessive investment in
inventory results into higher cost of funds because of misuse, loss, damaged inventories etc. In other hand,
inadequate inventories create stock-out problems and may stop the production process. Considering the above facts,
some of the importance of inventory management is as follows:
 It reduces the total cost of inventory.

 It helps in maintaining adequate inventory for smooth production and sales.
 It avoids stock-out problems and stock out costs.
 It reduces the chances of inventory being lost, misused and damaged.
Objectives of Holding Inventory

The main objective of holding inventories to reduce the cost associated with investment in inventory and maintaining
efficiency in production and sales operations. Some objectives are as follows:
 To avoid losses of sales: Holding adequate inventory ensures the timely production and sales. The
demand of customers can be fulfilled.
 To gain quantity discount: The firm can hold excessive inventories if the holding cost is relatively
lower. It provides discount to firm. However, the discount should be greater than cost of holding inventories.
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 To reduce ordering cost: Frequent order is not economical if ordering costs are higher. Instead, the
firm can hold inventories to decrease the number of orders and reduce the ordering costs.
 To achieve efficient production run: Firm can reduce the machines set up costs during production is
inventories are held adequately.
Determinants of Inventories
 Level of safety stock: If firm has policy of maintaining high amount safety stock, the investment in
inventories increases.
 Carrying cost: If the carrying or holding cost of inventories is low, the firm usually keeps more
inventories.
 Economy in purchase: If the quantity discount offered is beneficial, the firm takes discount and
higher amount of inventories are held.
 Possibility of price rise: If the prices of materials are expected to increase in future, the firm larger
purchase of the inventories.
 Demand of the product: If the firm expects the demand for its product will increase in future, the
firm makes more investment in inventories.
 Cost and availability of funds: If the funds that are to be invested in inventories are cheaper and
easily available, the investment in inventories is higher.
 Length of production cycle: The longer production cycle or time requires more amount of work in
progress and larger inventories.
 Availability of materials: If materials are available during specific seasons, the firm has to store
larger inventories of such materials.
Inventory Control System

a. ABC Analysis: This method of inventory control system categories the inventories in three namely
A, B and C on the basis of their relative value. Category A consists of inventories which are about 15 percent
of quantity out of total inventory but about 70 percent of investment value. Category B consists of those
inventories which covers 30 percent of total quantity and about 20 percent of investment value. Likewise,
category C inventory consist those inventories that cover about 55 percent of quantity and 10 percent of
investment value. This system emphasizes more on category A inventories since they are expensive of all.
b. Just in time (JIT) and Computerized System: In Just in time inventory control system, the firm
coordinates with its suppliers in such a way that the inventories are arrived when they are actually needed in
the production process. This system minimizes the carrying costs. However, the JIT system should have
efficient purchasing procedure, reliable suppliers and effective inventory handling method. JIT can be
facilitated with computer based programs. Computer can track the status of inventories continuously and
helps to place the order when the inventories are required considering for safety stock, reorder point etc.
c. Red Line Method: Under this system a red line is drawn inside the bin or container where the
inventories are stored. When the level of inventories falls below red line, orders are placed.
d. Two Bin Systems: Inventories are stored in two separate bins. When the inventories of the first bin
are completely used, the firm places the order and uses the inventories from second bin.
e. Budgetary Control System: A budget level or optimum level of inventory is determined. The actual
usage of inventory is compared against budgeted level or consumption.

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Chapter 14 Inventory

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Fundamentals of Financial Management

Chapter 14: Inventory Management

Significance or Importance of Inventory Management

 It reduces the total cost of inventory.

Objectives of Holding Inventory

Inventory Control System

Copyright © Bibek Khadgi Page 3

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