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What is Inventory ? | Definition, Objectives, Elements, Needs, Types & Benefits

Inventory


What is Inventory Planning and Control ?


Inventory planning and control are the activities associated with the inventory management. The management of the business needs to check the inventory as the inventory is the second largest expense in the business. Inventory planning comprises f predicting how much inventory is required to be in hand to fulfill customer's demand. Inventory planning is a method of estimating the optimal quantity and time of inventory for the need of arranging them with sales and production capacity. Smaller firms depend on the quick turnover of goods or materials as the planning of inventory has an important impact on the company's cash flow and profit margin.

The process used by the managers to check the number of inventory items and control them in the business is known as inventory control. The inventory control which usually covers 45% to 90% of the expenses in the business has to guarantee that the right goods are in hands for reducing stock-outs to prevent shrinkage (spoilage/theft) and they are also helpful in better accounting. Lot of firms face the problem of limited resources as their capital is blocked in the form of inventory.

What is Inventory ?


Inventory denotes "stock of goods". Various authors have defined this word in their own way. In terms of accounting, the word may be used to refer to stock of finished goods only, while in a manufacturing concern this may include work in process, stores, raw materials etc.

Definition of Inventory


According to Bolten S.E. :
"Inventory refers to stock-pile of product, a firm is offering for sale and components that make up the product".

The American Institute of Certified Public Accountants (AICPA) defines inventories as :
"Inventory in the sense of tangible goods, which are held for sale, in process of production and available for ready consumption".

International Accounting Standard Committee (L.A.S.C) defines inventories as :
"Tangible property 1) Held for sale in the ordinary course of business, 2) In the process of production for such sale, or 3) To be consumed in the process of production of goods or services for sale".

What is Inventory Management ?


Inventory costs are generally very high for business concerns. A firm generally invests a substantial amount of resources in its inventory. In many cases, inventory cost constitutes about 90 per cent of the total working capital. It is important for a firm to properly manage its inventory. Inventory management implies proper planning related to purchasing, handling, storing and accounting of goods.

Inventory management decides, "what to purchase, how much to purchase, where to purchase from. where to store, etc."

Inventory management also ensures that the firm maintains optimum level of inventory, minimizing the chances of over or under-stocking. Over-stocking may cause cash crunch whereas under-stocking may cause interruption in production process.

Objectives of Inventory


Following are the main objectives of inventory management :

objectives of inventory management

Operational Objectives


These objectives include material and other parts which are available in sufficient quantity:

1) Availability of Material : 
The main objective of inventory management is to ensure that a firm has availability of various goods, as and when required. This is done to ensure smooth production process.

2) Minimizing the Wastage : 
A firm should allow only normal level of wastage which is uncontrollable. It can minimize controllable wastage by maintaining proper level of inventory. A firm should ensure that it minimizes wastage occurring due to spoilage, theft, leakage, etc.

3) Promotion of Manufacturing Efficiency : 
A firm can increase its efficiency by providing right kind of material at the right time to its production department. It also boosts the morale of its workers.

4) Better Service to its Customers : 
A firm can offer better service to its customers by one maintaining uninterrupted production cycle. and making available required products to the customers.

5) Control of Production Level : 
Proper inventory management allows a firm to optimize its production level according to time requirements. It also helps in creating and maintaining buffer stock.

6) Optimum Level of Inventories : 
A firm should determine optimum level inventories, keeping in view its production schedule. It helps in avoiding sudden shortage in the production process.

Financial Objectives


A firm should ensure that its financial resources are not unduly tied in inventories :

1) Economy in Purchasing : 
A firm may receive quantity discounts when it purchases in bulk. This way, inventory maintenance helps the firm in reducing its costs.

2) Optimum Investment and Efficient Use of Capital : 
From financial viewpoint, the main objective of inventory management is to ensure that the company maintains optimum level of investment in inventory. Under or over-investment should be avoided. A firm should determine determine its minimum and maximum level of inventory to run the production cycle efficiently.

3) Reasonable Price : 
Proper inventory management may help the firm in obtaining materials at more reasonable prices. It is also useful in increasing production and maintaining the quality control.

4) Minimizing Costs : 
A firm may minimize various costs such as carrying and ordering costs through proper inventory management. Inventory costs are included in the cost of production, therefore optimization of these costs may help the firm in improving its profit margin.

Elements of Inventory 


The various elements of inventory are :

1) Raw-Material : 
Raw-material comprises of all the direct material used product manufacturing. The importance of holding raw material is to make sure that there is no delay in the production which results in timely delivery of products. There are a number of factors on which the amount of raw-material depends, such as the rate at which raw-material is ordered and obtained and uncertainty in the supply of this raw-material.

2) Work-in-Progress : 
Work-in-progress refers to holding of partly finished goods and material between manufacturing stages. It can also be referred to as the raw-material which is helpful in the production process and are not transformed into the end product

3) Consumable : 
The products bought by the customers more frequently like office products such as paper, pen, files, folders, post-it notes, computer disks and toner or ink cartridges are known as consumable products. The consumable products do not include capital goods such as computers, fax machines and other business machines or office furniture.

4) Finished Goods : 
Finished goods are the final products which are available for the customers in the market. It serves the purpose of lowering the risk related to the decrease in output due to strikes, breakdowns, shortage of material, etc.

5) Stores and Spares : 
Stores and spares are the components formed with the main product, for selling. They can be bolts, nuts, clamps, screws, etc. These components may be bought from outside or can be produced by the company itself.

Needs of Inventory


There are three main purposes for the need of holding inventories :

1) Transaction Motive : 
Every firm needs to maintain a certain level of inventories to meet its daily requirements related to the production and sales. In order to meet these requirements, a firm maintains an inventory of raw materials and finished goods. Maintaining of transaction motive makes the production process smoother.

2) Precautionary Motive : 
A company may face raw material shortage on account of natural causes, strikes or other unforeseen circumstances. Such shortage of raw material may interrupt production process. In order to avoid such circumstances, a company needs to maintain proper inventory level.

3) Speculative Motive : 
A company may maintain inventory to grab various opportunities for making profits such as sudden increase in prices. Such motives are speculative in nature and may help the firm in earning extra profit.

Types of Inventory 


The various kinds of inventory are as follows :

Types of Inventory

Decoupling Inventories


The decoupling of inventories refers to separating or disengaging the different parts of production system. It can be easily seen that each and every machinery and person have their own working capacity. 
For example, a portion of the final product is manufactured from a machine and the remaining portion of the product will be made next. The inventories in between the machine are held for separating the work on the machines. If these types of inventories are not present then the different machines and men cannot work together on an ongoing basis. The reason for holding these inventories is that if any machine stops then the production on others does not stop.

Seasonal Inventories


Seasonal inventory is made to meet the anticipated instability in demand The company usually makes use of seasonal inventory at the time of low demand and keep the stock for the period of high demand as they will not be able to manufacture at the time of high demand. The manager takes decision of whether to produce the seasonal inventory or not, the about to be produced, etc. In case, the company is able to quickly change the rate of production system at very low cost then the company will not require seasonal inventory as the production system can change to high demand period without incurring high cost. But if the changing production rate is costly (e.g. when workers must be hired or fired), then the company should be knowledgeable enough to ensure the continuous flow of production and store its inventory at the time of low demand. Hence, the primary patio faced by supply chain manager while defining the quantity of seasonal inventory is to compare the carrying cost of additional inventory against the cost of having a more flexible production rate.

Cycle Inventories 


The cycle inventories are stored because the purchases are made in lots on a regular basis instead of buying the exact number at a particular time Naturally, when all the purchases are done at the time when the product is demanded then there will be no cycle inventories. Although the company does the purchases in lots because if the purchases are done regularly and in small numbers, the cost incurred wit be too large.

Safety Inventories


These stocks are maintained to provide safety of there is any type of uncertainties in demand and supply. The organization usually knows the average demand for various items that they may require. But, the actual demand may be more than the average demand. To overcome such type of situation, the inventories can be stored if there is increase in the average anticipated demand. In the same way, the average delivery time must be known. The delivery time or lead time refers to the time in-between placing the order and having the goods in stock ready for use. Although there may be some uncertain events which may lead to an increase in average delivery time. So extra stocks should be stored for encountering the demand at the me when delivery is delayed. These inventories are stored for meeting the average demand and also or safeguarding at the time of variation in demand and lead-time.

Pipeline Inventories


Pipeline inventories come into picture when transportation time is required in moving substantial amount of resources. Pipeline inventories are also known as transit or movement inventories.
For example, when petrol is moved from the oilfield to the city by train, then the petrol which is shipment will not provide any kind of service to the customers for any purpose.

Anticipation Inventories


These kinds of inventories are stored for expected future demand of the product.
For example, crackers before Diwali, umbrellas and raincoat before rainy season or fan before summer season or accumulating inventories when the strike is being called.

Benefits of Inventory


The main benefits of holding the inventory are : 

1) Avoiding Lost Sales : 
The firm will suffer losses if there is no storage of finished goods. When the product is made only on order and when there is no other seller of that product, some customers may wait. Usually all the firms should be ready to manufacture the goods for the time of delivery of goods on demand. The items which are stored in the firm and will be sold with some or no changes are known as shelf stock. An example of shelf stock is automobiles.

2) Getting Quantity Discounts : 
When bulk purchases are made, some suppliers may reduce the price of the products and its components. The firms that are prepared to make large orders may avail discount on the given price. The discounts will help the firm to reduce the cost incurred when goods are sold and increase the profit while selling the goods.

3) Reducing Order Costs : 
Whenever the firm places the order, there will be some expenses while doing so. The order form should be complete, all the approvals must be attained and all goods which the firm has got should be accepted, inspected, and counted. After that, the invoice should be managed and the payment should be given. All these costs may depend on the number of orders done. For example, lesser the orders are placed, lesser will be the operating charges on it.

4) Achieving Efficient Production Runs : 
There will be some start-up costs for preparing its workers and machines to produce a product. As the production work starts, these costs are observed. The length of production run decides cost to start the production work.

5) Reducing Risk of Limited Production : 
The firms involved in manufacturing work usually produce goods with lots of accessory parts. If any of such parts are misplaced then the whole production operation will stop which will result in increase in costs. The firm should store larger amount of inventory than needed so that the production run does not stop due to inadequate raw-material or other parts.

Types of Inventory Costs


The classical inventory analysis identifies four major cost components :

Behavior and Types of Inventory Costs

Purchase Cost


It is also known as nominal cost of inventory. This is the purchase price of the item which is purchased from external sources and the cost of the production if the items are made inside the organization. Purchase costs depend on the quantity of items purchased. Usually, there is a situation where it may be specified like the unit price of the product is 740 for an order up to 50 units and 49.50 if the order is more than 50 units.

Ordering Cost/Set-up Cost


The cost suffered/experience when the inventory is reordered/replenished is known as ordering cost. These costs are related with the processing and chasing of the purchase order, transportation, inspection for quality, expediting overdue orders, etc. These are also known as procurement cost.
The ordering cost incurred is similar to set-up cost i.e. when the units are made within the organization. It describes the cost which has occurred while framing the production plan, the usage of resources while making the production system ready, etc. It consists of the following :

1) Reorder Cost : 
The cost of allocating and preparing an order by purchase and accounts department is known as reorder cost. It includes the cost incurred when the goods are purchased or if goods are produced by the firm or while organizing the production process.

2) Purchasing Cost : 
It is also known as manufacturing or variable cost. It basically depends on whether the firm is buying the goods from the supplier or producing itself.

3) Transportation Cost : 
The transportation cost is a cost which is not included in the price of purchased goods just for making it easy. The fixed transportation costs are included in the reorder cost and the variable costs are included in the purchasing cost

Shortage/Stock out Cost


The stock out cost refers to the cost related to not catering to the customers. Stock out indicates shortage. If there is internal stock-out, then this means that the production will stop and it will result into wastage of time of both workers and machines and it will also lead to delay in the work which will lead the firm to bear loss. If there is external stock out then there will be loss in sales due to loss of potential sales or loss of customer goodwill. The shortage will arise because of the different kind of from different customers due to which there will back-order or lost sales. In back-order, the sales will be delayed instead of loss in the sales. These are divided into the following :

1) Lost Sales Costs : 
When the customer buys ant unavailable item from the competitor, it is known as lost sale. The lost sales costs consist of the profit that would have been earned when the sale was done and also the adverse impact on the future sale due to shortage.

2) Back Order Costs : 
The delay in sales occurs when there is any kind of shortage if the goods are not easily exchangeable. This leads to adverse impact on the future sale and also leads to fines.

Carrying Cost 


Carrying cost refers to the cost which is incurred due to storing of an item in an inventory. It is also popular by the name of holding cost or storage cost The carrying cost is equal to the amount of inventory and the time period until which it is stored. The elements of carrying cost include the following : 
  • The opportunity cost of capital invested in the stock.
  • The costs directly linked/related to storing goods like store-men's salary, rates, heating and lighting, racking and palletization, protective clothing, store's transport, etc.
  • The obsolescence cost includes scrapping and possible rework.
  • The deterioration costs and costs incurred in preventing deterioration's.
The carrying cost is generally exhibited in the form of rate per unit or as a percentage of inventory value. It is assumed to be fixed for each unit of certain product or inventory store for a unit time. It consists of the following :

1) Opportunity Cost : 
The opportunity cost refers to as the cost showing the return on investment the firm would earn if the money had been invested in better profit bearing economic activity like in stock market instead of inventory. The cost is usually based on the standard banking interest rate.

2) Warehousing Cost : 
Warehousing cost refers to the sum paid in the form of fee for the storage of goods in a third party's warehouse. If the company has its own warehouse, it has to bear cost such as space and equipment costs. personnel wages, insurance on inventories, maintenance costs, energy costs and state taxes etc.

Inventory Turnover Ratio 


This ratio is calculated by dividing the cost of goods sold by the average inventory. This ratio is usually expressed as "x" number of times. The following is the formula :
                                                   Cost of Goods Sold
Inventory Turnover Ratio = -----------------------
                                                   Average Inventory

It also helps to show the average time taken for clearing the stocks This can be easily determined by calculating inventory conversion period. This period is calculated by dividing the number of days by inventory turnover. The formula may be as : 

Inventory Conversion Period

    12 months/52 weeks/365 days
= ------------------------------------
    Inventory Turnover Ratio

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