A business needs different types of materials to produce goods or services. These are called inventory. Such inventories could be in the form of raw materials, work in progress and finished goods. If such inventories are not available in time and required quantity, it hinders the production and sales proceeds of the company. Similarly, overstocking of such inventories means high investment holding. Both understocking as well as overstocking are not good for the smooth operation of a business. Hence, inventory management is a concept to manage and maintain adequate inventory levels with related cost control.
Managing the stock at the lowest cost without compromising on the production and sales activity is called inventory management. It is concerned with avoiding over or under stocking of inventories ensuring no interruption in the production process and zero delays in the sales process. It uses different techniques to manage, control and maintain inventory in a business. Inventory management is an essential part of an internal control system in all types of businesses including manufacturing concerns, non-manufacturing concerns and BFIs.
Objectives of Inventory Management
Inventory management is practiced to ensure the availability of stocks at the time of need. Moreover, the objectives of inventory management have been explained below:
- To supply the required materials continuously: Materials are needed by manufacturing firms for the production process and non-manufacturing firms (in the form of finished goods) for making sales. Hence, the objective of inventory management is to ensure continuous supply and adequate availability of such materials to ensure no interruption of production or sales.
- To minimize the risk of over or under stocking of materials: Inventories maintained without proper analysis could result in either over or under stocking of them. Overstocking means high investment in a purchase as well as holding such inventories. Similarly, understocking means no smooth operation of production or sales process. Hence, inventory management aims at minimizing risks resulting from over or under-stocking.
- To reduce losses, damages and misappropriation of materials: Another objective of inventory management is to reduce losses, damages and misappropriation of materials. This is done by applying different stocking methods and handling materials with utmost care.
- To maintain a systematic record of inventory: Different information related to inventory is required for planning and decision making. Such information can be used to prepare or revise inventory policies too. Hence, inventory management maintains a systematic record of inventory.
- To minimize the cost associated with inventory: Inventory management helps in determining the right lot size, re-order level, stock levels to be maintained etc. It also provides information so as to accept or reject purchase offers of different lot sizes along with a discount. All these done by inventory management is to minimize costs associated with inventory.
- To make stability in price: An effective inventory management system minimizes the effect of regular price inflation. This in turn helps to gain stability in selling price.
Motives of Holding Inventory
The main motive of holding inventory is to ensure supply of the right quantity at the right time when needed by the concerned department. Along with this, the reasons or motives of holding inventory are as follows:
- Transaction Motive: The manufacturing concerns need inventories of raw materials and work in progress so as to maintain regular production activity. Likewise, the trading concerns need the inventories of finished goods for supplying the goods and services to the customer regularly. Inthis way, holding inventories helps to have a regular transaction.
- Precautionary Motive: Due to different reasons, like storage of inventory with the supplier, weak relationship with the supplier, disturbance in transportation, delay in inventory supply etc. Might take place. It is also an important motive of holding the inventory to take precautions from such possible events.
- Speculative Motive: Generally, the price of inventories rises, so the companies may keep an additional amount of inventory to get benefit by selling the surplus inventory at a higher price than the purchase price. It creates risk when the price of inventories falls.
Techniques of Inventory Management
There are different objectives of inventory management. To achieve these objectives, it uses different techniques. Different techniques used for inventory management are as follows:
- Economic Order Quantity
- Stock Level
- Just in Time Purchase
- Perpetual Inventory System
- ABC Analysis
A. Economic Order Quantity (EOQ)
Economic Order Quantity (EOQ) is a technique of inventory management that determines the optimum quantity to be ordered at a time. This is a quantity at which the total inventory cost is minimum. EOQ is concerned with ordering cast and carrying the cost of the inventory. EOQ is a quantity at which both total ordering cost and total carrying cost are equal. No other ordering size hasa total inventory cost lower than that at the level of EOQ. Hence, EOQ is the optimum ordering size at which total carrying coat equals total ordering cost and total inventory cost is lowest. Economic order quantity is also called standard order quantity or economic lot size or economic ordering quantity or optimum ordering quantity.
EOQ is dependent on annual need quantity (A), ordering cost per order (O) and carrying cost (C). It is based on the assumption that purchase price, annual need, ordering cost and carrying cost are known, This also assumes all these variables do not change during a year and are held constant. EOQ is calculated with or without adjustment of the proposed discount by the supplier at the time of decidingthe order.
EOQ Analysis
- Total Carrying Cost = Average Inventory × Carrying Cost Per Unit
- Total Ordering Cost = No. of Order × Ordering Cost Per Order
- Economic Order Quantity (EOQ) =
Where,
A = Annual requirement or need
O = Ordering cost per order
C = Carrying cost or holding cost per unit
- Total Inventory Cost = Total Carrying Cost + Total Ordering Cost
- No. of Order =
- Average Inventory =
B. Stock Level
Stock level is the different levels of stock needed to be maintained by an organization to run its activity without any obstruction. Under it, different levels of stock are calculated as per the need of the organization. Stock levels are dependent upon the consumption level of the organization and re-order or lead time required for the ordered stock to reach the organization.
Stock level is concerned with maintaining different levels. It includes Re-Order Level (ROL), Minimum Stock Level, Maximum Stock Level, Average Stock Level and Danger Level. ROL is the level of stock at which new order is placed. Minimum Stock Level is the level of quantity that has to be held all the time. It is also called Safety Stock or Buffer Stock. Similarly, the Maximum Stock Level is the peak level of stock that can be maintained. Likewise, the Average Stock Level is the average to be maintained computed based on maximum and minimum stock level. Finally, Danger Level is the level at which normal issue of materials is stopped and issued only for some abnormal situations.
Different Stock Levels:
1. Re-Order Level (ROL) = Maximum Consumption × Maximum Lead Time
Or, ROL = Safety Stock + Daily Consumption × Lead Time
Or, ROL = Safety Stock + Normal Consumption × Normal Lead Time
2. Minimum Stock Level = ROL – (Normal Consumption ×Normal Lead Time)
3. Maximum Stock Level = ROL + ROQ – (minimum Consumption × Minimum Lead Time)
4. Average Stock Level =
Or, Average Stock Level = Minimum Stock Level +
5. Danger Level = Normal Consumption × Maximum Emergency Purchase Lead Time
Note that
- Lead Time is the re-order period
- Consumption is the daily usage of material
- EOQ (if available) can be used as ROQ (Re-Order Quantity)
- Normal Consumption =
- Normal Lead Time =
C. Just In Time (JIT) System
This is a recent concept or technique developed in an inventory management system. Under the JIT system, inventory is purchased just at the time of use. The inventories are acquired just at a time when they are needed. This is a technique that lowers investment in inventory and inventory costs by keeping stock as low as possible. Sometimes stock may be at zero levels under this system. Thus, under JIT, the inventories are received in time or purchased at the time of use. Generally, JIT is commonly used in developed countries where communication and transportation systems are efficient.
| Advantages | Disadvantages |
| Reduces investment in raw material, work in progress and finished goods Saving of space as low stock level is maintained No involvement of large storage facilities Minimization of wastage Improves labor efficiency | The effectiveness of JIT depends upon c0-operation and faith with the supplier Works well only when proper knowledge about quality and quantity of material exist Need of back up supplier as a regular supplier cannot supply efficiently all the time Dependent on communication and transportation system |
D. Perpetual Inventory (PI) System
The perpetual inventory system is the way of maintaining the record of inventory in such a way that the stock on hand can be ascertained at any time. It emphasizes the day-to-day checking of stock and maintains the up-to-date record, It is a method of recording inventory after every receipt and issue to facilitate regular checking and stock taking. It provides perfect stock control as we can easily find out and verify the level and position of stock lying in the store at any moment by physical counting. Under this system, such stock position is maintained through records shown by bin cards, two bin cards and store ledgers.
| Advantages | Disadvantages |
| Reduces the necessity of physical verification in the store Easy to prepare final account Reliable check on the store Accurate and up to date stock recordProduction planning is easy Easy detection of an error in the storage of stocks Controls capital investment in store Easy to make insurance claims with u to date record | Expensive technique as it uses more cards and ledgers Not suitable for small organizations Regular counting, weighing and measuring is difficult |
E. ABC Analysis
ABC analysis is a systematic way of categorizing the materials based on the quantity of use and their relative values. This system consists of three groups namely A, B and C. In group A, materials with a very high price and low consumption quantity are kept. In group B, materials with moderate price and consumption quantity are kept. Similarly, materials with low cost and high consumption quantity are kept in group C. Under ABC analysis, very close very control is exercised over the materials in group A and very little control is exercised over materials in group C.
| Advantages | Disadvantages |
| Strict control over the materials in group A which have a higher valueReduce the investment in materials by controlling investment in high price materials of group AMinimum storage cost of materialsSaves time to manage materials as groups are formedEconomical as no high number of labor and time is needed | Cannot be implemented if proper grouping is not doneNot suitable for organizations where material prices do not vary significantlyNo scientific base for inventory classificationNot suitable for small organizations as inventory classification is costly |
Importance of Inventory Management
Inventory management is important to all kinds of businesses. Without it, the production and sales activity of the business can never be smooth. The importance of inventory management has been mentioned below:
- Avoids Over or Under Stocking:
Both over or under stocking is not good for a business. Overstocking means over-investment in inventories and understocking means potential interruption in production or sales. Hence, with different techniques and methods, inventory management avoids over or under-stocking in the business.
- Reduces Storage Cost:
If a high inventory level is maintained, more space for storage is needed. This means a larger store or warehouse is needed. For more store or warehouse space, more cost has to be incurred. Hence, inventory management is important in reducing such storage costs by ensuring the right quantity of material is stored.
- Improves Order Accuracy:
Inventory management deals with ordering issues such as when to order, how much to order, how much is needed in the future, how long it will take to receive the order etc. Hence, the accuracy of the order is enhanced by proper inventory management.
- Fluency in Production:
Inventory management maintains raw materials and works in progress in the right quality and quantity to avoid interruption in production. Any shortage of materials during production is avoided by such an inventory management tactic. This results in fluent production within planned time, cost and efficiency.
- Balances Multiple Sales:
This applies to trading concerns. The proper availability of goods in store can balance multiple sales. This means sales from not just one point but from multiple locations or outlets can be made.
- Easy Tracking of Stocks:
Inventory management has an important role in tracking which stock is where and at what quantity. By this, we can know the status, need and deficiency of stock in the store.
- Achieve Economy:
Inventory management helps in achieving the economy in different ways. It can identify economic order quantity at which total inventory cost is minimum. Similarly, determining different stock levels with the view of minimizing cost aids in achieving economy in the business.
- Raises Company Profit:
Inventory management minimizes different costs. This includes ordering cost, carrying cost, storage cost etc. All these finally contribute towards increasing overall company profit.
