Inventory Management

  • Post last modified:29 November 2020
  • Reading time:5 mins read

What is Inventory Management?

Inventory management is the process of efficiently managing the constant flow of inventories into the business processes. This process usually involves controlling the transfer of units in order to prevent the inventory from becoming too high, or too less.

Because excessive investment in inventory results into more cost of fund being tied up so that it reduces the profitability, inventories may be misused, lost, damaged and hold costs in terms of large space and others.

At the same time, insufficient investment in inventory creates stock-out problems, interruption in production and selling operation. Investment in inventory should neither be excessive nor inadequate. It should just be optimum.

Maintaining optimum level of inventory is the main aim of inventory management:

  • Maintain sufficient stock of raw material in the period of short supply and anticipate price changes.

  • Ensure a continuous supply of material to production department facilitating uninterrupted production.

  • Minimize the carrying cost and time.

  • Maintain sufficient stock of finished goods for smooth sales operations.

  • Ensure that materials are available for use in production and production services as and when required.
  • Ensure that finished goods are available for delivery to customers to fulfil orders, smooth sales operation and efficient customer service.

  • Minimize investment in inventories and minimize the carrying cost and time.

Inventory Management Techniques

The primary objective of inventory management is to minimize the overall cost of inventory so that profitability of firm can be maximized. It can be achieved through maintaining the optimum level of inventory all the time.

Optimum level of inventory can be managed by answering two basic questions.

• What should be the size of order?
• When should it be ordered?

  • First question can be answered by determining Economic Order Quantity (EOQ)
  • Second question by determining Re-order Level

Economic Order Quantity (EOQ)

The most common inventory problem faced by manufacturers, retailers, and wholesalers is that stock levels are depleted over time and then are replenished by the arrival of a lot of new units. At the time of placing a order for new lot, manager faces a problem of determining the size of order.

EOQ model helps managers to determine optimum size of lot to be ordered. Simply, EOQ is the optimum size of the order for a particular item of inventory calculated at point where the total inventory cost is minimized.

Optimum order quantity can be determined by the trade-off of inventory holding and ordering cost because total inventory cost is calculated by adding up total ordering and total holding cost.

Normally holding and ordering costs involving the following costs.

(A) Ordering Cost

Also known as purchase cost or set up cost, this is the sum of the fixed costs that are incurred each time an item is ordered. These costs are not associated with the quantity ordered but primarily with physical activities required to process the order. It includes the following:

• Preparation of purchase order
• Cost of receiving goods
• Documentation processing cost
• Transport cost
• Intermittent cost of chasing orders

(B) Holding Cost

Also called carrying cost, is the cost associated with having inventory on hand. It is primarily made up of the costs associated with the inventory investment and storage cost. Below are the primary components of carrying cost.

• Storage cost
• Store staffing cost
• Material handling cost
• Obsolescence and deterioration cost
• Opportunity cost of money tied up with inventory
• Inventory insurance cost

Economic order Quantity
Determination of Economic order Quantity

Economic order quantity can also be calculated by using mathematical model which is known as Wilson EOQ Model or Wilson Formula. The model was developed by F. W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively. EOQ is essentially an accounting formula that determines the point at which the combination of order costs and inventory carrying costs are the least.

The result is the most cost effective quantity to order. In purchasing this is known as the order quantity, in manufacturing it is known as the production lot size.

Assumptions of EOQ model

• Demand is known and constant.
• Lead time is Known and constant

• Only one item is involved
• The stock is replenished instantaneously.
• There is known constant price per unit
• Stock-outs do not occur.
• Stock is monitored on a continuous basis and an order is made when the
stock level reaches a re-order point

EOQ Model
Stock movements under EOQ Model

Reorder Level

The reorder level is that level of stock at which a purchase requisition is initiated by the storekeeper for replenishing the stock. This level is set between the maximum and the minimum level in such a way that before the material ordered for is received into the stores, there is sufficient quantity on hand to cover both normal and abnormal circumstances.

The fixation of ordering level depends upon two important factors viz, the maximum delivery period and the maximum rate of consumption.

In designing reorder point subsystem, three items of information are needed as inputs to the subsystem.

  • Usage rate This is the rate per day at which the item is consumed in production or sold to customers. It is expressed in units. It may be calculated by dividing annual sales by 365 days. If the sales are 50,000 units the usage rate is 50,000/365 = 137 Units per day.

  • Lead time This is the amount of time between placing an order and receiving goods. This information is usually provided by the purchasing department. The time to allow for an order to arrive may be estimated from a check of the company’s record and the time taken in the past for different suppliers to fill orders.

  • Safety stock The minimum level of inventory may be expressed in terms of several days’ sales. The level can be calculated by multiplying the usage rate and time in the number of days that the firm wants to hold as a protection against shortages.

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