Indian Institute of Technology: Professor Arun Kanda’s “Basic Inventory Principle”

Inventory Types

Most manufacturing organizations usually divide their inventory into raw materials, work in process, finished goods, and goods for sales.

Most manufacturing organizations usually divide their inventory into raw materials, work in process, finished goods, and goods for sales. A good purchased as a “raw material” goes into the manufacture of a product. A good only partially completed during the manufacturing process is called “work in process. ” When the good is completed as to manufacturing but not yet sold or distributed to the end-user, it is called a “finished good. ”

1. Raw materials: Materials and components scheduled for use in making a product.

2. Work in process, WIP: Materials and components that have began their transformation to finished goods. These items are not yet completed but either just being fabricated or waiting in a queue for further processing or in a buffer storage. The term is used in production and supply chain management. Optimal production management aims to minimize work in process. Work in process requires storage space, represents bound capital not available for investment, and carries an inherent risk of earlier expiration of shelf life of the products. A queue leading to a production step shows that the step is well buffered for shortage in supplies from preceding steps, but may also indicate insufficient capacity to process the output from these preceding steps. Just-in-time (acronym: JIT) production is a concept to reduce work in process with respect to a continuous configuration of product. Sometimes, outside of a production and construction context “work in process” is used erroneously where the status “work in progress” would be correctly used to describe more broadly work that is not yet a final product.

3. Finished goods: Goods ready for sale to customers. Finished goods is a relative term. In a supply chain management flow; the finished goods of a supplier can constitute the raw material of a buyer.

4. Goods for resale: Returned goods that are salable.

Inventory Techniques

FIFO, LIFO, and average cost methods are accounting techniques used in managing inventory.

FIFO, LIFO, and average cost methods are accounting techniques used in managing inventory involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components. These methods are used to manage assumptions of cost flows related to inventory.

FIFO

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold. This expression describes the principle of a queue processing technique or servicing conflicting demands by ordering process by first come, first served (FCFS) behavior, where the persons leave the queue in the order they arrive, or waiting one’s turn at a traffic control signal.

LIFO

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States,

LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

Average Cost

Average cost method is quite straightforward. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. There are two commonly used average cost methods: Simple weighted average cost method and moving average cost method.

Weighted average cost method:

It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.

Moving average cost method:

Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to beginning inventory cost to get Cost of Current Inventory. Similarly, the number of units bought is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods. Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold, and the Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold. At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.

ABC Technique

The ABC analysis is an inventory categorization technique often used in material management wherein accuracy and control decreases from A to C.

The ABC analysis is a business term used to define an inventory categorization technique often used in material management. It is also known as “Selective Inventory Control. ” Policies based on ABC analysis:

• A ITEMS: very tight control and accurate records
• B ITEMS: less tightly controlled and good records
• C ITEMS: simplest controls possible and minimal records

The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls.

The ABC analysis suggests that inventories of an organization are not of equal value. Thus, the inventory is grouped into three categories (A, B, and C) in order of their estimated importance.

A items are very important for an organization. Because of the high value of these A items, frequent value analysis is required. In addition to that, an organization needs to choose an appropriate order pattern (e.g., “Just- in- time”) to avoid excess capacity.

B items are important, but of course less important, than A items and more important than C items. Therefore, B items are intergroup items.

C items are marginally important.

The following is an example of the Application of Weighed Operation based on ABC class in the electronics manufacturing company with 4,051 active parts.

Using this distribution of ABC class and change total number of the parts to 4,000.

• Uniform Purchase: When you apply equal purchasing policy to all 4,000 components, example weekly delivery and re-order point (safety stock) of two-week supply assuming that there are no lot size constraints, the factory will have a 16,000 delivery in four weeks and the average inventory will be 2.5 weeks supply.
• Weighed Purchase: In comparison, when weighed purchasing policy applied based on ABC class, example C class monthly (every four weeks) delivery with re-order point of three-week supply, B class Bi-weekly delivery with re-order point of two-week supply, A class weekly delivery with re-order point of one-week supply, total number of delivery in four weeks will be (A 200×4=800)+(B 400 x2=800) + (C 3400×1=3400)=5000 and average inventory will be (A 75%x1.5weeks)+(B 15%x3weeks)+ (C 10%x3.5weeks)= 1.925 week supply.

By applying weighed control based on ABC classification, required man hours and inventory level are drastically reduced.

Seasonal Production

Seasonal trends and internal projections of consumption in certain goods can have a significant impact on opportunity cost and potential profit for an organization.

Many industries are subject to dips and rises and demand as a result of seasonality. Logically, sourcing the same amount of a given product each month for inventory is not a practical choice in these industries. Inventory management in seasonally impacted businesses can become quite complex, as the accuracy of inaccuracy of forecasts can have substantial impacts on overall profitability.

Reasons to Keep Inventory

In an ideal world, a business would avoid the need for inventory through perfect operational management and completely accurate projections. Of course, this is impossible. As a result, business must balance risk and opportunity to ensure that inventory is available when it is needed and waste is minimized. Inventories are kept due to:

• Time – No supply chain is perfect, and often enough time lags can ruin potential business opportunities. Playing it safe and have certain items in stock ahead of time can avoid opportunity costs.
• Uncertainty – Supply and demand are not perfectly predictable. Uncertainty means keeping enough on hand to fill fluctuations in demand.
• Economies of scale – Many business exist solely because they take the risk of buying a high volume a given product at a lower price in hopes of marking up the price and selling each one individually to customers. This is called economies of scale, and by nature it requires some storage and inventory. Grocery stores function this way.
• Appreciation in Value – Some business keep inventory as an investment. Fine wines and cheese, for example, will appreciate in value over time. The downside is it will cost money to keep them (both require appropriate temperature conditions, for example).

Determining Seasonality

Among the many reasons to keep inventory is planning for seasonality. Businesses should first measure whether or not consumer demand and subsequent inventory requirement are subjected to predictable seasonal trends. There are a number of ways to do this utilizing existing historical sales data as well as data from external research on the industry itself. There are countless models and methods of organizing seasonal data to determine, but from the managerial frame mostly analysts preferred distribution of data should ultimately communicate the same correlations (or lack thereof) for differences in sales on a monthly basis.

Once seasonality is determined, business should measure the fluctuations from year to year and the opportunity costs of having too much or too little on hand. Once this is accomplished, the business can order the ideal amount based on data-driven projections to capture as much opportunity as possible without taking the risk of over ordering (and thus overpaying for storage).

Perishable Goods

An important aspect of seasonal inventory management is the concept of perishable goods. From food to fashion to technology, many goods simply either go bad or lose most of their value for no other reason that culture has passed it by. This is called a perishable good. Perishable goods have an even greater opportunity cost when it comes to mismanaging (and erroneously predicting) demand. If too much of a perishable good is ordered, not only will it cost the organization in unnecessary inventory fees, but also adds the risk of never been sold at all (a complete sunk cost at that point).

As a result, understanding the shelf life of a good, the risk of over or under stocking, and recognizing the ebb and flow of seasonal demand can add a great deal to the profitability of an organization.

Impact of Inflation on Inventory Management

High inflation encourages companies to keep a high level of inventories.

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money–a loss of real value in the internal medium of exchange and unit of account in the economy.

Inflation’s effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include an increase in the opportunity cost of holding money; uncertainty over future inflation which may discourage investment and savings; and if inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Therefore, high inflation encourages companies to keep a high level of inventories.

The Nobel laureate Robert Mundell noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending. That substitution would cause market clearing real interest rates to fall. Nobel laureate James Tobin noted that moderate inflation would cause businesses to substitute investment in physical capital (plant, equipment, and inventories) for money balances in their asset portfolios. That substitution would mean choosing the making of investments with lower rates of real return. (The rates of return are lower, because the investments with higher rates of return were already being made before. ) To put it in a word, companies purchase more inventories in case of high inflation. The two related effects are known as the Mundell-Tobin effect. Unless the economy is already over-investing according to models of economic growth theory, that extra investment resulting from the effect would be seen as positive.

Inventory Costs

Inventory costs depends on methods used, which include Specific Identification, Weighted Average Cost, Moving-Average Cost, FIFO, and LIFO.

Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials.

Inventory management involves a retailer seeking to acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and related costs are kept in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. It also may include ABC analysis, lot tracking, cycle counting support, etc. Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs.

There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of ‘adjusting’ assumptions may be used. These include:

Specific Identification

Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at the yearend inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost.

This method is also a very hard to use on interchangeable goods. For example, it is hard to relate shipping and storage costs to a specific inventory item. These number will need to be estimated, therefore reducing the specific identification’s benefit of being extremely specific.

Weighted Average Cost

Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as AVCO. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.

Moving-Average Cost

Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to beginning inventory cost to get Cost of Current Inventory. Similarly, the number of units bought is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.

Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold. The Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold.

At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.

FIFO and LIFO

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970’s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

Economic Order Quantity Technique

Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs: $${ \text{Q} }^{ * }=\left( \frac { 2\text{DS} }{ \text{H} } \right) ^{ \frac { 1 }{ 2 } }$$.

Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as “Barabas EOQ Model” or “Barabas Formula. ” The model was developed by Ford W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth analysis.

We want to determine the optimal number of units to order so that we minimize the total cost associated with the purchase, delivery, and storage of the product. The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed cost to place the order, and the storage cost for each item per year. Note that the number of times an order is placed will also affect the total cost, though this number can be determined from the other parameters.

Underlying assumptions are:

• The ordering cost is constant.
• The rate of demand is known, and spread evenly throughout the year.
• The lead time is fixed.
• The purchase price of the item is constant (i.e., no discount is available).
• The replenishment is made instantaneously; the whole batch is delivered at once.
• Only one product is involved.

Variables for the function are: Q = order quantity, Q*= optimal order quantity, D = annual demand quantity, S = fixed cost per order (not per unit, typically cost of ordering and shipping and handling. This is not the cost of goods), H = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space, refrigeration, insurance, etc., usually not related to the unit cost).

The single-item EOQ formula finds the minimum point of the following cost function:

Total Cost = purchase cost + ordering cost + holding cost

• Purchase cost: This is the variable cost of goods: purchase unit price × annual demand quantity. This is P×D.
• Ordering cost: This is the cost of placing orders: each order has a fixed cost S, and we need to order D/Q times per year. This is S × D/Q.
• Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so this cost is H × Q/2.

To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to Q (assume all other variables are constant) and set to 0:

Solving for Q gives Q* (the optimal order quantity):

Just-in-Time Technique

Just in time (JIT) is a production strategy that strives to reduce in-process inventory and carrying costs in a manufacturing system.

Just in time (JIT) is a production strategy striving to improve a business return on investment by reducing in-process inventory and associated carrying costs. To meet JIT objectives, the process relies on signals or Kanban between different points in the process. Kanban are usually “tickets” but can be simple visual signals, like the presence or absence of a part on a shelf. Implemented correctly, JIT focuses on continuous improvement and can improve a manufacturing organization’s return on investment, quality and efficiency. To achieve continuous improvement, key areas of focus are:

• flow
• employee involvement
• quality.

Noticing that stock depletion requires personnel to order new stock is critical to the inventory reduction at the center of JIT. But JIT relies on other elements in the inventory chain. Therefore, JIT is best implemented as one part of an overall lean manufacturing system.

Benefits of JIT:

• Reduced setup time. Cutting setup time allows the company to reduce or eliminate inventory for “changeover” time.
• The flow of goods from warehouse to shelves improves. Small or individual lot sizes reduce lot delay inventories, which simplifies inventory flow and its management.
• Employees with multiple skills are used more efficiently. Having employees trained to work on different parts of the process allows companies to move workers where they are needed.
• Production scheduling and work hour consistency are synchronized with demand. If there is no demand for a product at the time, it is not made. This saves the company money, either by not having to pay workers overtime or by having them focus on other work.
• Increased emphasis on supplier relationships. A company without inventory does not want a supply system problem that creates a part shortage. This makes supplier relationships extremely important.
• Supplies come in at regular intervals throughout the production day. Supply is synchronized with production demand and the optimal amount of inventory is on hand at any time. When parts move directly from the truck to the point of assembly, the need for storage facilities is reduced.
• Minimizes storage space needed.
• Smaller chance of inventory breaking/expiring.

Drawbacks

Just-in-time operation can leave suppliers and downstream consumers open to supply shocks and large supply or demand changes. In addition, very low stock levels means shipments of the same part can come in several times per day. This means firms favoring JIT are especially susceptible to flow interruption.

Benefits of Inventory Management

Improved inventory management can lead to increased revenue, lower handling and holding costs, and improved cash flows.

Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials.

The intent of inventory management is to continuously hold optimal inventory levels. The scope of inventory management concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods, and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.

Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs. Inventory management involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. It also may include ABC analysis, lot tracking, cycle counting support, etc. All of these practices leads to optimal product storage, helping minimize holding and handling costs.

Inventory management also can help companies improve cash flows. Companies with effective inventory management do not have to spend large capital balances for purchasing enormous amounts of inventory at once. This also saves handling and holding costs.

Dangers Involved in Inventory Management

Excessive inventory means idle funds which earn no profits; inadequate inventory means lost sales.

Inventory management is primarily about specifying the size and placement of stocked goods. Inventory management is required at different locations within a facility or within multiple locations of a supply network to protect the regular and planned course of production against the random disturbance of running out of materials or goods.

The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns, and defective goods and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.

Excessive inventory means the firm has idle funds which earn no profits for the firm. In addition, excessive inventory incurs extra handling costs and holding costs. However, it is not well advised for the firm to keep low inventory levels, since inadequate inventory means the firm does not have sufficient raw materials for production. When items are required on a breakdown basis and find out that there is not enough stock as a result of reducing it, this could lead to loss of production. Inadequate inventory also means not ample goods to sell. The company, as a result, faces the risk of losing customers to competitors.

Inventory management will be more complicated as moderate inflation and seasonality gets involved. Inflation encourages the firm to purchase more inventory, exposing them to excessive inventory. Without an accurate sales forecast, companies operating in sectors affected by seasonality face shortage during high time and excess of inventory during low time of the year.