The approach to stock in manufacturing company needs to be different from that in a trading or a commercial business. For a Supermarket the main reason for holding stock will be to provide good customer service. A high degree of such service will be required. If the cornflakes are out of stock, the customer will go elsewhere. The goods classed as “Stock” will mainly be finished goods; ready for sale, ordering from Suppliers will be done largely without considering the consequences on any manufacturing activity.
For a manufacturing company, stock control systems must take account of manufacturing activities. Inevitably there will be clashes or tradeoffs between the levels of stock carried, the service given to the customers, the cash flow involved in carrying stock and the influence stock ordering policy has on manufacturing costs.
“Stocks” will cover finished goods stocks, but also raw materials, work in process and components ready for use. The term “Inventory” refers to the stock of raw materials, Parts and finished products at hand at a given time (a tangible asset which can be seen, weighed or counted). In a wider sense “inventory consists of usable but idle resources”. The resources may be of any type; for example men, materials, machines or money. When the resource involved is material or goods in any stage of completion, inventory is referred to as stock”.
Inventory consists of the following:-
- Raw Materials: They are the physical resources to use in the production of finished goods. The purpose of holding raw material is to ensure uninterrupted production in the event of delays in delivery and to take advantage of bulk or other favorable terms of purchase.
- Bought out components: Items not manufactured/fabricated by the organization but used with or without further processing and/or packing the finished product, e.g. Rubber parts by Egg co. Tin cans by a Vanaspati Mill
- Work in process- or intermediate goods are in the process of production: Their purpose is to disconnect the various stages of production which facilitate production planning. Such Inventory helps to stabilize the rate of output at successive stages in the face of fluctuation. Partly manufactured/processed inventories awaiting further mfg/processing between two operations and are in the process of being fabricated or assembled into finished products, including materials lying with subcontractors and material lying in shop food for further processing or assembly.
- Finished Goods: They are the inventory held for sale in ordinary course of business. Such inventory serves as a buffer against fluctuations in demand for a product. Stock of finished goods facilitates a reasonable rate of output and enables the firm to provide a quick service to customers. It helps to reduce the risk associated with stoppages or reductions in production on account of strikes, break down, shortage of material/power etc.
- MRO: Maintenance, Repair and operating supplies. The group include spare parts and consumables which are required for use in the process but do not form a part of the finished product, e.g. Lubricants, V Belt, Electrodes, Pencil, Soap etc.
Inventory policies are important enough that production, marketing, and financial managers work together to reach agreement on these policies. That there are conflicting views concerning inventory policies underscores the balances that must be struck among conflicting goals-reduce production costs, reduce inventory investment, and increase customer responsiveness.
Opposing Views of Inventories: There are many reasons why we like to have inventories, but there are also reasons why holding inventories is considered to be unwise.
WHY We Want to Hold Inventories? Inventories are necessary, but the important issue is how much inventory to hold. Below are the summary and the reasons for holding finished goods, in-process, and raw materials inventories
Finished:
- Essential in produce-to-stock positioning strategies, of strategic importance.
- Necessary in level aggregate capacity plans.
- Products can be displayed to customers.
In-Process:
- Necessary in process-focused production; uncouples the stages of production; increases flexibility.
- Producing and transporting larger batches of products creates more inventories but may reduce materials-handling and production costs.
Raw Materials:
- Suppliers produce and ship some raw materials in batches.
- Larger Purchases result in more inventory, but quality discounts and reduced freight and materials handling costs may result.
Suppliers produce and ship some raw materials in batches. Larger Purchases result in more inventory, but quality discounts and reduced freight and materials handling costs may result.
- Ordering costs: Each time we purchase a batch of raw material from a supplier a cost is incurred for processing the purchase order. Expediting, record keeping and receiving the order into the warehouse. Each time we produce a production lot, a changeover cost is incurred for changing production over from a previous product to the next one. The larger the lot sizes, the more inventory we hold, we order fewer times during the year and annual ordering costs are lower.
- Stockpot costs: Each time we run out of raw materials or finished-goods inventory cots ma b incurred. In finished-goods inventory, stock out costs can include sales and dissatisfied customers. In raw materials, inventory, stock out costs can include the cost disruption to production and sometimes even lost sales and dissatisfied customers. Additional inventory, called safety stock, can be carried to provide insurance against excessive stock outs.
- Acquisition costs: For purchased materials, ordering larger batches may increase raw materials inventories, but unit costs may be lower because of quantity discounts and lower freight and materials-handling costs. For produced materials, larger lot sizes increase in process or finished goods inventories, but average unit costs may be lower because changeover costs are amortized over larger lots.
- Start-up quality costs: When we first begin a production lot, the risk of defectives is great. Workers may be learning, materials may not feed properly, machine settings may need adjusting, and a few products may need to be produced before conditions stabilize. Larger lot sizes mean fewer changeovers as per year and less scrap.
Inventories can be indispensable to the efficient and effective operation of production systems. But there are good reasons why we do not want to hold inventory.
Why We Do Not Want To Hold Inventories: Certain costs increase with higher levels of inventories:
- Carrying costs: Interest on debt, interest income foregone, warehouse rent, cooling, heating, lighting, cleaning, repairing, protecting, shipping, receiving, materials-handling, Taxes, insurance and management are some of the costs incurred to insure, finance, store, handle and manage larger inventories.
- Cost of Customer responsiveness: Large in -process inventories clog production systems. The time required to produce and deliver customer orders is increased, and our ability to respond to changes in customer orders diminishes.
- Cost of coordinating production: Because large inventories clog the production process, more people are needed to unsnarl traffic jams. Solve congestion-related production problems, and coordinate Schedules.
- Cost of diluted return on investment (ROI): Inventories are assets, and large inventories reduce return on investment, reduced return on investment adds to the finance costs of the firm by increasing interest rates on debt and reducing stock prices.
- Reduced-capacity costs: Inventory represents a form of waste. Materials that are ordered, held, and produced before they are needed waste production capacity.
- Large-lot quality cost: producing large production lots results in large inventories. On rare occasions, something goes wrong and a large part of a production lots a defective. In such situation, smaller lot sizes can reduce the number of defective products.
- Costs of production problems: Higher in – process inventories camouflage underlying production problems. Problems like machine breakdowns, poor product quality and material shortages never get solved.
At first, these costs may seem indirect, fuzzy and even inconsequential, but reducing these costs by holding fewer inventories can be crucial in the struggle to complete for world markets.
Nature of Inventories: Two fundamental issues underline all inventory planning:
- How much to order of each material when orders are placed with either outside suppliers or production departments with organization
- When to place the orders
The determination of order quantities, sometimes also called lot sizes, and when to place these orders, called order points, determine in large measure the amount of materials is inventory at any given time.
Types of Inventory: Include the following mentioned below:
- Anticipation inventories: When a firm anticipates a rise in prices, it may purchase in bulk quantities and hold the same until the prices rise. Similarly, products having seasonal demand (wool, umbrellas, fans, etc.) need to be produced and stocked in anticipation of sales during the season. These kinds of inventories are called anticipation inventories.
- Fluctuation inventories: Demand fluctuates over time and it is not possible to predict it accurately. Business firms maintain reserve stocks to meet unexpected demand and thereby to avoid the risk of losing sales. These safety stocks are known as fluctuation inventories; there is a time gap between production and use of certain products. The goods produced in one season are held in stock for sale and use throughout the year. Potato, wheat, rice, etc., are examples of such commodities. When the availability of raw materials is seasonal (e.g., cotton), bulk stocks are purchased for use throughout the year.
- Lot-size inventories: Goods are bought in large lots to get the benefit of discount. The gods so purchased are stocked until sale or use.
- Transportation inventories: Raw materials and finished goods are sent from one place to another. Some amount of inventory is always in transit. Longer the transportation period, greater is the amount of transportation inventories.
The problem of inventory management (inventory problem) deals with how many units/quantity of inventory should be carried in stock. This problem requires a balance between the risk of being out of stock and the cost of preparing inventory. Out of stock involves the cost of idle men and machines, loss of customers, etc. Too high inventories involve risk of loss due to changes in demand, price, style, technology, etc. The objective here is to minimize the cost of holding inventory without taking undue risks. Inventory decision in an important strategic decision because the level of inventories serves as a guide for production planning Production and sales policies are closely connected with inventory policy. Too much inventory is a cause for alarm as it may result in the failure of a business. Too low inventory may result in loss of sales. Planning the inventory level is one of the key areas of business decision making. An enlightened inventory policy has favorable effect on the costs of production.
Take the case of a firm which is manufacturing umbrellas. The season and demand for umbrellas is from June to September (a four month period). The firm has two alternatives.
- It may produce umbrellas throughout the year and sell them during the four-month period. In this case it will have to incur costs on carrying stock of raw materials and finished goods.
- Alternatively, the firm may produce only during the four months and avoid the costs of inventory. But this may result in loss of sales and production due to power failure, Strikes, machine breakdowns, etc.
If the cost of carrying inventory is less than these losses it would be preferable to stagger the production throughout the year and maintain inventory.
The level of inventory depends upon several factors:
- The rate of inventory turnover: e., the time period within which inventory completes the cycle of production and sales. When the turnover rate is high, investment in inventories tends to be low.
- Durable products are more susceptible: to inventory holding as the risk of perish ability and obsolescence is less. Perishable and fashion goods are not stocked in large amounts. Thus, the type of product also influences the inventory level.
- Under conditions of imperfect competition: demand is uncertain and stocks must be held if the firm wants to take advantage of profitable sales opportunities. The optimum level of inventory will demand upon the variability of sales and the cost revenue relationship. The level of inventory rises with increase in the difference between price and marginal cost. Thus, market structure influences the level of inventories.
- Economies of production runs: also determine the inventory level. Modern machinery is very costly and the cost of idle machine time is considerable. Therefore, every business firm likes to maintain sufficient stock of raw materials to ensure uninterrupted production.
- There are certain costs of carrying stock: Some of these costs (STORAGE costs, setup cost, change-over costs, costs of ordering, spoilage and obsolescence costs) are directly measurable. On the other hand, certain costs (opportunity cost of capital, costs caused by price level changes, cost of loss of sales due to shortage of stock) are not measurable. All these costs influence the level of inventories.
- Financial position of the firm: exercises significant influence on inventory levels. A financially sound company may buy materials in bulk and hold them for future use. A firm starved of funds cannot maintain large stocks.
- The inventory policy and attitude of management: also influence the inventory level.
Objectives of inventory Control
The main objectives of controlling inventory are as follows:
- To minimize capital investment in inventory by eliminating excessive stocks,
- To ensure availability of needed inventory for uninterrupted production and for meeting consumer demand;
- To provide a scientific basis for planning of inventory needs;
- To tiding over the demand fluctuations by maintaining reasonable safety stock;
- To minimize risk of loss due to obsolescence, deterioration etc., and
- To maintain necessary records for protecting against thefts, wastes, leakages of inventories and to decide timely replenishment of stocks.
Advantages of Inventory Control
Scientific inventory control provides the following benefits:
- It improves the liquidity position of the firm by reducing unnecessary typing up of capital in excess inventories.
- It ensures smooth production operations by maintaining reasonable stocks of materials.
- It facilitates regular and timely supply to customers through adequate stocks of finished products.
- It protects the firm against variation in raw materials delivery time.
- It facilitates production scheduling, avoids shortage of materials and duplicates ordering.
- It helps to minimize loss by obsolescence, deterioration, damage, etc.
- It enables the firms to take advantage of price fluctuations through economic lot buying when prices are low.
Costs of Holding Inventories
The building up and holding of inventories involves several costs. First of all there is the procurement cost. Procurement costs are of two types. When inventory is procured from outside suppliers, it is known as the ordering cost (expenses incurred on preparing and sending the purchase order). When the inventory is self-supplied by the businessman from his own factory, it is called setup costs. Strictly speaking, setup costs are relevant in job order production only. Setup costs include all the costs components of changing over the production process to manufacture the ordered item. It also comprises cost of time lost in changing the production process and clerical cost involved in sending an order to the production department.
The second categories of costs are called carrying costs which comprise the following costs:
- Capital cost.
- Cost of storage and handling and
- Cost of deterioration and obsolescence.
Capital cost: It refers to the cost of the money tied up in inventory. Such cost depends on the prevailing market rate of interest. But in a capital scarce country like India, market rate of interest is not a correct indicator of capital cost. What is relevant is the opportunity cost (loss of earnings of capital which could alternatively be utilized elsewhere).
Storage costs: Storage costs include rent of go down where inventories are stored, clerical costs of maintaining stock records, cost of air-conditioning (if any) required to protect the inventory, cost of night watchman, cost of insurance of inventory, etc.
Deterioration Costs: Any product or material is likely to deteriorate if stored for a long time. In addition to actual deterioration, there may be pilferage and obsolescence. Such loss is included in deterioration costs. In case of overstock inventory may be left after its demand has terminated. Such overstock cost also represents loss in value.
Stock- out Cost: When the inventory is required in factory or for sale to consumers and the company runs out of stock, it losses production or sales. There is the cost of ideal machine time, loss of man hours, failure to supply goods to customers on time and the resulting loss of goodwill. Thus there is a cumulative effect. All such costs are called shortage or penalty costs.
There are there aspects of inventory replenishment order – (1) the size of each order (called lot size or reorder quantity), number of orders and the time between the placement and receipt of an order (known as lead time).
Lead time: It refers to the interval between placing an order for a particular item and its actual receipt. Suppose, an order is placed for a particular item on 1st January and the material is received on 1st February. In this case the lead time is one month. Longer is the lead time higher will be the average level of inventory.
Safety stock: It implies the stock of inventory held as a safety measure against fluctuations in demand and lead time. Safety stock is a function of lead time. The longer the lead time, the greater the safety stock. Safety stock is also known as buffer stock or minimum stock. Safety stock should be differentiated from working stock. Safety stock refers to the stock of inventory which is supposed to take care of shortages. On the other hand, working stock refers to the inventory generated by orders.
During a cycle of production, the inventory is depleted. Assuming a constant rate of usage we get the slope of line eb. If inventory is not replenished, inventories will ultimately (time t2) reach zero level. In order to avoid it the firm would place on order in advance at time t1 as order cannot be carried out immediately. Depending on the lead time delivery procedure and daily usage rate of the inventory, the order point for the replenishment of inventory is decided. It is equal to lead time multiplied by the slope of the usage line.
While determining the safety stock, reorder cost and reorder quantity should be considered. The cost of reorder and the quantity to be reordered depend upon the following factors:
- The minimum level: The minimum level of inventory is decided by taking into account such factors as the usage value of the item, normal lead time, the availability of substitutes, etc. After taking these factors into consideration, a level has to be determined below which the stock of inventory should not fall. This is called the minimums level of inventory.
- The reorder point: The reorder point should obviously be the minimum level plus a safety margin which is kept to ensure that shortages (out of stock situation) do not occur.
- The standard order quantity: In order to minimize the cost of acquiring inventory, the size of order should be decided. Discount offered by suppliers and transport costs should be considered in deciding this quantity.
- The maximum level: This level can be determined by adding up the minimum level of inventory and the standard order quantity.
The actual level of inventory to support the production rate depends upon management policy concerning the cost of carrying inventory, the desired turnover rate, the desired service level, the use of economic ordering quantity, the degree of sales fluctuations and other similar policies. The rules, practices and procedures concerning inventory decide the terms of inventory control. In reviewing stock position, two main factors must be considered:
- When to order; and
- How much to order
Every manufacturing concern must maintain some inventory of materials and parts to ensure uninterrupted production.
