Concept of Inventory
Inventory’ may be defined as usable but idle resource’. If resource is some physical and tangible object such as materials, then it is generally termed as stock. Thus stock or inventory is synonymous terms though inventory has wider implications.
Broadly speaking, the problem of inventory management is one of maintaining, for a given financial investment, an adequate supply of something to meet an expected demand pattern. This could be raw materials work in progress finished products or the spares and other indirect materials.
Inventory can be one of the indicators of the management effectiveness on the materials management front. Inventory turnover ratio (annual demand/average inventory) is an index of business performance. A soundly managed organization will have higher inventory turnover ratio and vice-versa.
Inventory management deals with the determination of optimal policies and procedures for procurement of commodities. Since it is quite difficult to imagine a real work situation in which the required material will be made available at the point of use instantaneously, hence maintaining, inventories becomes almost necessary.
Thus inventories could be visualized as ‘necessary evil’.
Inventory Related Cost
An inventory system may be defined as one in which the following costs are significant:
- Cost of carrying inventories (holding cost)
- Cost of incurring shortages (stock out cost)
- Cost of replenishing inventories (ordering cost)
Cost of carrying inventory: This is expressed in Rs. /item held in stock/unit time. This is the opportunity cost of blocking material in the non-productive form as inventories. Some of the cost elements that comprise carrying cost are-cost of blocking, capital (interest rate); cost of insurances; storage cost; cost due to obsolescence, pilferage, deterioration etc. It is generally expressed as a fraction of value of the goods stocked per year. For example, if the fraction of carrying charge is 20% per year and a material worth Rs. 1,000 is kept in inventory for one year, the unit carrying cost will be Rs. 200/item/year. It is obvious that for items that are perishable in nature, the attributed carrying cost will be higher.
Cost of incurring shortages: It is the opportunity cost of not having an item in stock when one is demanded. It may be due to lost sales or backlogging. In the backlogging (or back ordering) case the order is not lost but is backlogged, to be cleared as soon as the item is available on stock. In lost sales case the order is lost. In both cases there are tangible and intangible costs of not meeting the demand on time. It may include lost demand; penalty cost; emergency replenishment; loss of good-will etc. This is generally expressed as Rs. /item short/unit time.
Cost of replenishing inventory: This is the amount of money and efforts expended in procurement or acquisition of stock. It is generally called ordering cost. This cost is usually assumed to be independent of the quantity ordered, because the fixed cost component is generally more significant than the variable component. Thus it is expressed as Rs. /order.
These three types of costs are the most commonly incorporated in inventory analysis, though there may be other costs parameters relevant in such an analysis such as inflation, price discounts etc.
Importance of Inventory Management
Scientific inventory management is an extremely important problem area in the materials management function. Materials account for more than half the total cost of any business and organizations maintain huge amount of stocks much of this could be reduced by following scientific principles. Inventory management is highly amenable to control. In the Indian industries there is a substantial potential for cost reduction due to inventory control. Inventory being a symptom of poor performance we could reduce inventories by proper design of procurement policies by reduction in the uncertainty of lead times by variety reduction and in many other ways.
