Inventory Basics

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Inventory is the collection of unsold products waiting to be sold. Inventory is listed as a current asset on a company’s balance sheet.

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.

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 become almost necessary. Thus, inventories could be visualized as `necessary evil’.

Inventory Definition

Inventory is the raw materials, work-in-process products and finished goods that are considered to be the portion of a business’s assets that are ready or will be ready for sale.

It is also defined as

  • An itemized catalog or list of tangible goods or property, or the intangible attributes or qualities.
  • The value of materials and goods held by an organization (1) to support production (raw materials, subassemblies, work in process), (2) for support activities (repair, maintenance, consumables), or (3) for sale or customer service (merchandise, finished goods, spare parts).
  • Inventory is often the largest item in the current asset’s category, and must be accurately counted and valued at the end of each accounting period to determine a company’s profit or loss. Organizations whose inventory items have a large unit cost generally keep a day to day record of changes in inventory (called perpetual inventory method) to ensure accurate and on-going control.

Inventory is commonly thought of as the finished goods a company accumulates before selling them to end users. But inventory can also describe the raw materials used to produce the finished goods, goods as they go through the production process (referred to as “work-in-progress” or WIP), or goods that are “in transit.”

Why to have inventory

There are generally five reasons companies maintain inventories:

  • To meet an anticipated increase in demand;
  • To protect against unanticipated increases in demand;
  • To take advantage of price breaks for ordering raw materials in bulk;
  • To prevent the idling of a whole factory if one part of the process breaks down; and,
  • To keep a steady stream of material flowing to retailers rather than making a single shipment of goods to retailers.
  • Inventory can also be used as collateral to obtain financing in some cases.

The basic requirement for counting an item in inventory is economic control rather than physical possession. Therefore, when a company purchases inventory, the item is included in the purchaser’s inventory even if the purchaser does not have physical possession of those items.

Inventory is usually classified in its own category as an asset on the balance sheet, following receivables. It is important to note that the balance sheet’s inventory account should also reflect costs directly or indirectly incurred in making an item ready for sale, including the purchase price of the item as well as the freight, receiving, unpacking, inspecting, storage, maintenance, insurance, taxes, and other costs associated with it.

Relevance of Inventory

Inventory is a key component of calculating cost of goods sold (COGS) and is a key driver of profit, total assets, and tax liability. Many financial ratios, such as inventory turnover, incorporate inventory values to measure certain aspects of the health of a business.

For these reasons, and because changes in commodity and other materials prices affect the value of a company’s inventory, it is important to understand how a company accounts for its inventory. Common inventory accounting methods include first in, first out (FIFO), last in, first out (LIFO), and lower of cost or market (LCM). Some industries, such as the retail industry, tailor these methods to fit their specific circumstances. Public companies must disclose their inventory accounting methods in the notes accompanying their financial statements.

Given the significant costs and benefits associated with inventory, companies spend considerable amounts of time calculating what the optimal level of inventory should be at any given time, and changes in inventory levels can send mixed messages to investors. Increases in inventory may signal that a company is not selling effectively, is anticipating increased sales in the near future (such as during the holidays), or has an inefficient purchasing department.

Declining inventories may signal that the company is selling more than it expected, has a backlog, is experiencing a blockage in its supply chain, is expecting lower sales, or is becoming more efficient in its purchasing activity.

Because there are several ways to account for inventory and because some industries require more inventory than others, comparison of inventories is generally most meaningful among companies within the same industry using the same inventory accounting methods, and the definition of a “high” or “low” inventory level should be made within this context.

Functions of Inventory

As mentioned earlier, inventory is a necessary evil. Necessary, because it aims at absorbing the uncertainties of demand and supply by `decoupling’ the demand and supply sub-systems Thus an organization maybe carrying inventory for the following reasons:

  • Demand and lead time uncertainties necessitate building of safety stock (buffer stocks) so as to enable various sub-systems to operate somewhat in a decoupled manner.
  • Time lag in deliveries also necessitates building of inventories. If the replenishment lead times are positive then stocks are needed for system operation.
  • Cycle stocks may be maintained to get the economics of scale so that total system cost due to ordering, carrying inventory and backlogging are minimized. Technological requirements of batch processing also build up cycle stocks.
  • Stocks may build up as pipeline inventory or work-in-process inventory due to 28finiteness of production and transportation rates. This includes materials actually being worked on or moving between work centers or being in transit to distribution Inventory Management centers and customers.
  • When the demand is seasonal, it may become economical to build inventory during periods of low demand to ease the strain of peak period demand.
  • Inventory may also be built up for other reasons such as: quantity discounts being offered by suppliers, discount sales, anticipated increase in material price, possibility of future non-availability etc.

Different functional managers of an organization may view the inventory from different viewpoints leading to conflicting objectives. This calls for an integrated systems approach to planning of inventories so that these conflicting objectives can be scrutinized to enable the system.

Inventory Management Basics

Inventory management is the management of inventory and stock. As an element of supply chain management, inventory management includes aspects such as controlling and overseeing ordering inventory, storage of inventory, and controlling the amount of product for sale.

Inventory management is all about having the right inventory at the right quantity, in the right place, at the right time, and at the right cost.

For companies with complex supply chains and manufacturing processes, balancing the risks of inventory gluts and shortages is especially difficult. To achieve these balances, firms have developed two major methods for inventory management: just-in-time and materials requirement planning.

Decisions regarding the amount of inventory that a company should hold and its location within a company’s logistics network are crucial in order to meet customer service requirements and expectations.

The Inventory Management Process

Inventory management is a complex process, particularly for larger organizations, but the basics are essentially the same regardless of the organization’s size or type. In inventory management, goods are delivered into the receiving area of a warehouse in the form of raw materials or components and are put into stock areas or shelves.

Compared to larger organizations with more physical space, in smaller companies, the goods may go directly to the stock area instead of a receiving location, and if the business is a wholesale distributor, the goods may be finished products rather than raw materials or components. The goods are then pulled from the stock areas and moved to production facilities where they are made into finished goods. The finished goods may be returned to stock areas where they are held prior to shipment, or they may be shipped directly to customers.

Inventory management uses a variety of data to keep track of the goods as they move through the process, including lot numbers, serial numbers, cost of goods, quantity of goods and the dates when they move through the process. 

Inventory Management Ttechniques

Inventory management uses several methodologies to keep the right amount of goods on hand to fulfill customer demand and operate profitably. This task is particularly complex when organizations need to deal with thousands of stocks keeping units (SKUs) that can span multiple warehouses. The methodologies include:

  • Stock review, which is the simplest inventory management methodology and is generally more appealing to smaller businesses. Stock review involves a regular analysis of stock on hand versus projected future needs.
  • Just-in-time (JIT) methodology, in which products arrive as they are ordered by customers, and which is based on analyzing customer behavior.
  • ABC analysis methodology, which classifies inventory into three categories that represent the inventory values and cost significance of the goods. Category A represents high-value and low-quantity goods, category B represents moderate-value and moderate-quantity goods, and category C represents low-value and high-quantity goods.

Inventory control is the area of inventory management that is concerned with minimizing the total cost of inventory, while maximizing the ability to provide customers with products in a timely manner. In some countries, the two terms are used as synonyms.

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.

Just-in-Time

Just-in-time (JIT) manufacturing originated in Japan in the 1960s and 1970s; Toyota Motor Corp. (TM) contributed the most to its development. The method allows companies to save significant amounts of money and reduce waste by keeping only the inventory they need to produce and sell products. This approach reduces storage and insurance costs, as well as the cost of liquidating or discarding excess inventory.

JIT inventory management can be risky. If demand unexpectedly spikes, the manufacturer may not be able to source the inventory it needs to meet that demand, damaging its reputation with customers and driving business towards competitors. Even the smallest delays can be problematic; if a key input does not arrive “just in time,” a bottleneck can result.

Materials Requirement Planning

The materials requirement planning (MRP) inventory management method is sales-forecast dependent, meaning that manufacturers must have accurate sales records to enable accurate planning of inventory needs and to communicate those needs with materials suppliers in a timely manner.

Inventory Management Software Systems

Inventory management software systems generally began as simple spreadsheets that tracked the quantities of goods in a warehouse, but have become more complex. Inventory management software can now go several layers deep and integrate with accounting and ERP systems. The systems keep track of goods in inventory, sometimes across several warehouse locations. The software also calculates the costs — often in multiple currencies — so that accounting systems always have an accurate assessment of the value of the goods.

Some inventory management software systems are designed for large enterprises, and they may be heavily customized for the particular requirements of those organizations. Large systems were traditionally run on premises, but are now also deployed in public cloud, private cloud and hybrid cloud environments. Small and midsize companies typically don’t need such complex and costly systems, and they often rely on stand-alone inventory management products, generally through SaaS applications.

Types of Inventory

All organizations (including JIT operations) keep supplies of inventory for reasons, such as maintaining independent operations, meeting variations in product demand, allowing flexibility in production scheduling, providing a safeguard for variation in raw material delivery time, and taking advantage of economic purchase order size.

The inventory of materials may occur at different stages as well as departments of an organization. For instance, a manufacturing organization holds the inventory of raw materials and consumables need for production process, in addition to that of semi-finished goods at different stages held with different departments. The inventory of finished goods remains at plant, stores, distribution centers, etc. until it reaches the market and end consumers. In addition, both raw materials and finished goods in transit at different locations, also constitute the inventory, basis the owner of the inventory at a particular period of time. Organizations also hold inventories of spares for product servicing. Not only this, even defective products, parts and scrap are held as long as they are inventoried in the books of the organization, with an economic value.

Inventories are also held on the basis of ‘Function’

Input Process Output
Raw materials Work-in-process Finished goods
Consumables needed for processing / manufacturing, such as fuel, nuts & bolts, stationary, etc. Semi-finished production at different stages, retained by different departments in an organization, such as production, work-in-process stores, quality control, final assembly, packaging, outbound store, etc. Finished goods inventoried at distribution centers during logistics or supply chain
Items for Maintenance / Consumables Production waste and scrap Finished goods in transit
Packaging Materials Defectives and rejections Finished goods held with warehouses and dealers
Items purchased locally to be used in production process Spare stocks & purchased items
Defectives, rejections and sales returns
Repaired stocks and component parts
Sales promotion & sample stocks

The main categories can be summarized as:

  • raw material, component and packaging stocks– generally used to feed into a production or manufacturing process;
  • in-process stocks– sometimes known as work-in-progress (WIP), these consist of part-finished stock that is built up between different manufacturing processes;
  • finished products– stocks that are held at the end of the production line normally in a finished goods warehouse and sometimes known as finished goods inventory (FGI);
  • pipeline stocks– probably the most common type of stock-holding, these are held in the distribution chain for eventual transfer to the final customer;
  • general stores– containing a mixture of products used to support a given operation, for example a large manufacturing plant;
  • spare parts– a special category because of the nature of the stock, which pro vides a crucial back-up to a manufacturer’s machinery or plant where any breakdown might be critical, and also held by service and maintenance companies for supply to their customers to support service contracts.

Within the above categories, stock can again be broken down into other major classification:

  • Working stock. This is likely to be the major element of stock within a distribution depot’s stock-holding, and it should reflect the actual demand for the product.
  • Cycle stock. This refers to the major production stock within a production ware house, and it reflects the batch sizes or production run lengths of the manufacturing process. This flow of inward supply and outward demand for a product in a warehouse is often depicted as a classic ‘saw-tooth’
  • Safety stock – This is the stock that is used to cover the unpredictable daily or weekly fluctuations in demand. It is sometimes known as ‘buffer’ stock, as it creates a buffer to take account of this unpredictability.
  • Speculative stock – This can be raw materials that are ‘bought forward’ for financial or supply reasons, or finished stock that is pre-planned to prepare for expected future increases in demand.
  • Seasonal stock – This is product that is stockpiled to allow for expected large increases in demand. Typically, this would include inventory built up prior to the Christmas demand peak.

 

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