Inventory management or control refers to the management of idle resources which have economic value tomorrow. Alternatively, Inventory may be defined as usable but idle resources that have economic value.
Inventory Management refers to maintaining, for a given financial investment, an adequate supply of something to meet an expected demand pattern. It thus deals with determination of optimal policies and procedures for procurement
In business management, inventory consists of a list of goods and materials held or available in stock. Management of inventory or Inventory management is all about handling functions related to the tracking and management of material. This includes the monitoring of material moved into and out of stockroom locations and reconciling the inventory balances, setting targets, providing replenishment techniques, reporting actual and projected inventory status.
The task of ABC analysis, lot tracking, cycle counting support etc. can even be a part of inventory management.
Inventory control is concerned with minimizing the total cost of inventory. The three main factors in inventory control decision making process are:
The cost of holding the stock (e.g., based on the interest rate). The cost of placing an order (e.g., for row material stocks) or the set-up cost of production. The cost of shortage, i.e., what is lost if the stock is insufficient to meet all demand.
The third element is the most difficult to measure and is often handled by establishing a “service level” policy, e. g, certain percentage of demand will be met from stock without delay.
Terminology used in Inventory management / control:
Maximum Limit: When devising a suitable Inventory model, the Maximum limit establishes the upper limit to which the stock of an inventory item shall be allowed.
Minimum Limit: It is the lower limit to which the stock can be allowed to fall in course of replenishment of the stock of an item. Normally, this is taken to be the safety stock also.
Safety Stock: This is the stock that is maintained to counter the variation in demand of an item during the replenishment lead time.
Demand or Usage: Replenishment of stock and usage of an item is an ongoing phenomenon in inventory control. Demand thus is the rate of usage of an item. Over a period of time demand is considered to be stable. However, demand can be seasonal or cyclical in nature depending upon an item’s nature.
Inventory Overview
Inventory refers to those idle resources which have economic value and thus it may be defined as usable but idle resources that have economic value.
Inventory is a stock of direct or indirect material, from raw material to finished goods stocked in order to meet an unexpected future demand.
In other words inventory is a physical stock of goods kept for the future purposes.
Inventory Management or control refers to maintaining, for a given financial investment, an adequate supply of something to meet an expected demand pattern. It thus deals with determination of optimal policies and procedures for procurement.
Inventory is expressed in terms of both quantity and monetary value. In terms of quantity , it can be expressed as the number of units of an item lying where as in monetary terms it is the sum total of the monetary value of all its items.
Functions of Inventory
Though Inventory is a blocked capital, in the sense that it is not being used in the present, it plays a distinct role in the life of any organization for a smooth and efficient running of business For example, if a firm does not have any inventory then as soon as it receives a supply order it will look for raw material to manufacture the items and thus the customers shall be kept waiting. It alone may cost the firm its customers who may not like to wait. Further, all the internal agencies shall have to work in emergency for getting the material, completing the production etc. if there is no inventory. Inventories decouple individual phases of the total operation.
Thus the functions of inventory are to:
- Protect against unpredictable fluctuations in demand and supply
- Take the advantage of price discounts through bulk purchases
- Take the advantage of batches and longer production run
- Provide flexibility to allow changes in production plans in view of changes in demands etc.
- Facilitate intermittent production
Why Inventory goes up or down?
There are several reasons, the most important for a high inventory being a High Lead time
Tendency to play safe Stock outs and shortages lead to criticism
Standardization and variety reduction not given emphasis
Uncertainty / scarcity of items triggering over stocking
The basic function of inventory is thus to insulate the production process from changes in the environment. It decouples various interlinked functions and thus enables each function to conduct itself independently like Purchasing, Production, and Marketing etc.
Why Inventory needs to be optimally used?
Inventory is Blocked money, the working capital. It has a cost (approx. 20% of Average inventory)
Opportunity cost of investment funds: Investment in external securities / Equipments can earn a return for the company
Insurance cost: Inventory is an asset needing insurance
Storage costs: Cost is associated just for storing an item. When large number of items are stored the following also become costs that cannot be ignored:
Obsolescence and deterioration Damage, pilferage or obsolescence
Inventory Management / Control basics
Inventory management or control refers to the management of idle resources which have economic value tomorrow. Alternatively, Inventory may be defined as usable but idle resources that have economic value.
What is Average Inventory Level?
The ideal inventory level is a material’s Economic Order Quantity (EOQ). This is the amount ordered when an order is placed. Next you need to determine your Safety Stock (SS). This is the amount that you should have remaining when the EOQ arrives.
Basically, Safety stock is the average bare minimum you will have at any given time, and EOQ+SS is the average maximum amount you will have at any given point in time. This should be intuitive because safety is what you have when your shipment arrives and when the order arrives (EOQ) it gets added to the safety stock.
There can be average minimum and maximum because you might not receive the EOQ exactly when you planned to and therefore may have more or less. On average you should have the SS amount when you receive shipments. Between these two average minimum and maximum values lies your long-term average inventory.
The formula for this is:
Optimal Average Inventory = (EOQ+SS+SS)/2
This is for materials. For finished goods, you should aim to keep an inventory level designed to prevent a stock out. This level would be a safety stock of finished goods, thus making the ideal average inventory for finished the safety stock value based on your company’s service level.
Assess Inventory Levels
Simplistic Method – Historical Inventory Levels
Most methods of accounting take the beginning inventory of a period, add it to the ending inventory of a period, and divide by 2. This essentially provides the mathematical average for a given month.
For example, if your inventory level for a good is 2000 on July 1st, you produce 3000 units and sell 1000 units by July 31st. This leaves you with 4000 units. The formula is:
Avg. Inventory = (Beginning Inventory + (Beginning Inventory ++its Produced-Units Sold))/2
Avg. Inventory = (2000 + (2000+3000-1000))/2 = 3000 or more simply:
Avg. Inventory = (Beginning Inventory Ending Inventory)/2
Avg. Inventory = (2000+4000)/2=3000
So this covers historical looks using an accounting approach. A lot of firms use this method to evaluate their average inventory levels.
Daily Weighted Average Inventory Approach
Suppose you start with 10,000 units on May 1st. Also suppose you produce 10,000 units in that month spread out across 21 business days. Now (and this is the important part) suppose you sold 20,000 units in May. This brings the ending inventory to 0. Using accounting methods, the formula gives us 10,000 as the average inventory.
So why is this so bad In short, because the average inventory is not 10,000 units. In fact, there were only two days in which 10,000 units or less were held and these days were May 1st (10,000 units) and May 31st (0 Units). Assuming that production was level through the 21 day working month, this means that 500 units were produced daily, thus raising inventory by 500 units a day until inventory was dropped by 20,000 on the 31st.
Thus weighted average is more suited than the simple average.
Why are inventory levels so important?
To put it simply, average inventory levels are important because they allow you to determine how much money you have tied up in inventory and how much value your inventory assets hold. Helping to determine what they should be can help cut back on unneeded inventory, and knowing what they are can help you determine average warehouse usage, inventory risk, percentage of assets that are made up inventory, holding costs, etc.
Optimization of Inventory
Optimization is probably the most overused word in management today. But what is optimization. The Concise Oxford Dictionary defines optimization as: “the most favorable condition; the best compromise between opposing tendencies; best or most favorable”. Before exploring the implications of that definition let’s go back and understand MRO inventory.
MRO inventory includes all the maintenance spares carried for responding to both breakdowns and scheduled maintenance, it covers all the operating supplies carried to keep the process running, it covers all the inventory held by OEMs (Original Equipment Manufacturers) to service the equipment they sell, it covers all the inventory held by suppliers that becomes your inventory (such as bearing suppliers). It is a very wide field.
For all types of inventory there are only three reasons why you purchase and hold onto inventory:
To enable supply in a timely manner: This means that when you need the part you need it faster than it can be supplied from your suppliers. You need the part and you need it now!
Project or shutdown work: With project work and shutdowns you have the uncertainty of what might be needed, perhaps the timing of when it might be needed and a workforce and timelines that can’t wait. You must hold some inventory.
Purchasing and manufacturing efficiencies: Sometimes it is just not economic to buy spares on a piece-by-piece basis. Therefore you buy the minimum economic quantity and have a spares inventory investment.
But if this was all there was we would all hold only as much inventory as we really need right Yes, that’s right but this is not all there is! You see sometimes we end up holding excess inventory because there have been changes since we last determined our appropriate holding (yes, we may have calculated the wrong inventory level in the first place but I’ll let that go for now.)
Some of the changes you might experience that will change your inventory requirements include:
Improvements in reliability (note that carrying spares doesn’t improve reliability it only reduces repair time but improved reliability results in reduced demand for spares) Changes in the criticality of the equipment due to market or technology changes in the capability of suppliers as they have improved their systems And this is where optimization comes in. Using the definition of optimization from the Concise Oxford Dictionary, typical optimization programs calculate the ‘compromise between the opposing tendencies of cost and availability’. This is achieved by recalculating the required holding and safety stock. Sometimes, optimization is presented as identifying excess or potentially excess holdings through a review of slow moving stock.
Inventory Holding Costs
The first section is going to discuss rough estimates and the second section will discuss methods involved with detailed holding cost analysis.
Rough Estimations
Typically, holding costs are estimated to cost approximately 15-35% of the material’s actual value per year.
The primary factors that drive this up include additional rent needed, great insurance premiums to protect inventory, opportunity costs, and the cost of capital to finance inventory.
A More Detailed Look at Holding Costs
First of all, it is generally best to think of holding costs in terms of their annual costs. To do this, you will need accurate representations of your annual inventory levels. It is always better to track inventory month by month and using these values to find the average holding cost as opposed to taking the year’s beginning, the year’s end and averaging the two.
So now you have your average inventory. This needs to be performed for finished goods, work in process, and raw materials inventory.
Now, you need to figure out what percentage of the total value of the good is being incurred as a holding cost. Cost of capital and opportunity costs should be the first things you think of.
If you are financing the goods with a 10%/year loan then the holding costs are at least 10% annually. When you are evaluating the total value, include the value of any labor that has been added to the goods.
Next step would be to consider the cost of storage. Based on the inventory you need to carry, how much space do you need and how much does that space cost per unit as a percentage of each good.
Again, determine the insurance cost that should be allocated to each good as a percentage of that good.
Evaluate the probability that a good will rot, or otherwise become obsolete and assess the average rate at which this occurs and use this to quantify the average holding cost per good as a percentage of that good on an annual basis.
Determine if there are any other costs you can think of that are incurred simply by being in possession of a good. If you can think of any, treat them as holding costs. Add up all of these percentages and together they make your holding costs.
