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  1. 1. 2. B THEORETICAL BACKGROUNDMeaning and Definition of InventoryThe inventory represents an essential component for the assets of the enterpriseand the economic analysis gives them special importance because their accuratemanagement determines the achievement of the activity object and the financial results.The efficient management of inventory requires ensuring an optimum level for them,which will guarantee the normal functioning of the activity with minimum inventoryexpenses and funds which are immobilized.Every enterprise needs inventory for smooth running of its activities. It serves as alink between production and distribution processes. There is, generally, a time lagbetween the recognition of a need and its fulfillment. The greater the time – lag, thehigher will be the requirements for inventory. The unforeseen fluctuation in demand andsupply of goods also necessitate the need for inventory. It also provides a cushion forfuture price fluctuation.The inventory means aggregate of those items of tangible personal property which(i) Are held for sale in ordinary course of business.(ii) Are in process of production for such sales.(iii) They are to be currently consumed in the production of goods or services to beavailable for sale.Inventories are expandable physical articles held for resale for use inmanufacturing a production or for consumption in carrying on business activity such asmerchandise, goods purchased by the business which are ready for sale. The inventory isof the trader, who does not manufacture it.Thus in the study of inventory the raw materials, stores and spare parts,consumables,finished goods and work-in-process have been included as inventories. Firm alsomanufactures inventory to supplies.Supplies included office and plant cleaning materials It is therefore quite natural thatinventory which helps in maximize profit occupies the most significant place amongcurrent assets.DVH-IMSR Page 48
  2. 2. A Study on Effectiveness and Application of Inventory Control TechniquesTaking the form of tangible current assets, the inventory is found in all the productionstages and is successively transformed from raw materials in elements of unfinishedproduction (work-in-process), then in finished goods destined for sale.Factors Influences the Level of each Component of InventoryRaw Material Inventory:1. The volume of safety stock against material shortages that interrupt production.2. Considerations of economy in purchase.3. The outlook for future movements in the price of materials.4. Anticipated volume of usage and consumption.5. The efficiency of procurement and inventory control function.6. The operating costs of carrying the stocks.7. The costs and availability of funds for investment in inventory.8. Storage capacity.9. Re-component cycle.10. Indigenous or foreign.11. The lead-time of supply.12. Formalities for importing.Work-in-process Inventory:1. The length of the complete production process.2. Management policies affecting length of process time.3. Length of process in runs.4. Action that speeds up the production process, e.g. adding second or third productionshifts.5. Management’s skills in production scheduling and control.6. Volume of production.7. Sales expectations.8. Level of sales and new orders.9. Price level of raw materials used, wages and other items that enter production cost andthe value added in production.10. Customer requirements.11. Usual period of aging.DVH-IMSR Page 49
  3. 3. A Study on Effectiveness and Application of Inventory Control TechniquesFinished Goods Inventory:1. The policy of the management to gear the production to meet the firm order in hand.2. The policy to produce for anticipated orders and stock keeping.3. Goods required or the purpose of minimum and safety stocks.4. Sales policies of the firm.5. Need for maintaining stability in production.6. Price fluctuations for the product.7. Durability, spoilage and obsolescence.8. Distribution system.9. Ability to fill orders immediately.10. Availability of raw material on seasonal basis while customer’s demand spreadthroughout the year.11. Storage capacity.Stores and Spares Inventory:1. Nature of the product to be manufactured and its lead-time of manufacture.2. State of technology involved.3. Consumption’s patterns.4. Lead time of supply.5. Indigenous or foreign.6. Minimum and safety stock and ordering quantities.7. Capacity utilization.8. Importing formalities.Some of the important inventory policies relates to :1. minimum, maximum and optimum stocks;2. safety stocks, order quantities, order levels and anticipated stocks;3. waste, scrap spoilage and defective;4. policies relating to alternative use;5. policies relating to order filling;Pricing of Raw MaterialsWhen issues are made out of various lots purchased at varying prices, the problem arisesas to which of the receipt price should be adopted for valuing the materials requisitions.DVH-IMSR Page 50
  4. 4. A Study on Effectiveness and Application of Inventory Control Techniques1. First In First Out Method(FIFO)2.Last In First Out Method(LIFO)3.Highest In First Out Method(HIFO)4.Base Stock Method5.Simple Average Method6.Weighted Average Method1. First In First OutMaterials received first will be issued first. The price of the earliest consignment is takenfirst and when that consignment is exhausted the price of the next consignment is adoptedand so on. This method is suitable in times of falling prices, because the material chargeto production will be high while the replacement cost of materials will be low.FIFO method of costing is used to introduce the subject of materials costing. The FIFOmethod of costing issued materials follows the principle that materials used should carrythe actual experienced cost of the specific units used. The method assumes that materialsare issued from the oldest supply in stock andthat the cost of those units when placed in stock is the cost of those same units whenissued. FIFO is one method used to determine Cost of Goods Sold for a business.Merits of FIFO Method:This method is suitable during the period of decreasing of prices. Itis simple to understand and easy to calculate.A stock is valued at the current purchase price, the value of closing stock representcurrent market price.De-merits of FIFO Method:This method is not suitable during the period of increasing prices.If this method is adopted during increase in price this method leads to tax liability.2. Last In First Out LIFO Method:Materials received last will be issued first. The price of the last consignment is taken firstand when that consignment is exhausted the price of the second last consignment isadopted and so on. In timing of rising prices this method will show a charge toproduction, which is closely related to current price levels provided that the last purchaseis made recently. This method is the opposite of the FIFO method. It assumes that theDVH-IMSR Page 51
  5. 5. A Study on Effectiveness and Application of Inventory Control Techniquesmaterial which is purchase last is issued first. Hence, material issues are priced on thebasis of the cost of most recent purchases.Merits of LIFO Method:This method is suitable during the period of increasing of prices Itis simple to understand and easy to calculateNo under or over recovery of cost as material are issued at actual cost price.As a stock is valued at the current purchase, the value of the closing stock representscurrent market prices.De-merits of LIFO Method:This method is not suitable during the period of decreasing prices.If this method is used at the time of decreasing prices, it leads to increase in the taxliability.This method will lead to fluctuations in cost of different jobs.3. Weighted Average Cost MethodUnder this method, material issued is priced at the weighted average cost of material instock:WAC = Value of material in stock/Quantity in stock.4. Standard Price MethodUnder this method a standard price is predetermined. The price of issues predeterminedfor a stated period taken into account all the factors affecting price such as anticipatedmarket trends, transportation charges, and normal quantity of purchase. Standard pricesare determined for each material and material requisition are priced at standardsirrespective of the actual purchase price. Any difference between the standard and actualprice results in materials price variance.5. Current priceAccording to this method, material issued is priced at their replacement or realizableprice at the time of issue. So the cost at which identical material could be purchased fromthe market should be ascertained and used for valuing material issuesDVH-IMSR Page 52
  6. 6. A Study on Effectiveness and Application of Inventory Control TechniquesValuation of Stocks:There are three important types of inventories carried by a manufacturing organization:(i) Raw material inventory(ii) Work-in-process inventory, and(iii) Finished goods inventory.The valuation of work-in-process and finished goods inventory depend on:(i) The method used for pricing materials, and(ii) The manner in which fixed manufacturing overhead costs are treated.Since the methods for pricing materials have been discussed earlier, let us look at howfixed manufacturing overheads costs are treated for this purposes, two systems of costingare used:1. Direct costing and2. Absorption costingUnder direct costing, fixed manufacturing overheads costs are treated as period costs andnot as product costs. Put differently, they are charged directly to the income statementand hence not reflected in the valuation of inventories.Under absorption costing, on the other hand, fixed manufacturing overheads cost aretreated as product costs and not period costs. Hence inventory valuation reflects anallocated share of fixed manufacturing overhead costs.Quite naturally, the valuation of work-in-process and finished goods inventory is lower,ceteris paribus, under direct costing and higher under absorption costing. Further, whenthe inventory level increases, the reported profit under direct costing is lower that thereported profit under absorption costing. By the same token, when the inventory leveldecreases, the reported profit under direct costing is higher than what it is underabsorption costing.Control of InventoriesInventories consist of raw materials, stores, spares, packing materials, consumables,works-in-progress and finished products in stock either at the factory or deposits. Themaintenance of inventory means blocking of funds and so it involves the interest andopportunity cost to the firm. In many countries great emphasis is placed on inventorymanagement. Efforts are made to minimize the stock of inputs and outputs byDVH-IMSR Page 53
  7. 7. A Study on Effectiveness and Application of Inventory Control Techniquesproper planning and forecasting of demand of various inputs and producing only thatmuch quantity which can be sold in the market.In general, a good inventory management implies their formation at a level that willensure both the requirements of the production process and the demand on the market,but will also allow the achievement of the company‟ s performance indicators. Control ofinventory, which typically represents 45% to 90% of all expenses for business, is neededto ensure that the business has the right goods on hand to avoid stock-outs, to preventshrinkage (spoilage/theft), and to provide proper accounting. Many businesses have toomuch of their limited resource, capital, tied up in their major asset, inventory. Worse,they may have their capital tied up in the wrong kind of inventory. Inventory may be old,worn out, shopworn, obsolete, or the wrong sizes or colors, or there may be an imbalanceamong different product lines that reduces the customer appeal of the total operation.THE ANALYSIS OF INVENTORY CONTROL SYSTEMThe financial management of firms pursues broad coverage regarding inventory, but interms of financial analysis, we consider relevant the inventory structure and its rotation.The inventory structure allows the financial analyst to highlight the following aspects:the oversize or sub dimensioning of inventory elements;highlighting inactive inventory or slow-moving inventory, which generatesexpenditures;the evolution over time of inventory structure. The relevant inventory for anenterprise is: raw materials, work-in-process and finished goods. The increase of theshare of raw materials within total inventory reflects the following aspects:the oversize of stock supply;the existence of inactive or slowly moving raw materials;reducing other categories of inventory due to the shortening of the production cycleand the speeding of distribution.Objectives of Inventory ControlThe primary objectives of inventory control are:(i) To minimize the possibility of disruption in the production schedule of a firm forwant of raw material, stock and spares.DVH-IMSR Page 54
  8. 8. A Study on Effectiveness and Application of Inventory Control Techniques(ii) To keep down capital investment in inventories.So it is essential to have necessary inventories. Excessive inventory is an idle resource ofa concern. The concern should always avoid this situation. The investment in inventoriesshould be just sufficient in the optimum level.The major dangers of excessive inventories are:(i) the unnecessary tie up of the firm‟ s funds and loss of profit.(ii) excessive carrying cost, and(iii) the risk of liquidityThe effective inventory control system should(i) maintain sufficient stock of raw material in the period of short supplyand anticipate price changes.(ii) ensure a continuous supply of material to production departmentfacilitating uninterrupted production.(iii) minimize the carrying cost and time.(iv) maintain sufficient stock of finished goods for smooth sales operations.(v) ensure that materials are available for use in production and production servicesas and when required.(vi)ensure that finished goods are available for delivery to customers to fulfil orders,smooth sales operation and efficient customer service.(vii) minimize investment in inventories and minimize the carrying cost and time.(viii) protect the inventory against deterioration, obsolescence and unauthorized use.(ix) maintain sufficient stock of raw material in period of short supply andanticipate price changes.(x) control investment in inventories and keep it at an optimum level.Inventory Control Features and BenefitsFollowing are some of the major features and benefits of the Inventory Control system• Scope we can obtain necessary information for supporting buying and sellingoperations.DVH-IMSR Page 55
  9. 9. A Study on Effectiveness and Application of Inventory Control Techniques• Stock and non stock items We can use the Inventory Tracking flag in the ItemLocation file to set up items as stock in an inventory location and non stock in asupply location.• Bin control We can control the bins you use for receipts, issues, incominginspection, lots, and serial numbered items.We can also control storage space limitations by bin and store items in multiple bins.• Lot, sub lot, and serial number tracking The system walks us through requireddetail forms to process transactions for lot and serial number tracked items.• Multiple levels of stock-on-hand balance controlWe can inquire on stock-on-hand detail for bins, lots, serial numbers, units of measure,allocated totals, location totals, and so onMultiple transaction types The system processes, by location, inventory receipts, issues,transfers, in transit transfers, bin transfers, physical inventory, and adjustments.• Multiple units of measure The system can track and order an item in differentunits of measure.• Availability control You can select the item availability calculation to includeon-order and in-transit quantities.• Catch weights The system can control and track the quantity of an item byweight plus one other unit of measure.• Comment types The system lets we group item comments into user-definedtypes. For example, you might define comment type S as shipping instructions.• Multiple costing methods (standard, average, LIFO, and FIFO)The system can manage negative stock-on-hand quantities using the average or standardcosting method.• Inventory auditing The system ensures that all the inventory transactions created in thesystem are defined correctly.Fixation of Norms of Inventory HoldingsEither by the top management or by the materials department could set the norms forinventories. The top management usually sets monitory limits for investment ininventories. The materials department has to allocate this investment to the various itemsDVH-IMSR Page 56
  10. 10. A Study on Effectiveness and Application of Inventory Control Techniquesand ensure the smooth operation of the concern. It would be worthwhile if norms ofinventories were set by the management by objectives, concept. This concept expects thetop management to set the inventory norms (limit) after consultation with the materialsdepartment. A number of factors enter into consideration in the determination of stocklevels for individual items for the purpose of control and economy. Some of them are:1. Lead time for deliveries.2. The rate of consumption.3. Requirements of funds.4. Keeping qualities, deterioration, evaporation etc.5. Storage cost.6. Availability of space.7. Price fluctuations.8. Insurance cost.9. Obsolescence price.10. Seasonal consideration of price and availability.11. EOQ (Economic Order Quantity), and12. Government and other statuary restrictionThe fixation of inventory levels is also known as the demand and supply method ofinventory control. Carrying too much or too little of the inventories is detrimental to thecompany. If too little inventories are maintained, company will have to encounterfrequent stock outs and incur heavy ordering costs. Very large inventories subjects thecompany to heavy inventory carrying cost in addition to unnecessary ties up of capital.Minimum LevelThe minimum level of inventories of their reorder point may be determined on thefollowing bases:1 Consumption during lead-time.2 Consumption during lead-time plus safety stock.3 Stock out costs.4 Customers irritation and loss of goodwill and production hold costs.DVH-IMSR Page 57
  11. 11. A Study on Effectiveness and Application of Inventory Control TechniquesTo continue production during Lead Time it is essential to maintain some inventories.Lead Time has been defined as the interval between the placing of an order (with asupplier) and the time at which the goods are available to meet the consumer needs.Maximum LevelThe upper limit beyond which the quantity of any item is not normally allowed to rise isknown as the “Maximum Level”. It is the sum total of the minimum quantity, and ECQ.The fixation of the maximum level depends upon a number of factors, such as, thestorage space available, the nature of the material i.e. chances of deterioration andobsolescence, capital outlay, the time necessary to obtain fresh supplies, the ECQ, thecost of storage and government restriction.Re-Order LevelAlso known as the „ordering level‟ the reorder level is that level of stock at which apurchase requisition is initiated by the storekeeper for replenishing the stock. This level isset between the maximum and the minimum level in such a way that before the materialordered for are received into the stores, there is sufficient quantity on hand to cover bothnormal and abnormal circumstances. The fixation of ordering level depends upon twoimportant factors viz, the maximum delivery period and the maximum rate ofconsumption.Re-Order QuantityThe quantity, which is ordered when the stock of an item falls to the reorder level, isknow as the reorder quantity or the EOQ or the economic lot size.Economy Order QuantityThe EOQ refers to the order size that will result in the lowest total of order and carryingcosts for an item of inventory. If a firm place unnecessary orders it will incur unneededorder costs. If a firm places too few order, it must maintain large stocks of goods and willhave excessive carrying cost. By calculating an economic order quantity, the firmidentifies the number of units to order that result in the lowest total of these two costs.DVH-IMSR Page 58
  12. 12. A Study on Effectiveness and Application of Inventory Control TechniquesReorder PointThe reorder point is the level of inventory at which the firm places an order in the amountof EOQ. If the firm places the order when the inventory reaches the reorder point, thenew goods will arrive before the firm runs out of goods to sell.In designing reorder point subsystem, three items of information are needed as inputs tothe subsystem.1. Usage rate- This is the rate per day at which the item is consumed in productionor sold to customers. It is expressed in units. It may be calculated by dividingannual sales by 365 days2. Lead time-- This is the amount of time between placing an order and receivinggoods. This information is usually provided by the purchasing department. Thetime to allow foran order to arrive may be estimated from a check of the company‟ s record and the timetaken in the past for different suppliers to fill orders.3. Safety stock-- The minimum level of inventory may be expressed in terms of severaldays‟ sales. The level can be calculated by multiplying the usage rate and time in thenumber of days that the firm wants to hold as a protection against shortages.Re-order point = (Usage rate)(Lead time + Days of safety) = (Lead Time x Consumptionrate) + Safety stock. The probabilistic approach is found to be cumbersome andunfeasible for a multi period problem. It is proposed an order point whereby an order isplaced. When inventory reaches so many unitsRe-order point S (L) +F√SR (L)L = Lead TimeR = Average number of units perorder F = Stock out acceptance factor.The foregoing analysis is based on certain simplifying assumption. In the real workedsome additional consideration ought to be taken into account:(i) Anticipated scarcity of raw material(ii) Expected price charge(iii)Obsolescence risk(iv)Government restriction on inventory(v) Competitive market.
  13. 13. DVH-IMSR Page 59
  14. 14. A Study on Effectiveness and Application of Inventory Control TechniquesInventories Control TechniquesStore / Inventory control technique is the important tool in the hands of the modernmanagement. It is indispensable for each and every manufacturing concern. Thefollowing are the important techniques of store control.ABC Analysis of InventoriesABC analysis is always a better control system. Under this method inventory items areclassified in to three categories such as ABC basing upon its value and cost significance.The number of items and the value of each class are expressed as percentage of the totaland categorize as under(i) Items of high value and small in numbers termed as A(ii) Items of moderate value and moderate in number is termed as B(iii)Items of small in value and large in number is termed as CThe ABC inventory control technique is based on the principle that a small portion of theitems may typically represent the bulk of money value of the total inventory used in theproduction process, while a relatively large number of items may from a small part of themoney value of stores. The money value is ascertained by multiplying the quantity ofmaterial of each item by its unit price. According to this approach to inventory controlhigh value items are more closely controlled than low value items. Each item ofinventory is given A, B or C denomination depending upon the amount spent for thatparticular item.“A” or the highest value items should be under the tight control and under responsibilityof the most experienced personnel, while “C” or the lowest value may be under simplephysical control.The relative position of these items show that items of category A should be under themaximum control, items of category B may not be given that much attention and item Cmay be under a loose control.DVH-IMSR Page 60
  15. 15. A Study on Effectiveness and Application of Inventory Control TechniquesTable No 2.1Particulars A item B item C itemControl Tight Moderate LooseRequirement Exact Exact EstimatedCheck Close Some LittleExpenditure Regular Some NoPosting Industrial Individual Group/noneSafety Stock Low Medium HighAfter classification, the items are ranked by their value and then the cumulativepercentages of total value against the percentage of item are noted. A detailed analysis ofinventory may indicate above figure that only 10 per cent of item may account for 75 percent of the value, another 10 per cent of item may account for 15 per cent of the valueand remaining percentage items may account for 10 per cent of the value. The importanceof this tool lies in the fact that it directs attention to the key items.Advantages of ABC Analysis1. It ensures a closer and a more strict control over such items, which are having asizable investment in there.2. It releases working capital, which would otherwise have been locked up for amore profitable channel of investment.3. It reduces inventory-carrying cost.4. It enables the relaxation of control for the „C‟ items and thus makes it possible for asufficient buffer stock to be created.5. It enables the maintenance of high inventory turnover rate.Fixation of various stock levels: Under this method various stock levels are fixedscientifically to avoid over stocking and under stocking of materials. Over stocking ofmaterials leads to unnecessary blockage of materials and investment and under stockingof material leads to disputation in production. These are the following stock levels whichhelp for planning of materials.DVH-IMSR Page 61
  16. 16. A Study on Effectiveness and Application of Inventory Control TechniquesEconomic ordering quantity: Economic ordering quantity is that quantity of materialwhich are to be ordered in one time in order to minimize ordering cost, carrying cost aswell as cost of holding stock.Perpetual inventory system: Perpetual inventory system is defined as "a system ofrecords maintained by the controlling department which reflects the physical movementof stocks and their current balances."Bin card and store ledger constitute the bedrock ofperpetual inventory system. It is a method of recording store after every receipt & everyissue and their current balances to avoid closing down the firm for stock taking. Toensure accuracy the physical verification may be made which must have to agree with thebalance of Bin Card & store ledger. If there is any discrepancy between the two, it maybe adjusted by preparing debit note and credit note.Perpetual Inventory System of inventory control is the maintenance of inventory controlon a continuous basis. After the material are received into the stores, the storekeeper willarrange for the storing of each item in the allotted rack, bin, shelf or other receptacles andattach a card to each bin for the purpose of making entries there-in, relating to thereceipts, issues and balance. The bin card or the locker card, this becomes a perpetualinventory record for each item of stores. If the stores balance is recorded on continuousbasis after every receipt and issue, the record is said to be one of perpetual inventory andthe method of recording is called the perpetual inventory system. Thus the perpetualinventory is a method of recording store balance after every receipt and issue to facilitateregular checking and to obviate closing down for stock locking .As a perpetual inventoryrecord, the bin card records the receipt, issues and the balance of every item of storesonly in physical quantities, and not in value. The advantages of a continuous stocktakingwhere perpetual inventory records are maintained may thus be summarized as follows:(i) The elaborate and costly work involved in periodic stock taking can be avoided.(ii) The stock verification can be done without the necessity of closing down thefactory.(iii)The preparation of interim financial statement becomes possible.(iv)Discrepancies are easily located and corrected immediately.(v) It ensure a reliable check on the stores.DVH-IMSR Page 62
  17. 17. A Study on Effectiveness and Application of Inventory Control Techniques(vi)It exercises a moral influence on the stores staff.(vii) Fast and slow moving items can be distinguished and the fixation of properstock levels prevents not only over-stocking, but under-stocking also.(viii) A perpetual inventory record of the nature of the bin cards enables thestorekeeper to keep an eye on the stock levels, and replenish the stock ofevery item whenever the limit falls to the reorder level.(ix)It provides reliable information to the management of the number of units, and thevalue of every item of stores.(x) It ensures secrecy of the items that are verified.Controlling InventoryThe reasons for inventory control are:• Helps balance the stock as to value, size, color, style, and price line in proportionto demand or sales trends.• Help plan the winners as well as move slow sellers• Helps secure the best rate of stock turnover for each item.• Helps reduce expenses and markdowns.• Helps maintain a business reputation for always having new, fresh merchandise inwanted sizes and colours.Controlling inventory does not have to be an onerous or complex proposition. It is aprocess and thoughtful inventory management. There are no hard and fast rules to abideby, but some extremely useful guidelines to help your thinking about the subject. A fivestep process has been designed that will help any business bring this potential problemunder control to think systematically thorough the process and allow the business to makethe most efficient use possible of the resources represented. The final decisions, ofcourse, must be the result of good judgment, and not the product of a mechanical set offormulas.STEP 1: Inventory PlanningInventory control requires inventory planning. Inventory refers to more than the goods onhand in the retail operation, service business, or manufacturing facility. It also representsgoods that must be in transit for arrival after the goods in the store or plant are sold orDVH-IMSR Page 63
  18. 18. A Study on Effectiveness and Application of Inventory Control Techniquesused. An ideal inventory control system would arrange for the arrival of new goods at thesame moment the last item has been sold or used. The economic order quantity, or baseorders, depends upon the amount of cash (or credit) available to invest in inventories, thenumber of units that qualify for a quantity discount from the manufacturer, and theamount of time goods spend in shipment.STEP 2: Establish order cyclesIf demand can be predicted for the product or if demand can be measured on a regularbasis, regular ordering quantities can be setup that takes into consideration the mosteconomic relationships among the costs of preparing an order, the aggregate shippingcosts, and the economic order cost. When demand is regular, it is possible to programregular ordering levels so that stock-outs will be avoided and costs will be minimized.STEP 3: Balance Inventory LevelsEfficient or inefficient management of merchandise inventory by a firm is a major factorbetween healthy profits and operating at a loss. There are both market-related and budget-related issues that must be dealt with in terms of coming up with an ideal inventorybalance:• Is the inventory correct for the market being served?• Does the inventory have the proper turnover?• What is the ideal inventory for a typical retailer or wholesaler in this business?To answer the last question first, the ideal inventory is the inventory that does not loseprofitable sales and can still justify the investment in each part of its whole.Customer will be especially irritated if the item out of stock is one they would normallyexpect to find from such a supplier. Repeated experiences of this type will motivatecustomers to become regular customers of competitors.STEP 4: Review StocksItems sitting on the shelf as obsolete inventory are simply dead capital. Keepinginventory up to date and devoid of obsolete merchandise is another critical aspect of goodinventory control. This is particularly important with style merchandise, but it isimportant with any merchandise that is turning at a lower rate than the average stockDVH-IMSR Page 64
  19. 19. A Study on Effectiveness and Application of Inventory Control Techniquesturns for that particular business. One of the important principles newer sellers frequentlyfind difficult is the need to mark down merchandise that is not moving well.STEP 5: Follow-up and ControlPeriodic reviews of the inventory to detect slow-moving or obsolete stock and to identifyfast sellers are essential for proper inventory management. Taking regular and periodicinventories must be more than just totaling the costs. Any clerk can do the work ofrecording an inventory. However, it is the responsibility of key management to study thefigures and review the items themselves in order to make correct decisions about thedisposal, replacement, or discontinuance of different segments of the inventory base.Caution and periodic review of reorder points and quantities are a must. Individualmarket size of some products can change suddenly and corrections should be made.COMMON CHARACTERISTICS OF INVENTORIESInventories share the following characteristics:Inventory represent a financial investment for the companyInventories become part of the cost of goods sold and are therefore a business expenses.The availability of the right item at the right time is necessary for operating anyproduction process or satisfies a demand by a customer for a finished product.Economic Order QuantityOne of the major inventory management problem to be resolved is how much inventoryshould be added when inventory is replenished .If the firm is buying raw materials, it hasto decide lots in which it has to be purchased on each replenishment. If the firm isplanning a production run, the issue is how much production to schedule. These problemsare called order quantity problems. The task of the firm is to determine economic orderquantity. The economic order quantity is that inventory level whichminimizes the costs.DVH-IMSR Page 65
  20. 20. A Study on Effectiveness and Application of Inventory Control TechniquesDetermine economic inventory level involves two types of costs.a) Ordering costsThe term ordering costs includes the entire costs of acquiring raw materials. They includecost incurred in the following activities : requisitioning purchase ordering, transporting,receiving, inspecting and ordering cost increases in proportion to the number of ordersplaced except clerical and staff costs on a pro –data basis. Ordering costs increases withthe number of orders : thus the more frequently inventory is acquired ,the higher the firmsordering costs. On the other hand if the firm maintains the inventory levels, there will befew orders placed and ordering costs will be relatively small. Thus ordering costsdecreases with increasing size of inventory.b) Carrying costs :Costs incurred for maintaining a given level of inventory called carrying costs.Theyinclude storage, insurance, taxes, deterioration and obsolescence. The storage costscomprise cost of storing space, stores handling costs of clerical and staff service costsincurred in recording and providing facilities. Carrying costs vary with inventory size. Itis contrary to that of ordering costs which decline with increase in inventory size .Theeconomic size of inventory would thus depend on trade off between carrying costs andordering costs.Assumptions of the EOQ Model:The basic EOQ model is based on the following assumptions:1. The forecast usage / demand for a given period; usually one year, is known.2. The usage / demand is even throughout the period.3. Inventory orders can be replenished immediately (there is no delay in placing andreceiving orders).4. There are two distinguishable cost associated with inventories: costs of orderingand costs of carrying.5. The cost per order is constant regardless of the size of order.6. The cost of carrying is a fixed percentage of the average value of inventory.EOQ Formula:For determining the EOQ formula we shall use the following symbols:U = annual usage / demandDVH-IMSR Page 66
  21. 21. A Study on Effectiveness and Application of Inventory Control TechniquesQ = quantity orderedF = Cost per orderC = per cent carryingcost P = price per unitTC = total costs of ordering and carrying.Given the above assumptions and symbols, the total cost of ordering and carryinginventories are equal toTC = U * F + Q * P * CQ 2Benefits of Holding InventoryHolding of inventories results in a following benefits.Quick Services:A customer desires a prompt fulfillment of orders. A firm will have to make the goodsavailable for sale. In the event of its not being able to offer quick service to customers,the latter are likely to get their orders executed by competitors.Reduction in Order CostsEach order increases certain costs. If the number of orders is reduced, it is possible toeconomize on these costs or the procedure involving each other need not be repeated eachtime.Discounts:A firm is in position to take advantage of trade discounts by placing bulk order withsuppliers. A proper proportion will have to be maintained between the costs ofmaintaining inventories and the discount that is likely to be gained.Effects of holding high stockIncreased storage costs.Increased risk of obsolescence.Increased capital investment, which reduces the capital available for other activities andprojects.DVH-IMSR Page 67
  22. 22. A Study on Effectiveness and Application of Inventory Control TechniquesCost of holding inventoriesInventories tie up funds. They also expose a firm to a number of risks and costs. Thedifferent costs are material cost, cost of ordering, holding or carrying the inventory, understocking costs and over-stocking costs.Material Cost:This is the cost of purchasing goods plus the transportation and handling charges.Order Cost:This is a variable cost of placing an order for goods. The cost of ordering also includesthe following costs:Stationery, typing and dispatch of orders and reminders.Rent and depreciation on the space and equipment utilized by the concernedpurchasing personnel.Insurance expenditure incurred to protect goods against fire and other risks etc.Cost of Carrying InventoriesThe components of these costs are:The cost of capital that is the cost of the money invested in theinventory. The salaries and statutory payment of stores personnel.Cost of tying of funds:When funds are invested in the inventory, it is obvious that they are not available for anyother use.Cost of under stocking:Excess inventories represent additional and unnecessary cost. Under stocking or out-of-stock cost is due to the non-stocking of an inventory.Cost of overstocking:It is basically opportunity cost arising out of the investment in inventory for a longerperiod than necessary.DVH-IMSR Page 68
  23. 23. A Study on Effectiveness and Application of Inventory Control Techniques3 RESEARCH DESIGNInventoryInventory in general means “stock of goods”. It covers the stock of raw materials,components, spare parts; work in process or semi-finished goods and finished goods.Inventories constitute the most significant part of current asset of a large majority inIndia. On the average, inventories are approximately 60% of the current asset in publiccompanies in India. Because of the large size of inventories maintained by firms, aconsiderable amount of fund is required to be committed in them. Inventory can bereviewed as idle resources of any kind having an economic value. They are those goodswhich are procured, stored and used for the day to day functioning of an organization.The term inventory includes materials-raw, in process, finished packaging, spares andothers stocked in order to meet an unexpected demand or distribution in the future.Inventory can be used to refer to the stock on hand at a particular time of raw materials,goods-in-process of manufacture, finished products, merchandise purchased for resale,and the like, tangible assets which can be seen, measured and counted. In connection withfinancial statements and accounting records, the reference may be the amount assigned tothe stock of goods owned by an enterprise at a particular time.COMMON CHARACTERISTICS OF INVENTORIESInventories share the following characteristics:Inventory represent a financial investment for the companyInventories become part of the cost of goods sold and are therefore a business expenses.The availability of the right item at the right time is necessary for operating anyproduction process or satisfies a demand by a customer for a finished product.DVH-IMSR Page 69
  24. 24. A Study on Effectiveness and Application of Inventory Control TechniquesOBJECTIVE OF INVENTORY CONTROL SYSTEM:In the context of inventory, the firm is faced with the problem of meeting two conflictingneeds:To maintain a large size of inventory for efficient and smooth production andoperations.To maintain a minimum investment in inventories to maximize profitability.Both excessive and inadequate inventories are not desirable. These are two danger pointswithin which the firm should operate. The objective of inventory management should beto determine and maintain optimum level of inventory investment. The optimum level ofinventory will lie between two danger points of excessive and inadequate inventories.The firm should always avoid a situation of over investment or under-investment ininventories. The major dangers of over investment are:a) Unnecessary tie-up of the firm‟ s funds and loss of profitb) Excessive carrying costs, andc) Risk of liquidity.The excessive level of inventories consumes funds of the firm, which cannot be used forany other purpose, and thus, it involves an opportunity cost. The carrying costs, such asthe cost of storage, handling, insurance, recording and inspection, also increase inproportion to the volume of inventory. These costs will impair the firm‟ s profitabilityfurther. Excessive inventories carried for long-period increase chances of loss ofliquidity. It may not be possible to sell inventories in time and at full value. Rawmaterials are generally difficult to sell as the holding period increases. There areexceptional circumstances where it may pay to the company to hold stocks of rawmaterials. This is possible under conditions of inflation and scarcity. Work in process isfar more difficult to sell. Similarly, difficulties may be faced to dispose of finished goodsinventories as time lengthens. The downward shifts in market and the seasonal factorsmay cause finished goods to be sold at low prices. Another danger of carrying excessiveinventory is the physical deterioration of inventories while in storage. In case of certaingoods or raw materials deterioration occurs with the passage of time, or it may be due tomishandling and improper storage facilities. These factors are within the control ofmanagement, unnecessary investment in inventories can thus, be cut down.DVH-IMSR Page 70
  25. 25. A Study on Effectiveness and Application of Inventory Control TechniquesMaintaining an inadequate level of inventories is also dangerous. The consequences ofunderinvestment in inventories are:a) Production hold-ups andb) Failure to meet delivery commitmentsInadequate raw materials and work in process inventories will result in frequentproduction interruptions. Similarly, if finished goods inventories are not sufficient tomeet the demands of customer regularly, customers may shift to competitors, which willamount to a permanent loss to the firm.The aim of inventory management, thus, should be to avoid excessive and inadequatelevels of inventories and to maintain sufficient inventory for the smooth production andsales operations. Efforts should be made to place an order at the right time with the rightsource of acquire the right quantity at the right price and quality. An effective inventorymanagement should:Ensure a continuous supply of raw materials to facilitate uninterrupted production.Maintain sufficient stocks of raw materials in periods of short supply and anticipateprice changes.Maintain sufficient finished goods inventory for smooth sales operation and efficientcustomer service.Minimise the carrying cost and time.Control investment in inventories and keep it at an optimum level.To maintain adequate accountability of inventory assets.To facilitate purchasing economies. Tocontribute to profitability.OBJECTIVES OF THE STUDY:1. To known the procedure /methods used in maintaining inventory levels andprovide accurate information about inventory management.2. To known the inventory control techniques.3. To achieve the use of ratio analysis as a tool for measuring the effectiveness ofinventory control system.DVH-IMSR Page 71
  26. 26. A Study on Effectiveness and Application of Inventory Control TechniquesOPERATIONAL DEFINATION OF THE CONCEPTSInventory:Inventory is used to designate the aggregate of those items of tangible property which areheld for sale in the ordinary course of business and goods which are in process ofproduction for such sale and also goods currently consumed in the production of goods orservices. Thus inventory means stock of items kept in reserve for certain period of time.It includes raw materials, work in progress, semi finished goods, finished goods and spareparts for the maintenance of equipment.Current Assets:Current assets are all those assets which change their form and substance and which areultimately converted into cash during the normal operating cycle of business i.e. 12months. In short all those assets which are changed into cash within a year are calledcurrent assets.Current liabilities:Current liabilities refer to all short term obligations or liabilities which are required to berepaid within a period of one year out of short term or current assets. They include billspayable, sundry creditors‟ bank overdraft etc.Sales:Cost of Goods Sold: Refers to opening stock of finished goods+ Purchase of finishedgoods + direct expenses- closing stock of finished goods.PURPOSE OF THE STUDYThe inventory control helps in providing information to efficiently managing the flow ofmaterials, effectively utilize people and equipment, coordinate internal activities, andcommunicate with customers. Thus this study provides the information which helps inmaking more accurate and timely decisions to manage operations in the organization.SCOPE OF THE STUDY:The scope of the study is-1. Present practices being followed at HIDP.2. Management performances in controlling the inventory.DVH-IMSR Page 72
  27. 27. A Study on Effectiveness and Application of Inventory Control TechniquesLIMITATION OF THE STUDYThe project has some of the limitation are as follows:-1) Some data which are given may not be up to date.2) More emphasis is given to the secondary data.3) There were some people who did not respond and much information wasnot obtained. So it was not possible to go in depth.4) The finance information is not given in depth, may be because of security.5) As market is fast changing and hence accurate calculation of value of stockis practically not possibleTOOLS AND TECHNIQUES FOR COLLECTION OF DATAThe research design for the study was assessed and collected by the particularinformation provided by the company regarding all types of stocks or inventories. Thefollowing tools and techniques were used for collecting the data:A. For collecting primary dataInformation provided by company executives and managers.B. For collecting secondary dataCompany websitesCompany handbookPrevious recordsMETHODOLOGYResearch methodology represents the strategies involves in collecting and analyzingdata collected, in order to have meaningful interpretations of the research findings. Thissection attempts to give an insight into the way and manner in which this research wascarried out. This includes the mode of data collection, how these data were analyzed andthe research design.Methods of Data CollectionEssential information for this research work were collected through primaryand secondary sources the combinations include:(i) Interview with some key personnel in the stores, purchasing, production and inventoryDVH-IMSR Page 73
  28. 28. A Study on Effectiveness and Application of Inventory Control Techniquesdepartments of the company.(ii)Observation of the production process was done to see the flow of goods in theconversion process. Materials handling and storage were also observed and so wasthe patrol /inspection procedures.(iii) Record analysis of relevant data was obtained from the company‟ s annual reportandjournals.(iv)Theoretical background information was gathered through review of relatedliterature on inventory management.Financial analysts have sounded enough warning on the danger expose to the long runprofitability as well as continuity of business concern when its inventories are leftunmanaged. First, a company, which neglects it management of inventory, runs the riskof production bottlenecks and subsequently unable to maintain the minimum investmentit requires to maximized profit. Second, inventories that are inefficiently managed mayapart from affecting sales create an irreparable loss in market for companies operating inhighly competitive industry. Invariably, a company must neither keep excess inventoriesto avoid an unnecessary tying down of funds as well as loss in fund due to pilferage,spoilage and obsolescence nor maintain too low inventories so as to meet production andsales demand as at when needed. Therefore, the mere fact that ineffective inventorymanagement affects virtually the organizational objectives necessitates this type ofresearch work.The analysis of the inventory was made using ratios; ABC analysis and inference weredrawn. Graphs are shown to pictorial depict the data.Findings are summarized and suggestions were made based on data.Type of research was-descriptive research aimed at identifying some of the keyproblem areas in the field of inventory management.Data source was –primary as well as secondary data source (last 4 years data oninventory).Data collection tool used was-website and company‟ s internal data.DVH-IMSR Page 74
  29. 29. A Study on Effectiveness and Application of Inventory Control TechniquesMETHODS OF ANALYSISMeasure of Effectiveness of Inventory Control1. Size of Inventory = Total inventory/Total Current assets2. Size of Raw material Inventory = Raw material inventory/Total inventory3. Size of Work in Process Inventory = Work in process Inventory/Total Inventory4. Size of Stores and Spares parts Inventory = Stores and Spares partsinventory/Total Inventory5. Size of Finished Goods Inventory = Finished goods inventory/Total inventory6. Overall inventory turnover ratio = Cost of goods sold/average total inventories at cost7. Raw material inventory turnover ratio = Annual consumption of Raw material /Average Raw material inventory8. Work-in-process inventory turnover ratio = Cost of manufacture/average work-in-process inventory at cost9. Finished Goods inventory turnover ratio = Cost of goods sold / Average finished stock10. Stores and spare parts inventory turnover ratio = Stores and Sparesconsumed/Average stock of stores and spares11. Age of Finished Goods inventory = 365/Finished Goods inventory turnover ratio12. Average age of raw material inventory = 365/Raw material inventory turnover ratio13. Average age of Work-in-Process inventory = 365/Work-in-Process inventoryturnover ratio14. Age of Stores and spare parts inventory = 365/Stores and spare parts inventoryturnover ratio15. Inventory holding period = 365/Inventory turnover ratioDVH-IMSR Page 75
  30. 30. A Study on Effectiveness and Application of Inventory Control TechniquesFINANCIAL RATIOSRatio analysis has a wider application as a measure of inventory control among mostmanufacturing firms. Some of the important ratios are explained below:(1) Inventory to Sales (Total Inventory/Sales for the Period)The ratio explains variations in the level of investment. An increase in inventory levels,substantially beyond that which might be expected from an increase in sales, may reflectsuch phenomena as the result of a conscious policy shift to higher stock levels, ofunintended accumulation of unsold stocks, and of inventory speculation, or simplystocking in anticipation of an almost certain surge of orders.(2) Inventory Turnover (Cost of Goods Sold/Average Inventory)The ratio tells us the rapidity with which the inventory is turned over into receivablesthrough sales. Generally, the higher the inventory turnover, the more efficient themanagement of a firm is. However, a relatively high inventory turnover ratio may be theresult of too low a level of inventory and frequent stock outs. Therefore, the ratio must bejudged in relation to the past and expected future ratios of the firm and in relations ofsimilar firms or the industry average or both.(3) Sales to Inventory (Annual Net Sales/Inventory at the End of Fiscal Period)The ratio indicates the volume of sales in relation to the amount of capital invested ininventories. When inventory for a firm is larger in relation to sales (the condition whichcauses it to have a lower net sales to inventory ratio than other firms) the firm‟ s rate ofreturn is less since it has more working capital tied up in inventories than has the firmwith a higher ratio.(4) Inventory to Current Assets (Total Inventory/Total Current Assets)The ratio indicates the amount of investment in inventory per rupee of current assetsinvestment. Generally an increasing proportion of inventory is indicative of inefficientinventory management. The ratio may also indicate the state of liquidity position ofconcern. The lower the inventory to current assets lowers the liquidity as compared toother current assets, viz., receivables, cash and marketable securities.(5) Inventories Expressed in Terms of Number of Days Sales (Inventory/Sales x 365)The ratio indicates the size of inventory in terms of number of day‟ s sales. For thispurpose first the sales per day are calculated and inventory is divided by the amount ofDVH-IMSR Page 76
  31. 31. A Study on Effectiveness and Application of Inventory Control Techniquessales per day. The increasing inventory in terms of number of day‟ s sales may indicate eitheraccumulation of inventory or decline in sales. Inventory for this purpose is assumed toinclude finished goods only. While the former situation signifies poor inventory management,the later indicates the poor performance of the marketing department.(6) Sundry Creditors to Inventory (Sundry Creditors/Inventory)The ratio reveals the extent to which inventories are procured through credit purchases.Inventories for this purpose are assumed to include raw materials and stores and spares only.If the ratio is less than unity, it reveals that the credit available is lower than the totalinventory required. It also explains the extent of inventory procured through cash purchases.Indirectly it emphasizes the inventory financing policy of the firm. If the ratio is more thanone, it explains that the entire inventory is purchased on credit.(7) Inventory to Net Working Capital (Inventory/Net Working Capital)The ratio explains the amount of inventory per rupee of equity/long-term financed portion ofcurrent assets. A higher ratio may mean greater amount of net working capital investment ininventory. In order to control each category of inventory, the following ratios can becalculated. The inventory represents an essential component for the assets of the enterpriseand the economic analysis gives them special importance because their accurate managementdetermines the achievement of the activity object and the financial results. The efficientmanagement of inventory requires ensuring an optimum level for them, which will guaranteethe normal functioning of the activity with minimum inventory expenses and funds which areimmobilized. The paper presents an analysis model for inventory management based on theirrotation speed and the correlation with the sales volume illustrated in an adequate study. Thehighlighting of the influence factors on the efficient inventory management ensures the usefulinformation needed to justify managerial decisions, which will lead to a balanced financialposition and to increased company performance.