Inventory types


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Inventory types

  2. 2. INTRODUCTIONInventories are assets of the firm and require investment and hence involve the commitment of firm’s resources. The inventories need not be viewed as an idle asset rather these are an integral part of firm’s operations. If the inventories are too big, they became a strain on the resources, however, if they are too small the firm may loose the sales. Therefore, the firm must have an optimum level of inventories.INVENTORY TYPESInventory is defined as a stock or store of goods. These goods aremaintained on hand at or near a businesss location so that the firm maymeet demand and fulfill its reason for existence. If the firm is a retailestablishment, a customer may look elsewhere to have his or her needssatisfied if the firm does not have the required item in stock when thecustomer arrives. If the firm is a manufacturer, it must maintain someinventory of raw materials and work-in-process in order to keep the factoryrunning. In addition, it must maintain some supply of finished goods in orderto meet demand.Sometimes, a firm may keep larger inventory than is necessary to meetdemand and keep the factory running under current conditions of demand. Ifthe firm exists in a volatile environment where demand is dynamic (i.e., rises
  3. 3. and falls quickly), an on-hand inventory could be maintained as a bufferagainst unexpected changes in demand. This buffer inventory also can serveto protect the firm if a supplier fails to deliver at the required time, or ifthe suppliers quality is found to be substandard upon inspection, either ofwhich would otherwise leave the firm without the necessary raw materials.Other reasons for maintaining an unnecessarily large inventory includebuying to take advantage of quantity discounts (i.e., the firm saves by buyingin bulk), or ordering more in advance of an impending price increase.Generally, inventory types can be grouped into four classifications: rawmaterial, work-in-process, finished goods, and MRO goods.RAW MATERIALSRaw materials are inventory items that are used in the manufacturersconversion process to produce components, subassemblies, or finishedproducts. These inventory items may be commodities or extracted materialsthat the firm or its subsidiary has produced or extracted. They also may beobjects or elements that the firm has purchased from outside theorganization. Even if the item is partially assembled or is considered afinished good to the supplier, the purchaser may classify it as a raw materialif his or her firm had no input into its production. Typically, raw materialsare commodities such as ore, grain, minerals, petroleum, chemicals, paper,wood, paint, steel, and food items. However, items such as nuts and bolts,ball bearings, key stock, casters, seats, wheels, and even engines may beregarded as raw materials if they are purchased from outside the firm.
  4. 4. The bill-of-materials file in a material requirements planning system (MRP)or a manufacturing resource planning (MRP II) system utilizes a tool knownas a product structure tree to clarify the relationship among its inventoryitems and provide a basis for filling out, or "exploding," the masterproduction schedule. Consider an example of a rolling cart. This cart consistsof a top that is pressed from a sheet of steel, a frame formed from foursteel bars, and a leg assembly consisting of four legs, rolled from sheetsteel, each with a caster attached. An example of this carts productstructure tree is presented in Figure 1.Figure 1Generally, raw materials are used in the manufacture of components. Thesecomponents are then incorporated into the final product or become part of asubassembly. Subassemblies are then used to manufacture or assemble thefinal product. A part that goes into making another part is known as acomponent, while the part it goes into is known as its parent. Any item thatdoes not have a component is regarded as a raw material or purchased item.
  5. 5. From the product structure tree it is apparent that the rolling carts rawmaterials are steel, bars, wheels, ball bearings, axles, and caster frames.WORK-IN-PROCESSWork-in-process (WIP) is made up of all the materials, parts (components),assemblies, and subassemblies that are being processed or are waiting to beprocessed within the system. This generally includes all material rawmaterials that has been released for initial processing up to material thathas been completely processed and is awaiting final inspection andacceptance before inclusion in finished goods.Any item that has a parent but is not a raw material is considered to bework-in-process. A glance at the rolling cart product structure tree examplereveals that work-in-process in this situation consists of tops, legassemblies, frames, legs, and casters. Actually, the leg assembly and castersare labeled as subassemblies because the leg assembly consists of legs andcasters and the casters are assembled from wheels, ball bearings, axles, andcaster frames.FINISHED GOODSA finished good is a completed part that is ready for a customer order.Therefore, finished goods inventory is the stock of completed products.These goods have been inspected and have passed final inspection
  6. 6. requirements so that they can be transferred out of work-in-process andinto finished goods inventory. From this point, finished goods can be solddirectly to their final user, sold to retailers, sold to wholesalers, sent todistribution centers, or held in anticipation of a customer order.Any item that does not have a parent can be classified as a finished good. Bylooking at the rolling cart product structure tree example one can determinethat the finished good in this case is a cart.Inventories can be further classified according to the purpose they serve.These types include transit inventory, buffer inventory, anticipationinventory, decoupling inventory, cycle inventory, and MRO goods inventory.Some of these also are know by other names, such as speculative inventory,safety inventory, and seasonal inventory. We already have briefly discussedsome of the implications of a few of these inventory types, but will nowdiscuss each in more detail.TRANSIT INVENTORYTransit inventories result from the need to transport items or material fromone location to another, and from the fact that there is some transportationtime involved in getting from one location to another. Sometimes this isreferred to as pipeline inventory. Merchandise shipped by truck or rail cansometimes take days or even weeks to go from a regional warehouse to aretail facility. Some large firms, such as automobile manufacturers, employfreight consolidators to pool their transit inventories coming from variouslocations into one shipping source in order to take advantage of economies of
  7. 7. scale. Of course, this can greatly increase the transit time for theseinventories, hence an increase in the size of the inventory in transit.BUFFER INVENTORYAs previously stated, inventory is sometimes used to protect against theuncertainties of supply and demand, as well as unpredictable events such aspoor delivery reliability or poor quality of a suppliers products. Theseinventory cushions are often referred to as safety stock. Safety stock orbuffer inventory is any amount held on hand that is over and above thatcurrently needed to meet demand. Generally, the higher the level of bufferinventory, the better the firms customer service. This occurs because thefirm suffers fewer "stock-outs" (when a customers order cannot beimmediately filled from existing inventory) and has less need to backorderthe item, make the customer wait until the next order cycle, or even worse,cause the customer to leave empty-handed to find another supplier.Obviously, the better the customer service the greater the likelihood ofcustomer satisfaction.ANTICIPATION INVENTORYOftentimes, firms will purchase and hold inventory that is in excess of theircurrent need in anticipation of a possible future event. Such events mayinclude a price increase, a seasonal increase in demand, or even an impending
  8. 8. labor strike. This tactic is commonly used by retailers, who routinely build upinventory months before the demand for their products will be unusuallyhigh (i.e., at Halloween, Christmas, or the back-to-school season). Formanufacturers, anticipation inventory allows them to build up inventory whendemand is low (also keeping workers busy during slack times) so that whendemand picks up the increased inventory will be slowly depleted and the firmdoes not have to react by increasing production time (along with thesubsequent increase in hiring, training, and other associated labor costs).Therefore, the firm has avoided both excessive overtime due to increaseddemand and hiring costs due to increased demand. It also has avoided layoffcosts associated with production cut-backs, or worse, the idling or shuttingdown of facilities. This process is sometimes called "smoothing" because itsmoothes the peaks and valleys in demand, allowing the firm to maintain aconstant level of output and a stable workforce.DECOUPLING INVENTORYVery rarely, if ever, will one see a production facility where every machine inthe process produces at exactly the same rate. In fact, one machine mayprocess parts several times faster than the machines in front of or behindit. Yet, if one walks through the plant it may seem that all machines arerunning smoothly at the same time. It also could be possible that whilepassing through the plant, one notices several machines are under repair orare undergoing some form of preventive maintenance. Even so, this does notseem to interrupt the flow of work-in-process through the system. Thereason for this is the existence of an inventory of parts between machines,
  9. 9. a decoupling inventory that serves as a shock absorber, cushioning thesystem against production irregularities. As such it "decouples" ordisengages the plants dependence upon the sequential requirements of thesystem (i.e., one machine feeds parts to the next machine).The more inventory a firm carries as a decoupling inventory between thevarious stages in its manufacturing system (or even distribution system), theless coordination is needed to keep the system running smoothly. Naturally,logic would dictate that an infinite amount of decoupling inventory would notkeep the system running in peak form. A balance can be reached that willallow the plant to run relatively smoothly without maintaining an absurd levelof inventory. The cost of efficiency must be weighed against the cost ofcarrying excess inventory so that there is an optimum balance betweeninventory level and coordination within the system.CYCLE INVENTORYThose who are familiar with the concept of economic order quantity (EOQ)know that the EOQ is an attempt to balance inventory holding or carryingcosts with the costs incurred from ordering or setting up machinery. Whenlarge quantities are ordered or produced, inventory holding costs areincreased, but ordering/setup costs decrease. Conversely, when lot sizesdecrease, inventory holding/carrying costs decrease, but the cost ofordering/setup increases since more orders/setups are required to meetdemand. When the two costs are equal (holding/carrying costs andordering/setup costs) the total cost (the sum of the two costs) is minimized.
  10. 10. Cycle inventories, sometimes called lot-size inventories, result from thisprocess. Usually, excess material is ordered and, consequently, held ininventory in an effort to reach this minimization point. Hence, cycleinventory results from ordering in batches or lot sizes rather than orderingmaterial strictly as needed.MRO GOODS INVENTORYMaintenance, repair, and operating supplies, or MRO goods, are items thatare used to support and maintain the production process and itsinfrastructure. These goods are usually consumed as a result of theproduction process but are not directly a part of the finished product.Examples of MRO goods include oils, lubricants, coolants, janitorial supplies,uniforms, gloves, packing material, tools, nuts, bolts, screws, shim stock, andkey stock. Even office supplies such as staples, pens and pencils, copierpaper, and toner are considered part of MRO goods inventory.THEORETICAL INVENTORYIn their book Managing Business Process Flows: Principles of OperationsManagement, Anupindi, Chopra, Deshmukh, Van Mieghem, and Zemel discussa final type of inventory known as theoretical inventory. They describetheoretical inventory as the average inventory for a given throughputassuming that no WIP item had to wait in a buffer. This would obviously bean ideal situation where inflow, processing, and outflow rates were all equalat any point in time. Unless one has a single process system, there always will
  11. 11. be some inventory within the system. Theoretical inventory is a measure ofthis inventory (i.e., it represents the minimum inventory needed for goods toflow through the system without waiting). The authors formally define it asthe minimum amount of inventory necessary to maintain a processthroughput of R, expressed as:Theoretical Inventory = Throughput Theoretical Flow TimeIth = R TthIn this equation, theoretical flow time equals the sum of all activity times(not wait time) required to process one unit. Therefore, WIP will equaltheoretical inventory whenever actual process flow time equals theoreticalflow time.Inventory exists in various categories as a result of its position in theproduction process (raw material, work-in-process, and finished goods) andaccording to the function it serves within the system (transit inventory,buffer inventory, anticipation inventory, decoupling inventory, cycleinventory, and MRO goods inventory). As such, the purpose of each seems tobe that of maintaining a high level of customer service or part of an attemptto minimize overall costs. What is "Inventory Management"Inventory management is the active control program which allows themanagement of sales, purchases and payments.Inventory management software helps create invoices, purchase orders,receiving lists, payment receipts and can print bar coded labels. Aninventory management software system configured to your warehouse,
  12. 12. retail or product line will help to create revenue for your company. TheInventory Management will control operating costs and provide betterunderstanding. We are your source for inventory management information,inventory management software and tools.A complete Inventory Management Control system contains the followingcomponents: • Inventory Management Definition • Inventory Management Terms • Inventory Management Purposes • Definition and Objectives for Inventory Management • Organizational Hierarchy of Inventory Management • Inventory Management Planning • Inventory Management Controls for Inventory • Determining Inventory Management Stock Levels MOTIVE OF HOLDING INVENTORY:- • Transaction Motive:- Every firm has to maintain some fuel of inventory to meet the day to day requirements of sale production process, customer demand etc. • Precautionary Motive:- The firm should keep some inventory for unforeseen circumstances also. For eg. The fresh supply of raw
  13. 13. materials may not reach the factory due to strike by the transports or due to natural calamities in a particular area. • Speculative Motive:- It may be required to keep some inventory in order to capitalize an opportunity to make profits. Example, sufficient level of inventory may help the firm to earn profit in case of expected shortage in market.REASONS AND BENEFITS OF INVENTORYThe inventory has cost as well as benefits associated with it. Whiledetermining the optimum level of inventories, the financial manager mustconsider the necessity of holding inventory & cost thereof. The optimumlevel of inventory is a subjective matter and depends upon the features of afirm. The following are some of the benefits or reasons for holdinginventories.1) Trading firm:If the firm has some stock of goods then the sale activity can beundertaken even if the procurement as stopped due to one reason or theother . Otherwise ,if stock is not there , there is likelihood that the ale will
  14. 14. stop as soon as there is an interruption in procurement. Moreover , it is notalways possible to procure goods whenever there is a sales opportunity , asthere is always a time gap required between the purchase & sale of thegoods. Thus , a trading concern should have some stock of finished goods inorder to undertake sales activities independent of each other. A firm mayhave several incentives being offered in terms of quantity discount or lowerprice etc. the inventory so purchased, at a discount/lower cost, will result inlowering the total cost resulting in higher to the firm. So , in case of tradingconcern, the inventory helps in de-linking the sales activity from purchaseactivity and also to capitalize a profit of opportunity.2) Manufacturing firm:A manufacturing firm should have inventory of not only the finished goods,but also, of raw material and work-in-progress for obvious reason as follows:i) Uninterrupted production schedule:Every firm must have sufficient stock of raw material in order to haveregular & uninterrupted production schedule. If there is stock-out of rawmaterial at any stage of production process , then the whole productionprocess may come to a halt. This may result in customer satisfaction as thegoods can not be delivered in time. The firm may have to incur heavy cost torestart the production process.Further, sufficient work-in-progress would let the production process to run
  15. 15. smoothly. The work-in-progress helps in fulfillment of sales orders even ifthe supply of raw material has stopped.ii) Independent sales activity:The production schedule is generally a time consuming process & in mostcases goods cannot be produced just after receiving orders. Everymanufacturing concern therefore, maintains a minimum level of finishedgoods in order to deliver the goods as soon as the order is received.COST OF INVENTORY: Every firm maintains some stock of raw materials,work in progress and finished goods depending upon the requirement andother features of the firm. It is benefited by holding inventory no doubt,yet it must also consider various costs involved in holding inventories. Thecost of holding inventories may include the following: 1. Carrying cost: This is the cost incurred in keeping or maintaining an inventory of one unit of raw material or work in progress or finished goods. Two basic costs are associated with holding a unit in inventory. These are: (a) Cost of storage- This means and includes the cost of storing one unit of raw material by firm .This cost may be in relation to rent of space occupied by the stock ,the cost of people employed for the security of the stock , cost of infrastructure required e.g., air conditioning ,etc ., cost of insurance , cost of pilferage , warehousing cost , handling cost ,etc.. (b) Cost of financing: This cost includes the cost of funds invested in the inventories. The funds used in the purchase / production
  16. 16. of inventories have an opportunity cost i.e. the income which could have been earned by investing these funds elsewhere. Moreover, if the firm has to pay interest on borrowings made for the purchase of materials / goods, then there is an explicit cost of financing in the form of interest.It may be noted that total carrying cost is entirely variable andrise in direct proportion to the level of inventories carried. Thetotal carrying cost move in the same direction as the annualaverage inventory.2. Cost of Ordering: The cost include the cost of acquisition ofinventories .it is the cost of preparation and execution of an order,including cost of paper work and communicating with the supplier.There is always minimum cost involved whenever an order forreplenishment of goods is placed. The total annual cost of orderingis equal to the cost per order multiplied by the number of orderplaced in a year. The number of orders determines the averageinventory being held by the firm. Therefore, the total order costis inversely related to the average inventory of the firm. Theordering cost may have a fixed component which is not affected bythe order size; and a variable component which changes with theorder size. For example, transportation charges may be payableper unit subject to a minimum charge per trip.
  17. 17. 3.Cost of stock outs- A stock out is a situation where the firm is not having units of an item in store but there is a demand for that either from the customers or the production department. The stock out refer to demand for an item whose inventory level has already reduced to zero or insufficient level. It may be noted that the stock out does not appear if the item is not demanded even if inventory level is fallen to zero. The whole theory of inventory management can be summarized as follows- 1. Maintaining sufficient stock of raw materials ensuring continuous supply to production schedule. 2. Maintaining sufficient supply of finished goods for achieving smooth sales operations, and 3. Minimizing the total annual cost of maintaining inventories. TECHNIQUES OF INVENTORY MANAGEMENTABC ANALYSIS-ABC analysis is a type of analysis of material dividing inthree groups called A-group items, B-Group items and C-group items For thepurpose of exercising control over materials. Manufacturing concerns find ituseful to divide materials into three categories.An analysis of the annual consumption of materials of any organisation wouldindicate that a handful to top high value items (less than 10 per cent of thetotal number) will account for a substantial portion of about 70 per cent oftotal consumption value.Remember: 10% of total number of items carries 70% of value. - "A" group
  18. 18. itemsSimilarly, a large number bottom items (over 70 per cent of the totalnumber of items) account for only about 10 percent of the consumptionvalue.Remember: 70% of total number of items account for only about 10% ofconsumption value - "C"-group items.Between these two extremes will fall those items the percentage number ofwhich is more or less equal to their consumption value.Remember: 20% of total number of items account for only about 20%consumption value - "B" group items.Items in the top category are treated as "A" items, items in the bottomcategory are called as "C" category items and the items that lie between thetop and the bottom are called "B" category items. Such an analysis ofmaterials is known as ABC analysis or Proportional parts value analysis.Classification of items into A, B and C categoriesThe logic behind this kind of analysis is that the management should studyeach item of stock in terms of its usage, lead time, technical or otherproblems and its relative money value in the total investment in inventories.
  19. 19. Critical items i.e., high value items deserve very close attention and low valueitems need to be devoted minimum expense and effort in the task ofcontrolling inventories.The Material Manager by concentrating on "A" class items is able to controlinventories and show visible results in a short span of time. By controlling"A" items and doing a proper inventory analysis, obsolete stocks areautomatically pinpointed.ABC analysis also helps in reducing the clerical costs and results in betterplanning and improved inventory turnover. ABC analysis has to be resorted tobecause equal attention to A, B and C items will not be worthwhile and wouldbe very expensive.The following steps will explain to you the classification of items into A, Band C categories.The following steps will explain to you the classification of items into A, Band C categories.1. Find out the unit cost and and the usage of each material over a givenperiod.2. Multiply the unit cost by the estimated annual usage to obtain the netvalue.3. List out all the items and arrange them in the descending value. (Annual
  20. 20. Value)4. Accumulate value and add up number of items and calculate percentage ontotal inventory in value and in number.5. Draw a curve of percentage items and percentage value.6. Mark off from the curve the rational limits of A, B and C categories.Stock LevelsMaintenance of proper stock of each item of materials is one of the mainfunctions of stores department. Large quantity of material in store lead tohuge investments, deterioration in quality, large space requirement etc. Lessstock also leads to higher costs, frequent purchases and loss of productionetc. Therefore, it is important to maintain stock level. One of the best wayto maintain stock is to determine the minimum and maximum stock levels asper the necessity and maintain it regularly.Store keepers usually use scientific technique of material management toensure optimum quantity of material in store and make purchasesaccordingly. In order to do that following levels are fixed in advance: 1. Maximum Stock Level
  21. 21. 2. Minimum Stock level 3. Re-ordering level 4. Danger levelReordering LevelRe-ordering level is a level at which the storekeeper will initiate the steps topurchase fresh supplies. This level is called re-ordering level or orderinglevel. This level usually lies between minimum and maximum stock level. Thislevel will usually be higher than the minimum stock level to cover unexpecteddelay in delivery of fresh supplies or abnormal usage of materials. Followingpoints need to be taken into consideration while fixing the re-ordering level1. Economic ordering quantity2. Rate of consumption3. Time required for the delivery of fresh supply.Following formulas can be used for calculating the re-ordering level.Reorder level = Maximum consumption x Maximum re-order periodorReorder level = Minimum level + consumption during the time required to getfresh deliveries
  22. 22. Example 1Calculate the reorder level from the following information:Maximum Consumption = 100 units per weekMinimum Consumption = 50 units per weekMaximum reorder period = 4 weeksSolution:Reorder level = Maximum consumption x Maximum reorder period= 100 x 4 = 400 units.Example 2Find out the order level from the following information:Maximum Stock: 250 unitsMinimum stock: 100 unitsTime required for receiving fresh supplies: 10 daysDaily consumption of material : 5 unitsSolution:Reorder level = Minimum level + consumption during the time required to get
  23. 23. fresh deliveries= 100 + (5 x 10)= 150 units.Minimum Stock LevelMinimum stock level is a level of stock which must be kept in store at alltimes. This is a level of an item of material below which the stock in hand isnot allowed to fall. The objective of this limit is to avoid the possibility ofinterruption of production due to shortage of material. The following pointsneeds to be taken into consideration while fixing the minimum stock level. 1. Time required for the fresh supply of material - Lead time 2. Rate of consumption of material during the lead time. 3. Reorder levelFollowing formula can be used for determine the minimum stock levelMinimum stock level = Reorder level - (Normal consumption x Normalreorder period)Example:Calculate the minimum stock level from the following data:Net normal consumption = 500 units per dayNormal reorder period = 10 daysReorder level = 8000 units
  24. 24. Solution:Minimum stock level = Reorder level - (Normal consumption x Normal reorderperiod)= 8000 - (500 x 10)= 3000 unitsMaximum stock levelMaximum stock level is a quantity of material above which the stock of anyitem should not be allowed. To avoid blocking of working capital and makingundue investments in stock, maximum stock level is to be fixed. It also helpsto maintain proper quality of raw materials. Following points must be takeninto consideration while fixing maximum stock level: 1. Availability of storage space 2. Cost of carrying the inventory 3. Amount of working capital available 4. Economic ordering quantity 5. Possibility of change in market trend 6. Normal rate of consumption of material during the reordering process. 7. Time necessary for fresh delivery of materials. 8. Possibility of loss due to deterioration/evaporation etc. 9. Price fluctuation. 10. Insurance costs if any.
  25. 25. Following formula is normally in use for calculating Maximum stock level.Maximum stock level = Reorder level + reorder quantity - (maximumconsumption X minimum re-order period)Example:Find out the Maximum stock level from the following information:Reorder Level = 32000 unitsReorder quantity = 30000 unitsMinimum Consumption = 3000 units per monthMinimum reorder period = 2 months.Solution:Maximum stock level = Reorder level + reorder quantity - (maximumconsumption X minimum re-order period)Maximum stock level = 32000 + 30000 - (3000 x 2)=62000 - 6000 = 56000 units.Danger LevelDanger level is a level below the minimum level. This is a level at which urgentaction must be taken to procure new stock otherwise the stock may exhaustand could affect the production. This level is calculated by taking intoaccount the time required to get the materials by the shortest possiblemeans. Generally following formula is used to calculate the Danger level:
  26. 26. Danger level = average consumption x Maximum reorder period foremergency purchase.Average stock levelAverage stock level can be determined by using the following formula:Average Stock Level = 1/2 of (Maximum stock level + Minimum Stock level)orAverage Stock Level = Minimum stock level + half of reorder quantity)Reorder Quantity or Economical order QuantityIt is better to determine in advance how much is to be purchased when thematerial reaches reorder level. This quantity is called reorder quantity. It isthe quantity when it received, it will not exceed the maximum stock level. Itis also called Economic Order Quantity because purchase of this quantity ofmaterial is most economical as well. Frequent purchase will result in increasein cost of transportation. Too much of goods may block the working capitalfor a long time. Following points needs to be taken into consideration whilefixing the reorder quantity.
  27. 27. 1. Cost of transportation2. cost of storage (warehouse rent, insurance, heating and lighting expenses)3. cost of ordering4. Availability of working capital5. Minimum and maximum consumption for the lead time.6. Time necessary to obtain deliveries7. Possibility of loss due to evaporation or deterioration8. Changes in the fashion trend.9. Interest on investment10. Obsolescence losses,