Inventory types

CONTENTS

1. INTRODUCTION

2. INVENTORY TYPES

*RAW MATERIALS

*WORK-IN-PROGRESS

*FINISHED GOODS

*TRANSIT INVENTORY

*BUFFER INVENTORY

*DECOUPLING INVENTORY

3. MOTIVE OF HOLDING INVENTORY

4. REASONS AND BENEFITS OF INVENTORY

5. INVENTORY MANAGEMENT

6. TECHNIQUES OF INVENTORY MANAGEMENT

INTRODUCTION

Inventories 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 TYPES

Inventory is defined as a stock or store of goods. These goods are

maintained on hand at or near a business's location so that the firm may

meet demand and fulfill its reason for existence. If the firm is a retail

establishment, a customer may look elsewhere to have his or her needs

satisfied if the firm does not have the required item in stock when the

customer arrives. If the firm is a manufacturer, it must maintain some

inventory of raw materials and work-in-process in order to keep the factory

running. In addition, it must maintain some supply of finished goods in order

to meet demand.

Sometimes, a firm may keep larger inventory than is necessary to meet

demand and keep the factory running under current conditions of demand. If

the firm exists in a volatile environment where demand is dynamic (i.e., rises

and falls quickly), an on-hand inventory could be maintained as a buffer

against unexpected changes in demand. This buffer inventory also can serve

to protect the firm if a supplier fails to deliver at the required time, or if

the supplier's quality is found to be substandard upon inspection, either of

which would otherwise leave the firm without the necessary raw materials.

Other reasons for maintaining an unnecessarily large inventory include

buying to take advantage of quantity discounts (i.e., the firm saves by buying

in bulk), or ordering more in advance of an impending price increase.

Generally, inventory types can be grouped into four classifications: raw

material, work-in-process, finished goods, and MRO goods.

RAW MATERIALS

Raw materials are inventory items that are used in the manufacturer's

conversion process to produce components, subassemblies, or finished

products. These inventory items may be commodities or extracted materials

that the firm or its subsidiary has produced or extracted. They also may be

objects or elements that the firm has purchased from outside the

organization. Even if the item is partially assembled or is considered a

finished good to the supplier, the purchaser may classify it as a raw material

if his or her firm had no input into its production. Typically, raw materials

are 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 be

regarded as raw materials if they are purchased from outside the firm.

The bill-of-materials file in a material requirements planning system (MRP)

or a manufacturing resource planning (MRP II) system utilizes a tool known

as a product structure tree to clarify the relationship among its inventory

items and provide a basis for filling out, or "exploding," the master

production schedule. Consider an example of a rolling cart. This cart consists

of a top that is pressed from a sheet of steel, a frame formed from four

steel bars, and a leg assembly consisting of four legs, rolled from sheet

steel, each with a caster attached. An example of this cart's product

structure tree is presented in Figure 1.

Figure 1

Generally, raw materials are used in the manufacture of components. These

components are then incorporated into the final product or become part of a

subassembly. Subassemblies are then used to manufacture or assemble the

final product. A part that goes into making another part is known as a

component, while the part it goes into is known as its parent. Any item that

does not have a component is regarded as a raw material or purchased item.

From the product structure tree it is apparent that the rolling cart's raw

materials are steel, bars, wheels, ball bearings, axles, and caster frames.

WORK-IN-PROCESS

Work-in-process (WIP) is made up of all the materials, parts (components),

assemblies, and subassemblies that are being processed or are waiting to be

processed within the system. This generally includes all material raw

materials that has been released for initial processing up to material that

has been completely processed and is awaiting final inspection and

acceptance before inclusion in finished goods.

Any item that has a parent but is not a raw material is considered to be

work-in-process. A glance at the rolling cart product structure tree example

reveals that work-in-process in this situation consists of tops, leg

assemblies, frames, legs, and casters. Actually, the leg assembly and casters

are labeled as subassemblies because the leg assembly consists of legs and

casters and the casters are assembled from wheels, ball bearings, axles, and

caster frames.

FINISHED GOODS

A 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

requirements so that they can be transferred out of work-in-process and

into finished goods inventory. From this point, finished goods can be sold

directly to their final user, sold to retailers, sold to wholesalers, sent to

distribution centers, or held in anticipation of a customer order.

Any item that does not have a parent can be classified as a finished good. By

looking at the rolling cart product structure tree example one can determine

that 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, anticipation

inventory, 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 discussed

some of the implications of a few of these inventory types, but will now

discuss each in more detail.

TRANSIT INVENTORY

Transit inventories result from the need to transport items or material from

one location to another, and from the fact that there is some transportation

time involved in getting from one location to another. Sometimes this is

referred to as pipeline inventory. Merchandise shipped by truck or rail can

sometimes take days or even weeks to go from a regional warehouse to a

retail facility. Some large firms, such as automobile manufacturers, employ

freight consolidators to pool their transit inventories coming from various

locations into one shipping source in order to take advantage of economies of

scale. Of course, this can greatly increase the transit time for these

inventories, hence an increase in the size of the inventory in transit.

BUFFER INVENTORY

As previously stated, inventory is sometimes used to protect against the

uncertainties of supply and demand, as well as unpredictable events such as

poor delivery reliability or poor quality of a supplier's products. These

inventory cushions are often referred to as safety stock. Safety stock or

buffer inventory is any amount held on hand that is over and above that

currently needed to meet demand. Generally, the higher the level of buffer

inventory, the better the firm's customer service. This occurs because the

firm suffers fewer "stock-outs" (when a customer's order cannot be

immediately filled from existing inventory) and has less need to backorder

the 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 of

customer satisfaction.

ANTICIPATION INVENTORY

Oftentimes, firms will purchase and hold inventory that is in excess of their

current need in anticipation of a possible future event. Such events may

include a price increase, a seasonal increase in demand, or even an impending

labor strike. This tactic is commonly used by retailers, who routinely build up

inventory months before the demand for their products will be unusually

high (i.e., at Halloween, Christmas, or the back-to-school season). For

manufacturers, anticipation inventory allows them to build up inventory when

demand is low (also keeping workers busy during slack times) so that when

demand picks up the increased inventory will be slowly depleted and the firm

does not have to react by increasing production time (along with the

subsequent increase in hiring, training, and other associated labor costs).

Therefore, the firm has avoided both excessive overtime due to increased

demand and hiring costs due to increased demand. It also has avoided layoff

costs associated with production cut-backs, or worse, the idling or shutting

down of facilities. This process is sometimes called "smoothing" because it

smoothes the peaks and valleys in demand, allowing the firm to maintain a

constant level of output and a stable workforce.

DECOUPLING INVENTORY

Very rarely, if ever, will one see a production facility where every machine in

the process produces at exactly the same rate. In fact, one machine may

process parts several times faster than the machines in front of or behind

it. Yet, if one walks through the plant it may seem that all machines are

running smoothly at the same time. It also could be possible that while

passing through the plant, one notices several machines are under repair or

are undergoing some form of preventive maintenance. Even so, this does not

seem to interrupt the flow of work-in-process through the system. The

reason for this is the existence of an inventory of parts between machines,

a decoupling inventory that serves as a shock absorber, cushioning the

system against production irregularities. As such it "decouples" or

disengages the plant's dependence upon the sequential requirements of the

system (i.e., one machine feeds parts to the next machine).

The more inventory a firm carries as a decoupling inventory between the

various stages in its manufacturing system (or even distribution system), the

less coordination is needed to keep the system running smoothly. Naturally,

logic would dictate that an infinite amount of decoupling inventory would not

keep the system running in peak form. A balance can be reached that will

allow the plant to run relatively smoothly without maintaining an absurd level

of inventory. The cost of efficiency must be weighed against the cost of

carrying excess inventory so that there is an optimum balance between

inventory level and coordination within the system.

CYCLE INVENTORY

Those who are familiar with the concept of economic order quantity (EOQ)

know that the EOQ is an attempt to balance inventory holding or carrying

costs with the costs incurred from ordering or setting up machinery. When

large quantities are ordered or produced, inventory holding costs are

increased, but ordering/setup costs decrease. Conversely, when lot sizes

decrease, inventory holding/carrying costs decrease, but the cost of

ordering/setup increases since more orders/setups are required to meet

demand. When the two costs are equal (holding/carrying costs and

ordering/setup costs) the total cost (the sum of the two costs) is minimized.

Cycle inventories, sometimes called lot-size inventories, result from this

process. Usually, excess material is ordered and, consequently, held in

inventory in an effort to reach this minimization point. Hence, cycle

inventory results from ordering in batches or lot sizes rather than ordering

material strictly as needed.

MRO GOODS INVENTORY

Maintenance, repair, and operating supplies, or MRO goods, are items that

are used to support and maintain the production process and its

infrastructure. These goods are usually consumed as a result of the

production 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, and

key stock. Even office supplies such as staples, pens and pencils, copier

paper, and toner are considered part of MRO goods inventory.

THEORETICAL INVENTORY

In their book Managing Business Process Flows: Principles of Operations

Management, Anupindi, Chopra, Deshmukh, Van Mieghem, and Zemel discuss

a final type of inventory known as theoretical inventory. They describe

theoretical inventory as the average inventory for a given throughput

assuming that no WIP item had to wait in a buffer. This would obviously be

an ideal situation where inflow, processing, and outflow rates were all equal

at any point in time. Unless one has a single process system, there always will

be some inventory within the system. Theoretical inventory is a measure of

this inventory (i.e., it represents the minimum inventory needed for goods to

flow through the system without waiting). The authors formally define it as

the minimum amount of inventory necessary to maintain a process

throughput of R, expressed as:

Theoretical Inventory = Throughput Theoretical Flow Time

Ith = R Tth

In this equation, theoretical flow time equals the sum of all activity times

(not wait time) required to process one unit. Therefore, WIP will equal

theoretical inventory whenever actual process flow time equals theoretical

flow time.

Inventory exists in various categories as a result of its position in the

production process (raw material, work-in-process, and finished goods) and

according to the function it serves within the system (transit inventory,

buffer inventory, anticipation inventory, decoupling inventory, cycle

inventory, and MRO goods inventory). As such, the purpose of each seems to

be that of maintaining a high level of customer service or part of an attempt

to minimize overall costs.

What is "Inventory Management"

Inventory management is the active control program which allows the

management of sales, purchases and payments.

Inventory management software helps create invoices, purchase orders,

receiving lists, payment receipts and can print bar coded labels. An

inventory management software system configured to your warehouse,

retail or product line will help to create revenue for your company. The

Inventory Management will control operating costs and provide better

understanding. We are your source for inventory management information,

inventory management software and tools.

A complete Inventory Management Control system contains the following

components:

• 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

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

INVENTORY

The inventory has cost as well as benefits associated with it. While

determining the optimum level of inventories, the financial manager must

consider the necessity of holding inventory & cost thereof. The optimum

level of inventory is a subjective matter and depends upon the features of a

firm. The following are some of the benefits or reasons for holding

inventories.

1) Trading firm:

If the firm has some stock of goods then the sale activity can be

undertaken even if the procurement as stopped due to one reason or the

other . Otherwise ,if stock is not there , there is likelihood that the ale will

stop as soon as there is an interruption in procurement. Moreover , it is not

always possible to procure goods whenever there is a sales opportunity , as

there is always a time gap required between the purchase & sale of the

goods. Thus , a trading concern should have some stock of finished goods in

order to undertake sales activities independent of each other. A firm may

have several incentives being offered in terms of quantity discount or lower

price etc. the inventory so purchased, at a discount/lower cost, will result in

lowering the total cost resulting in higher to the firm. So , in case of trading

concern, the inventory helps in de-linking the sales activity from purchase

activity 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 have

regular & uninterrupted production schedule. If there is stock-out of raw

material at any stage of production process , then the whole production

process may come to a halt. This may result in customer satisfaction as the

goods can not be delivered in time. The firm may have to incur heavy cost to

restart the production process.

Further, sufficient work-in-progress would let the production process to run

smoothly. The work-in-progress helps in fulfillment of sales orders even if

the supply of raw material has stopped.

ii) Independent sales activity:

The production schedule is generally a time consuming process & in most

cases goods cannot be produced just after receiving orders. Every

manufacturing concern therefore, maintains a minimum level of finished

goods 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 and

other features of the firm. It is benefited by holding inventory no doubt,

yet it must also consider various costs involved in holding inventories. The

cost 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

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 and

rise in direct proportion to the level of inventories carried. The

total carrying cost move in the same direction as the annual

average inventory.

2. Cost of Ordering: The cost include the cost of acquisition of

inventories .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 for

replenishment of goods is placed. The total annual cost of ordering

is equal to the cost per order multiplied by the number of order

placed in a year. The number of orders determines the average

inventory being held by the firm. Therefore, the total order cost

is inversely related to the average inventory of the firm. The

ordering cost may have a fixed component which is not affected by

the order size; and a variable component which changes with the

order size. For example, transportation charges may be payable

per unit subject to a minimum charge per trip.

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 MANAGEMENT

ABC ANALYSIS-ABC analysis is a type of analysis of material dividing in

three groups called A-group items, B-Group items and C-group items For the

purpose of exercising control over materials. Manufacturing concerns find it

useful to divide materials into three categories.

An analysis of the annual consumption of materials of any organisation would

indicate that a handful to top high value items (less than 10 per cent of the

total number) will account for a substantial portion of about 70 per cent of

total consumption value.

Remember: 10% of total number of items carries 70% of value. - "A" group

items

Similarly, a large number bottom items (over 70 per cent of the total

number of items) account for only about 10 percent of the consumption

value.

Remember: 70% of total number of items account for only about 10% of

consumption value - "C"-group items.

Between these two extremes will fall those items the percentage number of

which 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 bottom

category are called as "C" category items and the items that lie between the

top and the bottom are called "B" category items. Such an analysis of

materials is known as ABC analysis or Proportional parts value analysis.

Classification of items into A, B and C

categories

The logic behind this kind of analysis is that the management should study

each item of stock in terms of its usage, lead time, technical or other

problems and its relative money value in the total investment in inventories.

Critical items i.e., high value items deserve very close attention and low value

items need to be devoted minimum expense and effort in the task of

controlling inventories.

The Material Manager by concentrating on "A" class items is able to control

inventories and show visible results in a short span of time. By controlling

"A" items and doing a proper inventory analysis, obsolete stocks are

automatically pinpointed.

ABC analysis also helps in reducing the clerical costs and results in better

planning and improved inventory turnover. ABC analysis has to be resorted to

because equal attention to A, B and C items will not be worthwhile and would

be very expensive.

The following steps will explain to you the classification of items into A, B

and C categories.

The following steps will explain to you the classification of items into A, B

and C categories.

1. Find out the unit cost and and the usage of each material over a given

period.

2. Multiply the unit cost by the estimated annual usage to obtain the net

value.

3. List out all the items and arrange them in the descending value. (Annual

Value)

4. Accumulate value and add up number of items and calculate percentage on

total 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 Levels

Maintenance of proper stock of each item of materials is one of the main

functions of stores department. Large quantity of material in store lead to

huge investments, deterioration in quality, large space requirement etc. Less

stock also leads to higher costs, frequent purchases and loss of production

etc. Therefore, it is important to maintain stock level. One of the best way

to maintain stock is to determine the minimum and maximum stock levels as

per the necessity and maintain it regularly.

Store keepers usually use scientific technique of material management to

ensure optimum quantity of material in store and make purchases

accordingly. In order to do that following levels are fixed in advance:

1. Maximum Stock Level

2. Minimum Stock level

3. Re-ordering level

4. Danger level

Reordering Level

Re-ordering level is a level at which the storekeeper will initiate the steps to

purchase fresh supplies. This level is called re-ordering level or ordering

level. This level usually lies between minimum and maximum stock level. This

level will usually be higher than the minimum stock level to cover unexpected

delay in delivery of fresh supplies or abnormal usage of materials. Following

points need to be taken into consideration while fixing the re-ordering level

1. Economic ordering quantity

2. Rate of consumption

3. 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 period

or

Reorder level = Minimum level + consumption during the time required to get

fresh deliveries

Example 1

Calculate the reorder level from the following information:

Maximum Consumption = 100 units per week

Minimum Consumption = 50 units per week

Maximum reorder period = 4 weeks

Solution:

Reorder level = Maximum consumption x Maximum reorder period

= 100 x 4 = 400 units.

Example 2

Find out the order level from the following information:

Maximum Stock: 250 units

Minimum stock: 100 units

Time required for receiving fresh supplies: 10 days

Daily consumption of material : 5 units

Solution:

Reorder level = Minimum level + consumption during the time required to get

fresh deliveries

= 100 + (5 x 10)

= 150 units.

Minimum Stock Level

Minimum stock level is a level of stock which must be kept in store at all

times. This is a level of an item of material below which the stock in hand is

not allowed to fall. The objective of this limit is to avoid the possibility of

interruption of production due to shortage of material. The following points

needs 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 level

Following formula can be used for determine the minimum stock level

Minimum stock level = Reorder level - (Normal consumption x Normal

reorder period)

Example:

Calculate the minimum stock level from the following data:

Net normal consumption = 500 units per day

Normal reorder period = 10 days

Reorder level = 8000 units

Solution:

Minimum stock level = Reorder level - (Normal consumption x Normal reorder

period)

= 8000 - (500 x 10)

= 3000 units

Maximum stock level

Maximum stock level is a quantity of material above which the stock of any

item should not be allowed. To avoid blocking of working capital and making

undue investments in stock, maximum stock level is to be fixed. It also helps

to maintain proper quality of raw materials. Following points must be taken

into 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.

Following formula is normally in use for calculating Maximum stock level.

Maximum stock level = Reorder level + reorder quantity - (maximum

consumption X minimum re-order period)

Example:

Find out the Maximum stock level from the following information:

Reorder Level = 32000 units

Reorder quantity = 30000 units

Minimum Consumption = 3000 units per month

Minimum reorder period = 2 months.

Solution:

Maximum stock level = Reorder level + reorder quantity - (maximum

consumption X minimum re-order period)

Maximum stock level = 32000 + 30000 - (3000 x 2)

=62000 - 6000 = 56000 units.

Danger Level

Danger level is a level below the minimum level. This is a level at which urgent

action must be taken to procure new stock otherwise the stock may exhaust

and could affect the production. This level is calculated by taking into

account the time required to get the materials by the shortest possible

means. Generally following formula is used to calculate the Danger level:

Danger level = average consumption x Maximum reorder period for

emergency purchase.

Average stock level

Average stock level can be determined by using the following formula:

Average Stock Level = 1/2 of (Maximum stock level + Minimum Stock level)

or

Average Stock Level = Minimum stock level + half of reorder quantity)

Reorder Quantity or Economical order Quantity

It is better to determine in advance how much is to be purchased when the

material reaches reorder level. This quantity is called reorder quantity. It is

the quantity when it received, it will not exceed the maximum stock level. It

is also called Economic Order Quantity because purchase of this quantity of

material is most economical as well. Frequent purchase will result in increase

in cost of transportation. Too much of goods may block the working capital

for a long time. Following points needs to be taken into consideration while

fixing the reorder quantity.

1. Cost of transportation

2. cost of storage (warehouse rent, insurance, heating and lighting

expenses)

3. cost of ordering

4. Availability of working capital

5. Minimum and maximum consumption for the lead time.

6. Time necessary to obtain deliveries

7. Possibility of loss due to evaporation or deterioration

8. Changes in the fashion trend.

9. Interest on investment

10. Obsolescence losses,

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