Inventory is the accounting of items, component parts and raw materials that a company either uses in production or sells. As a business leader, you practice inventory management in order to ensure that you have enough stock on hand and to identify when there’s a shortage.
Importance of Inventory
§ Inventory, which describes any goods that are ready
for purchase, directly affects an organization’s financial health and
prosperity.
§ While there are many types of inventories, the four
major ones are raw materials and components, work in progress, finished goods
and maintenance, repair and operating supplies.
§ While there are many ways to count and value your
inventory, the importance lies in accurately tracking, analysing and managing
it.
§ Inventory control helps the business in knowing the
shortfall and quantities to be ordered considering the net stock available.
Thus, it ensures that enough stocks are maintained to meet customer needs, at
any point in time.
Types of Inventories
§ Raw Materials: Raw materials are the materials a company uses to
create and finish products
§ Components: Components are similar to raw materials in that they are the materials
a company uses to create and finish products, except that they remain
recognizable when the product is completed, such as a screw.
§ Work In Progress (WIP): WIP inventory refers to items in production and
includes raw materials or components, labour, overhead and even packing
materials.
§ Finished Goods: Finished goods are items that are ready to sell.
§ Maintenance, Repair and Operations (MRO) Goods: MRO is inventory — often in the form of supplies —
that supports making a product or the maintenance of a business.
§ Packing and Packaging Materials: There are three types of packing materials.
Primary packing protects the product and makes it usable. Secondary packing is
the packaging of the finished good and can include labels or SKU information.
Tertiary packing is bulk packaging for transport.
§ Safety Stock and Anticipation Stock: Safety stock is the extra inventory a company buys
and stores to cover unexpected events. Safety stock has carrying costs, but it
supports customer satisfaction.If a raw material’s price is rising or peak
sales time is approaching, a business may purchase safety stock.
§ Decoupling Inventory: Decoupling inventory is the term used for extra
items or WIP kept at each production line station to prevent work stoppages.
Whereas all companies may have safety stock, decoupling inventory is useful if
parts of the line work at different speeds and only applies to companies that
manufacture goods.
§ Cycle Inventory: Companies order cycle inventory in lots to get the right amount of
stock for the lowest storage cost.
§ Service Inventory: Service inventory is a management accounting
concept that refers to how much service a business can provide in a given
period. A hotel with 10 rooms, for example, has a service inventory of 70
one-night stays in a given week.
§ Transit Inventory: Also known as pipeline inventory, transit inventory
is stock that’s moving between the manufacturer, warehouses and distribution
centers. Transit inventory may take weeks to move between facilities.
§ Theoretical Inventory: Also called book inventory, theoretical inventory
is the least amount of stock a company needs to complete a process without
waiting. Theoretical inventory is used mostly in production and the food
industry. It’s measured using the actual versus theoretical formula.
§ Excess Inventory: Also known as obsolete inventory, excess inventory is unsold or unused
goods or raw materials that a company doesn’t expect to use or sell, but must
still pay to store.
Purpose of Inventory
·
Better management and implementation of inventory control help the
company in case of a sudden increase and a sudden decrease in demand for the
products.
·
They help the company provide better services to customers and timely
services.
·
The better management of inventory stock reduces the risk of
deterioration of stock as well as wastage of stocks. The controlling and
storing of only required stock also helps in case of any unforeseen
extraordinary incidence that may happen in the future resulting in loss of the stocks.
·
Inventory control plays the role of a bridge for the inventory in case
of a major difference in the planned production and actual production by the
production team and function due to any unforeseeable reason.
·
Avoiding overstocking and understocking of the stock of an inventory;
What
Is Storage Cost?
Storage
cost refers to the amount of money spent over the storage or holding of
inventory.Storage cost would be a subset of inventory carrying costs,
which includes cost that are not limited to;
- Equipment Maintenance
- Warehouse Utilities
- Material Handling
- Security Personnel
- Building Maintenance
Only
companies with tightly linked components that do not generate any type of
irregularities within the production do not need to maintain any kind of
storage, hence no inventory cost analysis.
While
some companies may only require a specific product or material to be stored,
other companies need to store many different materials, this could include but
is not limited to:
- Raw Materials
- Finished Products
- Equipment Parts
- Shipping Materials
To
offset the storage costs of inventory, some companies will include their
storage cost into the final price of a material or finished product. While most
companies do not add their storage and transportation costs onto the price of
the finished product, some products with very high storage costs do have hidden
or indirect storage costs added to their price.
Methods
of Effective Inventory management
Here
are the most popular and effective inventory management methods which could
improve your inventory system.
1) ABC analysis
ABC
analysis stands for Always Better Control Analysis. Inventory items are classified
into three categories namely:
● Category
A – high-value items with a low frequency of sales,
● Category B – moderate-value items with a moderate frequency
of sales,
● Category C – low-value items with a high frequency of sales.
ABC
analysis identifies the items you should reorder more often and which items you
don’t
need to stock as frequently. ABC analysis optimizes your inventory turnover
rate and
reduces obsolete inventory.
2) Economic order quantity (EOQ)
This
method helps to determine how much inventory need to be ordered. It does so by
taking into account the demand of the product and its cost. This method can
help reduce
costs related to purchases, delivery, and storage of the inventory.
3) FIFO and LIFO
LIFO and FIFO are methods to determine the cost of inventory. FIFO, or First in, First out, method’s principle is that the first item on the inventory is the first one to go out. FIFO is a great way to keep inventory fresh. LIFO, or Last-in, First-out, method’s principle is that the last item on the inventory is the first one to go out. LIFO helps prevent inventory from going bad.
4) Just in time (JIT) method
To
avoid the costs of overstocking, many companies use “just in time,” or JIT,
method. With this strategy, they order only what they need to meet immediate
demand. With no excess inventory in hand, the company saves the cost of storage
and insurance. The company orders further inventory when the old stock of
inventory is close to replenishment. This is a little risky method because a
little delay in ordering new inventory can lead to stock out situation. Thus
this method requires proper planning so that new orders can be timely placed.
5)
XYZ Analysis
An XYZ stock analysis is the complement to an
ABC analysis, and adds a layer of statistical review that shows the standard
deviation of usage. Other names for this analysis include Runners, Repeaters,
or Strangers (RRS). The goal of this analysis is to understand which parts have
steady usage and which parts have unpredictable demand so companies can make
the best inventory decisions, successfully manage their shortages, and
accurately determine order policies.
Using variations in demand, the XYZ model
classifies goods as one of three categories:
· X Items: X items have very little demand variation. Demand can be reliably
forecasted because it does not change as often or as drastically compared to
other items.
· Y Items: Y items have fluctuating demand. The demand is typically due to a known or predictable cause, such as specific seasons, holidays, or changes in economic factors.
· Z Items: Z items have the highest demand variations. These variations are sporadic and unpredictable, caused by unknown factors or unusually strong changes in demand.
SAFETY
STOCK
Safety stock is simply extra inventory held
by a retailer or a manufacturer in case demand increases unexpectedly. This
means it’s additional stock above the desired inventory level that you would
usually hold for day-to-day operations.
One of the main reasons that retailers and
manufacturers implement a safety stock strategy is to prevent stockouts.
Stockouts are usually caused by:
·
Changes in consumer demand
·
Incorrect stock forecasts
·
Variability in lead times for raw materials
ECONOMIC
ORDER QUANTITIY OR WILSON MODEL
Economic Order Quantity (EOQ),
also known as the Wilson formula, is a calculation used to determine the least
costly number of units to order. The aim is to minimize the cost of ordering
and holding stock, while still meeting demand and service level
requirements.
Why you should be calculating EOQ?
Minimize inventory costs
Having extra items in your inventory can quickly increase storage costs. Inventory costs can also go up depending on how you order, what gets damaged, and what products never sell.
Minimize stockouts
EOQ can help you better understand how much you need to re-order and how often. By calculating how much you need based on how much you sell in a given period of time, you can avoid stockouts without having too much inventory on hand for too long.
Improve overall efficiency
Overall, calculating EOQ can help you make a better decision when it comes to storing and managing inventory.
1. Holding costs (H)
Holding cost (also known as carrying costs) refers to the total cost of holding inventory. Minimizing inventory costs is an important retail supply chain management strategy.
2. Annual demand (D)
How much demand do you get for a product each year? By looking into historical order data, you can determine the number of units you sell year over year.
3. Order cost (S)
Also referred to as ‘setup cost,’ how much does an order cost per purchase? This is done on a per-order basis and includes both the shipping and handling costs.
Numericals on EOQ’s
A manufacturing company places a semi-annual order
of 24,000 units at a price of $ 20
per unit. Its carrying cost is 15% and the order cost is $ 12
per order.
No. of orders per year =
Annual Requirement / EOQ
= 48,000 units / 620 units
= 77 orders approximately
To compute the annual
requirement:
24,000 units are ordered
semiannually, therefore:
Annual requirement = 24,000 units x 2 = 48,000 units.
LEAD TIME
It relays on: supply delay (the period between
ordering and receiving inventory) and reordering delay (the period you have to
wait before ordering supplies). These two factors, between them, cover the
amount of time it takes for suppliers to process and fulfil orders.
Lead time = reordering
delay + supply delay
Numerical on Lead Time
Ques. Orders
are picked up the day after they’re placed (pre-processing), and it takes two
weeks to make an item to order (processing). Once packaged and sent out
(post-processing), it can take three days to be delivered to the customer.
Ans.
Manufacturing
lead time = pre-processing time + processing time + post-processing time.
1 day
+ 14 days + 3 days = 18 days (Lead Time)
REORDER POINT
It is the point at
which you need to order a product or parts before you start using your safety
stock. So, if you have a 15 day lead time you know that you will need to place
your order 15 days in advance of your current stock running out.
Reorder
Point (ROP) = average
demand × lead time
Here
is the formula for reorder level if you do keep a safety stock:
Reorder level = average demand × lead
time + safety stock
Numericals on Reorder Point
Ques. If
they added up orange juice sales over 30 days and had 300 sales, their average
daily usage would be 10. it takes three days for orange juice to
get from the supplier to the store after the order is placed. Calculate the
Reorder Point.
Ans. Total
sales in 30 days is 300, Therefore average daily usage would be (300/30) 10.
It takes three days for orange juice to get from
the supplier to the store after the order is placed This means the average lead
time is 3.
Reorder
Point (ROP) = average
demand × lead time
Therefore ROP = 10 X 3=30.
