Inventories are goods that are found in the warehouses of the company. These are the materials used in the production process or they meet customer demand, and consist of raw materials, materials pulled into the production in process, and finished products. These products usually belong to the company itself and it represents its most important asset. Inventories are stockpiles of raw materials, supplies, components, work in process, and finished goods that appear at numerous points throughout a firm’s production and logistics channel.

An inventory strategy is a day-to-day methodology to follow for ordering, maintaining and processing items in your warehouse.

How to Develop an Inventory Strategy

1. Settle on a place for storing and processing your inventory.

2. Choose an inventory management software program to use for your business.

3. Set up a vendor agreement with suppliers that contains details about your payment

and shipping arrangement.

4. Set a reorder point for ordering new inventory to replace sold items

5. Aim for a higher inventory turnover.

6. Establish a clear cut process for getting rid of excess (unsold inventory) if your

return policy has expired.

7. Write your inventory strategy down in your business plan and include it with your

other business policies.

TYPES OF INVENTORY

CYCLE INVENTORY- varies in proportion to order quantity—larger orders result in higher cycle inventory, while smaller orders result in lower.

SAFETY STOCK INVENTORY- is excess inventory that a company holds to guard against uncertainty in demand, lead time, and supply. Safety stock is used to improve customer service and reduce stocksouts resulting from unpredictable changes in demand, lead time, or supply.

ANTICIPATION INVENTORY- is inventory that is held for future use at a time when demand will exceed available capacity.

PIPELINE INVENTORY- is inventory that is process of moving from one location in the supply chain to another.

WORK-IN-PROCESS (WIP) INVENTORY- is inventory that is in the process of being transformed from one state to another.

REMANUFACTURED/ RECONDITIONED INVENTORY- consists of products that have been used by a customer and then reacquired by a company and either remanufactured or reconditioned for resale.

FUNCTIONS OF INVENTORY

Inventory includes all the materials and goods that are purchased, partially completed materials and component parts and the finished goods produced. The primary function of inventory are to buffer uncertainty in the marketplace and to decouple, or break the dependencies between stages in the supply chain.

ADVANTAGES ANG DISADVANTAGES OF HOLDING INVENTORY

Advantage: Wholesale Pricing

Many business owners can take advantages of lower wholesale costs when they buy larger quantities of units. This makes sense for regular items that the business knows will sell, because the business is confident it will move product effectively and not be left with it. The lower costs could be significant depending on the price points of the product.

Advantage: Fast Fulfillment

When things are in stock, customers get products in hand much faster. Even when customers don't have an immediate need for the product, when the decision to buy is made, the customer likes to walk out with the product in hand. This is a fundamental part of quality customer service.

Advantage: Low Risk of Shortages

There are times when demand spikes higher. For some items, demand might be cyclical around a specific holiday or season. When you have excess inventory, you don't run the risk of being the business that ran out of stock when everyone was looking for one particular product.

Advantage: Full Shelves

When you keep just enough inventory to get through the normal sales cycle, shelves can look sparse as you get closer to the next time to order. The appearance of full shelves sends a positive message to the customer that business is good and the store is ready for business.

Keeping a store stocked with items to sell requires adequate inventory. Business owners should look at several types of inventory control to determine the best method.

Disadvantage: Obsolete Inventory

Overstocking on products runs the risk of the product becoming obsolete. This is true especially in technology sectors such as smartphones and televisions, but no industry is exempt. Even the latest kid's game craze might inspire you to place a large order. If the buzz dissipates quickly and kids aren't looking for the game, you'll be left holding a lot of inventory you can't move.

Disadvantage: Storage Costs

The more stuff you have, the more space you need. Commercial space is leased per square foot. Consider the costs to store excess inventory compared to the savings on wholesale orders. It also costs to do more inventory control and audits, potentially requiring additional manpower to work the warehouse.

Disadvantage: Potential Insurance Costs and Loss

Insurance costs go up with larger storage areas and larger inventory values. This factor needs to be considered and compared to wholesale savings. If there is a fire, theft or another natural disaster, not only will the business be recuperating, it will need to pay higher premiums as insurance rates go up.

Disadvantage: Tying Up Capital

When you have excess inventory, you pay for the order, the storage and insurance. You can't get around this. For businesses that are working with small margins and on tight monthly budgets, this can hamper business development decisions because they don't have cash on hand.

Business owners might examine the disadvantages pertinent to the business and then decide whether carrying excess inventory makes sense. It is up to each business owner to review the financial health of his company. Inventory is one key factor in that.

DEPENDENT DEMAND AND INDEPENDENT DEMAND

An inventory of an item is said to be falling into the category of independent demand when the demand for such an item is not dependant upon the demand for another item.

Another way to understand inventory is to separate it into two broad categories: dependent

and independent demand. Understanding this difference is important as the entire inventory

policy for an item is based on this. Independent demand is demand for a finished product,

such as a computer, a bicycle, or a pizza. Dependent demand, on the other hand, is demand

for component parts or subassemblies. For example, this would be the microchips in the

computer, the wheels on the bicycle, or the cheese on the pizza.

Dependent demand order quantities are computed using a system called material

requirements planning (MRP), which considers not only the quantities of each of the

component parts needed, but also the lead times needed to produce and receive the items

An inventory of an item is said to be falling into the category ofindependent demand when

thedemand for such an item is not dependant upon the demand for another item. Finished

goods Items, which are ordered by External Customers or manufactured for stock and sale,

are called independent demand items.

Independent Demand

If the demand for inventory of an item is dependant upon another item, such demands are categorized as Independent demand. Raw materials and component inventories are dependant upon the demand for Finished Goods and hence can be called as Indendent demand inventories.

Inventory Model

Inventory model is a mathematical model that helps business in determining the optimum

level of inventories that should be maintained in a production process, managing frequency

of ordering, deciding on quantity of goods or raw materials to be stored, tracking flow of

supply of raw materials and goods to provide uninterrupted service to customers without

any delay in delivery.

There are two types of Inventory model widely used in business.

Fixed Reorder Quantity System.

Fixed Reorder Quantity System is an Inventory Model, where an alarm is raised

immediately when the inventory level drops below a fixed quantity and new orders are

raised to replenish the inventory to an optimum level based on the demand. The point at

which the inventory is ordered for replenishment is termed as Reorder Point. The inventory

quantity at Reorder Point is termed as Reorder Level and the quantity of new There are two

types of Inventory model widely used in business.

1. Fixed Reorder Quantity System

2. Fixed Reorder Period System.

3. Fixed Reorder Quantity System.

4. Fixed Reorder Quantity System is an Inventory Model, where an alarm is raised

immediately when the inventory level drops below a fixed quantity and new

orders are raised to replenish the inventory to an optimum level based on the

demand. The point at which the inventory is ordered for replenishment is termed

as Reorder Point. The inventory quantity at Reorder Point is termed as Reorder

Level and the quantity of new

Fixed Reorder Period System.

Fixed Reorder Period System is an Inventory Model of managing inventories, where an

alarm is raised after every fixed period of time and orders are raised to replenish the

inventory to an optimum level based on the demand. In this case replenishment of inventory

is a continuous process done after every fixed interval of time.

Regular Intervals (R): Regular Interval is the fixed time interval at the end of which the

inventories would be reviewed and orders would be raised to replenish the inventory

Inventory on Hand (It): Inventory on hand is the Inventory level measured at any given

point of time.

Maximum Level (M): It is the maximum level of inventory allowed as per the production

guidelines. The maximum level is derived by analyzing historical data.

Order Quantity: In this system, inventory is reviewed at regular intervals (R), inventory on

hand (It) is noted at the time of review and order quantity is placed for a quantity of (M) –

(It).

Inventories refer to those products or goods a firm is manufacturing for sale and

components that make up the product.

The forms of inventories existing in a manufacturing enterprise can be classified into three categories:

(i) Raw Materials:

These are those goods which have been purchased and stored for future productions. These are the goods which have not yet been committed to production at all.

(ii) Work-in-Progress:

These are the goods which have been committed to production but the finished goods have not yet been produced. In other words, work-in-progress inventories refer to ‘semi-manufactured products.’

(iii) Finished Goods:

These are the goods after production process is complete. Say, these are the final products of the production process ready for sale. In case of wholesaler or retailer, inventories are generally referred to as ‘merchandise inventories.’ Some firms also maintain the fourth type of inventories called ‘supplies.’ Examples of supplies are office and plant cleaning materials, oil, fuel, light bulbs and the like.

Needless to mention, maintaining the required size of inventory is necessary for the smooth

and effective functioning of production activity. Holding required inventories provides

certain advantages to the entrepreneur. For example, it helps in avoiding losses of sales,

reducing ordering costs, and achieving efficient production run.

However, against these benefits are some costs as well associated with inventories? It is

said that every noble acquisition is attended with risk; he who fears to encounter the one

must not expect to obtain the other. This is true of inventories also.

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There are broadly two costs involved in holding inventories:

(i) Ordering Costs:

These include costs which are associated with placing of orders to purchase raw materials and components. Clerical and administrative salaries, rent for the space occupied, postage, telegrams, bills, stationery, etc. are the examples of ordering costs. The more the orders, the more will be the ordering costs and vice versa.

(ii) Carrying Costs:

These include costs involved in holding or carrying inventories like insurance charges for

covering risks, rent for the floor space occupied, wages of labourers, wastages,

obsolescence, or deterioration, thefts, pilferages, etc. These also include ‘opportunity

costs.’ This simply means had the money blocked in inventories been invested elsewhere

in the business, it would have earned a certain return. Hence, the loss of such return may

be considered as an ‘opportunity costs.’

Models of Inventory Management:

While it is very necessary to maintain the optimum level of inventory, it is not so easy as

well. Nonetheless, some models or methods have been developed in the recent past for

determining the optimum level of inventories to be maintained in the enterprise.

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All models are classified into two major types:

(i) Deterministic Models, and

(ii) Probabilistic Models.

In brief, the deterministic models are built on the assumption that there is no uncertainty

associated with demand and replenishment of inventories. On the contrary, the probabilistic

models take cognizance of the fact that there is always some degree of uncertainty

associated with the demand pattern and lead time of inventories.

Usually, the following three deterministic models are in use:

Let us discuss these one by one.

1. Economic Ordering Quantity (EOQ) Model:

One of the important decisions to be taken by a firm in inventory management is how much

inventory to buy at a time.

This is called ‘Economic Ordering Quantity (EOQ). EOQ also gives solutions to other

problems like:

(i) How frequently to buy?

(ii) When to buy?

(iii) What should be the reserve stock?

Assumptions:

Like other economic models, EOQ Model is also based on certain assumptions:

1. That the firm knows with certainty how much items of particular inventories will be used

or demanded for within a specific period of time.

2. That the use of inventories or sales made by the firm remains constant or unchanged

throughout the period.

3. That the moment inventories reach to the zero level, the order of the replenishment of

inventory is placed without delay.

The above assumptions are also called as limitations of the EOQ Model.

Determination of EOQ:

EOQ Model is based on Baumol’s cash management model. How much to buy at a time,

or say, how much will be EOQ is to be decided on the basis of the two costs:

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(i) Ordering Costs, and

(ii) Carrying Costs.

These are just discussed. Hence are not repeated again. The above two costs are inversely

associated. If holding inventory cost increases, ordering cost decreases and vice versa. A

balance is, therefore, struck between the two opposing costs and economic ordering

quantity is determined at a level for which the aggregate of two costs is the minimum.

The various components of ordering costs and carrying costs are shown in the following

Table 27.3:

Table 27.3: Components of Ordering Costs and Carrying Costs:

Ordering Costs Carrying Costs

RequisitioningWarehousing

Order Placing Handling

TransportationAdministrative

StoringInsurance

AdministrativeDeterioration and Obsolesce

EOQ can be determined by applying the following commonly used formula:

Q = 2UxP/S

Where:

Q = Economic Ordering Quantity (EOQ)

U = Quantity purchased in a year or month

P = Cost of placing an order

S = Annual or monthly cost of storage of one unit known as ‘carrying cost.’

Let us illustrate this with an imaginary example:

Let us assume the following data for a firm:

Annual requirements 800 units

Ordering Cost (per order) Rs. 50

2. ABC Analysis:

This is also called ‘Selective Inventory Control.’ The ABC analysis of selective inventory

is based on the logic that in any large number, we usually have ‘significant few’ and

‘insignificant many.’ This holds true in case of inventories also. A firm maintaining several

types of inventories does not need to exercise the same degree of control on all the items.

The firm adopts selective approach to control investments in various types of inventories.

This selective approach is called the ABC Analysis. The items with highest value are

classified as ‘A Items’. The items with relatively low value as ‘B Items’ and the items least

valuable are classified as ‘C Items.’ Since the ABC analysis concentrates on important

items, hence, it is also known as ‘Control by Importance and Exception (CIE).’

Items % of Numbers % of Value

A 9 57

B 10 18

C 81 25

Total 100 100

The composition of these items in terms of quantity and value is lopsided. In a study

conducted sometimes ago, the shares of various items, viz. A, B and C in total number and

value of an automobile company were found as follows:

In case of ABC Analysis, stringent control is imposed on ‘A Items’ maintaining bare

minimum necessary level of inventories of these. While ‘B Items’ will be kept under

reasonable control, ‘C Items’ will be under simple control.

The FSN analysis classifying goods into Fast-Moving, Slow-Moving, and Non-Moving

and VED analysis classifying goods into Vital, Essential, and Desirable are similar to ABC

Analysis in principle.

3. Inventory Turnover Ratio:

Inventory can also be managed by using accounting ratios like Inventory Turnover Ratio.

Inventory ratio establishes relationship between average inventory and cost of inventory

consumed or sold during the particular period.

This is calculated with the help of the following formula:

Cost of Good Consumed or Sold during the year/Average Inventory during the year.

A comparison of current year’s inventory ratio with those of previous years will unfold the

following points relating to inventories:

Fast-Moving Items:

This is indicated by a high inventory ratio. This also means that such items of inventory

enjoy high demand. Obviously, in order to have smooth production, adequate inventories

of these items should be maintained. Otherwise, both production and sales will be

adversely affected through uninterrupted supply of these items.

Slow-Moving Items:

That some items are slowly moving is indicated by a low turnover ratio. These items are,

therefore, needed to be maintained at a minimum level.

Dormant or Obsolete Items:

These refer to items having no demand. These should be disposed of as early as possible

to curb further losses cause by them.

I. Single Period Inventory Model

. A single period inventory model is a business scenario faced by companies that order

seasonal or one-time items. There is only one chance to get the quantity right when

ordering, as the product has no value after the time it is needed. There are costs to both

ordering too much or too little, and the company's managers must try to get the order right

the first time to minimize the chance of loss.

The following formula is used to calculate the amount of inventory that should be ordered

in a single period inventory model:

Single period inventory model are used for a one time ordering decision, like t shirts to be

sold at a special event that can only be sold at that event. The objective of this model is to

balance the impact of running out of stock with the impact of being left with stock that

does not sell.

Multiple Period Inventory Model

A multi period inventory model can have two variations. ... Levels of inventory in a fixed

time period model are only checked at the time that an order is due to be placed. In the

fixed order quantity model inventory levels are usually higher and this system tends to be

used for more expensive, important items.

The following formula is used to calculate the amount of inventory that should be ordered

in a multiple period inventory model:

A multi period inventory model can have two variations. Fixed order quantity systems are

where orders are placed for a fixed amount each time they are placed. The placement of

an order is done when an event occurs – such as reaching a minimum stock level. The

second variation is fixed time period models where orders are placed at specific times, for

example when there is a monthly review of stock levels. The amount of the order will

depend on the amount of inventory that is needed.

II. Inventory Cost

Inventory costs are the costs associated with the procurement, storage and management of inventory. It includes costs like ordering costs, carrying costs and shortage / stock out costs.

Ordering cost- of inventory refers to the cost incurred for procuring inventory. It includes

cost of purchase and the cost of inbound logistics. In order to minimise the ordering cost

of inventory we make use of the concept of EOQ or Economic Order Quantity.

Carrying cost- of inventory refers to the cost incurred towards inventory storage and

maintenance. The inventory storage costs typically include the cost of building rental and

other infrastructure maintained to preserve inventory. The inventory carrying cost is

dependent upon and varies with the decision of the management to manage inventory in

house or through outsourced vendors and third party service providers.

Shortage or stock out costs- and cost of replenishment are the costs incurred in unusual

circumstances. They usually form a very small part of the total inventory cost.