Wednesday, November 30, 2011

Inventory Management - Part I

Due to readers request, I am writing articles on Inventory Management  from the perspective of Supply Chain Management.  In the next few sessions, we will cover the followings on Inventory Management.

®     What is Inventory  & Types of Inventory

      ®     Inventory Related Cost

®     Selective Inventory Control method  (ABC / FSN / VED Analysis)

®     Terms used in Inventory and their  calculation methodology  (Cycle Inventory, Lot Size,  Economic Order Quantity (EOQ), Reorder Level (ROL), Safety Stocks etc)

®     Financial Terms related to Inventory management(Inventory Turn over Ratio, Working capital etc) for effective Inventory management and control

What is Inventory and Types of Inventory

Inventory  means the goods and services that businesses hold in stock, which are idle resources, to meet future demand.   The business keep the inventory which are idle resources for various reason like to meet the demand fluctuation /,  variation, Economy of Scale, Price discount etc.  For example you may require 500g of Surf Excel pack on monthly basis.  But HLL company is promoting 1 Kg Surf Excel with 30% extra, ie., 1300g Surf Excel at the rate of 1 Kg.  You indent to buy 1Kg Surf Excel with 30% Extra  for economy.    You fully aware of the fact that Surf Excel (1300g) inventory will last for next 2-1/2 months , but still you are planning to keep the inventory because of cost benefit.

There are  different  types of inventory. They are

Ø  Raw Materials and components. This usually consists of the essential items needed to create or make a finished product.  Example Mother board for a computer

Ø  WIP, or work in progress inventory in sub assemblies. This refers to items that are partially completed, but are not the entire finished product. Example Body of a Maruti Swift is WIP and when the same is fitted with Engine, Wheel and other components then it become finished product.

Ø  Finished goods. These are the final products that are ready to be purchased by consumers.

Please note that most people think of the finished goods like car as being part of an inventory stock, but the parts like tyre, tube, engine etc  that create them are held accountable in inventory as well.

Category of Inventory / Stock

Ø  Cycle Inventory that builds up in the supply chain because  company  either produces or purchases materials in lots or batch that are larger than those demanded by the customer.

Ø  Pipeline Inventory  which are In Process or Transit Stock.  The concept is similar to that of water pipeline where the water will flow in the tap only when the pipeline is filled with water.  If pipeline is lengthy, you require more water to get filled in the pipeline and it will take time to get water in the tap.  Similarly when a manufacturing process is lengthy you require more inventory to be filled in the sub assembly lines and it will take time to get the final product.  It is the process design and hence one cannot do anything in controlling the pipeline inventory, provided the top management is willing to redesign the manufacturing process which involves capital expenditure.

Ø  Safety Inventory to meet the uncertainties in Demand/Sales, Supply/Production and Lead time.

Ø  Seasonal Inventory.  Certain raw materials can be available only during some season.    For example Coca Cola company produces MAAZA mango drink.  Mango fruits are available in India only during summer season (April – July).  Hence the company will procure quality Mango during this season and manufacture mango drink to make available in all season.    

Inventory Related Cost

Ø  Inventory carrying cost -  This is the cost a business incurs over a certain period of time, to hold and store its inventory.  Carrying cost of inventory is often described as a percentage of the inventory value.  Carrying costs include storage costs, maintenance , Handling, insurance and other less tangible expenses, such as opportunity costs and losses due to theft. 

Even though calculating Inventory carrying cost is related to Finance, we can understand the same through simple illustration.

Amount (Rs.)/ Year
Warehouse Rent or Storage Cost for keeping inventory   
Administrative Expenses include maintenance
Obsolescence / Outdated
Breakage / Damage
Pilferage / Theft

Please note that obsolescence is common feature in Electronic Industry due to technology change or upgrade.  If you keep mobile stocks  in your warehouse for more than two year then you cannot sell those model in market  as it become outdated.

Divide the cost (Rs. 42500) which we have calculated above by Average Inventory value.  We will see how to calculate Average Inventory value in later session.  Let us assume the average inventory value is Rs. 5 Lac then the percentage is calculated as  Rs.42500/500000 which is 8.5%. 

With 8.5% you need to add opportunity cost, insurance and taxes in terms of percentages.  The opportunity cost is the expected reasonable  return or interest rate, if you invested  the money elsewhere. It could be fixed deposit in bank or government bond etc.  Let us assume opportunity cost or return is 6.5%.

Since you are keeping Inventory at godown you may insure the stocks .  In such cases you should include the insurance rate .  Let us assume insurance rate is 3%

Taxes is 4% (assumption).  Hence the inventory carrying rate works out to be 22% ie., 8.5+6.5+3+4. 

Now we can calculate Inventory carrying cost by multiplying average inventory value X Inventory carrying rate.  Average inventory value  is Rs. 500000 and Inventory carrying rate is 22% or 0.22.  Multiplying both we will get Rs. 1,10,000 as inventory carry cost.

Ø  Material Cost is derived by multiplying Annual Demand with Cost per unit.  For example Cadbury India expects 10 Lac units of Bournvita 500g bottle to be sold in the Market for the given year.  Each 500g bottle cost say Rs. 2/- and the material cost of 500g bottle is Rs. 20 Lac.

Ø  Ordering Cost is the total expenses incurred in placing one order.  The cost includes

v  cost of preparing a purchase order (clerical work of preparing, releasing, monitoring, and receiving orders) ie purchase department expenses in a year

v  Inbound logistics cost (Transportation charges and loading and unloading charges). 

v  Material Inspection cost

Ø  Shortage Cost is due to loss of sales.  Loss of sales occur when demand is more than supply.  Loss of sales include lost sales value and loss of good will (which is arbitrary in nature).  Hence we will not focus on shortage cost in our further discussion.

In the next session we will discuss about Selective Inventory control method like ABC , VED, FSN Analysis.


  1. Hello Sir,

    Your post is very interesting and knowledge enhancing

    But i still have a doubt about calculating the Ordering cost

    If You could explain it with the help example I will be highly delighted

    1. Hi Prasad,

      Thanks for your acknowledgement. I am going to cover inventory management in details very shortly after completing warehouse management topics. Inventory Management and control is vast and interesting subject and it has to be written in such a way that all users should understand the contents easily. While writing the blog I will get in touch with you so that your query will be clarified