Inventory Management

Inventory Types

Most manufacturing organizations divide their inventory into raw materials, work in process, finished goods, and goods for sale. A good purchased as a "raw material" goes into the manufacture of a product. A good only partially completed during the manufacturing process is called "work in process. " When the good is completed as to manufacturing but not yet sold or distributed to the end-user, it is called a "finished good."

Manufacturing process: From raw materials to work in process to finished goods.

1. Raw materials: Materials and components are scheduled to make a product.
   
   
2. Work in process, WIP: Materials and components that have begun transforming into finished goods. These items are not yet completed but are just fabricated and waiting in a queue for further processing or buffer storage.
   
   The term is used in production and supply chain management. Optimal production management aims to minimize work in process. Work in process requires storage space, represents bound capital not available for investment, and carries an inherent risk of earlier expiration of the product's shelf life.
   
   A queue leading to a production step shows that the step is well buffered for supply shortages from preceding steps. It may also indicate insufficient capacity to process the output from these preceding steps. Just-in-time (acronym: JIT) production is a concept to reduce work in process with respect to a continuous configuration of product.
   
   Sometimes, outside of a production and construction context, "work in process" is used erroneously, where the status "work in progress" would be correctly used to describe more broadly work that is not yet a final product.
   
   
3. Finished goods: Goods ready for sale to customers. Finished goods is a relative term. In a supply chain management flow, a supplier's finished goods can constitute the raw material of a buyer.
   
   
4. Goods for resale: Returned salable goods.

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Inventory Techniques

Inventory: U.S. Army unit badges from a wall of military uniform items.

First In, First Out (FIFO)

FIFO means that the oldest inventory items are recorded as sold first but does not necessarily mean that the exact oldest physical object has been tracked and sold. This expression describes the principle of a queue processing technique or servicing conflicting demands by ordering process by first come, first served (FCFS) behavior, where the persons leave the queue in the order they arrive or wait their turn at a traffic control signal.

Last In, First Out (LIFO)

LIFO means that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies have shifted toward using LIFO, which reduces their income taxes during times of inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States.

LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.

Average Cost

The average cost method is straightforward. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. Two commonly used average cost methods are the simple weighted average cost method and the moving average cost method.

Weighted Average Cost Method

This method divides the cost of goods available for sale by the total amount of goods from beginning inventory and purchases, giving a weighted average cost per unit. A physical count is performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by the weighted average cost per unit to estimate the ending inventory cost.

Moving Average Cost Method

After each purchase, divide the cost of the current inventory by the current goods available for sale to get the current cost per unit of goods.

Meanwhile, several sales occur during the year. The current goods available for sale are deducted from the number of goods sold, and the cost of the current inventory is deducted by the number of goods sold times the latest (before this sale) current cost per unit of goods.

Add this deducted amount to the cost of goods sold. At the end of the year, we can use the last cost per unit of goods, along with a physical count, to determine the ending inventory cost.

ABC Technique

The ABC analysis is a business term used to define an inventory categorization technique often used in material management. It is also known as "Selective Inventory Control. " Policies based on ABC analysis:

• A ITEMS: very tight control and accurate records
  
  
• B ITEMS: less tightly controlled and good records
  
  
• C ITEMS: simplest controls possible and minimal records

The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost while also providing a mechanism for identifying different categories of stock that will require different management and controls.

The ABC analysis suggests that an organization's inventories are not of equal value. Thus, the inventory is grouped into three categories (A, B, and C) according to their estimated importance.

• A items are very important for an organization. Because of the high value of these A items, frequent value analysis is required. In addition to that, an organization needs to choose an appropriate order pattern (e.g., "Just-in-time") to avoid excess capacity.
  
  
• B items are important, but less important than A items and more important than C items. B items are intergroup items.
  
  
• C items are marginally important.

The following is an example of the application of weighted operation based on the ABC class in an electronics manufacturing company with 4,051 active parts.

ABC analysis Actual distribution of ABC class in the electronics manufacturing company with 4051 active parts.

ABC techniques Distribution of ABC class

• Uniform Purchase: When you apply an equal purchasing policy to all 4,000 components, for example, weekly delivery and re-order point (safety stock) of two-week supply, assuming that there are no lot size constraints, the factory will have 16,000 deliveries in four weeks, and the average inventory will be 2.5 weeks supply.
  
  
• Weighed Purchase: In comparison, when weighed purchasing policy applied based on ABC class, for example, C class monthly (every four weeks) delivery with the re-order point of three-week supply, B class Bi-weekly delivery with the re-order point of two-week supply, A class weekly delivery with re-order point of one-week supply, total number of delivery in four weeks will be (A 200x4=800)+(B 400 x2=800) + (C 3400x1=3400)=5000 and average inventory will be (A 75%x1.5weeks)+(B 15%x3weeks)+ (C 10%x3.5weeks)= 1.925 week supply.

By applying weighed control based on ABC classification, required man hours and inventory level are drastically reduced.

Seasonal Production

Many industries are subject to dips and rises in demand due to seasonality. Logically, sourcing the same amount of a given product each month for inventory is not a practical choice in these industries. Inventory management in seasonally impacted businesses can become quite complex, as the accuracy or inaccuracy of forecasts can have substantial impacts on overall profitability.

Reasons to Keep Inventory

In an ideal world, a business would avoid the need for inventory through perfect operational management and completely accurate projections. Of course, this is impossible. As a result, businesses must balance risk and opportunity to ensure that inventory is available when needed and waste is minimized. Inventories are kept due to:

• Time – No supply chain is perfect, and often enough time lags can ruin potential business opportunities. Playing it safe and having certain items in stock ahead of time can avoid opportunity costs.
  
  
• Uncertainty – Supply and demand are not perfectly predictable. Uncertainty means keeping enough on hand to meet fluctuations in demand.
  
  
• Economies of Scale – Many businesses exist solely because they take the risk of buying a high volume of a given product at a lower price in hopes of marking up the price and selling each one individually to customers. This is called economies of scale, and by nature, it requires some storage and inventory. Grocery stores function this way.
  
  
• Appreciation in Value – Some businesses keep inventory as an investment. Fine wines and cheese, for example, will appreciate in value over time. The downside is it will cost money to keep them (both require appropriate temperature conditions, for example).

Determining Seasonality

Among the many reasons to keep inventory is planning for seasonality. Businesses should first measure whether or not consumer demand and subsequent inventory requirements are subjected to predictable seasonal trends.

There are a number of ways to do this, using existing historical sales data as well as data from external research on the industry itself. There are countless models and methods of organizing seasonal data to determine, but from the managerial frame, most analysts preferred that the distribution of data should ultimately communicate the same correlations (or lack thereof) for differences in sales on a monthly basis.

Once seasonality is determined, businesses should measure the fluctuations from year to year and the opportunity costs of having too much or too little on hand. Once this is accomplished, the business can order the ideal amount based on data-driven projections to capture as much opportunity as possible without taking the risk of overordering (and thus overpaying for storage).

Perishable Goods

An important aspect of seasonal inventory management is the concept of perishable goods. From food to fashion to technology, many goods simply either go bad or lose most of their value for no other reason than that culture has passed it by. This is called a perishable good.

Perishable goods have an even greater opportunity cost when it comes to mismanaging (and erroneously predicting) demand. If too much of a perishable good is ordered, not only will it cost the organization unnecessary inventory fees, but it also adds the risk of never being sold at all (a complete sunk cost at that point).

As a result, understanding a good's shelf life, the risk of over or understocking, and the ebb and flow of seasonal demand can greatly enhance an organization's profitability.

Seasonality Plot Example In this chart, electricity consumption (demand) over a 12-month time frame is illustrated. Higher capacities are required in certain months (in this case, August), and capacity must be expanded to account for this.

Impact of Inflation on Inventory Management

Inflation is a rise in the general level of prices of goods and services in an economy over time. When the general price level rises, each currency unit buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy.

Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include an increase in the opportunity cost of holding money; uncertainty over future inflation, which may discourage investment and savings; and, if inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future.

Therefore, high inflation encourages companies to keep a high level of inventories.

Inflation in France in 2002

Nobel laureate Robert Mundell noted that moderate inflation would induce savers to substitute lending for some money holding to finance future spending. That substitution would cause market-clearing real interest rates to fall. Nobel laureate James Tobin noted that moderate inflation would cause businesses to substitute investment in physical capital (plant, equipment, and inventories) for money balances in their asset portfolios.

That substitution would mean making investments with lower rates of real return. (The rates of return are lower because investments with higher rates have already been made. ) To put it in a word, companies purchase more inventories in case of high inflation. The two related effects are known as the Mundell-Tobin effect unless the economy is already over-investing. According to economic growth theory models, extra investment resulting from the effect can be seen as positive.

Inventory Costs

Inventory costs depend on the methods used, which include Specific Identification, Weighted Average Cost, Moving Average Cost, FIFO, and LIFO. Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stocking materials.

Inventory management involves retailers who acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and keeping related costs in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material. 

This would include monitoring material moved into and out of stockroom locations and reconciling inventory balances. It may include ABC analysis, lot tracking, cycle counting support, etc. Managing inventories involves determining/controlling stock levels within the physical distribution system and balancing the need for product availability against the need to minimize stock holding and handling costs.

Inventory: The inventory costs depend on which method is used.

So many variables can be hidden under this appearance of simplicity that various "adjusting" assumptions may be used.

These include:

Specific Identification

Specific identification is a method of determining the ending inventory cost. It requires a detailed physical count so the company knows exactly how many of each good brought on specific dates remained in the yearend inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date to get a number for the ending inventory cost.

This method is also very hard to use on interchangeable goods. For example, it is hard to relate shipping and storage costs to a specific inventory item. These numbers must be estimated, reducing the specific identification's benefit of being extremely specific.

Weighted Average Cost

Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as AVCO. It takes the Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by the Weighted Average Cost per Unit to estimate the ending inventory cost.

Moving-Average Cost

Moving Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them, the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made.

Each time, purchase costs are added to the beginning inventory cost to get the Cost of the Current Inventory. Similarly, the number of units bought is added to the beginning inventory to get Current Goods Available for Sale. After each purchase, the Cost of the Current Inventory is divided by the Current Goods Available for Sale to get the Current Cost per Unit of Goods.

Also, during the year, multiple sales happen. The Current Goods Available for Sale are deducted from the goods sold. The current inventory cost is deducted by the number of goods sold at the latest (before this sale) current cost per unit of goods. This deducted amount is added to the Cost of Goods Sold.

At the end of the year, the last Cost per Unit of Goods, along with a physical count, is used to determine the ending inventory cost.

FIFO and LIFO

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies have shifted toward using LIFO, which reduces their income taxes during inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.

Economic Order Quantity Technique

Just-in-Time Technique

Just in time (JIT) is a production strategy striving to improve a business's return on investment by reducing in-process inventory and associated carrying costs. To meet JIT objectives, the process relies on signals or Kanban between different points in the process.

Kanban is usually "tickets" but can be simple visual signals, like the presence or absence of a part on a shelf. Implemented correctly, JIT focuses on continuous improvement and can improve a manufacturing organization's return on investment, quality, and efficiency. To achieve continuous improvement, key areas of focus are:

• flow
  
  
• employee involvement
  
  
• quality

Noticing that stock depletion requires personnel to order new stock is critical to the inventory reduction at the center of JIT. But JIT relies on other elements in the inventory chain. Therefore, JIT is best implemented as one part of an overall lean manufacturing system.

Benefits of JIT:

• Reduced setup time. Cutting setup time allows the company to reduce or eliminate inventory for "changeover" time.
  
  
• The flow of goods from warehouse to shelves improves. Small or individual lot sizes reduce lot delay inventories, which simplifies inventory flow and its management.
  
  
• Employees with multiple skills are used more efficiently. Having employees trained to work on different parts of the process allows companies to move workers where they are needed.
  
  
• Production scheduling and work hour consistency are synchronized with demand. If there is no demand for a product at the time, it is not made. This saves the company money, either by not having to pay workers overtime or by having them focus on other work.
  
  
• Increased emphasis on supplier relationships. A company without inventory does not want a supply system problem that creates a part shortage. This makes supplier relationships extremely important.
  
  
• Supplies arrive at regular intervals throughout the production day. They are synchronized with production demand, and the optimal amount of inventory is always on hand. When parts move directly from the truck to the assembly point, the need for storage facilities is reduced.
  
  
• Minimizes storage space needed.
  
  
• Smaller chance of inventory breaking/expiring.

Drawbacks

Just-in-time operation can leave suppliers and downstream consumers open to supply shocks and large supply or demand changes. In addition, very low stock levels mean shipments of the same part can come in several times daily. This means firms favoring JIT are especially susceptible to flow interruption.

Benefits of Inventory Management

Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials.

Inventory Management A clerk doing inventory work with a handheld computer in a Tesco Lotus supermarket in Sakon Nakhon, Thailand.

Inventory management intends to hold optimal inventory levels continuously. The scope of inventory management concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns, and defective goods, and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an ongoing process as the business needs shift and react to the wider environment.

Inventory management, with the primary objective of determining/controlling stock levels within the physical distribution system, balances the need for product availability against the need for minimizing stock holding and handling costs. Inventory management involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material.

This would include monitoring material moved into and out of stockroom locations and reconciling inventory balances. It also may include ABC analysis, lot tracking, cycle counting support, etc. All of these practices lead to optimal product storage, helping minimize holding and handling costs.

Inventory management can also help companies improve cash flows. Companies with effective inventory management do not have to spend large capital balances to purchase enormous amounts of inventory at once, which also saves handling and holding costs.

Dangers Involved in Inventory Management

Inventory management primarily concerns specifying the size and placement of stocked goods. It is required at different locations within a facility or within multiple locations of a supply network to protect the regular and planned production course against the random disturbance of running out of materials or goods.

The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns, and defective goods and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an ongoing process as the business needs shift and react to the wider environment.

Inventory control inventory cost elements (holding cost, order cost, total) Parameters: Order-cost (C) 10, demand (D) 1,000, holding cost (i) 20% (of price), price (p) 10 => EOQ = 100

Excessive inventory means the firm has idle funds, which earn the firm no profits. Excessive inventory also incurs extra handling and holding costs. However, low or inadequate inventory levels could mean the company lacks sufficient raw materials for production. The lack of available stock can lead to a loss of production when items are required on a breakdown basis. Inadequate inventory also means there are not enough goods to sell. The company risks losing customers to competitors.

Inventory management becomes more complicated when we factor in moderate inflation and seasonality. Inflation encourages firms to purchase more inventory, exposing them to excessive inventory. Without an accurate sales forecast, companies that operate in sectors affected by seasonality face shortages during high times and excess inventory during low times of the year.