Production and Operation Management3

7/27/2019 Production and Operation Management3

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Amity Global Business School MUMBAI Sem II

Santosh Pathak

MODULE XMEANING AND NATURE OF INVENTORY

The dictionary meaning of inventory is stock of goods, or a list of goods.The work Inventory is understood differently by various authors, inaccounting language it may mean stock of finished goods only. In amanufacturing concerns, it may include raw materials, work in process andstores, etc.

a. Raw Material: The quantity of raw materials required will be determinedby the rate of consumption and the time required for replenishing thesupplies. The factors like the availability of raw materials and governmentregulations, etc. too affect the stock of raw materials.

b. Work-in-Progress: The work-in-progress is that stage of stocks which are inbetween raw materials and finished goods. The greater the time taken inmanufacturing, the more will be the amount of work in progress.

c. Consumables: These materials do not directly enter production but theyact as catalyst, etc. There can be instances where these materials mayaccount for much value than the raw materials. The fuel oil may form asubstantial part of cost.

d. Finished Goods: These are the goods which are ready for the consumers.The stock of finished goods provides a buffer between production andmarket. The purpose of maintaining inventory is to ensure proper supply of goods to consumers. In some concerns the production is undertaken onorder basis, in these concerns there will not be a need for finished goods.The need for finished goods inventory will be more when production isundertaken in general without waiting for specific orders.

e. Spares: Spares also form a part of inventory. Some industries like transportwill require more spares than the other concerns. The costly spare partslike engines, maintenance spares etc. are not discarded after use, rather

they are kept in ready position for further use. All decision about spares arebased on the financial cost of inventory on such spares and the costs thatmay arise due to their non-availability.


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PURPOSE / BENEFITS OF HOLDING INVENTORIES Although holding inventories involves blocking of a firms funds and thecost of storage and handling, every business enterprise has to maintain acertain level of inventories to facilitate uninterrupted production and

smooth running of business. There are three main purpose or motives of holding inventories.i. The Transaction Motive which facilitates continuous production and timely

execution of sales orders.ii. The Precaution Motive which necessitates the holding of inventories for

meeting the unpredictable changes in demand and supplies of materials.iii. The Speculative Motive which induces to keep inventories for taking

advantage of price fluctuations, saving in re-ordering cost and quantitydiscount, etc.

RISK AND COSTS OF HOLDING INVENTORIES The various costs and risks involved in holding inventories are as below:

i. Capital Costs: Maintaining of inventories results in blocking of the firmsfinancial resources. The funds may be arranged from own resources orfrom outsides. In the former case, there is an opportunity cost of investment while in the later case, the firm has to pay interest to theoutsides.

ii. Storage and Handling costs: The storage costs include the rental of thegodown, insurance charges, etc.iii. Risk of Price Decline: This may be due to increased market supplies,

competition or general depression in the market.iv. Risk of Obsolescence: The inventories may become obsolete due to

improved technology, changes in requirements, change in customerstastes, etc.

v. Risk Deterioration in Quality: The quality of the materials may alsodeteriorate while the inventories are kept in store.


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TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT AND CONTROL The following are the important tools and technique of inventorymanagement and control.

1. Determination of stock levels.

2. Determination of safety stocks.3. Selecting a proper system of ordering for inventory.4. Determination of economic order quantity.5. A.B.C. Analysis.6. V.E.D. Analysis.7. Inventory turnover ratios.8. Aging schedule of inventories9. Classification and codification of inventories10. Preparation of inventory reports.

1. Determination of stock levels: Carrying of too much and too little of inventories is detrimental to the firm. If the inventory level is too little, thefirm will face frequent stock-outs involving heavy ordering cost and if theinventory level is too high it will be unnecessary tie-up of capital. Therefore,an affective inventory management requires that a firm should maintain anoptimum level of inventory where inventory costs are the minimum and atthe same time there is no stock-out which may result in lost of sale or

stoppage of production. Various stock levels are discussed as such.a. Minimum Level: This represents the quality which must be maintained in

hand at all times. If stocks are less than the minimum level then the workwill stop due to shortage of materials. Following factors are taken intoaccount while fixing minimum stock level:

Lead Time: The time taken in processing the order and then executing it isknown as lead time. It is essential to maintain some inventory during theperiod.

Rate of Consumption: It is the average consumption of material in the

factory. Nature of Material: If a material is required only against special orders of the customer than minimum stock will not be required for such materials.Minimum stock level can be calculated with the help of following formula:

Minimum stock level = Re-ordering level (Normal consumption) Normal Re-order period)


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b. Re-ordering Level: Re-ordering level or ordering level is fixed betweenminimum level and maximum level. Re-ordering level is fixed with thefollowing formula:

Re-ordering Level = Maximum Consumption Maximum Re-orderperiod. c. Maximum Level: It is the quantity of material beyond which a firm should

not exceed its stocks. If the quantity exceeds maximum level limit then itwill be overstocking. A firm should avoid overstocking because it will resultin high material costs. Overstocking will mean blocking of more workingcapital, more space for storing the materials, more wastage of materialsand more chances of losses from obsolescene.

Maximum Stock Level = Re-ordering Level + Re-ordering Quantity

(Minimum Consumption Minimum Re-ordering period).

d. Danger Level: It is the level beyond which materials should not fall in anycase. If danger level arises then immediate steps should be taken toreplenish the stocks even if more cost is incurred in arranging the materials.If materials are not arranged immediately there is a possibility of stoppageof work. Danger level is determined with the following formula:

Danger Level = Average Consumption Maximum re-order period foremergency purchases.

e. Average Stocks Level: The average stock level is calculated as such:

Average Stock Level = Minimum Stock Level + of re-order quantity.

2. Determination of Safety StocksSafety stock is a buffer to meet some unanticipated increase in usage. The

usage of inventory cannot be perfectly forecasted. It fluctuates over aperiod of time. The demand for materials may fluctuate and delivery of inventory may also be delayed and in such a situation the firm can face aproblem of stock-out. The stock-out can prove costly by affecting thesmooth working of the concern. In order to protect against the stock outarising out of usage fluctuations, firms usually maintain some margin of safety or safety stocks. The basic problem is to determine the level of


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quantity of safety stocks. Two costs are involved in the determination of this stock i.e. opportunity cost of stock-outs and the carrying costs. Thestock outs of raw materials cause production distruption resulting intohigher cost of production. Similarly, the stock-out of finished goods result

into the failure of the firm in competition as the firm cannot providecustomer service. If a firm maintain low level of safety frequent stock-outswill occur resulting into the large opportunity costs. On the other hand, thelarger quantity of safety stocks involve higher carrying costs.

3. Ordering systems of Inventory The basic problem of inventory is to decide the re-order point. This pointindicates when an order should be placed. The re-order point is determined

with the help of these things: (a) average consumption rate, (b) duration of lead time, (c) economic order quantity, when the inventory is depleted tolead time consumption, the order should be placed. There are threeprevalent system of ordering and a concern can choose any one of these:

a. Fixed order quantity system generally known as economic order quantity(EOQ) system;

b. Fixed period order system or periodic re-ordering system or periodic reviewsystem;

c. Single order and schedule part delivery system.

4. Economic Order Quantity (EOQ) Economic order quantity is the size of the lot to be purchased which iseconomically viable. This is the quantity of materials which can bepurchased at minimum costs. Generally, economic order quantity is thepoint at which inventory carrying costs are equal to order costs. Indetermining economic order quantity it is assumed that cost of managinginventory is made up solely of two parts i.e., ordering costs and carryingcosts.

Ordering costs: These are the costs which are associated with thepurchasing or ordering of materials. These costs include:

1. Costs of staff posted for ordering of goods. A purchase order is processedand then placed with suppliers. The labour spent on this process is includedin ordering costs.

2. Expenses incurred on transportation of goods purchased.


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3. Inspection costs of incoming materials.4. Cost of stationery, typing, postage, telephone charges, etc.

These costs are also known as buying costs and will arise only when somepurchases are made. When materials are manufactured in the concern thenthese costs will be known as set-up costs. These costs will include costs of setting up machinery for manufacturing materials, time taken up in setting,cost of tools, etc.

The ordering costs are totalled up for the year and then divided by thenumber of orders placed each year.

B. Carrying Costs: These are the costs of holding the inventories. These costswill not be incurred if inventories are not carried. These costs include:

1. The cost of capital invested in inventories. An interest will be paid on theamount of capital locked-up in inventories.

2. Cost of storage which could have been used for other purpose.3. The lost of materials due to deterioration and obsolescence. The materials

may deteriorate with passage of time. The loss of absolescence arises whenthe materials in stock are not usable because of change in process orproduct.

4. Insurance cost.5. Cost of spoilage in handling of materials.6. The longer the materials kept in stocks, the costlier it becomes by 20

percent every year. The ordering and carrying costs have a reverserelationship. The ordering cost goes up with the increase in number of orders placed. On with the increase in number of units, purchased andstored. It can be shown in the diagram shown.

7. The ordering and carrying costs of materials being high, an effort should bemade to minimise these costs. The quantity to be ordered should be large

so that economy may be made in transport costs and discounts may also beearned. On the other hand, storing facilities, capital to be locked up,insurance costs should also be taken into account.


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Assumptions of EOQ: While calculating EOQ the following assumptions aremade.

1. The supply of goods is satisfactory. The goods can be purchased wheneverthese are needed.

2. The quantity to be purchased by the concern is certain.3. The prices of goods are stable. It results in stabilising carrying costs.4. When above-mentioned conditions are satisfied, economic order quantity

can be calculated with the help of the following formula:

Where A = Annual consumption in rupees.S = Cost of placing an order.I = Inventory carrying costs of one unit.

EOQ and Quality Discount: Customer is offered some discount for bulkpurchase or if the size of a single order is large. Thus, the price per unit of an item may decrease for buying larger quantities. The quantity discountaffect inventory cost in three ways:

i. As the price per unit is reduced, the total price for the lot is reduced.ii. The lot size is increased, the number of offers is reduced and as a result the

total ordering cost is reduced.iii. The average inventory holding increase and as a result the storage cost will

increase.

Thus, to decide whether to avail the quantity discount or not, first of allEOQ is determined and then its total cost without quantity discount andwith quantity discount is determined. In case, the total cost is less due toquantity discount the offer is accepted, other wise it is rejected. Thefollowing example illustrates the point.


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Illustration 4. Economic Enterprises require90,000 units of a certain item annually. Thecost per unit is Rs.3, the cost per purchase

order Rs. 300 and the inventory carrying costRs. 6 per unit per year.i. What is the Economics Order Quantity?ii. What Should the firm do if the suppliers offer

discount as below:

Order Discount

4500-5999 2%

6000 and above 3%

Solution. (i)

Where, A = Annual Usage in units = 90,000S = Cost of placing an order = Rs. 300

I = Inventory carrying costs of one unit. = Rs.6

As the supplier offers discount on order quantity,we shall calculate the total cost of 3000 units,4500 units and 6000 units as below:

ISA2

EOQ

units000,3000,906

300000,902EOQ


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Since the total cost at order of 4500 units isthe lowest, the firm should place order for 4500 units and obtain 2% discount.

Order Size AverageInventory

Annualrequirements(units)

No. of orders(3 divided 1)

Pri ce per uni t Cos t o f purchase(3) X (5) Rs.

Carrying costat Rs. 6 per unit (Rs.)

Total orderingcost at Rs. 300

per order (Rs.)

Total Cost (6+ 7 + 8) (Rs.)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

3,00045,006,000

1,5002,2503,000

90,00090,00090,000

302015

3.002.942.91

2,70,0002,64,6002,61,900

9,00013,50018,000

9,0006,0004,500

2,88,0002,48,1002,48,400

5. A-B.C AnalysisThe materials are divided into a number of categories for adopting aselective approach for material control. Under A-B-C analysis, the materialsare divided into three categories viz, A, B and C. Past experience has shownthat almost 10 percent of the items contribute to 70 percent of value of

consumption and this category is called A Category. About 20 percent of the items contribute about 20 percent of value of consumption and this isknown as category B materials. Category C covers about 70 percent of items of materials which contribute only 10 percent of value of consumption. There may be some variation in different organisations andan adjustment can be made in these percentages.

6. VED Analysis

The VED analysis is used generally for spare parts. Spare parts are classifiedas Vital (V), Essential (E) and Desirable (D). The vital spares are a must forrunning the concern smoothly and these must be stored adequately. Thenon-availability of vital spare will cause havoc in the concern. The E type of spares are also necessary but their stocks may be kept at low figures. Thestocking of D type of spares may be avoided at times. If the lead time of these spares is less, then stocking of these spares can be avoided. The


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classification of spares under three categories is an important decision. Theclassification of spares should be left to the technical staff because theyknow the need urgency and use of these spares.

7. Inventory Turnover RatiosInventory turnover ratios are calculated to indicate whether inventorieshave been used efficiently or not. The purpose is to ensure the blocking of only required minimum funds in inventory. The inventory turnover ratioalso known as stock velocity is normally calculated as sales/averageinventory or cost of goods sold/average inventory cost. Inventoryconversion period may also be calculated to find the average time taken forclearing the stocks.

Symbolically,

8. Aging Schedule of InventoriesClassification of inventories according to the period (age) of their holdingsalso helps in identifying show moving inventories thereby helping in

effective control and management of inventories. The following tableshown aging of inventories of a firm.

9. Classification and Codification of InventoriesThe inventories of a manufacturing concern may consist of raw materials,work in process, finished goods, spares, consumable stocks, etc. All thesecategories may have their sub-divisions. The raw materials used may be of 3-4 types, finished goods may also be of more than one type, spares may be

of a number of types and so on. For a proper recording and control of inventory, a proper classification of various types of items is essential. Theinventories should first be classified and then code numbers should beassigned for their identification.

The identification of short names are useful for inventory management notonly for large concerns but also for small concerns. Lack of proper

CostatInventoryAverageSoldGoodof CostRatioTurnover Inventory

Inventory)Average(Sales Net


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classification may also lead to reduction in production. Generally, materialare classified according to their nature such as construction materials,consumable stocks, spares, lubricants, etc. The coding class of materials isassigned two digits and then two or three digits are assigned to thecategory of materials in that class. The third distinction is needed for thequality of goods and decimals are used to note this factor.

10.Inventory ReportsFrom effective control, the management should be kept informed with thelatest stock position of different items. This is usually done by preparingperiodical inventory reports. These reports should contain all informationnecessary for managerial action. On the basis of these reports managementtakes corrective action wherever necessary. The more frequently thesereports are prepared the less will be the chances of lapse in theadministration of inventories.

JUST IN TIME (JIT) INVENTORY CONTROL SYSTEM The term JIT refers to a management tool that helps to produce only theneeded quantities at the needed time. According to the official terminologyof C.I.M.A., JIT is a technique for the organisation of workflows, to allow

rapid, high quality, flexible production whilst minimizing manufacturingwork and stock level. There are bro adly two aspects of JIT (i) just in timeproduction, and (ii) just in time purchasing.

Just in time inventory control system involves the purchase of materials insuch a way that delivery of purchased material is assured just before theiruse or demand. The philospohy of JIT control system implies that the firmshould maintain a minimum (zero level) of inventory and rely on suppliersto provide materials just in time to meet the requirements. The traditionalinventory control system, on the other hand, requires maintaining a healthy

level of safety stock to provide protection against uncertainties of production and supplies.


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Objective of JIt The ultimate goal of JIT is to reduce wastage and enhance productivity. Theimportant objectives of JIT include:

1. Minimum / zero inventory and its associated costs.

2. Elimination of non-value added activities and all wastes.3. Minimum batch / lot size.4. Zero breakdowns and continuous flow of production.5. Ensure timely delivery schedules both inside and outside the firm.6. Manufacturing the right product at right time.

Features of JITa. It emphasises that firms following traditions inventory control system

overestimate ordering cost and underestimate carrying costs associated

with holding of inventories.b. It advocates maintaining good relations with suppliers so as to enable

purchase of right quantity of material at right time.c. It involves frequent production / order runs because of smaller batch/lot

sizes.d. It requires reduction in set up time as well as processing time.e. Purchase of produce in response to need rather than as per the plans and

forecasts.

Documents

Production and Operation Management3