Inventory Management & its importance
Every organization should/must take step to manage its inventories. Following are a few reasons for having to do so.
- It ties up your working capital. Pretty much you would be spending your working capital on purchasing these stocks, and so it will be stuck till the stocks are utilized.
- By having these good stored for long periods of time, you run the risk of damaging them, them being stolen and the deterioration of the goods.
- You would have to unnecessarily spend on handling costs, administering costs etc.
Thus, it is very much evident that the managing of Inventories is a must, and that it is very much vital for any organization in the long run.
Mathematical Models in Inventory Management
Economic Order Quantity: is the level at which the inventory must be maintained at in order to minimize the total inventory holding and ordering costs. The equation used to calculate the EOQ level and the factors in the equation are as follows:
Q = order quantity
Q * = optimal order quantity
D = annual demand quantity of the product
P = purchase cost per unit
C = fixed cost per order (not per unit, in addition to unit cost)
H = annual holding cost per unit
Re-order Point: is the level of inventory, once reached signals that new stock must ordered. It is calculated thus:
Reorder Point = Normal consumption during lead-time + Safety Stock.
Re-order level: is the level at which new stocks are ordered following is how it is calculated:
Re-order level = Average daily usage rate * lead-time in days.
Use of Information Technology in Inventory Management
Enterprise Resource Planning System (ERP)
Enterprise Resource Planning Systems are high end, and extremely sophisticated systems that are now being used by organizations to plan-out, maintain, and computerize their business activities. SAP is such an ERP system.
Inventory management could be just a small part of such a system. ERP systems are also liked with its suppliers and other components of the supply chain, and most importantly the organization’s Inventory. All discharges from and into the inventories are recorded in the system. Once the re-order level, Re-order Point & EOQ is determined, the ERS system could be used to send automated massages to the organizations preferred suppliers to order the amount required to reach the EOQ.
Doing so would make the whole system very much efficient, and would help reduce unwanted tying of Working Capital in the organization’s inventories.
Inventory Management Systems
Unlike the large scale ERP systems, Inventory Management Systems are simpler systems which are specifically produced for the job. It would be linked to the Inventory and maybe the suppliers also, according to the organization’s needs.
The system will keep track of the stock level in the inventory and take measures to re-order etc. This also would help the organization by reducing the tying up of its Working Capital in Inventories.
Valuing of Inventories
First In First Out Inventory Valuing System (FIFO)
As described in the name itself, is a method of valuing inventory at the price of the first goods brought into the stores. Practically what happens is that, when goods are discharged from the inventory, they are valued at the price of the stock first inserted into the stores. And once an amount of stock, equivalent to the amount of stock first purchased is discharged, the next lot is valued at the price of the next batch entered into the stock.
Impact on Financial Figures:
- In a time of inflation, since the price of these goods rise, the final stock may be assessed at a high value, which could lead to the financial statements showing a low production cost.
- With low production costs comes High Profits
- High Profits mean the organization will have to pay higher taxes.
- You release goods according to present market prices, thus the chances of making a Loss on the inventories, are low.
- The value of the last stock released is almost equivalent to that of the Present Market.
Last In First Out Inventory Valuing System (LIFO)
In the LIFO system, it is assumed that the goods purchased last are sent out first when valuing the goods. I.e. when goods are released from the Inventory they are priced at the amount of the good entered last in to the Stores. Is a new Stock at a new price is entered into the stores; the next batch sent out of the stores is valued at that price.
Impact on Financial Figures:
- This system would be advantages for use when in time of Inflation, because it would show a generally Low profit, which means the organization would have to pay Low tax rates.
- You release goods according to present market prices, thus the chances of making a Loss on the inventories, are low.
- The value of the last stock released is almost equivalent to that of the Present Market. Which makes the Cost of Goods purchased accurate.
- The Price of the goods discharged last would not be equivalent to the current market price.
The fundamental difference between FIFO and LIFO is that the goods released, are valued at the price of good first entered to the Stores or last entered into the stores respectively. In a time of Inflation FIFO would show a phantom Profit level, which increases the tax rate, where as LIFO does not do so. But on the long run both these two systems add up to give the same value.
Approaches to Inventory Planning and Control
Two-bin system
The two-bin system which is also referred to as the “Min-Max System” is a straight forward and easy to understand system. Basically the store will have two bins (not necessarily bins, but some sort of inventory containment compartments). Stocks in Bin 1 are used first. Once that is used completely, the stocks in Bin 2 are used. Meanwhile the Bin 1 being replenished. Bin two is pretty much designed in such fashion that the quantity in it is the required amount of goods till the 1st Bin is replenished.
Just-In-Time System (JIT)
The Just-In-Time system works in pursuit of Zero inventories, as suggested by its name. The system tries to acquire only the required amount of stock just when it is needed, in order to avoid having to store them.
Advantages for the Just-In-Time system:
- Reduces unwanted investments in Stocks.
- Reduces need for storage space.
- Higher Utilization of equipment
- Lower DPM’s
- Lower costs
- Higher Profits
References
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Answers.com, ‘Optimal Ordering Quantity’, 2007. [Online] Available at: http://www .answers.com/topic/economic-order-quantity [Accessed 1st march 2009]
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Britannica Encyclopedia, ‘Two-bin system’, 2007 [Online]. Available at: http://www. britannica. com /EBchecked/topic/611186/two-bin-system [Accessed 1st March 2009]
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Investopedia, ‘LIFO-Last In First Out’, 2008 [Online]. Available at: http://www. investopedia.com/terms/l/lifo.asp [Accessed 28th Feb 209]
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Investopedia, FIFO - First In First Out’, 2008 [Online]. Available at: http://www.investopedia. com/terms/f/fifo.asp [Accessed 28th Feb 209]
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Silicon Far East, ‘JIT – Just-in-Time’, 2007. [Online] Available at: http://www. siliconfareast.com/jit.htm [Accessed 1st March 2009]
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Wikipedia, ‘FIFO & LIFO Acounting’ 2007 [Online]. Available at: http://en.wikipedia.org /wiki/FIFO_and_LIFO_accounting [Accessed 1st March 2009]
