THE NEED FOR INVENTORY

The ordinary dictionary meaning of inventory is 'a list of goods an estate

contains'. In industry, inventory means 'stock of goods'. It may mean raw
materials, work-in-progress, maintenance materials, processed and semiprocessed materials, oils, fuels and lubricants as well as finished and semifinished goods. They may be either in solid, liquid or gaseous form, required
for future use, mainly in the production process as in the case of finished
goods for re-sale. In any case, it is an idle resource having an economic value
awaiting conversion, consumption or re-sale. Thus inventories are held
primarily for some transaction. 'Today's inventory is tomorrow's production'.
In case of production inventory, generally there is a time-lag between the
recognition of the need and fulfillment of that need. This time-lag; which is
technically called 'leadtime', is due to the time required for ordering,
processing and time needed by the vendor for actual delivery of the
materials. Consequently, leadtime greatly influences holding of the volume
of inventory. Had it been so that materials were readily available right on
placing orders, there would have been no need for holding inventory. The
second element is that inventories are held as a precautionary measure for
increases in both leadtime and consumption rate. Also, there are reasons for
holding inventory as a matter of speculation, because prices may
subsequently go up or the material may become scarce in the future. This is
however, not 'of so much importance for our purpose. Finally, inventories
also serve to decouple materials from consumption at successive stages of
production operations.

THE NEED FOR CONTROL

We have already seen how important it is to improve upon the return on
capital, that is, profit margin. But there are obvious limitations such as
competition in the business world. One way of improving the profit margin is
to turn inventories into saleable products with less investment and as quickly
as possible so that higher sales targets can be achieved and more profits
made with less investment. In other words, a high inventory to sales turn
over ratio is necessary to achieve an improvement over return on capital.
The inventory-turnover ratio can be defined as the gross sales revenue to
average inventory held during a year. This ratio is too low in India. While it is
roughly about 3:1 in India, it is about 12 to 18 in the USA on an average. The
same is about 7 in West Germany and about 6 to 8 in the UK.
An RBI study on 700 Joint Stock Companies shows the following investment
structure:
Raw Materials and Inventories . Rs. 600 crores
Plant and Machineries
. Rs. 540 crores
The above figures show higher capital outlay in raw materials and
inventories than in plant and machinery. A constant attempt should be made
to reduce investment in inventories. If a modest
5 per cent reduction is possible, that would mean release of 1m extra
amount of investable funds for other productive purpose. The overall picture
is gloomier. It has been variously estimated that in India about Rs. 15,000
crores is blocked in immovable inventory of which about Rs.2,500 crores is
blocked in dead inventories. One wonders whether a developing economy
can afford to block so much money in an idle resource.

FINANCE FOR INVENTORIES

Like their counterparts all over the world, Indian industries also performance
their inventories primarily through bank credit. Banks extend credit by way
of advance against inventories. It is generally made available under pledge
or hypothecation. As a matter of fact, full value of inventories is not
advanced. A margin is retained by the bank and the borrower is required to
meet the financial requirements of inventory through internal resources.
Margins, however, vary widely depending upon many factors which are taken
into account by the bankers while they extend credit. Large portions of
working capital of many companies are sunk in inventories and banks
generally provide the working capital requirements. Traditionally, organized
industrial sector of the economy accounts for more than 50 to 60 per cent of
the total bank credit. The quantum of bank credit for industries has always
been on the increase. As such, inventory financing has becoming a very
important part of credit planning for the banking system in India.
The Reserve Bank of India, in order to regulate and control bank credit, from
time to time issues policy directives to commercial banks. As for example,
banks are required to maintain a statutory reserve in the form of cash. The
liquidity ratio of cash to demand and time liabilities are periodically reviewed
and varied in order to control credit. The Variable Reserve Ratio (VRR), as it is
called, is a powerful tool in the hands of RBI for controlling credit and money
supply in the country. The RBI also lowers or increases lending rates to
commercial banks for such purposes. Over and above, it also exercises
3

selective credit control for a large number of commodities and recommends

a minimum margin to banks for advances and loans. For others, banks are
left free to advance loans and credits at their discretions. In July .1974, RBI
appointed a study group to frame some guide lines for hank credit to
industries. The committee headed by the then Chairman of the Punjab
National Bank, Sri Prakash Tandon, recommended three methods of financing
inventories.
(a) Firstly, the borrowing organisation is expected to finance 25 per cent of
the working capital requirements from its own internal resources.
(b) Secondly, the borrowing organisation is required to finance to the extent
of at least 25 per cent of its current assets from its own internal resources.
(c) Thirdly, the borrowing organisation is expected to finance its 'core current
assets'.
The implication is that individual borrowing organisations will need to take
care to minimize their current assets. They must reduce inventory and will
try to increase the inventory-turnover ratio .in order to maintain a steady
flow of funds and liquidity. They will have to streamline procedures to cut
administrative and internal leadtimes. This in turn requires an analytical
approach to inventory control, flow of information, documentation,
organisational restructuring and delegation of financial powers for smooth
flow of materials, to, through and out of an organisation. Thus, inventory
control has assumed great importance to industries.

WHAT IS INVENTORY CONTROL

The simplest language, inventory control may be said to be a planned
method whereby investment in inventories held in stock is maintained in
such a manner that it ensures proper and smooth flow of materials needed
for production operations as 'well sales, while at the same time, the total
costs of investment in inventories is kept at a minimum. From the above
definition it follows that a comprehensive inventory control system must be
closely coordinated with other planning and control activities, such as,
(planning, capital budgeting, sales forecasting, including production
planning, production scheduling and control. This impinges on a wide range
of operations, operating decisions and policies for production, sales and
finance. The finance controller of a company regards inventory as a
necessary evil, since it drains off cash which could he used elsewhere to earn
some profits. The marketing manager always wants enough of ready stock of
finished goods inventories in order to give better customer service to ensure
the company's goodwill and would not like to see a sales opportunity lost for
want of saleable ready stock. The production manager does not want an outof. Stock condition for which production might be held up. It will, therefore,
he seen that everyone- has some objectives which arc connecting in nature.
The basic problem is, therefore, to strike a balance between operating
efficiency and the costs of investment and other associated costs with large
inventories, with the object to keep the basic conflicts at the minimum while
optimizing the inventory holding.

THE TECHNIQUES
Some of the techniques which will follow include methods of fixing purchase
quantities, setting of order points and safety stocks. The decisions as to
which item to make when and to keep inventories in balance requires
application of a wide range of techniques from simple graphical methods to
more sophisticated and complex quantitative techniques. Many of these
techniques employ concepts and tools of mathematical and statistical
methods and make use of various control theories from engineering and
other fields. They arc primarily aimed at helping to make better decisions
and getting people involved and follow a wise policy. As such, they are far
from academic exercises only. However, making decisions more intelligently
and making actions follow these decisions is not easy. Thus while these
quantitative techniques have taken much out of the decision-making
managers what was being done through bunch or intuitive judgment, real
business acumen demands that these must be blended with practical
business sense. It is an axiomatic truth that these techniques alone cannot
turn bad judgement into good ones simply because they are exact. However,
before focusing our attention on such techniques, let us first attempt to
analyze different types of inventories

TYPES OF INVENTORIES
Inventories may be classified as under:(1) Raw materials and production inventories:
These are raw - materials, parts and components which enter into the
product
Direct during the production process and generally form part of the product.
(2) In-process inventories:
Semi-finished parts, work-in-process and partly finished products formed at
various stages of production.
(3) M.R.O. Inventories:
Maintenance, repairs and operating supplies which are consumed during the
production process and generally do not form part of the prod.uct itself (e.g.
POL, Petroleum products like petrol, kerosene, diesels, various oils and
lubricants, machinery and plant spares, tools, jibs and fixtures, etc.)
(4) Finished goods inventories:
Complete finished products ready for sale.
Inventories may also be classified according to the function they serve, such
as,
(a) Movement and transit inventories:
This arises because of the time necessary to move stocks from one place to
another. The average amount can be determined mathematically thusI=S x T
Where, S represents the average rate of sales (say, weekly or monthly
average) and
T the transit time required to move from one place to another, and I the
movement inventory needed.
As for example, if it takes three weeks to move materials to aware house
from the plant and if the warehouse sells 110 per week, then the average
inventory needed will be 110 units x 3 weeks = 330 units. In fact, when a
unit of finished product is manufactured and ready for sale, it must remain
idle for three weeks for movement to warehouse. Therefore, the plant stock
on an average must be equal to three weeks' sale in transit.
(b) Lot-size inventories:
7

In order to keep costs of buying, receipt, inspection and transport and

handing charge slow, larger quantities are bought than are necessary for
immediate use. It is common practice to buy some raw materials in large
quantities in order to avail of quantity discounts.
(c) Fluctuation inventories:
In order to cushion against unpredictable demands these are maintained,
but they are not absolutely essential in the sense that such stocks are always
uneconomical. Rather than taking what they can get, general practice of
serving the customer better is the reason for holding such type of
inventories.
(d) Anticipation inventories:
Such inventories are carried out to meet predictable changes in, demand. In
case of seasonal variations in the availability of some raw materials, it is of
inventory and also to some extent economical to build up stocks where
consumption pattern may be reasonably uniform and predictable. of the
types of inventories discussed above, the Lot-size, Fluctuation and
Anticipation Inventories may be said to he 'Organization Inventories'. As
more of these, basic types of inventories are carried into stock, less
coordination and planning are required. Also less clerical and administrative
efforts are needed and greater economies can be obtained in handling,
manufacturing and dispatching.
But the difficulty is that gains are not directly proportional to the size of
inventories maintained.
As the size increases, even if they are efficiently maintained, handled and
properly located, gains from additional stock become less and less prominent
The cost of warehousing, obsolescence and capital costs associated with
maintenance of large quantities grow at a faster rate than the inventories
themselves. As such, the basic problem is to strike a balance between the
increase in costs and the decline in return from holding additional
inventories. Striking a balance in a complex business situation through
intuition alone is not easy. Costs, and to be sure, the balancing of opposite
costs, lie at the heart of all inventory control problems, for which cost
analyses are necessary to which we shall turn in this chapter now.
As has already been said that even a typically medium-size industrial
organization may use 10,000 to 15,000 different items which are carried in
inventory. Initial planning and subsequent control of such inventories can
only be accomplished on the basis at knowledge about them. Consequently,
the starting point in inventory management and control is the development
of a stores catalogue, which is more or less comprehensive and complete in
all respects. All inventories should be fully and carefully described and a
code number should be allotted. Similar items should be grouped together
and standard codification should be adopted.
8

ABC ANALYSIS OR SELECTIVE INVENTORY

CONTROL (SIC)
80 per cent of the income and wealth were concentrated in the hands of
about 20 per cent of the population. This 80-20 relationship also holds good
in most cases of inventories where it may be found that about 20 per cent of
the total number of items are responsible for about 80 per cent of the value.
The idea of studying such, inventory value is to find out 'where the money
lies'. AS this '20 per cent of items, 80 per cent of value' rule holds good in
many inventory situations, high value items need more stringent control,
which may be termed 'A' class items, and the remaining ones can be
classified as 'B' and 'c' class items according to descending order of value.
Thus, the principle of graduated control may be affected and the degree of
control may be equated with the frequency of reviews. Controlling tightly
means reviewing frequently, and frequency in turn tends to determine the
order quantity, A items would be reviewed frequently, and because of their
high value they will be ordered in small quantities in order to keep the
inventory investment minimum. B items will be renewed less frequently and
C items still less, The following graphical illustration will make the meaning
of ABC Analysis more clear, which is based on selective control technique.

CLASS
A
B
C
TOTAL

NO. OF ITEMS IN USE

(%)
20
30
50
100

VALUE (%)
80
15
5
100

THE TWO-BIN SYSTEM

One of the earliest systems of stock control is two-bin system, which is a
simple method of control exercised by two simple rules. One is when the
order should be placed, and the other is what quantity should be covered.
The following diagram shows this simple method. The bins contain, say, mildsteel bolts and nuts. The bolts and nuts are issued from the first bin as and
when required, and as soon as the first bin is empty, more bolts and nuts are
ordered.
The replenishment arrives just when the second bin is empty. While delivery
is awaited, the nuts and bolts from the second bin are issued. When the
delivery arrives, then both the bins are again filled in.

BIN NO 1

BIN NO 2

Use till Bin no 1 is empty

Use Bin No 2 when Bin no 1 is

empty

Such a method is appropriate only when consumption rate is constant, that is

to say, it is a deterministic system. We know from our experience what
quantity of bolts and nuts are necessary for a given period as well as we
know their rate of consumption.

10

MAX MINI SYSTEM

Under this method, maximum level and minimum level are fixed. Re-ordering
is done after a period of review and order or re-order is placed when the
quantity touches a certain level.
Suppose you have an item in inventory for which maximum is fixed at 1,000
and minimum quantity to be held in stock is 250units. Previous experience
shows that a safety stock of 250 units is quite sufficient. If during the past
two months consumption rate has been 300 units per month on an average,
and if the leadtime is taken to be two months time, then you will run out
soon, if either delivery is not received just after two months or if during the
subsequent months consumption rate increases. The weakness of this
system is:
(a) Stock levels are actually fixed at lower levels since managers have no
time to study inventory levels of individual items.
(b) Re-order points and safety levels once fixed are not frequently changed
after study.
(c) Delay in postings makes the records useless for control as often even a
critical item can be held up for want of posting which otherwise would have
been shown that the re-order point has been touched. Thus, we may
conclude that in any inventory management and control system, control is
exercised through various levels, and the order point and the order quantity:
i.
ii.
iii.
iv.

Maximum level
Minimum level
Order level or re-order level or the order point
Order quantity

There are two basic control systems:

1. Periodic review system.
2. Fixed order quantity system.
1. Periodic review system:
11

This is a time-bound system which requires periodic reviews of the stocklevels of all items. Here, period of review is fixed either at three months,
six months or once in a year, when requirements of all items are worked
out ,a fresh, and the quantity varies. This system works well for
production raw materials and components for which long leadtimes are
necessary.

2. Fixed order quantity system:

Under this system, order quantity is fixed but the time varies. This system
recognizes the fact that each item in inventory possesses its own
characteristics and optimum order quantity requirements. Designing of
this system requires consideration of many factors, such as, price, usage
rate and other pertinent factors. Maximum and minimum levels are
determined for each inventory item and an order or re-order point is
established in between the two levels. The order point is computed in
such a manner that by the time new supplies is received, the stock
balance will fall to the minimum and it will be replenished again to the
maximum.
The major advantages are:
(i)
Each item can be procured at the most economical price and
quantity,
(ii)
Purchasing and inventory control people automatically pay
attention to the items when they need it.
Thus, in order to devise a good inventory control system, we have to
consider the following:
(a) What to order.
(b) When and how much.
The first involves planning with due regard to production and marketing
requirements. The second has two aspects:
(i) Order point
(ii) Order or re-order quantity
Order quantity will be discussed along with safety stock or buffer stock since
subtle influence of time in transit on .total inventory is closely related to the
safety stock provisioning to create an impact on inventory control. At this
point, it would be better to draw a distinction between
Accounting costs and operational costs. The former is based on historical
cost concept used for financial reporting and the latter is, by and large, used
for day-to-day decision-making and insensitive to small variations.
12

Accounting system typically distinguishes three types of costs, viz., direct

cost, indirect cost and overheads. As against the principles and consistency
of accounting costs, the definition of costs in an inventory system may vary
from time to time, depending upon the length of time being planned and
other circumstances. However, the objective underlying inventory control is
to minimize the total cost of procurement, storage,
handling, distribution and other charges. Economic ordering starts with an
analysis of these various components of costs.

ECONOMIC ORDER QUANTITY OR EOQ

FORMULA
The inventory costs may be broadly divided components:
A PROCUREMENT COST (this includes administrative and
costs.)

provisioning

B. STORAGE. COST (this includes carrying, handling, etc.)

C. STOCK-OUT COST (this may be laid down by management
its policy.)

according to

The first two may be broken down into a number of components.

Typically they are:
A.
(i) Requisitioning
(ii) Order-placing
(iii) Processing and progress-chasing
(iv) Receiving, checking and inspection
B.
(i) Interest on capital
(ii) Expected return on capital (imputed cost)
(Hi) Warehousing (this includes insurance, lighting and other maintenance
costs).
A point of minimum cost is reached at which the ordering cost will be just
equal to the carrying cost so that the tota1 cost is minimum at that point. In
other words, neither excess quantity of material is ordered, nor too
fr6quently too many orders are placed for the same material during a period
of time. We assume, however, that no stock-out or idle-time cost has to be
accounted for. Also, where quantity discounts are allowed on lot-purchases or
where there are price-breaks, this will not hold true. In such cases, linear
13

relationship of the unit price with purchase quantity breaks down and distorts
the formula given below as we shall presently see, When unit price is same
regardless of the quantity purchased, we can use the following formula when
we find that the order quantity varies in proportion to the square root of the
demand. These are indices given on scientific basis to order quantity,
keeping in view position states of inventories, viz., the set of costs, ordering
cost and carrying cost. This is known as Economic Order Quantity

(EOQ) or Square Root Formula developed by R.H Wilson.

EOQ or D2 = (2Qa)
C
Where Q= Annual requirements in units (estimated demands)
a = Unit cost of placing an order (in Rupees)
c = Annual carrying cost (this is generally expressed in percent)
In determining the EOQ, this mathematical model has assumed that the
costs of managing. an inventory item consist solely of two parts:
(1) Ordering cost and
(2) Carrying cost, ignoring the idle time or stock-out cost, which cannot be
altogether ruled out.
Ordering cost:
This is the additional cost of placing an order or re-order. Its characteristic is
that it is independent of the order size. It increases with the number of
orders and is not influenced by the size of the order.
Carrying cost:
On the other hand, the characteristic of the carrying cost is that it increases
with the volume of inventory irrespective of the number of orders. It is
linearly related with the quantum of inventory. The cost of inventory carrying
is generally expressed as an annual percentage of the unit purchase cost.
From the above graph, it will thus be noticed that the above two costs are
opposite in nature. The former varies with the number of orders and the
latter varies directly with the volume of inventory. Thus, if purchases are
made frequently and in small lots, carrying cost can be kept low, but the
order or re-order cost will be higher. It will, therefore, be appreciated that
when the slope of the order cost curve meets the rising carrying cost curve,
that is to say, where the marginal ordering cost is equal to the marginal
carrying cost, the total minimum cost point is reached. In other words, this is
14

the point where we hold the optimum inventory meet this point the order
cost curve begins to rise again.

Limitations of the EOQ formula

However, the very restrictive nature of the assumptions made in the EOQ
formula restrains the use of the formula in many cases of practical inventory
situations. The cost-analyses on the basis
Of which the formula has been developed are merely notional rather .than
actual in some cases. In practice, unit cost of purchase of an item varies,
lead times are uncertain and also requirements or demands of inventory
items are not perfectly predictable in advance. Rate of consumption varies
greatly in many cases. As such, the Application of the formula often becomes
difficult and complicated.
Price Breaks or Quantity Discounts
In many cases, quantity discounts are allowed by firms in order to boost their
sales and it becomes preferable to purchase in some bulk quantities to avail
of the discounts. In such cases, it is only worthwhile to calculate the EOQ for
an item in order to see that if it is really profitable to order in EOQ quantity.
This will also mean that the usage rate must be steady. Again, if the, unit
cost of purchase fluctuates greatly from time to time, then the EOQ for that
particular item will also not hold good.
Leadtime variation
The formula was' also developed on the basis of invariant leadtime, that is,
the time interval between placement of an order and actual replenishment
will not vary for all practical purposes.
Often this supposition is invalid, because schedule of deliveries varies for
many reasons. Moreover, some items have longer leadtimes than others and
even for the same items, it will differ from one lot purchase to another. For
this reason also, it is difficult to use
EOQ for many times
Order or re-order Point
15

Thus, while EOQ tells us something about how much to order, it tells us
almost nothing about when to order or re-order, for, this depends upon the
level of inventory in question. The order or reorder point should be set at
such a level that the stock on hand plus on orders should last till fresh
supplies are received. This will require ascertaining the usage rate of that
particular item. If the rate of consumption greatly varies and there is an
upward surge in the consumption pattern suddenly, this will lead ultimately
to stock-out condition.
For this reason only, for many items additional stocks have to be maintained
in order to meet unanticipated demand due to variation in usage rate due to
normal consumption and during lead times.

SAFETY OR BUFFER STOCK

Some additional stocks are always provided in order to meet contingencies
of unanticipated, demand due to both (a) leadtime variations usage pattern
during leadtime. This additional stock, safety or buffer stock as it is called
will, however, depend upon the service level desired on the one hand, and,
the risk of stock-out, on the other. If the rate of consumption remains fairly
constant, the suppliers' delivery times do not vary, there are no rejections
during inspection, it would have been a simple matter to place a new order
whenever stock on hand reaches the quantity equal to the lead time usage.
A hundred per cent service level can be easily .attained in such
circumstances when there will be no occasion for stock-outs as fresh supplies
would always be arriving before the existing stock out.
The EOQ was developed on the presumption that such an ideal situation
holds true and the average inventory holding during the twelve-month period
is 1/2 during the year. So, the inventory level is equal to Q or EOQ
intermediately upon receipt of the order quantity and is reduced at a
constant rate of depletion until it reaches a zero-level again. But such an
ideal situation is hard to come across. In practice, demands vary greatly,
supplies are uncertain, prices do not remain constant and a host of other
variables and seen circumstances and difficulties are experienced, which
may lead to occasional stock -out conditions. On the other hand,
unnecessary apprehension about stock shortages leads to holding of a
building up of huge stock piles. So, an inventory control system should be
provided that can absorb the shocks or bumps up and down, the system
itself not being too costly at the same time. In designing such a system, we
have already stressed the importance of service level desired by
management. Some additional stocks are kept on hand always in reserve to
avoid temporary shortages or stock-out conditions. As more and more safety
16

or buffer stocks are provided, this eliminates the changes of shortages and
means holding of unnecessary additional inventories. But when less are
provided, this means there are chances of occasional stock-outs and
management has to run the risk or production hold ups. Thus the
provisioning of safety stock assumes great importance in the face of
uncertainties. The following illustration depicts the situation. The problem of
determining safety stock of buffer stock is a comparatively simple matter,
where the rate of consumption fairly constant or can be accurately forecast.
At this point mill be appreciated that variations in future consumption are not
only cause of stock-outs. The variations in leadtime use ages and related
uncertainties of delivery time must also be taken into account, which make
the calculation of safety stock a complicated affair. It involves numerous
repeated trials or tests of the combined effect of variations in demand and in
leadtime useages to arrive at an ideal safety stock level.

FSN/VED analysis
A-B-C Analysis was evolved on the principle of graduated control stringency.
The degree of control was equated with the frequency of reviews of a given
inventory record.
Controlling tightly means reviewing frequently, which tends to determine
order quantity.
A-items would be reviewed frequently and order in small quantities to keep
inventory investment low.
B-items less, C-items still less. But this approach does not take into account
the fact that sometimes a low-valued small item of critical nature needs as
much attention as high-valued A-class item, so that inventories also need to
be classified according to Vital, Essential and Desirable (V -E-D), which in
essence means that stress is more on importance rather than on value.
Again, inventories may also be classified according to Fast-moving, Slowmoving and Non-moving items in order to see the rapidity of their use and to
weed out the unnecessary ones. This is aimed at keeping the total inventory
size down and reduces investment.
Thus, selective control may be exerted under different types of classification
according to necessity. A single-type approach may not prove fruitful under
all circumstances.

17