CHAPTER No. 1

Inventory Management

Inventory

►It is the existing stock at a certain time of raw

material or semi-finished or finished production in a

certain area of the organization.

1. Role of inventory in Working Capital.

Current Assets.

Level of liquidity.

Liquidity lags.

Creation lag (+ve)

Storage lag (-ve)

Sale lag (-ve)

Circulating Activity.

2. Purpose of inventory.

Avoiding lost sales.

Shelf stock or goods refer to the good

which

do not enquire specification e.g. Buying

Car.

No need charge.

Getting quality Discounts / bulk.

Reducing Ordering Costs.

Maintain efficient production sum.

Buffer Stock.

Contingent Demand.

3. Types of inventory.

Raw material

Spares, stores & tools

Work-in progress.

Packaging materials

Finished goods

4. Cost associated with inventory

Material

Direct Ordering Cost

Carrying

Goodwill (No inventory)

Indirect

Opportunity Cost

1. Role of inventory in Working Capital.

►Current Assets in working capital refers to Current Assets to

the difference of Current assets over Current liability. It

indicates the amount of money required for better

operations of any particular company for an establishment.

Inventory is a component of current Assets. Hence, its

monetary value reflected in the balanced sheet would

effect the requirement of Working Capital.

A) Current assets

► As mentioned above inventory is a part of Current asset

and the more inventory held the more W.C. is required

and Vice-Versa.

Level of Liquidity

► Current assets are converted into cash by selling those

products. The more easily inventory is converted into

Sales and then after in to cash. The less working capital

required and Vice-Versa.

E.g. Operation of winner.

(Wine for selling W.C. less)

(Fast food outlet W.C. more)

In a Winn’s shop the Wine hose to be made and the age for

some days. It cannot be sell until it is completed to W.C. will

be less. While, in fast food outlet, burger did not required

storing and it is ready and it is sell to the fast food outlet.

Working Capital will be more and Degree of liquidity is more

in fast food outlet Degree of liquidity is less in Wines shop.

B) Liquidity lag

The lag here, refer to the time space in the

manufacturing, storing and sell of the products and the

cost associated their aff. There are three types of lag

♦ Creation lag

►The time associated with the creation of particular

product and the payment of direct& indirect related

cost after the said period is known as creation lag. The

cost of wage of a worker at the end of the month who

prepared the finished product, the payment of raw

material after certain data the payment of electricity

bills after certain period are all examples of creation

lag. The creations lag time the more beneficial it is for

the establishment & vice-versa.

♦ Storage lag

► This refers to the time required for storing of the

inventories. When stocks of goods are stored it requires

certain amount of expenditure. Such as paying for the

storekeeper salary depreciation of building and furniture

& fixtures etc. More the storage lag is the more W.C.

require and vice-versa. The greater the lag lowers the

level of liquidity or degree of liquidity vice-versa.

E.g. Wine yard.

♦ Sales lag

►These refers to that time required for collection of

receivable after the goods are sold. It is generally

seen that no business of whatever the type be runs

on 100℅ cash sales. The firm has to sell on credit to

attract customers and built brand image. In this

context, the longer the sale lag the more W.C.

required and less the profit and vice-versa.

C) Circulating activity.

In a business, there is a definite cycle in operation where

leys, raw material are purchased converted into finished

goods and sold into market generating the cash which is

again used for the purchase of inventory. These cyclic

nature or Circulation of monitory funds if referred to as

circulating activity in the business. Generally, it is seen

that W.C. requirement is done on the first or initial cycles

of the business. The more elaborate cycle is the more

W.C. required and vice-versa.

E.g. Retail stores would require less W.C. whereas ethnic

restaurants require more W.C.

2) Purpose of inventory

The purpose of inventory it is done because to avoid lost sale, if we

purchase quantity in bulk to we get discounts, it also helps in

reducing the ordering cost and helps in maintaining efficient

production room in kitchen area, and it also help if any flucation

come in business, and it helps for keeping the things ready if it

occurs immediately in large number.

A) Avoiding lost sales

Without goods on hand which are ready to be sold, most firms would

lose business. Some customers are willing to wait, particularly when an

item must be made to order or is not widely available from

competitors. In most cases, a firm must be prepared to deliver goods

on demand. Shelf stock or goods refers to the goods which do not

require specification or modification for any item?

E.g. when we buy a Car then only we have to service of

machines only and the body of the car is same there is no need

do any modification in body but only in machinery.

B) Getting quantity Discounts (Bulk)

►It refers to that if we purchase the quantity in bulks and it will be

discounted and it will helpful in inventory control. So, this is purpose

of inventory.

For e.g. If we buy a 7 Kg. tomatoes at the rate of 5 Rs for Kg and if

we buy whole box of 10 Kg it will lost Rs. 40 and it is discounted to

us.

C) Reducing Ordering Cost

►It refers to that inventory helps in reducing ordering cost like we

have to transport the goods from one place to another and ------

what items should be ordered and not unnecessary items are not

ordered .

For e.g. If we ordered 10 tin in auto-rickshaw and our requirement is

of 20 tin then we have to do 2 auto-rickshaws but if we load all 20

tin in a truck then it will reduce our ordering cost.

D) Maintain efficient production run

► Inventories are required for a letters and efficient production run. If

the materials are not in hand in right proportion and right quantity,

then the producing& processing cost increased many fold. For e.g.

The cost associated would be starting of the machinery several

times, thereby consuming lot of electricity, the wastage of labour

hours and the hour maintenance of quality. This kind of set up

would be seen in a kitchen which operated on cooked chilled&

cooked freezed methods. Whereby finished products can be

retained up to a maximum of approximately 21 or 22 days

E.g. If a Paneer Masala is prepared and it is kept in cooked chilled &

cooked freezed methods. The Paneer Masala will be chilled 40-45

Sec to this method converts the temperature and it maintain its

nutrition value. When we serve after 21 or 22 days it will maintains

the quality, quantity and its nutritive value should be as it served as

a fresh items. This practice is mostly done in foreign but it is less

followed in India.

E) Buffer Stock

►Buffer stock is a maintained to avoid any unexpected market

fluctuation. This is to maintain to strike the hammer at the right

time for right commodity at right prier favorable to the

establishment.

E.g. the material should be purchased at a right time like if any good

is to be empty it should be ordered at right time and purchased the

commodity at a right price only to it said while purchased any

commodity it should be right time & right price.

♦ Contingency Demand

In this it refers to that we have to keep are stock ready for

immediate cause to as for the requirement to immediate cause the

contingency demand should be mode do it does not create any

problem if the immediately cause come.

For e.g. if a party is arranged for 200 portion then the m--- should

be ready for that but also you should be ready with more 400

portion. If it increase the portion to it does not create any problem

so, contingent demand if required the purpose of inventory.

Types of Inventory

► Function of inventory.

♦ Inventories serve as a cushion to absorve planning errors and

fluctuations in supply and demand.

♦ Another function of inventories is to facilitate smooth production

and marketing operations.

♦ Levels of Inventory Control.

A) Unit control.

B) Value Control.

♦ Objective of Inventory Control.

1) Effective use of Capital.

2) Service to customers.

3) Promotion of manufacturing efficiency.

4) Minimizing Risk of loss.

5) Avoidance of out of stock danger.

1. Raw Material

►Raw material inventory is the value of materials in the godown at

a particular time. Raw materials are tomatoes, oranges etc. and

daily requirement items. Inventory should be done of raw

material in proper way and in time.

2) Work-in-progress

Work-in-progress consists of materials, labour and factory

expenses spent on the production while the goods are in various

storages of being converted into finished products. The inventory

value of each unit of goods includes the materials, labour and

factory expenses applied to the unit through the cost operation

performed on it.

E.g. In a hotel, we prepare white sauce and different kinds of

gravy in advance so while the order comes too much then we

have that much stock, so work-in-progress.

3) Finished Goods

►Finished goods inventory comprise finished goods in the

warehouse at inventory data. For e.g. in a hotel, Paneer Masala is

prepared for 25 person.

E.g. Include work-in-progress, Raw material and finished Goods.

► In case there is present a costing system, the cost of materials

consumed can be calculated by means of an appropriate method

for pricing issues. Hence the value of closing inventory of raw

material is simply the balancing figures. In the second the cost of

goods completed can be calculated by means of cost account the

balancing figures. In the second the cost of goods completed can

be calculated by means of cost account the balancing figure is the

value of in complete items. In the third the method of pricing out

the completed goods from finished goods sold. Thus the values of

the closing inventory of the work in progress and finished goods

are simply banking figures.

The above analysis is based on the rule that the cost of inputs has

to be balanced by the cost of output.

4) Spares, Stores & tools

► Tools might comprise nuts, bolt, screws, electric wires, electric

coal, burners, knobel spares refer inventory associated with the

various type of apparatus, equipment various wares / cooking

ware, glass ware, steel ware used in the manufacturing, producing

or processing of finished product.

Stores: Inventory which might require various form and formats

and the like can be termed as inventory associated with stores.

5) Packaging Material.

It is one kind of inventory, in those we used different material for

packing the material like plastic tag and plates for dinner and

lunch and soup bowl all those comes under packaging material.

Cost Associated with Inventory

In these the cost associated with inventory in two different way

by direct then it will material cost, ordering cost indirect then it

will cost goodwill and opportunity cost. By doing inventory by

direct or indirect way we come to know that what is the actual

cost of the particular material and also we know the perfect

figure that hour much cost as associated with inventory.

♦ Direct Cost

In those there are three types of cost are there and which is

associated with inventory. For e.g. off we order 1000kg tomato

to supplies for party then this is counted as direct way and it is

accounted as a direct cost.

1) Ordering Cost

2) Carrying Cost.

3) Material Cost.

♦ Ordering Cost

► It refers to that the cost of ordering material. The material used

in kitchen or service that should be ordered properly do it will

not increase the ordering cost it include ordering of raw material,

and other items which is required for the operation. Inventory

manager must check that How much to order? When to order?

and What is the minimum safety level to avoid under stock out?

The quantity level is known as ‘ordering level’.

♦ Carrying Cost

► It is one kind of holding costs. It shows interests on investment in

inventory. It has taxes and insurances. It also induces

warehousing and storage exp. It helps in material handling and

clerical charges and deterioration and spoilage and it also

includes personal property taxes.

For e.g. If we order 10 tins of oil in Rishaw but we required 20

tins then we have to do two Rishaw. Instead of this we do one

tempo it will reduce over carrying cost. It includes the charge of

transporting from one place to another place.

♦ Material Cost

► This includes raw food and others ingredients that make up a

dish, meal or beverage and is commonly referred to as “Material

Cost” or “Food Cost”

E.g. If we prepare Paneeer Butter Masala for 25 person, then

what material is used and that material cost is counted and their

cost is associated with inventory.

2) Indirect Cost

► In this cost associated with inventory in indirect way that is known

as indirect cost. In this what is the outcome of the item. There

cost can be associated with inventory in two ways by goodwill

cost and opportunity cost.

1) Goodwill Cost

► These cost originated from the basic purpose of inventory

that is to avoid lost sales. As a seller it is very embraising of

not able to provide the goods on demand and there by loosing

the custom, reputation and associated brand image and

market.

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DERIVATION OF EOQ MODEL

EOQ refers to the quantity at which the total economic cost is

minimum where by we are able to purchase the desired quantity which

suits our operation.

When you speak of total economic cost, the economic cost in the

inventory comprises ordering cost and carrying cost.

Equation “A”:- Total Cost = Ordering Cost + Carrying Cost

Ordering cost is the cost which is incurred for the purchase of

commodities in the form of the bills of the stationary, transportation,

telecommunication, legal documents and demurrage.

Demurrage is the price that a restaurant has to pay for not lifting the

order or not excepting the delivers at a specific time and day through

the supplier.

Carrying cost is the cost incurred in holding the inventories

commodities over a certain period of time. This cost includes the

maintenance cost of the stores, salary of a store keeper, fixed

overheads of walk in coolers/ fridges and the depreciation cost which is

getting incurred in the day to day use of the stores in the form of

furniture and fixtures, plants and trollies.

Equation “B”:-

Ordering Cost = No. of Orders × Fixed cost per Order

i.e. Ordering Cost = U/Q × F

Where,

No. of Orders = U/Q

U = Annual or Monthly Consumption

Q = Quantity ordered at a given time

F = Fixed cost per order

From the physical observations it is generally seen that the graph of

ordering cost has a diminishing curve with a negative shop which is

shown as in the form of a following graph.

C

Q

Carrying cost is represented by the formulas

Cu C = Q/2 × P × C

Where,

P = Price of the commodity

C = A definite percentage

Again from the empherical studies it is observed that “C” lies in

between 15 & 35 ℅. In the previous formula “Q/2” has been adopted

on the bases of the following assumption that the previous stock gets

replineshed. This quantity is further divided by “2” because for a given

period of time from (say) “T0” to “T1” we find that half of the

commodity for a given time frame is carried over in the stores. This is

being explained with the help of a graph:-

Q

Q/2

T0 T1 T 2

From the empherical data it is seen that carrying cost is represented in

the form of a straight curve / line which is increasing in nature,

slopping upwards and has a positive slop. It is explained with the help

of a following graph:-

C

Q

From the equation “A” we find that

TC = OC + CC

It is also seen that the total cost first slops downwards and then

upwards which is explained with the help of following graph:-

C

Q

The total cost is minimum when the first derivative of total cost is

equal to zero. At this point, carrying cost is equal to the carrying cost.

Therefore,

U/Q × E = Q/2 × P × C

This relationship is shown with the help of another graph. The quantity

where Carrying Cost = Ordering Cost that quantity is known as

Economic Order Quantity.

TC

CCC

A

OC

Q*

With the help of the mathematical operations we have

2UF = Q2 PC

There fore,

Q 2 = 2UF/PC and

Q = √2 UF/PC

This “Q” is Economic Order Quantity.

INFLATION OF EOQ

Inflation affects the EOQ model in 2 major ways:

1. While the EOQ model can be modified to assume constant price

increases. Many times major price increases occur only once or

twice a year and are announced ahead of time. If this is the case,

the EOQ model may loose its applicability and may be replaced

with ‘anticipatory buying.

As with most decisions there are trade offs between liquidity and

profitability. The cost are the added carrying cost associated with

inventory that one would not normally be holding. The benefits

come from buying the inventory at the loer price.

2. Inflation affects the EOQ model is through increased carrying

cost. As inflation pushes interest rates up the cost of carrying

inventory increases. In the EOQ model this means that as “c’

increases the optimum Economic Order Quantity gets decreased.

EOQ Discount Policy

The optimum order quantity is based on EOQ model which assumes

that there is a constant price mechanism working in the required

formula. This constant price assumption is one of the weakness of the

EOQ model where it does not take in to consideration:

1. Seasonal variation in price.

2. Inflationary affect in price.

3. The discount policy operating in the price and supply finance

work..

In the discount policy we give the ones of providing the discount lies

with the supplier, who in his terms and conditions may state that.

a) To avail discount you/one must purchase the specified quantity

at one time.

b) To avail discount you must provide the payment in specified

number of days.

The first parameter concentrates on bulk discount where as the latter

part focuses on cash and trade discount policy. In the given framework

3 situations arise in our practical purchase mechanism.

I. The specified quantity is equal to the predetermined optimum

order quantity.

II. The specified quantity is less then the optimum order quantity.

III. The specified quantity is more than the optimum order quantity.

In the first and second case the pre-determined optimum order

quantity is final and re--- supreme in any decision making situation.

In case third when the quantity specified is more than the optimum

order quantity than the incremental cost benefit analysis has to be

done in deciding which decision should one take.

STEP 1

The first step is to determine the total benefit available from the

discount specified on the proposed quantity which is calculated as

DISCOUNT ALLOWED = U × D

Where,

U = Annual or Monthly consumption.

D = Discount amount available to the restaurant.

STEP 2

The next step is to determine the benefit available to the restaurant

due to the reduction of the number of orders. This is shown as a

difference of ordering cost which is represented by the equation as

(U/Q* - U/X) × F

Where,

Q* = Economic Order Quantity.

X = Specified quantity.

F = Fixed cost per order.

This step is also a cost saving function to the restaurant.

STEP 3

The third step is to identify the extra cost increased in carriage of the

specified quantity at a new discounted rate. This is represented by the

equation.

X (P-D) C/2 –Q*PC/2

Where,

X = Specified quantity

P = Existing Price

D = Discount amount

Q* = Economic Order Quantity

C = Carrying cost ℅

This equation is a cost incurring function on the part of the restaurant.

The first and second equation is positive in nature where as third

equation is negative in nature.

If the summation of all this 3 equation is negative or less than “0” then

go for the EOQ quantity. But if the summation is more than “0” or

positive in nature then go for the specified quantity on which the

discount is available.

In real life situations the chances of happening of above two cases is

very high but if the summation gives “0” as a figure then the way of

deciding which/ how much quantity to purchase is decided by the 3

different analysis that is done in both quantities.

They are:

a) Opportunity cost Analysis.

b) Cost Benefit Analysis

c) Liquidity- Profitability Analysis.

The above three analysis lies in the ambit of micro-economic analysis

which is not relevant in this topic.

RE-ORDER SUBSYSTEM

In the EOQ subsystem we had made an assumption that the lead time

is zero (lead refers to the time which is required by the supplier to

deliver the specific quantity to the purchaser or the establishment).

But in real life situations such things of having lead time means zero is

hardly possible. So we need to order the specified quantities of specific

commodities before they run out of stock. At what level the purchase

order should be made is decided upon 2 factors:-

1. Lead time taken

2. Average daily usage units

The reorder level determined by obtaining a value which is the

product of factor “1” and factor “2” stated above. In short

Re-order Level (ROL) = Lead Time × Average Daily Usage Units

This means that as soon as the quantity in the stores of the specific

commodity falls to this level a new order should be placed to the

supplier so that the operations do not run short of stock. The order

which is placed equals to the EOQ.

But the question arises that what would happen if during the lead

time there is sudden spirit (rise) in demand of a specific commodity

during a lead time. In such case the operation would run short of

stock even before a new order is being received. For such situations

there arises a necessicity of maintaining a stock of commodities in

specified quantities know as Safety Stock or Buffer Stock. How

much safety stock or buffer stock has to be maintained is decided

upon the chances of running out of stock in 100 incidents (It is the

profitability expressed in the ℅ form).The higher the stock out

factor the higher safety stock has to be maintained. There are 2

methods of determining the safety stock namely;

a) Probability method including mathematical calculation.

b) Statistical mathematics which involves the use of a ready

rackanur distribution curve.

The first method is tedious in nature and by the time we are able to

calculate the safety stock one or more than one factor in the external

environment might have changed. So this method is rarely used. We

focus on 2nd method which requires the use of ready rackanur

distribution curve which is also known as Poisson Distribution Method.

It also involves the use of probability but instead of mathematical

calculation we are able to know the safety stock by mean plotting on

the distribution graph. Method 2 requires the use re-order level.

ROL = A×B+C √A×B×Q*

Where,

A = Lead time

B = Average daily usage units

C =Stock out factor

Q* = Economic Order Quantity

In the above formula

C√A×B×Q*

represents safety stock component which is the minimum quantity

which should be in the stores 365days a year. In the above formula “C”

can be known from the following graph:-

3 -

C 2 -

1 -

| | | |5℅ 10℅ 15℅ 20℅

STOCK FACTOR

Which is known as Poisson Distribution Curve, On “Y “axis we get the

value of “C” and on “X” axis we have got the stock factor percentage

probability. So in the reorder subsystem the

Re-order level = Safety Stock + Lead Time Stock

ABC Analysis

Categorized

1. Amount of Investment

2. Movement

3. Percentage of item on total items

In the models of EOQ and re-order level we find that the investment

factor has been ruled –out but for continuing the operations we require

some amount of working capital and we know that the working capital

and we know that the working capital is the difference of current

assets over current liabilities. Current Assets also include inventories

as an integral part and then by affect the working capital and hereby

affecting the better management of financial resources.

For an affective management of financial resources, ABC analysis of

inventory management technique is applied.

The stocks of goods or inventory are categorized into different groups

for an affective control of funds. Normally, for categorizing the

commodities or groups of commodities into various groups, the 3

parameters are taken into consideration.

1. The percentage of the investment done.

2. The movement of goods from the stores ( Slow, fast and

average )

3. The percentage of the selective commodity in the stores.

On the above parameters the entire stock gets categorized in to 3

different groups namely A, B and C.

“A” group commands 70% of the investment; “B” commands 20% of

the investment and “C” the remaining 10%. From the empherical data

it is observed that “A” has 10% of weightage in stores, “B” has 20%

and “C” the remaining 70%. But it is not necessary that “A“cannot

have more then 10% weightage, “B” more or less than 20% and “C”

more or less than 70%.

Depending upon the investment and the movement of the goods, we,

restaurentiers and hoteliers also do 2 different activities:-

a) VED analysis which stands for Vital Essential and Desirable.

b) Menu Engineering is done in the selection and removal of

menu item from the existing menu.

DEMURAGE COST

Demurrage cost is a cost which is marked and taken from the buyer

when he fails to pickup the goods on purchase at a stipulated date and

such costs generally include the maintenance cost sustained by the

seller.