Inventory controls Fundamentals

Vilnius Gediminas Technical UniversityThe Department of Business Management

Inventory ControlFundamentals

Student: D. Fiodorovaitė Professor: J. Merkevičius

2002, VilniusContents:

Inventory as a current assets……………………………………………………………………3Types of inventory………………………………….…………………………………………..3“Why inventories exist?”……………………………………………………………………….4Functions provided by inventories………………….…………………………………………..4Control of inventories…………………………………………………………………………..5Corporate level control…………………………………………………………………………5Detailed control…………………………………….…………………………………………..6Conclusions…………………………………………………………………………………….7


Inventory as a current assets

The way that an organization uses its funds and then controls and monitors these investments is a critical management function. However, inventory management, although important, is not usually allocated sufficient resources or given adequate attention. While the decisions to use funds for plant and equipment purchases are usually carefully judged and monitored, the effort normally put into controlling inventory is relatively low and usually comes too late. Increases in inventory invariably happen first and a company becomes concerned about controlling them later. There are several reasons for this control:1. Inventory is an inherent part of a company’s operations. Inventory increases when production exceeds sales, or purchases exceed production. Thus it is a consequence of a company’s day-to-day activities.2. Inventory all looks the same and there are normally large but acceptable quantities of it; more of the same is not easy to detect. However, new equipment, no matter how small, draws attention, questions and control.3. The control of inventory investments needs to be going-on. Plant investment on the other hand is a one-off decision and often, therefore, is not so demanding over period of time.4. Inventory control is often not seen as a part of the task of senior executives. It contains no qualities that make it attractive it brings it to attention of top management. It is a task of day-to-day detail seen by most as mundane. As a consequence it is not normally an agenda item for a management meeting. However, the result of companies allocating resources and sufficient effort to the control of inventory has been to achieve low levels of inventory with little adverse effect on the manufacturing efficiency.

5. Companies fail to distinguish between records and controls. Consequently information provided is usually in a form of a record – a statement of the past often for historical, financial purposes. However, companies mistakenly interpret this as control data, while the information obtained expresses the value of inventory in a format required for financial statements.

Types of inventory

The types of inventory and amount of inventory that an organization should hold would depend upon several aspects including the products manufactured or services provided, product/service range, type of process and span of process. The principal types are:1. Raw materials, bough-out parts and components to be used in making the products.2. Partly finished WIP items awaiting the next stage in the process.3. Finished goods consisting of products ready for sale.In addition to these, others are used in the process itself or to keep the plant and equipment going. These include supplies, consumables, spare parts, tools, jigs and fixtures. Generally, organizations whose activities are centered around products or manufacturing processes have more tangible inventory systems than do service organizations. However, in those service organizations that are less labor-intensive, inventories may be much more significant. Retail shops, for instance, have substantial inventories essential for their business.


Why inventories exist?

Why does the organization invest so heavily in inventory? What is the return? Although there are common reasons for holding inventories, there are also advantages that are particularly important and which relate to one type of inventory that another:• Raw materials and bought-out parts inventory will allow the organization to:1. Cater for the variability of supply;2. Take advantage of quantity discounts or market prices;3. Provide strategic stocks of items which could be in short supply due, for instance, to strikes or other supply problems;4. To guard against inflation;5. As a form of investment when price increases are anticipated.

• WIP inventory helps maintain the independence of stages in the process by decoupling the production steps involved. This leads to:1. Greater flexibility in production scheduling especially at times machine breakdown;2. Stabilizing the different outputs rates at each part of process;3. Improving the utilization of plant, processes and labor.• Finished goods inventory with which the organization can:1. Provide off-the-shelf customer service;2. Achieve a steady supply of goods in the face of intermittent production or supply;3. Cope with fluctuations in demand, particularly in the case of seasonal products;4. Provide an insurance against plant or equipment breakdowns and, in some cases, against internal or supplier’s strikes.

Thus “Why to hold inventory?” is easily answered. It is more difficult or even impossible to measure return. Some hold the view that the costs of not holding inventories are usually greater than the costs of holding them. Recognizing that an organization needs inventory and that this investment is costly, the more pertinent question is, therefore “Is the amount of inventory necessary?” Some inventory may be unnecessary and will have no return. For example:1. The inventory holding of an item may be in excess what provides us no return;2. An item may be readily available from a reliable supplier who holds stock;3. One standardized item could replace the inventory holdings of a number of other items.How an organization balances the investment/return relationship thus becomes an important feature in the control of inventory.

The functions provided by inventories

Regardless to their form, inventories may be further described as one or more of decoupling, cycle, pipeline, capacity-related and buffer inventories. Each of these fulfils a specific function:1. Decoupling inventory separates one process from another. Decoupling inventory is predominantly found in batch. Inventory in this category decouples one process from the next, allowing them to work independently and separating otherwise dependent parts of the total operation.

2. Cycle inventory is a function which line does not require as it is continually set up to manufacture an agreed range of products.-5-

3. Capacity-related inventory concerns transferring work from one time period to the next in the form of inventory, and provides one way of stabilizing production capacity in an environment of fluctuating sales levels.4. Buffer inventory helps to protect the process core against the unpredictable variations in demand levels or supply availability. Also it provides the function of supporting process flexibility investments concerned with the ability of the process to respond the demands of a wide range of products.

Control of inventories

Two approaches are used to help determine the types of control and their level of application. The first deals with corporate perspective of control and the second consider control at the detailed level.

Corporate level control

1. The initial step in corporate-level control is to recognize that inventory is held for many reasons. In manufacturing and the less labor-intensive service companies, the main categories involve raw material and components, WIP and finished goods. In the labor-intensive organizations, the main type of inventory is supplies. However, only inventory which genuinely fulfils the production/operation, sales or processes needs should be included in the inventory category that provides the production/operation-related functions. Thus, this inventory is known as corporate inventory. Having recognized that this inventory exists, the next step is to decide what types of corporate inventory are involved. There are some of them: a) Service level – customer service parts or repaired items being held until requested by the customer;b) Customer banks – inventory held at a customer’s request;c) Design and development labor – labor that is charged to inventory for a part-completed item;d) Safety supplies – resulting from a corporate decision to hold raw material and component inventory as a safeguard against future supplies;

e) Foreign supplies – the amounts of above-normal inventory purchased in large quantities because of changing lead times and transportation costs associated with imports;f) Discount stock – inventory held at above-normal levels which has been acquired to gain the purchasing discounts involved;g) Export holding – inventory packed and awaiting export;h) Customer delay – inventory held due to the customer delaying the delivery date;i) Credit holds – inventory ready for delivery but held for reasons of customer credit;j) Marketing – inventory holdings above the normal level as a part of marketing strategy;k) Sales – inventory, that did cot correspond the actual sales and is below forecast;l) Phased-out parts – inventory holding of a phased-out part, including spare parts to service previous sales;m) Prototype inventory – inventory supporting the R&D function of the business;n) Slow-moving – that inventory which falls within an organization’s definition of this category;o) Policy inventory – inventory over and above normal levels which has been caused as a direct consequence of a policy decision: for example, to make certain items due to low sales or material unavailability. -6-

2. The next step is to develop a master plan needed to achieve the required production level. Inventory here relates only to the three main categories given earlier of raw materials, WIP and finished goods.3. The organization then needs to establish an inventory standard. It has to be completed for the large inventory categories of raw materials, WIP and finished goods and also for the corporate categories of inventory.4. The final stage is to compare actuals to forecast and to analyze discrepancies. These can be attributed to sales or production volume, price or purchasing discrepancies.

Detailed control

Corporate inventoriesInventories in this category may arise for many reasons. The recognition, categorization and separation of these are the first step in their control.

Mainstream inventoriesFor the mainstream or principal forms of inventory (raw materials and components, WIP, finished goods) it is necessary to review these using the dependent/independent demand principle. There are two basic methods for determining when to issue this replenishment order, and they relate to the assumptions underlying the demand pattern of each particular item.The dependent/independent demand principleWhere the rate of use for an item does not relate directly to the use of any other item then it should be treated as an item with an independent pattern of demand. Conversely, items for which demand is linked the use of other items are said to have a dependent pattern of demand. The choice of inventory system depends upon whether the items have a dependent or independent pattern of demand. As an organization will tend to have items, which fall into each category, then it will need to employ both systems. The systems should be used side by side, complementing each other. Inventory control for independent itemsThe basis for inventory control of independent items is that of past demand as a guide to future requirements. The control is concerned with establishing a mechanism for initiating the order to replenish inventory. To determine the nature of the controls to use, it is important to understand the relative values of inventory. When this is known it is the possible to decide the type of control to apply to each item of inventory in order to maximize the return. Organizations have to keep track of a large number of items, all of which vary in terms of their annual usage and unit cost. Using the Pareto curve of annual requirement value easily solves the problem. For each item two facts are needed: unit value and annual usage. The product of these two figures is known as the annual requirement value – ARV.
The inventory items are then placed in the order, largest ARV first, then the next and so on. Pareto spreads the idea of the “80/20” rule. In general it can be said that about 20 per cent of the items in inventory will account for 80 per cent of the total ARV. This approach to inventory control is further extended into the ABC analysis. Here the high ARV items are classified as A items, the middle range as B items and the low ARV as C items. Once this has been accomplished there is the approach table to control items in each of these categories:

Aspect A B C

Degree of control High Moderate LowBasis of control Calculated Past records When needed -7-

Records required Exact Global NoneChecks necessary torevise the schedule Close Some NoneExpediting Continual Only regarding None shortages

Reorder levels and buffer inventoryThe first question to deal with is “When should an order be placed to replenish inventory?” Assuming that the company does not want to run out of the inventory then the level at which it must reorder is calculated by multiplying the time it takes to get an order into the company from an outside supplier by the number of units used of this particular item during the same period. Ideally, the time to place the order is such that the last item of inventory is used as delivery of the next order is made. Variable demandUsage of a particular item will tend to vary considerably. While it is not possible to forecast exact usage it is possible to relate usage to forecast sales where a production plan is made and to determine the average usage expected from the past figures. To avoid the stockout it will be necessary to carry extra inventory to cater for the higher-than-average demand during a lead-time. This extra quantity is called buffer inventory. When there is sufficient information buffer inventory can be calculated using basic statistics. This should normally apply only to A items and possibly some of the B items.


Inventory control involves a complex set of decisions because of the many forms and functions of inventories. In addition, inventories are the result of functional policies within the organization as well as short- and longer-term decisions in the buying, making and selling functions of the business. Therefore the inventory investment has to be taken at the highest level as well as the detailed control. Furthermore the nature of the investment requires that the responsibility has to be understood and resolved not only vertically but between departments at the same level in the organization.