Inventory Management: Concept & Methods

Inventory is an important resource of every business to run its day-to-day operations uninterruptedly. It impacts various steps of the supply chain such as manufacturing,warehousing, sales etc. The amount of inventory available with a business should be sufficient enough so that various activities of the business are not adversely affected.

Likewise, there should not be excessive amount of investment in inventories. This is because over investment can lead to inventories remaining idle. Thus, it would result in blocking of working capital. Therefore, inventory plays a very important role in managing the various operations of the business. So, let’s understand what is inventory and various types of inventory before understanding the concept of inventory management.

Meaning and Types Of Inventory

Inventory forms the most important current assets of the business. According the Indian Accounting Standard 2, inventories are the assets that are:

• Held for sale in the ordinary course of the business
• Still in the process of production for sale of such inventory
• To be used currently in the production of goods or services that are eventually sold

Thus, inventory is classified into the following three categories:

1. Raw Material

These are the inputs used by the business to manufacture goods smoothly. The quantity of raw materials to be held by a business depends on:

• The rate at which raw materials are utilized,
• Time it takes to restock raw materials and
• Other factors like government policies, availability of raw materials etc

2. Work-In-Progress

Work-in-progress refers to the semi-finished goods that are still under production and have not reached the final stage of the finished product. The quantity of work-in-progress of a business depends on the length of its manufacturing process. Here, length of production process means the time it takes to convert the raw materials into finished goods. Greater the time gap, more is the quantity of work-in-progress of the business.

3. Finished Goods

Finished goods refer to the final goods sold to the customers. Businesses keep stock of finished goods to avoid supply shortages. The amount of finished goods in inventory depends on the nature of business, demand for the goods etc.

Purpose of Holding Inventory

As mentioned above, an adequate quantity of inventory needs to be maintained by a business to avoid stock runouts in times of peak demand. Similarly, too much inventory can lead to locking of the working capital funds thereby impacting the profitability of the business.

Thus, every business aims at maintaining optimum level of inventory to avoid such situations. So, there are three important motives for holding inventory. These include:

Transaction Motive

As per this motive, businesses hold adequate amount of inventory for uninterrupted production and timely fulfillment of the same order.

Precautionary Motive

This motive makes it necessary for the businesses to hold inventory for unforeseen changes in demand and supply of materials.

Speculatory Motive

As per this motive, businesses maintain inventories to take benefit of price changes. This results in savings in the reordering cost and quantity discount.

What is Inventory Management?

It is important to manage inventory efficiently as it plays an important role in various aspects of business. Thus inventory management includes proper planning of buying, managing, warehousing and accounting of inventory. Businesses having proper inventory management systems are able to know:

• what to buy,
• how much to buy,
• where to buy,
• at what time to buy
• Where to store etc.

Now, various departmental heads of business would always disagree with the issue of inventory. For instance, the finance head would want to invest lesser amount in inventory given the cost involved and idle inventory impacting the profitability.

Likewise, the production manager would want to invest more in inventory to avoid running out of stock and to produce goods uninterruptedly. The ultimate aim of inventory management is to maintain adequate stock levels. This is because excessive inventory leads to blocking of working capital. And inadequate inventory results in shortage of raw material leading to stalled production process.

So, let’s understand what are the objectives of inventory management in order to have adequate inventory levels at place.

Objectives of Inventory Management

The objectives of inventory management are as follows:

• Maintaining uninterrupted flow of raw materials and finished goods. This is to ensure continuous production process and timely fulfillment of demand for goods by customers.
• Getting rid of excessive or inadequate inventory.
• Keeping a check on raw material cost thereby reducing the cost of production and the overall cost of running the business.
• Reducing losses on account of wastage, damage or spoilage of raw material inventory.
• Ensuring continuous inventory control. This is done so that inventory reflecting in the financial statements should always match with the physical inventory in warehouses.
• Holding optimum inventory as needed by production and sales process.
• Ensuring that goods are of high quality and are offered at favorable prices.
• Maintaining optimum level of inventory. This is to ensure that all the activities including production and operations are carried out seamlessly.
• Avoiding double ordering of the same raw material stock.
• Providing necessary statistics for future inventory control and planning.
• Holding various management levels accountable by laying out clear cut inventory management policy.

Inventory Management Techniques

There are several inventory management techniques that are in practice. A business entity needs to implement an inventory control system based on its convenience. Further, this inventory control system needs to be such that it covers each type of inventory item required at every stage of production cycle.

Following are a few of the important inventory control techniques that a business can implement:

1. ABC Analysis
2. Economic Order Quantity
3. Just-in-Time
4. Material Requirement Planning (MRP)
5. Safety Stock
6. VED Analysis