Inventory Basics

Inventory is referred to as the stock of any item or resource used in an organization. The system is the set of policies and controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be. By convention, manufacturing inventory generally refers to items that contribute to or become part of an organization’s product output. Manufacturing inventory is typically classified into raw materials, finished products, component parts, supplies and work-in-progress. In services, inventory generally refers to the tangible goods to be sold and the supplies necessary to administer the service.

The basic purpose of inventory analysis in manufacturing and stock keeping services is to specify (1) when items should be ordered and (2) how large the order should be. Many organizations are tending enter into long-term relationships with vendors to supply their requirements for probably the entire year. This changes the “when” and “how many to order” to “when” and “how many to deliver”.

Inventory is the collection of unsold products waiting to be sold. Inventory is listed as a current asset on a company’s balance sheet.

Concept of Inventory

Inventory’ may be defined as usable but idle resource’. If resource is some physical and tangible object such as materials, then it is generally termed as stock. Thus stock or inventory is synonymous terms though inventory has wider implications.

Broadly speaking, the problem of inventory management is one of maintaining, for a given financial investment, an adequate supply of something to meet an expected demand pattern. This could be raw materials work in progress finished products or the spares and other indirect materials.

Inventory can be one of the indicators of the management effectiveness on the materials management front. Inventory turnover ratio (annual demand/average inventory) is an index of business performance. A soundly managed organization will have higher inventory turnover ratio and vice-versa.

Inventory management deals with the determination of optimal policies and procedures for procurement of commodities. Since it is quite difficult to imagine a real work situation in which the required material will be made available at the point of use instantaneously, hence maintaining, inventories becomes almost necessary. Thus inventories could be visualized as `necessary evil’.

Inventory Definition

Inventory is the raw materials, work-in-process products and finished goods that are considered to be the portion of a business’s assets that are ready or will be ready for sale.

It is also defined as

• An itemized catalog or list of tangible goods or property, or the intangible attributes or qualities.
• The value of materials and goods held by an organization (1) to support production (raw materials, subassemblies, work in process), (2) for support activities (repair, maintenance, consumables), or (3) for sale or customer service (merchandise, finished goods, spare parts).
• Inventory is often the largest item in the current assets category, and must be accurately counted and valued at the end of each accounting period to determine a company’s profit or loss. Organizations whose inventory items have a large unit cost generally keep a day to day record of changes in inventory (called perpetual inventory method) to ensure accurate and on-going control.

Inventory is commonly thought of as the finished goods a company accumulates before selling them to end users. But inventory can also describe the raw materials used to produce the finished goods, goods as they go through the production process (referred to as “work-in-progress” or WIP), or goods that are “in transit.”

Why to have inventory

There are generally five reasons companies maintain inventories:

• To meet an anticipated increase in demand;
• To protect against unanticipated increases in demand;
• To take advantage of price breaks for ordering raw materials in bulk;
• To prevent the idling of a whole factory if one part of the process breaks down; and,
• To keep a steady stream of material flowing to retailers rather than making a single shipment of goods to retailers.
• Inventory can also be used as collateral to obtain financing in some cases.

The basic requirement for counting an item in inventory is economic control rather than physical possession. Therefore, when a company purchases inventory, the item is included in the purchaser’s inventory even if the purchaser does not have physical possession of those items.

Inventory is usually classified in its own category as an asset on the balance sheet, following receivables. It is important to note that the balance sheet’s inventory account should also reflect costs directly or indirectly incurred in making an item ready for sale, including the purchase price of the item as well as the freight, receiving, unpacking, inspecting, storage, maintenance, insurance, taxes, and other costs associated with it.

Relevance of Inventory

Inventory is a key component of calculating cost of goods sold (COGS) and is a key driver of profit, total assets, and tax liability. Many financial ratios, such as inventory turnover, incorporate inventory values to measure certain aspects of the health of a business.

For these reasons, and because changes in commodity and other materials prices affect the value of a company’s inventory, it is important to understand how a company accounts for its inventory. Common inventory accounting methods include first in, first out (FIFO), last in, first out (LIFO), and lower of cost or market (LCM). Some industries, such as the retail industry, tailor these methods to fit their specific circumstances. Public companies must disclose their inventory accounting methods in the notes accompanying their financial statements.

Given the significant costs and benefits associated with inventory, companies spend considerable amounts of time calculating what the optimal level of inventory should be at any given time, and changes in inventory levels can send mixed messages to investors. Increases in inventory may signal that a company is not selling effectively, is anticipating increased sales in the near future (such as during the holidays), or has an inefficient purchasing department.

Declining inventories may signal that the company is selling more than it expected, has a backlog, is experiencing a blockage in its supply chain, is expecting lower sales, or is becoming more efficient in its purchasing activity.

Because there are several ways to account for inventory and because some industries require more inventory than others, comparison of inventories is generally most meaningful among companies within the same industry using the same inventory accounting methods, and the definition of a “high” or “low” inventory level should be made within this context.

Functions of Inventory

As mentioned earlier, inventory is a necessary evil. Necessary, because it aims at absorbing the uncertainties of demand and supply by `decoupling’ the demand and supply sub-systems Thus an organization maybe carrying inventory for the following reasons:

• Demand and lead time uncertainties necessitate building of safety stock (buffer stocks) so as to enable various sub-systems to operate somewhat in a decoupled manner. It is obvious that the larger the uncertainty of demand and supply; the larger will have to be the amount of buffer stock to be carried for a prescribed service level.
• Time lag in deliveries also necessitates building of inventories. If the replenishment lead times are positive then stocks are needed for system operation.
• Cycle stocks may be maintained to get the economics of scale so that total system cost due to ordering, carrying inventory and backlogging are minimized. Technological requirements of batch processing also build up cycle stocks.
• Stocks may build up as pipeline inventory or work-in-process inventory due to 28finiteness of production and transportation rates. This includes materials actually being worked on or moving between work centers or being in transit to distribution Inventory Management centers and customers.
• When the demand is seasonal, it may become economical to build inventory during periods of low demand to ease the strain of peak period demand.
• Inventory may also be built up for other reasons such as: quantity discounts being offered by suppliers, discount sales, anticipated increase in material price, possibility of future non-availability etc.

Different functional managers of an organization may view the inventory from different viewpoints leading to conflicting objectives. This calls for an integrated systems approach to planning of inventories so that these conflicting objectives can be scrutinized to enable the system to operate at minimum total inventory related costs-both explicit such as purchase price, as well as implicit such as carrying, shortage, and transportation and inspection costs.