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Inventory (Stock)
Inventory Valuation
One of the primary functions of the cost management system is inventory valuation
and profit measurement.
It is important to allocate costs between products sold and products partly completed
which are unsold.
What’s the intention to hold Inventory?
The cost of purchasing inventory is usually one of the largest costs faced by a
company, once obtained, inventory has to be carefully controlled and monitored.
The main reasons for holding Inventories can be summarised as follows:
- To ensure sufficient goods are available to meet expected demand.
- To provide a buffer between processes.
- To meet any future shortages
- To take advantage of bulk purchasing discounts.
- To absorb seasonal fluctuations and any variation in usage and demand.
- To allow production processes to flow smoothly and efficiently without stockouts.
- As a necessary part of the production process for example cheese and alcohol need
time to mature when manufactured.
- As a deliberate inflation policy, especially in times of inflation or possible shortages.
Inventory Control or Inventory Management
There are three types of inventories:
- Raw material inventory
- Work-in-progress
- Finished goods.
Inventory Control
Costs involved in maintaining an inventory i.e. storing inventory:
- Rent
- Security (alarm, security guard)
- Insurance
- Electricity (Light)
- Labour/Staff
- Shelving (bespoke), bins & palates
- Transports
- Health & Safety requirements
- Refrigeration (frozen /perishable goods)
- Temperature control / appropriate ventilation
- Computerised Inventory control systems called MRP1 and MRPII (Material
requirements planning)
Inventory (Stock)
MRP
CIMA Official Terminology defines materials requirement planning (MRP) as ‘a
system that converts a production schedule into a listing of the materials and
components required to meet the schedule, so that adequate inventory levels are
maintained and items are available when needed’.
MRP context described
Materials Requirement Planning, now known as MRP1, originated in the 1960s.
It is a computerised system which co-ordinates the planning of inventory used in
production and the timing of inventory purchases.
The components and sub-components of the finished product may take different
lengths of time to produce and MRP takes account of this.
MRPII is an extension of MRP1. CIMA Official Terminology defines MRPII as ‘an
expansion of materials requirement planning (MRP) to give a broader approach than
MRP to the planning and scheduling of resources, embracing areas such as finance,
logistics, engineering and marketing.’
The objectives of storekeeping are as follows:
- Fast issue and receipt of materials.
- Fully Identification of all materials at all times.
- Correct location of all materials at all times.
- Protection of materials from damage and deterioration.
- Provision of secure store to avoid pilferage, theft and fire.
- Efficient use of storage space.
- Maintenance of correct inventory levels.
- Keeping correct and up-to-date records of receipts, issues and inventory levels.
Inventory Control
Most large companies opt for one centralised storage facility because:
- It reduces the costs
- Avoids duplication
- Optimise economies of scale
Inventory Valuation
There are various methods of valuing inventory, and these include:
- FIFO (First in first out)
The calculation of this level should allow for forecast material usage and delivery lead times
(The window of opportunity between the time deliveries come and go).
Inventory (Stock)
The Maximum inventory level can be calculated as follows:
Re-Order Level – (Minimum Consumption × Minimum Re-Order Point/Period)
Example 1
The following information relates to product X:
Re-Order Quantity = 900 units
Re-Order Period = 1 1 / 2
weeks
Maximum Consumption = 225 units per week
Normal Consumption = 150 units per week
Minimum Consumption = 75 units per week
Re-Order level = Maximum Re-Order Period i.e.
Maximum Consumption × Maximum Re-Order Period
225 × 2.5 = 562.5 units re-order (563 units)
Minimum Inventory / Margin of Safety =
Re-Order Level – (Normal Consumption × The Normal Re-Order Period)
Note: Normal Re-Order Period is the average of the minimum and maximum re-order
periods
Average =
Minimum ℜ− Order Period + Maximum ℜ− Order Period
= 2 = Normal Re-Order Period
ROL – (NC × NRP)
563 – (150 × 2 )
263 units
Maximum Inventory Level
Re-Order Level – (Minimum Consumption × Minimum Re-Order Period)
563 – (75 × 1.5) +
563 – (113) + 900 = 1,350 units
Question 1
A large retailer with multiple outlets maintains a central warehouse from which the outlets are
supplied. The following information is available for Part No. SF525.
Normal Consumption = 350 units per day.
Minimum usage = 180 units per day.
Maximum usage = 420 units per day.
The lead time for replenishment = 11-15 days.
Re-Order Quantity = 6,500 units.
Re-Order Level = 6,300 units.
Calculate: (1) Minimum Inventory and (2) Maximum Inventory
- Minimum Inventory
Re-Order Level – (Normal Consumption × The Normal Re-Order Period)
6,300 – (350 × 13)
6,300 – 4,550 = 1,750 units
- Maximum Inventory
Re-Order Level – (Minimum Consumption × Minimum Re-Order Period)
6,300 – (180 × 11 ) + 6,
6,300 – 1980 + 6500 = 10,820 units
Average Inventory
The formula for the average inventory levels assumes that inventory levels fluctuate between
the minimum (or safety) inventory level and the highest possible inventory level (which is the
amount of inventory immediately after an order is received, i.e. safety inventory plus re-order
quantity).
Average Inventory Level = Minimum/Safety inventory +
Re-Order Quantity
Continuous inventory taking overcomes the disadvantage of a periodic inventory
taking routine. Inventory items are checked on a random or selective basis whenever it
is felt appropriate. This approach enables discrepancies to be discovered more quickly
and should cut costs by:
- Reducing losses by deterioration and obsolescence.
- Reducing losses due to disruption of production.
- Deterring theft of high value items which are readily resold.
- Improving management decision making through better information flow.
- Encouraging higher quality control by stores personnel.
Economic Order Quantity (EOQ)
Formula:
2 CoD
Ch
Where: Ch = Cost of holding one unit of Inventory.
Co = Cost of ordering consignment from the supplier.
D = Demand for the year.
Example 1:
The cost of ordering inventory = € 32
Demand during the period = 25,000 units
Cost of holding one unit of inventory = €6.
EOQ =
2 CoD
Ch
64 × 25,
√
Example 2:
The cost of holding ordering inventory = € 32
Demand during the period = 25,000 units
Cost of ordering = € 64
EOQ =
2 CoD
Ch
128 × 25,
√ 10 0,
=316 (as can’t order a fraction of a unit)
Question 2
A retailer with multiple outlets stocks a popular kettle, for which the following information is
available:
Normal Consumption = 75 units per day.
Minimum usage = 50 units per day.
Maximum usage = 95 units per day.
The lead time for replenishment = 12-18 days.
Re-Order Quantity = 1,750 units.
Calculate: (1) The Re-Order Level and (2) Maximum Inventory.
- The Re-Order Level
Re-Order level = Maximum Re-Order Period i.e.
Maximum Consumption × Maximum Re-Order Period
95 × 18 = 1,710 units
- Maximum Inventory
Re-Order Level – (Minimum Consumption × Minimum Re-Order Period)
1,710 – (50 × 12) + 1,
1,710 – 600 + 1,750 = 2,860 units
Average Inventory
A component has a safety inventory of 1,100 units, a re-order quantity of 5,
Calculate the Average Inventory.
