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Chapter: Business Science : Financial Management : Working Capital Management

Inventory Management

INVENTORY M ANAGEMENT 1 Kinds of Inventories 2 Objectives of Inventory Management 3 Techniques of Inventory Management 4 Techniques Based On The Classification Of Inventories

Inventory Management


Inventories constitute the most significant part of current assets of the business concern. It is also essential for smooth running of the business activities.

A proper planning of purchasing of raw material, handling, storing and recording is to be considered as a part of inventory management. Inventory management means, management of raw materials and related items. Inventory management considers what to purchase, how to purchase,  how much to  purchase, from where to purchase, where to store and when  to use for production etc.     


The  dictionary meaning of the inventory  is stock  of  goods  or  a  list  of  goods.  In accounting language, inventor y  means stock  of finished goods. In a manufacturing point  of view, inventory includes, raw material, work in process,  stores, etc.

1 Kinds of Inventories            

Inventories can be classified  into five major categories.      

Raw Material                

 It is basic and important part  of inventories. These are goods which have not yet been committed to production in  a manufacturing business concern.

Work in Progress               

 These include   those   materials   which have  been committed to  production  process but have not  yet been  completed.      


 These are the materials which are needed to smooth running  of the manufacturing process.           

Finished Goods                

 These are the final output of the production process of the business concern. It is ready for consumers.        


 It  is also  a part  of inventories,  which  includes  small  spares  and  parts.


2 Objectives of Inventory Management


The  major objectives  of the inventory manage me nt are as follows:

 To efficient and  smooth  production process.

 To maintain optimum inventory to maximize  the profitability.

 To meet the seasonal demand  of the products.

 To avoid price increase in future.    

 To ensure  the level and site of inventories required.  

 To plan  when  to purchase and  where  to purchase  

 To avoid  both  over stock  and  under stock  of inventory. 


3 Techniques of Inventory Management   

Inventory   management  consists of effective control and ad ministration  of inventories.  Inventory control refers to  a system which  ensures supply of required quantity and  quality of inventories at the required time  and at the  same time prevent unnecessary investment in  inventories. It needs  the following  important techniques.

Inventory management techniques may be classified  into  various types:


A. Techniques based on the order quantity of Inventories


Order quantity of inventories can be deter mined with the help of the following techniques :


Stock Level

Stock level is the level of stock which is maintained by the business concern at all times. Therefore, the business concern must maintain optimum level of stock to smooth running of the business process. Different level of stock can be determined based on the volume of the stock.


Minimum Level

The business concern must maintain minimum level of stock at all times. If the stocks are less than the minimum level, then the work will stop due to shortage of material.


Re-order Level

Re-ordering level is fixed between minimum level and maximum level. Re-order level is the level when the business concern makes fresh order at this level.

Re-order level= maximum consumption × maximum Re-order period.


Maximum Level

It is the maximum limit of the quantity of inventories, the business concern must maintain. If the quantity exceeds maximum level limit then it will be overstocking. Maximum level = Re-order level + Re-order quantity – (Minimum consumption × Minimum delivery period)


Danger Level

It is the level below the minimum level. It leads to stoppage of the production process.


Lead Time

Lead time is the time normally taken in receiving delivery after placing orders with suppliers. The time taken in processing the order and then executing it is kno wn as lead time.


Safety Stock

Safety stock implies extra inventories that can be drawn down when actual lead time and/ or usage rates are greater than expected. Safety stocks are deter mined by opportunity cost and carrying cost of inventories. If the business concerns maintain low level of safety stock, it will lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying costs.


Economic Order Quantity (EOQ)

EOQ refers to the level of inventory at which the total cost of inventory comprising ordering cost and carrying cost. Determining an optimum level involves two types of cost such as ordering cost and carrying cost. The EOQ is that inventor y level that minimizes the total of ordering of carrying cost.


EOQ can be calculated with the help of the mathematical formula:


a = Annual usage of inventories (units)

b = Buying cost per order

c = Carrying cost per unit


4 Techniques Based On The Classification Of Inventories

A-B-C analysis

It is the inventory management techniques that divide inventory into three categories based on the value and volume of the inventories; 10% of the inventory‘s item contributs to 70% of value of consumption and this category is known as A category. About 20% of the inventor y item contributes about 20% of value of consumption and this category is called category B and 70% of inventor y item contributes only 10% of value of consumption and this category is called C category.

Inventory Breakdown Between Value and Volume

ABC analysis  can be explained with  the help of the  following  Graphical presentation.



Inventor ies are classified according to the period of their holding and also this method helps to identify the movement of the inventories. Hence, it is also called as, FNSD analys is—


F = Fast moving inventories

N = Normal moving inventories

S = Slow moving inventories

D = Dead moving inventories

VED Analysis

This technique is ideally suited for spare parts in the inventory management like ABC analysis. Inventories are classified into three categories on the basis of

usage of the inventories.


V = Vital item of inventories


E = Essential item of inventories

D = Desirable item of inventories


HML Analysis


Under this analysis, inventories are classified into three categories on the basis of the value of the inventories.


H = High  value of inventories


M = Medium value of inventories

L = Low value of inventories

Techniques On The Basis Of Records

A. Inventory budget

It is a kind of functional budget which facilitates the estimated inventory required

for the business concern during a particular period. This budget is prepared based

on the past experience.

B. Inventory reports

Preparation of periodical inventory reports provides information regarding the order level, quantity to be procured and all other information related to inventories. On the basis of these reports, Management takes necessary decision regarding

inventory control and Management in the business concern.

Valuation of Inventories

Inventories are valued at different methods depending upon the situation and

nature of manufacturing process. Some of the major methods of inventory

valuation are mentioned as follows:

  First in First Out Method (FIFO)


v   Last  in  First Out Method (LIFO)

v Highest  in  First       Out      Method  (HIFO

v   Nearest            in  First       Out         Method       (NIFO)

v   Average  Price  Method

v   Base  Stock  Method

v   Standard  Price  Method

v   Market  Price  Method

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