Chapter 08

financial
Management
- Part One
“Management of Inventory”
– Chapter Eight
1
Chapter Eight “Management of Inventory”
“Managing inventory is like tight rope walking.
To satisfy customers you must maintain a

continuous record of on time (on demand?)
deliveries; at the same time to protect margins,
you need to minimize costs involved in holding
inventory.”
Financial Management Part One

2
Learning Objectives
1. Categories of inventory
2. Inventory management is a multi-function task.
3. When do business entities hold large inventory?
4. Inventory carrying costs and inventory ordering costs.
5. Decisions on economic order quantities.
6. Ways of classifying inventory for greater control.
7. Alternative methods to value inventory,
8. Benefits from Just in Time inventory

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8.01 Introduction
8.01.01 Nature of Inventory
Inventory is the next major component of working capital.

In a manufacturing company inventory is classified into
three basic categories.
a) Raw materials – used for processing into final product.
b) Work in process – represents inventory removed from
stocks for conversion into final product.
c) Finished products – stored in the factory or
warehouse/s ready for sale awaiting delivery to
customers.
4
Business entity does not have full control over its volume
as quantity of materials required is determined by supply
chain, market conditions, production cycles, distribution
channels and customer demand.
For many items like, say, automobiles, the demand is
seasonal. So stocks have to be built up prior to festive
seasons. If the festive demand is under estimated, the
automaker can lose market share for want of ready stocks
for delivery. On the other hand if it is overestimated,
there would be a huge pile up of idle stocks at the end of
the season.
5
You must bear in mind

that inventory is the least
liquid of current assets
and hence it must provide
the highest yield to justify While a CFO has a certain
investment. degree of control over
trade receivables,
managing inventory is a
joint effort of purchasing,
production and marketing
functions..

6
8.01.02 Management of Inventory
Traditionally the responsibility for inventory management

rested with marketing, production and finance
departments individually reporting to the CEO. The
desired results were not forthcoming due to conflict
among the objectives of these three individual
departments.
In an attempt to realize the goals of his function, the
manager was inadvertently jeopardizing the objectives of
other functions. You need to study the conflict between
marketing and finance functions while optimizing
revenues for their business entities.
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Management of Inventory
marketing head
finance head
production head
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Marketing objective: maximize sales & customer

satisfaction.
Create an extensive and

costly distribution system so
that goods can be shipped to
customers located all
over the country overnight.
9
Production objective: maximize machine utilization
Release work orders

continuously so that
workforce is busy. No idle
time.
10
Finance objective: maximize profit margin by

minimizing Inventory costs

11
8.01.02 Management of Inventory
To resolve this conflict business entities undertake supply

chain management approach that is the synchronization
of a business unit’s processes with those of its suppliers
and customers to match the flow of materials, services
and information with the customer demand.
Supply Chain Management is the integration of key
business processes from end user - the customer, through
original suppliers who provide products, services, and
information that add value for customers and other
stakeholders.

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8.02 Fundamentals of Inventory
8.02.01 Inventory Cycle
Higher level,
more costs
More flow,
more earnings

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8.02.01 Inventory Cycle
Remember, it is not the amount of inventory held in the

tank that determines profits of the business unit. This
profit is primarily decided by how much material outflow
is there from the tank in the form of products demanded
by the customers.
Not inventory levels but inventory turnover drives
business unit’s earnings for any period. A fundamental
question in supply chain management is how much
inventory to hold. The answer to this question involves a
tradeoff between the advantages and disadvantages of
holding inventory.
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8.02.02 Pressures for Larger Inventory

When funds are utilized to build inventory they seize to
earn income. But there are business pressures that
encourage large inventories.
Large inventory speeds delivery to customers and
improves record of on time delivery of goods & services.
Whatever customers want is always maintained in this
high level of inventory. This holding of all items creates
customer goodwill and builds business unit’s brand
equity, a must for long term returns. Large inventories
reduce the potential for stock outs and back orders which
are key concerns of both wholesalers and retailers.
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But any stock out due to smaller inventory means
A) Interruption in processing of materials into finished
products, idle time of men and machinery and
B) A failure to fulfill a customer order that results in
customer complaints and possible loss of an order. You
lose not just that particular customer order, but may be
all future orders from that customer. You lose customer
confidence and this can have a far reaching negative
impact on your sales growth.
C) Contractual penalties and the payments of liquidated
damages are also possible.
16

Costs incurred each time an order is placed include
Salaries of the purchase personnel.
Travelling and living and other expenses of expeditors
who have to visit suppliers.
c
v Transportation and shipping expenses for delivery to
warehouse.
Costs of receiving and incoming inspection
Costs of accounting, vendor payments and auditing.
Less number of orders result in less ordering costs and
larger inventory.
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It is quite common for

vendors to announce extra
quantity discounts for a
limited period. If larger
inventory levels are
permitted, quantity orders
Hedge against raw
can be placed to enjoy
material price fluctuations
discounts.
can be obtained by
holding larger stocks.

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By creating larger inventory through high volume orders,
you can increase labour productivity and facility
utilization in four different ways:
i) direct reduction in the number of production set ups
which add no value to a service or the product; ii) no
costly rescheduling of production orders for want of
input; iii) stabilizing the output rate all through year
even though demand for the product is cyclical or
seasonal, no overtime nor rush purchases of inputs and
iv) reduction on outward freight charges as by increasing
inventory levels dispatches are arranged in an organized
manner per predetermined schedules.
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Finance managers must build these cost
advantages into account when they decide levels
of inventory to be maintained for smooth and
profitable business operations and for customer
satisfaction or delight.

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8.03 Cost of Carrying Inventories

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To finance inventory it holds, a business unit may obtain

loan finance from its banks and pay interest or forgo the
opportunity of assigning its accumulated funds in most
promising investment.
Inventory has to be received, stored, counted and issued
in business unit’s own premises or in a rented facility. In
both cases there is expense involved in the form of
opportunity cost of unit’s own property or the rent paid
to the outside warehouse owner.
And this expense directly increases with the volume of
the inventory carried by the business unit.
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When the inventory is stored on business unit’s own

premises, it has to incur expenses in the form of
depreciation of the building that houses inventory. Then
there are expenses involved in maintaining the
warehouse, cleaning, ventilating, illuminating, securing,
and repairing as and when required.
You have to employ labour force to handle inventory and
its wages / salaries and ancillary expenses also form a
major part of inventory storage costs. Inventory is insured
against theft, fire, deluge and other risks so insurance
premiums also form a part of inventory handling cost.
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Insurance premium
Interest lost on for protecting
funds idle in stocks from theft,
inventory fire, deluge etc.
Inventory
Rent and Carrying
expenses of Costs Interest lost on
store room funds idle in
operations inventory
Obsolescence,
shrinkage and
evaporation

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Then there is shrinkage cost. It takes three forms

i) Pilferage or theft of inventory by customers or
employees; ii) Obsolescence occurs when
inventory cannot be used or sold at full value owing
to engineering modifications, fashion changes or
unexpected fall in demand; and iii) Deterioration
through physical spoilage or damage due to rough or
excessive material handling that result in loss of value
of goods stored.
When the rate of deterioration is high it is unwise to build
large inventories.
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Total inventory carrying costs can vary from

18% to 30% of the inventories held.
(Refer next slide below for the detailed break up).
If a business unit is carrying inventory of, say,
20% of its sales, then its profit margins
are affected by four to six percent just
by inventory carrying expenses.
Thus it is prudent for management to keep its
inventories lean and trim.
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Cost Elements Cost as % of Average Valued Stock

Minimum Maximum
Cost of capital 10 14
Loss, breakage 2 5
Inventory management 1 2
Depreciation 1.5 2
Plant Maintenance 1 2
Disposal / obsolescence 1 2
Taxes 1 2
Insurance 0.5 1
Total stockholding costs 18 30

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8.04 Cost of Ordering Inventories

8.04.01 Order Quantity Decisions
To replenish inventory levels regular orders need to be

issued. They can be issued using different systems.
Lot-for-Lot Ordering: A method

of deciding upon the order Fixed Order Quantity: Here
quantity is to order lot-for-lot. you fix some arbitrary
Under this rule, quantity order quantity for each unit in
will be exactly equal to what is stock that has to be ordered
required – no more, no less. The when stocks need to be
order quantity changes replenished. This is a very
whenever a change occurs in simple system to operate.
requirements. But has no other benefit.

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.
Orders After Fixed Interval : You

place orders after fixed interval. Economic Order Quantity:
You have pre - determined Here you attempt to
maximum and minimum levels. minimize the total cost of
After a month, you check the ordering and carrying
quantity on hand and place an inventory. You assume that
order for the quantity predetermined quantity can
determined as under be ordered when stock level
Maximum level less stock on reaches reorder point. In
hand = order quantity. reality that is not the case,

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Then we have the period order quantity lot size: this concept
is based on the same theory as the economic order quantity.
It uses the EOQ formula to calculate the economic time
between orders by dividing the EOQ by demand rate.
Instead of ordering the same quantity as per EOQ method,
orders are placed for requirements for time interval decided
above. The number of orders placed is same as in the EOQ
system, but the quantity order each time differs per
requirements. Thus the ordering costs are same, but since
the quantity ordered each time varies, inventory carrying
cost is reduced.
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8.04.02 Costs per Order

Ordering costs are incurred every time stocks have to be
replenished by placing an order on vendor or on the factory.
This cost has no bearing on quantity ordered as it is one time
cost that occurs once the order is released until it is
completed.
Every order has to be scheduled, released, expedited and
closed. Full-fledged materials control organization has to
work to handle on time release of orders on its suppliers and
factories. These production control costs form a main
component of inventory ordering costs. They include staff
salaries, records and maintenance of software used

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32

When order is released factory, work centers have to be set
up, equipment for the new item to has be procured and
dismantled when the order quantity is delivered. This
onetime cost does not change with quantity ordered but
with number of orders released in a year.
Whenever production of a new item is commenced there are
initial startup problems, rejections or seconds until the
process is stabilized. This waste also forms a part of ordering
cost. The time taken in setting up the production line for the
new item and time taken to tear it down constitutes factory
idle time and this lost capacity cost is second component of
ordering cost.
33

When the item is outsourced, there is a onetime purchasing
cost. These expenses are for preparation of enquiries and
purchase order, follow up, receiving, incoming inspection,
record keeping accounting and release of payment. This
purchase cost varies with number of orders and not with the
quantity of the purchase order.
This ordering cost can be reduced by releasing fewer orders
but with larger quantities. As noted earlier while ordering
costs are reduced by this action, it generates larger inventory
and resulting higher inventory holding costs. We need a
solution to this conflict and Economic Order Quantity
attempts to provide one.
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Costs to Costs of initial startup

schedule, problems, rejections
release, expedite or seconds.
and close.
Ordering
Costs
Machine set up,

tooling. Vendor enquiries and
order, follow up, receiving,
incoming inspection, and
release of payment.

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8.05 Inventory Management Techniques

8.05.01 Three types of management techniques
Inventory Management Techniques Based on
Refer 8.08
Order Quantity Classification Records
ABC HML VED Aging Inventory Inventory

Analysis Analysis Analysis Schedule Report Budget
Refer 8.06
Determination Economic Order
of Stock Levels Quantity

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8.05.01 Three types of management techniques
The primary reason for keeping inventories small is that

inventory represents a temporary monetary investment. As
such, the business unit incurs an opportunity cost, which is
termed the cost of capital, arising from the money tied up in
inventory that could be beneficially put to use for other
business purposes.
Larger inventories need storage place, greater handling and
personnel to protect them from deterioration, pilferage and
obsolescence. Steps arranged to keep inventories at
minimum practical levels directly add to the earnings of a
business unit.
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8.05.02 Stock Level Control
For low value C class items (Refer ABC Analysis 8.08.01

below) this simple stock level control (Shown on the next
slide) can be exercised to have good results with the least
efforts.
When re-order level is reached an order of predetermined
quantity is released and stock levels remain within
prescribed limits so long as consumption pattern remains the
same and materials are delivered per agreed lead times.
When stocks cross the prescribed levels signals are provided
to management to intervene for corrective action.
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S Maximum level
O Order Qty
C 350# order point
On hand 100 # Minimum Stock
Lead Time
Week 01 02 03 04 05 06 07 08 09 10 11 12
Reorder point Graph 8.05

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A] Minimum Stock Level
This level of stock has to be maintained by the business unit
all throughout the year. But if there is any failure in obtaining
material of right quantity at right time (delays in delivery),
the stocks on hand fall below this minimum level. Such
situation also arises when the requirements suddenly
increase over the average consumption.
Steps are immediately initiated to expedite supplies against
pending orders. If there is consumption of the material over
and above the previous normal usage, additional
procurement of the item has to be arranged by placing fresh
orders to cover shortfall.

40

The Minimum Stock Level quantity is calculated using the
following formula
Minimum level = Re-order level – (Normal consumption per
day × Normal delivery period in days)
But if the replenishment of stocks does not happen as
planned, stocks dip further below to danger level. At this
point in addition to expediting fresh supplies, issues are
rationed and item is issued under controlled conditions. And
efforts for replenishment doubled.
Danger level =Average consumption per day × Maximum re-

order period in days for emergency purchase
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B] Maximum Level
This is the maximum quantity that stock of an item is allowed

to form. It is normally reached when there is a fresh
replenishment on supply against order due.
Maximum level = (Re-order level + Re-order quantity) – (Minimum
consumption × Minimum delivery period)
If stocks cross this level, you re-examine inventory usage

assumptions to check fall if any, in average consumption of
an item and if so, reset inventory levels. The situation arises
on receipts before the due dates for delivery.

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C] Re-Order Level
When stocks of an item reach this level arrangements have to be initiated

for replenishment through release of a fresh order for pre-determined
quantity.
The re-order level is calculated by the formula: -
Maximum consumption per day x maximum lead time in days for

replenishment order.

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8.06 Economic Order Quantity
8.06.01 The Concept
In a fixed order quantity system, when inventory reaches the

reorder point, a pre- fixed quantity is ordered. The most
widely used means for determining how much to order is the
economic order quantity (EOQ) model.
EOQ is a continuous inventory system; a good starting point
for balancing conflicting inventory holding cost and inventory
ordering cost and finding the best cycle inventory (that part
of inventory which varies with order quantity). EOQ is the lot
size that minimizes total annual cost of holding and ordering
materials. .
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8.06.01 The Concept

The concept of economic order quantity presumes that:-
1. Demand rate for an item is constant.

2. There are no constraints in determining the lot size of the
order.
3. Decision on order quantity of item X can have no effect in
deciding on order size of any other item to be ordered on
a vendor or on factory.
4. There are only ordering and holding costs to be
considered.
5. Materials are delivered per agreed lead time in a single
lot.

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8.06.02 Determining Economic Order Quantity
We know that while determining order quantities, we need

to consider effect of quantity on number of orders that have
to be released to fulfill annual requirements and cost of such
orders. Ordering cost is reduced when order quantity
increases as less number of orders have to be issued. But
when order quantity increases higher inventory has to be
maintained and there is increase in inventory carrying costs.
We should therefore draw a graph that combines curves for holding
costs and ordering cost. The point of intersection will minimize the total
of the two costs.

46

47
Any business unit therefore has to release orders of that

quantity where the curve of ordering costs meets the one of
inventory carrying / holding, as at that point total of the
ordering and holding costs would be minimum. This then is
known as Economic Order Quantity. There is a formula
available to arrive at the economic order quantity.
2𝐷𝐶𝑜
EOQ =
𝑝𝐶
Where D is annual demand for the inventory item in units; Co

is ordering cost per order; p unit price and C inventory
holding cost in %
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8.07 EOQ vs. Quantity Discounts

8.07.01 Is EOQ the only order quantity?
EOQ determined as above need not always be the final

quantity that the business unit utilizes. It has to be modified
i) When the vendor offers significant price discount for
quantity purchases, the EOQ may have to be increased to
avail of the lower prices.
ii) If the order size is constrained by capacity limitations
such as the size of the business units processing tanks or
amount of testing equipment or delivery trucks.

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iii) The annual demand divided by the EOQ may not

result in whole number. (demand is 5300 and EOQ 50o) It
has to be modified to 530.
iv) The vendor may stipulate a certain minimum order
quantity. If exceeds EOQ, change in EOQ is necessary.
v) Transportation costs are high in purchases from a
vendor located far off. Here, EOQ may have to be modified to
optimize transportation costs.
vi) For imported items quantity has to match the import
licence.
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Use of the EOQ is justified when you follow a “make to stock”

strategy and the item has relatively stable demand. It is also
recommended when the business unit observes that carrying
cost per unit and set up or ordering costs of the unit are
known and relatively stable.

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8.07.02 How do we decide whether to accept quantity

discounts?
While deciding whether to revise economic order quantity to
accept quantity discount offered by any supplier, you have to
recognize that
There is a saving due to discount in the purchase cost.
There is another saving in ordering costs as increased
order quantity has resulted into lesser number of
orders per year
But there is increase in inventory carrying cost as we have to
order larger quantity. You weigh the first two against the last
and find out if there is a saving to accept the discount. Then
there is a non-monetary issue about availability of additional
storage space.
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8.07.03 Effect of inflation on order quantity
When we apply EOQ formula for determining the most

profitable order quantity, we assume that the price per unit
is constant through the year. But in our Indian economy
prices are always on the increase.
If the rate of inflation can be predicted with any degree of
accuracy, the above EOQ formula can be applied with one
modification. We need to readjust the annual carrying cost
by deducting the rate of inflation. But remember, inflation
increases the unit price of the item held in inventory, it also
correspondingly increases the percentage of inventory
holding cost
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8.08 Inventory Analysis

8.08.01 ABC Analysis
Inventory of an organization are not of equal value, hence it

is grouped into three categories (A, B, and C) in order of
estimated importance.
'A' items are very important, even though they are a few they
account for a large part of total consumption. They are
consumed with high frequency. Because of the high
consumption value, frequent analysis is required to note any
major variations. Plus, an organization needs to choose an
appropriate order pattern (e.g. ‘Just- in- time’) to avoid
excess inventory.
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20% items
Consumption value
70% value
A
20% items
20% value 60% items

B
C 10%
value
Number of inventory items
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'B' items are important, but of course less important than ‘A’
items and more important than ‘C’ items.
Therefore ‘B’ items are intergroup items.
'C' items are many but marginally important and cause about
on average 20% of total material consumption.
A set ordering pattern can be set for them which then can be
reviewed may be at quarterly intervals.
Management by focusing on just A items is in a position to
manage total inventory effectively.

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The advantages
• It is very easy to use and can be carried from data
that, in most cases, already exists in the organization. Most
IT software contains ABC analysis modules.
• It has universal application and can be fruitfully
employed for analysis of, in addition to inventory, customer
sales distribution, vendor purchase volumes or distribution
costs per sales rupee.
• The results can be graphically presented providing
clear overview. It allows you to understand trends clearly.
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A caution
1. To be effective the data fed for analysis has to be
consistent, standardized and codified. You should, therefore,
pay specific attention to the quality of available data.
2. The separation into three classes A, B and C is very
rough. It may be necessary to add one or two more classes
to suit your business unit requirements. (say for class)
3. Every time there is a major price variation, analysis
has to be carried again.

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8.08.02 Classification into A, B and C
The breakup of materials usually reflects
Quantity Consumption value

A class 10% approx. 70% approx.
B class 20% approx. 20% approx.
C class 70% approx. 10% approx.
TOTAL 100% 100%

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8.08.02 Classification into A, B and C
The main objective of ABC analysis is to enable management

to focus on essential processes in the supply chain by
separating the (few) essential from (numerous)
nonessentials. The essential items are to be controlled by
regular intervention while nonessentials are taken care of
established processes.
ABC technique is also beneficial in purchase function to sort
vendors by invoice value, in production to classify centers by
scrap value or in plant maintenance to segment equipment
by downtime hours.

60
8.08.03 Class A Inventory Main Characteristics

High level of control exercised
by senior management.
Very low or nil safety stocks
Rigorous value analysis & daily reviews
Planning based on accurate data

Class A More & flexible sources
Inventory Centralized purchasing & storage.
Minimum lead time.
Precise forecast from marketing

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8.08.04 Class B Inventory

Moderate control
Periodic follow up
Low safety stocks
Normal value analysis & quarterly reviews
Class B Planning based on past data
Inventory Three / four sources
Combined purchasing & storage.
Normal lead time.

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8.08.05 Inventory Class C

Annual Consumption %
100
85
70
A Class B Class C Class
0 % of Inventory Items 100

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8.08.05 Inventory Class C
This class covers the least important around 70% of the

inventory items that account for approximately 20% of entire
annual usage of materials.
Consequently business unit can afford to keep more buffers
in safety stocks of C class items and arrange their bulk
purchases once or twice a year.
Quantities would be decided either on the basis of past
consumption or rough estimates.

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8.08.06 Aging Schedule of Inventories

Inventory items are classified according to the number of
days of their remaining in stock.
This method helps to identify the movement of the
inventories and apply varying degree of management focus
accordingly. Sometimes the analysis is also called as, FNSD
analysis— where,
F = Fast moving inventory: Full management focus
N = Normal moving inventory: Limited Focus
S = Slow moving inventory: Nil Focus
D = Dead moving inventory: This class is mainly identified for
the purpose of taking disposal decision.
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8.08.07 VED Analysis

This technique is ideally suited for spare parts inventory
management like ABC analysis.
Stocks of spares are classified into three categories on the
basis of their usage.
V = Vital item of inventories- Frequent scrutiny
E = Essential item of inventories – Periodical scrutiny
D = Desirable item of inventories – No scrutiny

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8.08.09 HML Analysis
Under this analysis, inventories are classified into three

categories on the basis of the value of the inventories held
on hand. Instead of annual usage which is the key for ABC
analysis, individual price of an item is the criterion applied
for classification.
H = High value of inventories
M = Medium value of inventories
L = Low value of inventories

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8.09 Methods for Valuing Issues
You have option to use a typical method of pricing inventory

issues which suits your business unit and your objective.
Inventory valuation methods are used to calculate the cost of
goods sold (or materials issued from stock) and cost of
ending inventory.
If the changes in the price at which you receive materials are
not significant each method will provide you with more or
less identical results. However, in rising and falling prices,
there can be a pronounced difference.

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.Always remember

69

Different methods available to you for pricing issues include:-
a. FIFO – First in First Out

b. LIFO – Last in First Out
c. Average Price and Weighted Average
d. Actual Price
e. Replacement Price or Current Value.
f. Standard Price or Standard Cost
g. Inflated Price

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8.09.01 FIFO – First in First Out

According to FIFO, it is assumed that items from the
inventory are sold (or issued) in the order in which they are
purchased or produced. This means that cost of older
inventory is charged to cost of goods sold first and the ending
inventory consists of those goods which are purchased or
produced later.
This is the most widely used method for inventory valuation.
In the economy with rising prices (which is the normal trend
in India) this method understates the cost of sales as
replacements are at higher prices than that used in cost of
sales.
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8.09.02 LIFO – Last in First Out
The last in, first out (LIFO) method is used to place an

accounting value on inventory.
While valuing issues under LIFO the last price paid for the
item available in stock is applied.
If you were to use LIFO in inflationary situation, the cost of
the most recently acquired inventory will always be higher
than the cost of earlier purchases, so your ending inventory
balance will be valued at earlier costs, while the most recent
costs appear in the cost of goods sold.

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By shifting high-cost inventory into the cost of goods sold, a

company can reduce its reported level of profitability, and
thereby defer its recognition of income taxes.
Since income tax deferral is the only justification for LIFO in

most situations, it is banned under international financial
reporting standards. But it is still allowed in the United
States after the approval of the Internal Revenue Service.

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ISSUES VALUE
RECEIPTS FIFO 3 2 1
Value
3 2 1
LIFO 1 2 3

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8.09.03 Average Price and Weighted Average Price

Average Price
In this method, the issues are valued on the basis of a simple

average price. The prices of purchases prior to any issues are
added and average price is calculated by dividing the total
value by number of prices used. Issues as well as stock are
valued at this average price.
The method has only one advantage and that is it is easy to
use. When prices fluctuate the method does not provide a
true picture as prices are not weighed by the quantities
purchased at each price.

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8.09.04 Weighted Average Price
Here the issues are valued on the basis of a weighted

average price of materials in stock from which the issues is
arranged. The value (Price x Quantity) of purchases prior to
any issues is divided by the quantity to arrive at the weighted
average price.
It is realistic; simple to operate and reflects the price levels
resulting in stabilization of cost figures.
As it reflects actual costs it is being used by most business
units. and is acceptable to income tax authorities.

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8.09.04 Actual Price
In this method actual cost of purchase is charged for the

materials to be issued from the store room. The method is of
use when the purchases are made for the specific purposes
such as spare parts, special dies, jigs and fixtures and other
special purpose equipment.
Usually a separate ledger is maintained for each purchase
and issues from this quantity are valued at the purchase cost
rate. In jobbing industry, when few costly items or non-
standard components are purchased to meet production
requirements against a specific customer order, this method
is appropriate.

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8.09.05 Replacement Price or Current Value
It is also known as market value method. When adopted the

issues are priced not at the rates at which the stock was
purchased, but at the current market price of the item on the
date of issue.
The principle is that materials issued for sale or production of
any job on a particular date should be charged at the rate at
which the materials consumed could be replaced
immediately from fresh purchases.
This ensures that costs are current and profit indicates
correct margins on the transaction. The price at which
materials were purchased (either higher or lower) has no
influence on reported profits.
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8.09.05 Replacement Price or Current Value
The method is normally used for materials of standard

grades which are traded at the commodity exchanges such as
cotton, cereals, and certain metals for which prices are
published in the media.
It enjoys two advantages : 1) it considers current market
prices for materials thereby reporting current material costs.
Thus unbiased margins are calculated, 2) it enables
comparison of operating efficiencies with those of
competitors.
But you cannot obtain market price every time the materials
are issued. Under inflation stock on hand is understated, but
overvalued requiring write offs if prices were to fall.
79
8.09.06 Standard Price or Standard Cost
Standard costing is the practice of substituting an expected

cost for an actual cost in the accounting records, and then
periodically recording variances that are the difference
between the expected and actual costs. This approach
represents a simplified alternative to cost layering systems,
such as the FIFO and LIFO methods, where large amounts of
historical cost information must be maintained for items held
in stock.
Here are some potential uses for standard costs:
1. Budgeting. 2. Inventory costing. 3. Overhead application
and 4. Price formulation.

80
Under this method the most realistic price to be used for

pricing issues is predetermined after considering all the
economic factors – market conditions, usage rates, market
trends etc. Unless there is any major change to any of these
factors, this rate – termed standard rate – is used all
throughout the accounting period.
Materials receipts are recorded at actual costs and issues are

priced at standard rate. The difference between the two is
charged to material price variance account. This account is
also known in accounting terms as Purchase Price variance or
PPV.
81
The net balance to this account at the yearend is charged to

the income statement directly and thus amount does not
form a part of product cost.
If standard prices are determined with required accuracy and

market prices behaviour stays as anticipated when the
standard price was fixed, the PPV balance at the end of
accounting period is not a concern.
But if these conditions do not exist and PPV balance is
significant, net income figure seizes to be realistic; that can
create audit and tax complications.
82
8.09.07 Inflated Price
In this method the purchase prices are inflated by a certain

percentage and used for issues, this percentage takes care of
losses that occur during processing on account of theft,
obsolescence, breakage, evaporation etc. It allows this loss to
be distributed over entire production in an even manner.
In an industry where the material wastage in process is say
10%, inflated price used for issues will be 10% or more.
The use of inflated price method has resolved the problem of
how to account for wastage by spreading the same evenly
over total production. The success of the method again
depends upon how correctly the wastage percentage is
determined for inflation of the price.
83
8.10 JIT – Just in Time Inventory Management
JIT inventory management was designed

for Toyota by the Japanese and now
enjoys universal acceptance. Business
entities adopting JIT have reported
significant reduction in the inventory to
net sales ratio some very significant. The
JIT inventory management is a part of
total production concept that interfaces
with total quality management (TQM).

84
JIT requires management to ensure three preconditions
o Quality production that continuously meets customer

requirements.
o Close ties among vendors, manufacturer and

customers.
o Close monitoring and reduction in lead times all over.
Fulfillment of these conditions results in reduction in inventory levels.

85
 Suppliers are generally located in close proximity of the

manufacturer. This allows suppliers to deliver inputs in
small batches at frequent intervals.
 Manufacturers too reduce number of vendors (vendors

are assured of higher volumes) and enter into long term
attractive contacts (eliminating complexity of ordering,
invoicing and disbursements).
 Up to date computerized production and inventory data is

available on the terminals of both the manufacturer and
suppliers.
86
In addition to lesser investment in inventories JIT allows the

parties to reduce floor space required for operations thereby
minimizing one time and recurring cost of operations. JIT
believes in elimination rather than detecting defects and
these cost savings need to be recognized by financial
analysts.
It is important to note that JIT is compatible with EOQ

system. The focus is to balance reduced carrying costs from
maintaining less inventory stocks with increased ordering
costs. With annual contracts and on line materials
management cost per order is on the decline.
87

88
8.11 Summary
After trade receivables, inventory is another major but less

liquid component of working capital. it takes three forms
a) Raw materials – used for processing into final product;
b) Work in process – represents inventory removed from

stocks for conversion into final product and
c) Finished products – ready for sale awaiting delivery to

customers in the factory or warehouse/s.

89
8.11 Summary
Traditionally the responsibility for inventory management of

a business unit rested with marketing, production and
finance departments individually reporting to the CEO. The
desired results were not forthcoming as there was a conflict
among the objectives of these three departments.
To resolve this conflict business entities undertake a supply

chain management approach that is the synchronization of a
business unit’s processes with those of its suppliers and
customers to match the flow of materials, services and
information with the customer demand.

90
8.11 Summary
In spite of the fact that funds get locked in inventory, there

are business pressures that encourage business units to hold
large inventories. These include –
 assured on time (sometimes on demand) deliveries to

customers,
 fear of stock outs and resulting production stoppages,
 desire to reduce number of orders and anticipated

increase in prices etc.

91
8.11 Summary
The inventory carrying cost (or holding cost) is the
sum of cost of capital plus the variable costs of
keeping materials on hand such as storage and
handling costs; shrinkage, deterioration and
obsolescence costs; taxes and insurance. As these
expenses change with inventory levels so does the
holding cost. These costs can vary from 18% to 30% of
the inventories held.
Ordering costs are incurred by a business unit every
time stocks have to be replenished by placing order
on vendor or on the business unit’s factory. This cost
has no bearing on quantity ordered as it is one time
cost that occurs once the order is released. Every
order to be released has to be scheduled, released,
expedited and closed.
92
8.11 Summary
Management goal is to place orders in such a way that

above two costs of holding and ordering inventory
together are minimized. EOQ or economic order
quantity technique is the answer here. The EOQ needs
revision in certain cases when quantity discounts are
offered or prices are expected to increase.
Three categories of techniques are in use to manage

inventory within acceptable limits. A- Managing stock
levels and order quantities; B- Classifying inventory
items for different degrees of control and C- Keeping
appropriate inventory records for control.

93
8.11 Summary
ABC analysis of inventory allows management to focus on a

few but important large consumption value A items leaving
balance large items to routine control.
Under aging schedule of inventories items are classified

according to the number of days of their remaining in stock.
The analysis is also called as, FNSD analysis— where, F = Fast
moving inventory: that demands full management focus; N =
Normal moving inventory: for limited management focus; S =
Slow moving inventory: Nil Focus and D = Dead moving
inventory: This class is mainly identified for the purpose of
taking disposal decisions.
94
8.11 Summary
VED analysis technique is ideally suited for spare parts
in the inventory management like ABC analysis. Stocks
of spares are classified into three categories on the
basis of their usage V = Vital item of inventory.
Frequent scrutiny carried out; E = Essential item of
inventory – Periodical scrutiny and D = Desirable item
of inventory – No scrutiny.
Under HML analysis inventories are classified into
three categories on the basis of the value of the
inventories held on hand. Instead of usage which is
the key for ABC analysis, individual price of an item is
the criterion applied for classification. H = High value
of inventories; M = Medium value of inventories and L
= Low value of inventories.

95
8.11 Summary
You have option to use that method of evaluating inventory

which suits your business unit and your objective. Different
methods available to you:-
a) FIFO – First in First Out;

b) LIFO – Last in First Out;
c) Average Price and Weighted Average;
d) Actual Price;
e) Replacement Price or Current Value;
f) Standard Price or Standard Cost and the last
g) Inflated Price.

96
8.11 Summary
JIT inventory management was designed for Toyota by the

Japanese and now enjoys universal acceptance. Business
entities adopting JIT have reported reduction in the
inventory to net sales ratio some very significant.
The JIT inventory management is a part of total production

concept that interfaces with total quality management
(TQM). JIT requires management to ensure a) Quality
production that continuously meets customer requirements;
b) Close ties among vendors, manufacturer and
customers and c) Close monitoring and reduction in lead
times all over.
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.
98

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financial

“Managing inventory is like tight rope walking.

To satisfy customers you must maintain a

Financial Management Part One

Financial Management Part One

8.01.01 Nature of Inventory

Inventory is the next major component of working capital.

8.01.01 Nature of Inventory

8.01.01 Nature of Inventory

You must bear in mind

Financial Management Part One

8.01.02 Management of Inventory

Traditionally the responsibility for inventory management

Marketing objective: maximize sales & customer

Create an extensive and

Production objective: maximize machine utilization

Release work orders

Finance objective: maximize profit margin by

Financial Management Part One

8.01.02 Management of Inventory

To resolve this conflict business entities undertake supply

Financial Management Part One

8.02 Fundamentals of Inventory

8.02.01 Inventory Cycle

Financial Management Part One

8.02.01 Inventory Cycle

Remember, it is not the amount of inventory held in the

8.02.02 Pressures for Larger Inventory

8.02.02 Pressures for Larger Inventory

8.02.02 Pressures for Larger Inventory

8.02.02 Pressures for Larger Inventory

It is quite common for

Financial Management Part One

8.02.02 Pressures for Larger Inventory

8.02.02 Pressures for Larger Inventory

Finance managers must build these cost

advantages into account when they decide levels

of inventory to be maintained for smooth and

profitable business operations and for customer

Financial Management Part One

8.03 Cost of Carrying Inventories

Financial Management Part One

To finance inventory it holds, a business unit may obtain

When the inventory is stored on business unit’s own

Financial Management Part One

Then there is shrinkage cost. It takes three forms

Total inventory carrying costs can vary from

Cost Elements Cost as % of Average Valued Stock

Total stockholding costs 18 30

Financial Management Part One

8.04 Cost of Ordering Inventories

To replenish inventory levels regular orders need to be

Lot-for-Lot Ordering: A method

Financial Management Part One

8.04.01 Order Quantity Decisions

Orders After Fixed Interval : You

Financial Management Part One

8.04.01 Order Quantity Decisions

8.04.02 Costs per Order

Financial Management Part One

8.04.02 Costs per Order

Financial Management Part One

8.04.02 Costs per Order

8.04.02 Costs per Order