CHAPTER No.

Inventory Management
Inventory
It is the existing stock at a certain time of raw
material or semi-finished or finished production in a
certain area of the organization.

1. Role of inventory in Working Capital.

Current Assets.

Level of liquidity.

Liquidity lags.

Creation lag (+ve)

Storage lag (-ve)

Sale lag (-ve)
Circulating Activity.
2.

Purpose of inventory.
Avoiding lost sales.

Shelf stock or goods refer to the good

which
do not enquire specification e.g. Buying
Car.
No need charge.

Getting quality Discounts / bulk.

Reducing Ordering Costs.

Maintain efficient production sum.

Buffer Stock.
Contingent Demand.

3. Types of inventory.
Raw material
Spares, stores & tools
Work-in progress.
Packaging materials
Finished goods

4. Cost associated with inventory

Material
Direct

Ordering Cost
Carrying
Goodwill (No inventory)

Indirect

Opportunity Cost

1. Role of inventory in Working Capital.

Current Assets in working capital refers to Current Assets to

the difference of Current assets over Current liability. It
indicates the amount of money required

for better

operations of any particular company for an establishment.

Inventory is a component of current Assets. Hence, its
monetary value reflected in the balanced sheet would
effect the requirement of Working Capital.

A) Current assets

As mentioned above inventory is a part of Current asset

and the more inventory held the more W.C. is required
and Vice-Versa.

Level of Liquidity

Current assets are converted into cash by selling those

products. The more easily inventory is converted into
Sales and then after in to cash. The less working capital
required and Vice-Versa.
E.g. Operation of winner.
(Wine for selling W.C. less)
(Fast food outlet W.C. more)

In a Winns shop the Wine hose to be made and the age for
some days. It cannot be sell until it is completed to W.C. will
be less. While, in fast food outlet, burger did not required
storing and it is ready and it is sell to the fast food outlet.
Working Capital will be more and Degree of liquidity is more
in fast food outlet Degree of liquidity is less in Wines shop.

B)

Liquidity lag
The

lag

here,

refer

to

the

time

space

in

the

manufacturing, storing and sell of the products and the

cost associated their aff. There are three types of lag

Creation lag

The time associated with the creation of particular

product and the payment of direct& indirect related
cost after the said period is known as creation lag. The
cost of wage of a worker at the end of the month who
prepared the finished product, the payment of raw
material after certain data the payment of electricity
bills after certain period are all examples of creation
lag. The creations lag time the more beneficial it is for
the establishment & vice-versa.
Storage lag
This refers to the time required for storing of the
inventories. When stocks of goods are stored it requires
certain amount of expenditure. Such as paying for the
storekeeper salary depreciation of building and furniture
& fixtures etc. More the storage lag is the more W.C.
require and vice-versa. The greater the lag lowers the
level of liquidity or degree of liquidity vice-versa.
E.g. Wine yard.
Sales lag

These refers to that time required for collection of

receivable after the goods are sold. It is generally
seen that no business of whatever the type be runs
on 100 cash sales. The firm has to sell on credit to
attract customers and built brand image. In this
context, the longer the sale lag the more W.C.
required and less the profit and vice-versa.
C)

Circulating activity.
In a business, there is a definite cycle in operation where
leys, raw material are purchased converted into finished
goods and sold into market generating the cash which is
again used for the purchase of inventory. These cyclic
nature or Circulation of monitory funds if referred to as
circulating activity in the business. Generally, it is seen
that W.C. requirement is done on the first or initial cycles
of the business. The more elaborate cycle is the more
W.C. required and vice-versa.
E.g. Retail stores would require less W.C. whereas ethnic
restaurants require more W.C.

2) Purpose of inventory
The purpose of inventory it is done because to avoid lost sale, if we
purchase quantity in bulk to we get discounts, it also helps in
reducing the ordering cost and helps in maintaining efficient
production room in kitchen area, and it also help if any flucation
come in business, and it helps for keeping the things ready if it
occurs immediately in large number.

A) Avoiding lost sales

Without goods on hand which are ready to be sold, most firms would
lose business. Some customers are willing to wait, particularly when an
item must be made to order or is not widely available from
competitors. In most cases, a firm must be prepared to deliver goods
on demand. Shelf stock or goods refers to the goods which do not
require specification or modification for any item?
E.g. when we buy a Car then only we have to service of
machines only and the body of the car is same there is no need
do any modification in body but only in machinery.
B) Getting quantity Discounts (Bulk)
It refers to that if we purchase the quantity in bulks and it will be
discounted and it will helpful in inventory control. So, this is purpose
of inventory.
For e.g. If we buy a 7 Kg. tomatoes at the rate of 5 Rs for Kg and if
we buy whole box of 10 Kg it will lost Rs. 40 and it is discounted to
us.
C) Reducing Ordering Cost
It refers to that inventory helps in reducing ordering cost like we
have to transport the goods from one place to another and -----what items should be ordered and not unnecessary items are not
ordered .
For e.g. If we ordered 10 tin in auto-rickshaw and our requirement is
of 20 tin then we have to do 2 auto-rickshaws but if we load all 20
tin in a truck then it will reduce our ordering cost.

D) Maintain efficient production run

Inventories are required for a letters and efficient production run. If
the materials are not in hand in right proportion and right quantity,
then the producing& processing cost increased many fold. For e.g.
The cost associated would be starting of the machinery several
times, thereby consuming lot of electricity, the wastage of labour
hours and the hour maintenance of quality. This kind of set up would
be seen in a kitchen which operated on cooked chilled& cooked
freezed methods. Whereby finished products can be retained up to
a maximum of approximately 21 or 22 days
E.g. If a Paneer Masala is prepared and it is kept in cooked chilled &
cooked freezed methods. The Paneer Masala will be chilled 40-45
Sec to this method converts the temperature and it maintain its
nutrition value. When we serve after 21 or 22 days it will maintains
the quality, quantity and its nutritive value should be as it served as
a fresh items. This practice is mostly done in foreign but it is less
followed in India.
E) Buffer Stock
Buffer stock is a maintained to avoid any unexpected market
fluctuation. This is to maintain to strike the hammer at the right
time

for

right

commodity

at

right

prier

favorable

to

the

establishment.
E.g. the material should be purchased at a right time like if any good
is to be empty it should be ordered at right time and purchased the
commodity at a right price only to it said while purchased any
commodity it should be right time & right price.

 Contingency Demand
In this it refers to that we have to keep are stock ready for
immediate cause to as for the requirement to immediate cause the
contingency demand should be mode do it does not create any
problem if the immediately cause come.
For e.g. if a party is arranged for 200 portion then the m--- should
be ready for that but also you should be ready with more 400
portion. If it increase the portion to it does not create any problem
so, contingent demand if required the purpose of inventory.

Types of Inventory
Function of inventory.
Inventories serve as a cushion to absorve planning errors and
fluctuations in supply and demand.
Another function of inventories is to facilitate smooth production
and marketing operations.
Levels of Inventory Control.
A) Unit control.
B) Value Control.
Objective of Inventory Control.

1) Effective use of Capital.

2) Service to customers.
3) Promotion of manufacturing efficiency.
4) Minimizing Risk of loss.
5) Avoidance of out of stock danger.
1. Raw Material
Raw material inventory is the value of materials in the godown at
a particular time. Raw materials are tomatoes, oranges etc. and
daily requirement items. Inventory should be done of raw
material in proper way and in time.
2) Work-in-progress
Work-in-progress consists of materials, labour and factory
expenses spent on the production while the goods are in various
storages of being converted into finished products. The inventory
value of each unit of goods includes the materials, labour and
factory expenses applied to the unit through the cost operation
performed on it.
E.g. In a hotel, we prepare white sauce and different kinds of
gravy in advance so while the order comes too much then we
have that much stock, so work-in-progress.
3) Finished Goods
Finished goods inventory comprise finished goods in the
warehouse at inventory data. For e.g. in a hotel, Paneer Masala is
prepared for 25 person.

E.g. Include work-in-progress, Raw material and finished Goods.

In case there is present a costing system, the cost of materials
consumed can be calculated by means of an appropriate method
for pricing issues. Hence the value of closing inventory of raw
material is simply the balancing figures. In the second the cost of
goods completed can be calculated by means of cost account the
balancing figures. In the second the cost of goods completed can
be calculated by means of cost account the balancing figure is the
value of in complete items. In the third the method of pricing out
the completed goods from finished goods sold. Thus the values of
the closing inventory of the work in progress and finished goods
are simply banking figures.
The above analysis is based on the rule that the cost of inputs has
to be balanced by the cost of output.
4) Spares, Stores & tools
Tools might comprise nuts, bolt, screws, electric wires, electric
coal, burners, knobel spares refer inventory associated with the
various type of apparatus, equipment various wares / cooking
ware, glass ware, steel ware used in the manufacturing, producing
or processing of finished product.
Stores: Inventory which might require various form and formats
and the like can be termed as inventory associated with stores.
5) Packaging Material.

It is one kind of inventory, in those we used different material for

packing the material like plastic tag and plates for dinner and
lunch and soup bowl all those comes under packaging material.

Cost Associated with Inventory

In these the cost associated with inventory in two different way

by direct then it will material cost, ordering cost indirect then it
will cost goodwill and opportunity cost. By doing inventory by
direct or indirect way we come to know that what is the actual
cost of the particular material and also we know the perfect
figure that hour much cost as associated with inventory.
Direct Cost
In those there are three types of cost are there and which is
associated with inventory. For e.g. off we order 1000kg tomato
to supplies for party then this is counted as direct way and it is
accounted as a direct cost.
1) Ordering Cost
2) Carrying Cost.
3) Material Cost.
Ordering Cost
It refers to that the cost of ordering material. The material used
in kitchen or service that should be ordered properly do it will
not increase the ordering cost it include ordering of raw material,
and other items which is required for the operation. Inventory
manager must check that How much to order? When to order?

and What is the minimum safety level to avoid under stock out?
The quantity level is known as ordering level.
Carrying Cost
It is one kind of holding costs. It shows interests on investment in
inventory.

It

has

taxes

and

insurances.

It

also

induces

warehousing and storage exp. It helps in material handling and

clerical charges and deterioration and spoilage and it also
includes personal property taxes.
For e.g. If we order 10 tins of oil in Rishaw but we required 20
tins then we have to do two Rishaw. Instead of this we do one
tempo it will reduce over carrying cost. It includes the charge of
transporting from one place to another place.
Material Cost
This includes raw food and others ingredients that make up a
dish, meal or beverage and is commonly referred to as Material
Cost or Food Cost
E.g. If we prepare Paneeer Butter Masala for 25 person, then
what material is used and that material cost is counted and their
cost is associated with inventory.
2) Indirect Cost
In this cost associated with inventory in indirect way that is known
as indirect cost. In this what is the outcome of the item. There

cost can be associated with inventory in two ways by goodwill

cost and opportunity cost.
1) Goodwill Cost
These cost originated from the basic purpose of inventory
that is to avoid lost sales. As a seller it is very embraising of
not able to provide the goods on demand and there by loosing
the custom, reputation and associated brand image and
market.

********

DERIVATION OF EOQ MODEL

EOQ refers to the quantity at which the total economic cost is
minimum where by we are able to purchase the desired quantity which
suits our operation.
When you speak of total economic cost, the economic cost in the
inventory comprises ordering cost and carrying cost.
Equation A:- Total Cost = Ordering Cost + Carrying Cost
Ordering cost is the cost which is incurred for the purchase of
commodities in the form of the bills of the stationary, transportation,
telecommunication, legal documents and demurrage.
Demurrage is the price that a restaurant has to pay for not lifting the
order or not excepting the delivers at a specific time and day through
the supplier.
Carrying cost is the cost incurred in holding the inventories
commodities over a certain period of time. This cost includes the
maintenance cost of the stores, salary of a store keeper, fixed
overheads of walk in coolers/ fridges and the depreciation cost which is
getting incurred in the day to day use of the stores in the form of
furniture and fixtures, plants and trollies.
Equation B:Ordering Cost = No. of Orders Fixed cost per Order
i.e. Ordering Cost = U/Q F
Where,
No. of Orders = U/Q
U = Annual or Monthly Consumption
Q = Quantity ordered at a given time
F = Fixed cost per order

From the physical observations it is generally seen that the graph of

ordering cost has a diminishing curve with a negative shop which is
shown as in the form of a following graph.

Q
Carrying cost is represented by the formulas
Cu C = Q/2 P C
Where,
P = Price of the commodity
C = A definite percentage
Again from the empherical studies it is observed that C lies in
between 15 & 35 . In the previous formula Q/2 has been adopted
on the bases of the following assumption that the previous stock gets
replineshed. This quantity is further divided by 2 because for a given
period of time from (say) T0 to T1 we find that half of the

commodity for a given time frame is carried over in the stores. This is
being explained with the help of a graph:-

Q/2
T0

T1

T2

From the empherical data it is seen that carrying cost is represented in

the form of a straight curve / line which is increasing in nature,
slopping upwards and has a positive slop. It is explained with the help
of a following graph:-

Q
From the equation A we find that
TC = OC + CC
It is also seen that the total cost first slops downwards and then
upwards which is explained with the help of following graph:-

Q
The total cost is minimum when the first derivative of total cost is
equal to zero. At this point, carrying cost is equal to the carrying cost.
Therefore,
U/Q E = Q/2 P C
This relationship is shown with the help of another graph. The quantity
where Carrying Cost = Ordering Cost that quantity is known as
Economic Order Quantity.

TC
CC
C
A
OC
Q*
With the help of the mathematical operations we have
2UF = Q2 PC
There fore,
Q 2 = 2UF/PC and
Q = 2 UF/PC
This Q is Economic Order Quantity.

INFLATION OF EOQ
Inflation affects the EOQ model in 2 major ways:

1. While the EOQ model can be modified to assume constant price

increases. Many times major price increases occur only once or
twice a year and are announced ahead of time. If this is the case,
the EOQ model may loose its applicability and may be replaced
with anticipatory buying.
As with most decisions there are trade offs between liquidity and
profitability. The cost are the added carrying cost associated with
inventory that one would not normally be holding. The benefits
come from buying the inventory at the loer price.
2. Inflation affects the EOQ model is through increased carrying
cost. As inflation pushes interest rates up the cost of carrying
inventory increases. In the EOQ model this means that as c
increases the optimum Economic Order Quantity gets decreased.
EOQ Discount Policy
The optimum order quantity is based on EOQ model which assumes
that there is a constant price mechanism working in the required
formula. This constant price assumption is one of the weakness of the
EOQ model where it does not take in to consideration:
1.

Seasonal variation in price.

2.

Inflationary affect in price.

3.

The discount policy operating in the price and supply finance

work..

In the discount policy we give the ones of providing the discount lies
with the supplier, who in his terms and conditions may state that.

a)

To avail discount you/one must purchase the specified quantity at

one time.

b)

To avail discount you must provide the payment in specified

number of days.

The first parameter concentrates on bulk discount where as the latter

part focuses on cash and trade discount policy. In the given framework
3 situations arise in our practical purchase mechanism.
I.

The specified quantity is equal to the predetermined optimum

order quantity.

II.

The specified quantity is less then the optimum order quantity.

III.

The specified quantity is more than the optimum order quantity.

In the first and second case the pre-determined optimum order

quantity is final and re--- supreme in any decision making situation.
In case third when the quantity specified is more than the optimum
order quantity than the incremental cost benefit analysis has to be
done in deciding which decision should one take.
STEP 1
The first step is to determine the total benefit available from the
discount specified on the proposed quantity which is calculated as
DISCOUNT ALLOWED = U D
Where,
U = Annual or Monthly consumption.
D = Discount amount available to the restaurant.

STEP 2
The next step is to determine the benefit available to the restaurant
due to the reduction of the number of orders. This is shown as a
difference of ordering cost which is represented by the equation as
(U/Q* - U/X) F
Where,
Q* = Economic Order Quantity.
X = Specified quantity.
F = Fixed cost per order.
This step is also a cost saving function to the restaurant.
STEP 3
The third step is to identify the extra cost increased in carriage of the
specified quantity at a new discounted rate. This is represented by the
equation.
X (P-D) C/2 Q*PC/2
Where,
X = Specified quantity
P = Existing Price

D = Discount amount
Q* = Economic Order Quantity
C = Carrying cost
This equation is a cost incurring function on the part of the restaurant.
The first and second equation is positive in nature where as third
equation is negative in nature.
If the summation of all this 3 equation is negative or less than 0 then
go for the EOQ quantity. But if the summation is more than 0 or
positive in nature then go for the specified quantity on which the
discount is available.
In real life situations the chances of happening of above two cases is
very high but if the summation gives 0 as a figure then the way of
deciding which/ how much quantity to purchase is decided by the 3
different analysis that is done in both quantities.
They are:
a) Opportunity cost Analysis.
b) Cost Benefit Analysis
c) Liquidity- Profitability Analysis.
The above three analysis lies in the ambit of micro-economic analysis
which is not relevant in this topic.
RE-ORDER SUBSYSTEM
In the EOQ subsystem we had made an assumption that the lead time
is zero (lead refers to the time which is required by the supplier to
deliver the specific quantity to the purchaser or the establishment).
But in real life situations such things of having lead time means zero is

hardly possible. So we need to order the specified quantities of specific

commodities before they run out of stock. At what level the purchase
order should be made is decided upon 2 factors:-

1. Lead time taken

2. Average daily usage units
The reorder level determined by obtaining a value which is the
product of factor 1 and factor 2 stated above. In short
Re-order Level (ROL) = Lead Time Average Daily Usage Units
This means that as soon as the quantity in the stores of the specific
commodity falls to this level a new order should be placed to the
supplier so that the operations do not run short of stock. The order
which is placed equals to the EOQ.
But the question arises that what would happen if during the lead
time there is sudden spirit (rise) in demand of a specific commodity
during a lead time. In such case the operation would run short of
stock even before a new order is being received. For such situations
there arises a necessicity of maintaining a stock of commodities in
specified quantities know as Safety Stock or Buffer Stock. How
much safety stock or buffer stock has to be maintained is decided
upon the chances of running out of stock in 100 incidents (It is the
profitability expressed in the form).The higher the stock out
factor the higher safety stock has to be maintained. There are 2
methods of determining the safety stock namely;
a) Probability method including mathematical calculation.
b) Statistical mathematics which involves the use of a ready
rackanur distribution curve.

The first method is tedious in nature and by the time we are able to
calculate the safety stock one or more than one factor in the external
environment might have changed. So this method is rarely used. We
focus on 2nd method which requires the use of ready rackanur
distribution curve which is also known as Poisson Distribution Method.
It also involves the use of probability but instead of mathematical
calculation we are able to know the safety stock by mean plotting on
the distribution graph. Method 2 requires the use re-order level.
ROL = AB+C ABQ*
Where,
A = Lead time
B = Average daily usage units
C =Stock out factor
Q* = Economic Order Quantity
In the above formula
CABQ*
represents safety stock component which is the minimum quantity
which should be in the stores 365days a year. In the above formula C
can be known from the following graph:-

3C

21 -

|
5

|
10

|
15

|
20

STOCK FACTOR
Which is known as Poisson Distribution Curve, On Y axis we get the
value of C and on X axis we have got the stock factor percentage
probability. So in the reorder subsystem the
Re-order level = Safety Stock + Lead Time Stock

ABC Analysis
Categorized
1. Amount of Investment
2. Movement
3. Percentage of item on total items
In the models of EOQ and re-order level we find that the investment
factor has been ruled out but for continuing the operations we require
some amount of working capital and we know that the working capital
and we know that the working capital is the difference of current assets
over current liabilities. Current Assets also include inventories as an
integral part and then by affect the working capital and hereby
affecting the better management of financial resources.
For an affective management of financial resources, ABC analysis of
inventory management technique is applied.
The stocks of goods or inventory are categorized into different groups
for an affective control of funds. Normally, for categorizing the
commodities or groups of commodities into various groups, the 3
parameters are taken into consideration.

1. The percentage of the investment done.

2. The movement of goods from the stores ( Slow, fast and
average )
3. The percentage of the selective commodity in the stores.
On the above parameters the entire stock gets categorized in to 3
different groups namely A, B and C.
A group commands 70% of the investment; B commands 20% of
the investment and C the remaining 10%. From the empherical data
it is observed that A has 10% of weightage in stores, B has 20%
and C the remaining 70%. But it is not necessary that Acannot have
more then 10% weightage, B more or less than 20% and C more or
less than 70%.
Depending upon the investment and the movement of the goods, we,
restaurentiers and hoteliers also do 2 different activities:a) VED analysis which stands for Vital Essential and Desirable.
b) Menu Engineering is done in the selection and removal of
menu item from the existing menu.
DEMURAGE COST
Demurrage cost is a cost which is marked and taken from the buyer
when he fails to pickup the goods on purchase at a stipulated date and
such costs generally include the maintenance cost sustained by the
seller.