November 27, 2014

Financial Management of Inventory


Inventory management usually is not the direct operating responsibility of the financial manager. But  the investment of funds in inventory is a very important aspect of financial management. The finance manager has to appraise the proposed investment in inventory like the appraisal he does for fixed capital assets. Consequently, the financial manager must be familiar with methods proposed in the theory to plan and control inventories. Planning of the inventory is based on minimising the costs associated with keeping inventory.

The inventory control or management methods described give  a means for determining an optimal level of inventory, and also to decide when to ordered and in what quantity. . These tools are necessary for
managing inventory efficiently and balancing the advantages of additional inventory against the cost of carrying this inventory. With the use of computers, great improvements in inventory control have been made
and are continuing to be made. Also there are manyu applications of operations research to inventory management.

New ideas to reduce inventory required normally occur with in the inventory management theory. But even finance theory sometimes may come out with principles related to optimizing inventory. When the innovation occurs in the finance field, finance managers have to take the responsibility of implementing it within their activity or within inventory management activity.

Inventories, like receivables, represent a significant portion of most firms’ assets, and, accordingly, require substantial investments. Inventories must be managed efficiently.

Inventories provide a very important link in the production and sale of a product. For a company engaged in manufacturing, a certain amount of inventory is absolutely necessary in the production distribution system. Toyota Production System came out of the efforts of managers identify and eliminate excess inventory which was thought at that time as essential.

 The obvious disadvantages of inventory are the total cost of holding the inventory, including storage and handling costs, and the required return on capital tied up in the investment in inventory. Inventories, like accounts receivable, should be increased as long as the resulting savings exceed the total cost of holding the added inventory. The balance finally reached depends upon the estimates of actual savings, the cost of carrying additional inventory, and the efficiency of inventory control.


Without inventory between production stages, each stage of production would be dependent upon the preceding stage’s finishing its operation on a unit of production. As a result, there probably would be delays and considerable idle time in certain stages of production.

According to traditional inventory theory,  the advantages of increased inventories, then, are several. The firm can effect economies of production and purchasing and can fill customer orders more quickly. In short, the firm is more flexible.

For a given level of inventory, the efficiency of inventory control affects the flexibility of the firm. Two essentially identical firms with the same amount of inventory may have significantly different degrees of
flexibility in operations due to differences in inventory control. Inefficient procedures may result in an unbalanced inventory —the firm may frequently be out of certain types of inventory, and overstock other
types, necessitating excessive investment. These inefficiencies ultimately have an adverse effect upon profits. Turning the situation around, differences in the efficiency of inventory control for a given level of flexibility
affect the level of investment required in inventories. The less efficient the inventory control, the greater the investment required. Similarly, excessive investment in inventories affects profits adversely.



The economic order quantity (EOQ) is an important concept in inventory management.

The optimal order quantity for a particular item of inventory, given its forecasted usage, ordering cost, and carrying cost is determined using mathematics. Ordering can mean either the purchase of the item or its production. Assume for the moment that the usage of a particular item of inventory is known with certainty. Moreover, assume that ordering costs per order, O, are constant regardless of the size of the order. In the purchase of raw materials or other items, these costs represent the clerical costs involved in placing an order as well as certain costs of receiving and checking the goods once they arrive.

For finished-goods inventories, ordering costs involve scheduling a production run. For in-transit inventories, ordering costs are likely to involve nothing more than record keeping. The total ordering cost for
a period is simply the number of orders for that period, times the cost per order. It is important to state at this point that Toyota reduced its ordering cost or set up cost and thereby reduced its economic order quantities.

Carrying costs per period, C, represent the cost of inventory storage, handling, and insurance, together with the required rate of return on the investment in inventory. These costs are assumed to be constant per unit
of inventory, per unit of time. Thus, the total carrying cost for a period is the average number of units of inventory for the period, times the carrying cost per unit. In addition, it is  assumed  that inventory orders are filled immediately, without delay.

If the usage of an inventory item is perfectly steady over a period of
time and there is no safety stock, average inventory (in units) can be expressed
as:  EOQ/2

The EOQ formula is  SQRT(2AS/I)

A = annual demand
S = ordering cost
I = inventory carrying cost per unit


In practice, the demand or usage of inventory generally is not known with certainty; usually it fluctuates during a given period of time. Typically, the demand for finished-goods inventory is subject to the fluctuation. . In addition to demand or usage, the lead time required to receive delivery of inventory once an order is placed is usually subject to some variation. Owing to these fluctuations, it is not feasible in most cases to allow expected inventory to fall to zero before a new order is expected to be received, as could be done when usage and lead time were known with certainty.

Most firms maintain some margin of safety, or safety stock; otherwise, they may at times be unable to satisfy the demand for an item of inventory. There are opportunity costs to being out of stock. In the case of
finished-goods inventory, the customer is likely to become irritated and may take his business elsewhere. In the case of raw-materials and intransit inventories, the cost of being out of stock is a delay in production.
While this opportunity cost is measured more easily than that associated with finished-goods inventory, a stockout of the latter has a cost; and the firm must recognize it.

. If we know the cost per unit of stockout, we can calculate the expected cost of stockouts and then compare this cost with the cost of carrying additional inventory.

Uncertainty o f Lead Time. Suppose that the lead time required for procurement, like demand or usage, is subject to a probability distribution. Based on this probability distribution can determine the optimal level of safety stock for the period.


At order point which is a stock level, an order is placed.

Order Point* = S(L) +  Safety Stock

where S is the usage, L is the lead time required to obtain additional inventory

Suggestions for Inventory Efficiency

When demand or usage of inventory is uncertain, the financial manager may try to effect policies that will reduce the average lead time required to receive inventory once an order is placed. The lower the
average lead time, the lower the safety stock needed and the lower the total investment in inventory, all other things held constant. The greater the opportunity cost of funds invested in inventory, the greater the
incentive to reduce this lead time. In the case of purchases, the purchasing department may try to find new vendors that promise quicker delivery or place pressure on existing vendors for faster delivery. In the
case of finished goods, the production department may be able to schedule production runs for faster delivery by producing a smaller run. In either case, there is a tradeoff between the added cost involved in reducing the lead time and the opportunity cost of funds tied up in inventory. This discussion serves to point out the importance of inventory management to the financial manager. The greater the efficiency with which
the firm manages its inventory, the lower the required investment in inventory, all other things held constant.

The modern inventory system is zero inventory system. It is also being called lean system (non stock system). To know how nonstock highly efficient systems were developed in Toyota read
Toyota Production System Industrial Engineering.

MBA Core Management Knowledge - One Year Revision Schedule

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