Inventory management is a
discipline primarily about specifying the shape and placement of stocked goods.
It is required at different locations within a facility or within many
locations of a supply network to precede the regular and planned course of
production and stock of materials.
The concept of inventory, stock or work-in-process has been extended from
manufacturing systems to service businesses[1][2][3] and projects,[4][5] by
generalizing the definition to be "all work within the process of
production- all work that is or has occurred prior to the completion of
production." In the context of a manufacturing production system,
inventory refers to all work that has occurred – raw materials, partially
finished products, finished products prior to sale and departure from the
manufacturing system. In the context of services, inventory refers to all work
done prior to sale, including partially process information.
Contents
1 Definition
2 Business inventory
2.1 Reasons for keeping
stock
2.2 Special terms used in
dealing with inventory management
2.3 Typology
2.4 Inventory examples
2.4.1 Manufacturing
2.4.2 Capital projects
2.4.3 Virtual inventory
2.5 Costs associated with
inventory
3 Principle of inventory
proportionality
3.1 Purpose
3.2 Applications
3.3 Roots
4 High-level inventory
management
5 Accounting for
inventory
5.1 Financial accounting
5.2 Role of inventory
accounting
5.3 FIFO vs. LIFO
accounting
5.4 Standard cost
accounting
5.5 Theory of constraints
cost accounting
6 National accounts
7 Distressed inventory
8 Stock rotation
9 Inventory credit
10 Journal
11 See also
12 Notes
13 References
14 Further reading
Definition
The scope of inventory management
concerns the balance between replenishment lead time, carrying costs of
inventory, asset management, inventory forecasting, inventory valuation,
inventory visibility, future inventory price forecasting, physical inventory,
available physical space, quality management, replenishment, returns and
defective goods, and demand forecasting. Balancing these competing requirements
leads to optimal inventory levels, which is an ongoing process as the business
needs shift and react to the wider environment.
Inventory management involves a retailer seeking to acquire and maintain a
proper merchandise assortment while ordering, shipping, handling and related
costs are kept in check. It also involves systems and processes that identify
inventory requirements, set targets, provide replenishment techniques, report
actual and projected inventory status and handle all functions related to the
tracking and management of material. This would include the monitoring of
material moved into and out of stockroom locations and the reconciling of the
inventory balances. It also may include ABC analysis, lot tracking, cycle
counting support, etc. Management of the inventories, with the primary
objective of determining/controlling stock levels within the physical
distribution system, functions to balance the need for product availability
against the need for minimizing stock holding and handling costs.
Business inventory
Reasons for keeping stock
There are five basic reasons for
keeping an inventory
Time – The time lags present in
the supply chain, from supplier to user at every stage, requires that you
maintain certain amounts of inventory to use in this lead time. However,
in practice, inventory is to be maintained for consumption during 'variations
in lead time'. Lead time itself can be addressed by ordering that many days in
advance.
Seasonal Demand: demands varies
periodically, but producers capacity is fixed. This can lead to stock
accumulation, consider for example how goods consumed only in holidays can lead
to accumulation of large stocks on the anticipation of future consumption.
Uncertainty – Inventories are
maintained as buffers to meet uncertainties in demand, supply and movements of
goods.
Economies of scale – Ideal
condition of "one unit at a time at a place where a user needs it, when he
needs it" principle tends to incur lots of costs in terms of logistics. So
bulk buying, movement and storing brings in economies of scale, thus inventory.
Appreciation in Value – In some
situations, some stock gains the required value when it is kept for some time
to allow it reach the desired standard for consumption, or for production. For
example; beer in the brewing industry
All these stock reasons can apply
to any owner or product.
Special terms used in dealing
with inventory management
Stock Keeping Unit (SKU)
SKUs are clear, internal identification numbers assigned to each of the
products and their variants. SKUs can be any combination of letters and numbers
chosen, just as long as the system is consistent and used for all the products
in the inventory.[6]
Stockout means running out
of the inventory of an SKU.[7]
"New old stock"
(sometimes abbreviated NOS) is a term used in business to refer to merchandise
being offered for sale that was manufactured long ago but that has never been
used. Such merchandise may not be produced anymore, and the new old stock may
represent the only market source of a particular item at the present time.
Typology
Buffer/safety stock
Reorder level
Cycle stock (Used in batch
processes, it is the available inventory, excluding buffer stock)
De-coupling (Buffer stock held
between the machines in a single process which serves as a buffer for the next
one allowing smooth flow of work instead of waiting the previous or next
machine in the same process)
Anticipation stock (Building up
extra stock for periods of increased demand – e.g. ice cream for summer)
Pipeline stock (Goods still in
transit or in the process of distribution – have left the factory but not
arrived at the customer yet)
Average Daily/Weekly usage
quantity X Lead time in days + Safety stock
Inventory examples
While accountants often
discuss inventory in terms of goods for sale, organizations – manufacturers, service-providers and not-for-profits –
also have inventories (fixtures, furniture, supplies, etc.) that they do not
intend to sell. Manufacturers', distributors', and wholesalers' inventory
tends to cluster in warehouses. Retailers' inventory may exist in a
warehouse or in a shop or store accessible to customers.
Inventories not intended for sale to customers or to clients may be
held in any premises an organization uses. Stock ties up cash and, if
uncontrolled, it will be impossible to know the actual level of stocks and
therefore impossible to control them.
While the reasons for holding stock were covered earlier, most manufacturing
organizations usually divide their "goods for sale" inventory into:
Raw materials – materials and components scheduled for use in making a
product.
Work in process, WIP – materials
and components that have begun their transformation to finished goods.
Finished goods – goods
ready for sale to customers.
Goods for resale – returned
goods that are salable.
Stocks in transit.
Consignment stocks.
Maintenance supply.
For example:
Manufacturing
A canned food manufacturer's
materials inventory includes the ingredients to form the foods to be canned,
empty cans and their lids (or coils of steel or aluminum for constructing those
components), labels, and anything else (solder, glue, etc.) that will form part
of a finished can. The firm's work in process includes those materials from the
time of release to the work floor until they become complete and ready for sale
to wholesale or retail customers. This may be vats of prepared food, filled
cans not yet labeled or sub-assemblies of food components. It may also include
finished cans that are not yet packaged into cartons or pallets. Its finished
good inventory consists of all the filled and labeled cans of food in its
warehouse that it has manufactured and wishes to sell to food distributors
(wholesalers), to grocery stores (retailers), and even perhaps to consumers
through arrangements like factory stores and outlet centers.
Capital projects
The partially completed work (or
work in process) is a measure of inventory built during the work execution of a
capital project,[8][9][10] such as encountered in civilian infrastructure
construction or oil and gas. Inventory may not only reflect physical items
(such as materials, parts, partially-finished sub-assemblies) but also
knowledge work-in-process (such as partially completed engineering designs of
components and assemblies to be fabricated).
Virtual inventory
A "virtual inventory"
(also known as a "bank inventory") enables a group of users to share
common parts, especially where their availability at short notice may be
critical but they are unlikely to required by more than a few bank members at
any one time.[11] Virtual inventory also allows distributors and
fulfilment houses to ship goods to retailers direct from stock regardless of
whether the stock is held in a retail store, stock room or warehouse.[12]
Costs associated with inventory
There are several costs associated with inventory:
Ordering cost
Setup cost
Holding Cost
Shortage Cost
Principle of inventory proportionality
Purpose
Inventory proportionality is the
goal of demand-driven inventory management. The primary optimal outcome is to
have the same number of days' (or hours', etc.) worth of inventory on hand
across all products so that the time of runout of all products would be
simultaneous. In such a case, there is no "excess inventory," that
is, inventory that would be left over of another product when the first product
runs out. Excess inventory is sub-optimal because the money spent to obtain it
could have been utilized better elsewhere, i.e. to the product that just ran
out.
The secondary goal of inventory proportionality is inventory minimization. By
integrating accurate demand forecasting with inventory management,
rather than only looking at past averages, a much more accurate and optimal
outcome is expected.
Integrating demand forecasting into inventory management in this way also
allows for the prediction of the "can fit" point when inventory
storage is limited on a per-product basis.
Applications
The technique of inventory
proportionality is most appropriate for inventories that remain unseen by the
consumer, as opposed to "keep full" systems where a retail consumer
would like to see full shelves of the product they are buying so as not to
think they are buying something old, unwanted or stale; and differentiated from
the "trigger point" systems where product is reordered when it hits a
certain level; inventory proportionality is used effectively by just-in-time
manufacturing processes and retail applications where the product is hidden
from view.
One early example of inventory proportionality used in a retail application in
the United States was for motor fuel. Motor fuel (e.g. gasoline) is generally
stored in underground storage tanks. The motorists do not know whether they are
buying gasoline off the top or bottom of the tank, nor need they care.
Additionally, these storage tanks have a maximum capacity and cannot be
overfilled. Finally, the product is expensive. Inventory proportionality is
used to balance the inventories of the different grades of motor fuel, each
stored in dedicated tanks, in proportion to the sales of each grade. Excess
inventory is not seen or valued by the consumer, so it is simply cash sunk
(literally) into the ground. Inventory proportionality minimizes the amount of
excess inventory carried in underground storage tanks. This application for
motor fuel was first developed and implemented by Petrolsoft Corporation in
1990 for Chevron Products Company. Most major oil companies use such
systems today.
Roots
The use of inventory
proportionality in the United States is thought to have been inspired by
Japanese just-in-time parts inventory management made famous by Toyota Motors
in the 1980s.[14]
High-level inventory management
It seems that around 1880[15] there
was a change in manufacturing practice from companies with relatively
homogeneous lines of products to horizontally integrated companies with
unprecedented diversity in processes and products. Those companies (especially
in metalworking) attempted to achieve success through economies of scope - the
gains of jointly producing two or more products in one facility. The managers
now needed information on the effect of product-mix decisions on overall
profits and therefore needed accurate product-cost information. A variety of
attempts to achieve this were unsuccessful due to the huge overhead of the
information processing of the time. However, the burgeoning need for financial
reporting after 1900 created unavoidable pressure for financial accounting of
stock and the management need to cost manage products became overshadowed. In
particular, it was the need for audited accounts that sealed the fate of
managerial cost accounting. The dominance of financial reporting accounting
over management accounting remains to this day with few exceptions,
and the financial reporting definitions of 'cost' have distorted effective
management 'cost' accounting since that time. This is particularly true of
inventory.
Hence, high-level financial inventory has these two basic formulas, which
relate to the accounting period:
Cost of Beginning Inventory at
the start of the period + inventory purchases within the period +
cost of production within the period = cost of goods available
Cost of goods available − cost
of ending inventory at the end of the period = cost of goods
sold
The benefit of these formulas is
that the first absorbs all overheads of production and raw material costs into
a value of inventory for reporting. The second formula then creates the new
start point for the next period and gives a figure to be subtracted from the
sales price to determine some form of sales-margin figure.
Manufacturing management is more interested in inventory turnover ratio or average
days to sell inventory since it tells them something about relative
inventory levels.
Inventory turnover ratio (also
known as inventory turns) = cost of goods sold / Average Inventory = Cost
of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)
and its inverse
Average Days to Sell Inventory =
Number of Days a Year / Inventory Turnover Ratio = 365 days a year / Inventory
Turnover Ratio
This ratio estimates how many times the inventory turns
over a year. This number tells how much cash/goods are tied up waiting for the
process and is a critical measure of process reliability and effectiveness. So
a factory with two inventory turns has six months stock on hand, which is
generally not a good figure (depending upon the industry), whereas a factory
that moves from six turns to twelve turns has probably improved effectiveness
by 100%. This improvement will have some negative results in the financial
reporting, since the 'value' now stored in the factory as inventory is reduced.
While these accounting measures of inventory are very useful because of their
simplicity, they are also fraught with the danger of their own assumptions.
There are, in fact, so many things that can vary hidden under this appearance
of simplicity that a variety of 'adjusting' assumptions may be used. These include:
Specific Identification
Lower of cost or market
Weighted Average Cost
Moving-Average Cost
FIFO and LIFO.
Queueing theory. [16]
Inventory Turn is a financial accounting tool for evaluating inventory and it
is not necessarily a management tool. Inventory management should be forward
looking. The methodology applied is based on historical cost of goods sold. The
ratio may not be able to reflect the usability of future production demand, as
well as customer demand.
Business models, including Just in Time (JIT) Inventory, Vendor Managed
Inventory (VMI) and Customer Managed Inventory (CMI), attempt to minimize
on-hand inventory and increase inventory turns. VMI and CMI have gained
considerable attention due to the success of third-party vendors who offer
added expertise and knowledge that organizations may not possess.
Inventory management in modern days is online oriented and more viable in
digital. This type of dynamics order management will require end-to-end
visibility, collaboration across fulfillment processes, real-time data
automation among different companies, and integration among multiple systems.[17]
Accounting for inventory
Each country has its own rules about accounting for inventory that
fit with their financial-reporting rules.
For example, organizations in the U.S. define inventory to suit their
needs within US Generally Accepted Accounting Practices (GAAP), the
rules defined by the Financial Accounting Standards Board (FASB) (and
others) and enforced by the U.S. Securities and Exchange Commission (SEC)
and other federal and state agencies. Other countries often have similar
arrangements but with their own accounting standards and national agencies
instead.
It is intentional that financial accounting uses standards that allow
the public to compare firms' performance, cost accounting functions
internally to an organization and potentially with much greater flexibility. A
discussion of inventory from standard and Theory of Constraints-based (throughput) cost
accounting perspective follows some examples and a discussion of inventory
from a financial accounting perspective.
The internal costing/valuation of inventory can be complex. Whereas in the past
most enterprises ran simple, one-process factories, such enterprises are quite
probably in the minority in the 21st century. Where 'one process' factories
exist, there is a market for the goods created, which establishes an
independent market value for the good. Today, with multistage-process
companies, there is much inventory that would once have been finished goods
which is now held as 'work in process' (WIP). This needs to be valued in the
accounts, but the valuation is a management decision since there is no market
for the partially finished product. This somewhat arbitrary 'valuation' of WIP
combined with the allocation of overheads to it has led to some unintended and
undesirable results.
Financial accounting
An organization's inventory can
appear a mixed blessing, since it counts as an asset on the balance
sheet, but it also ties up money that could serve for other purposes and
requires additional expense for its protection. Inventory may also cause
significant tax expenses, depending on particular countries' laws regarding
depreciation of inventory, as in Thor Power Tool Company v. Commissioner.
Inventory appears as a current asset on an organization's balance
sheet because the organization can, in principle, turn it into cash by selling
it. Some organizations hold larger inventories than their operations require in
order to inflate their apparent asset value and their perceived profitability.
In addition to the money tied up by acquiring inventory, inventory also brings
associated costs for warehouse space, for utilities, and for insurance to
cover staff to handle and protect it from fire and other disasters,
obsolescence, shrinkage (theft and errors), and others. Such holding costs can
mount up: between a third and a half of its acquisition value per year.
Businesses that stock too little inventory cannot take advantage of large
orders from customers if they cannot deliver. The conflicting objectives of
cost control and customer service often put an organization's financial and
operating managers against its sales and marketing departments.
Salespeople, in particular, often receive sales-commission payments, so
unavailable goods may reduce their potential personal income. This conflict can
be minimised by reducing production time to being near or less than customers'
expected delivery time. This effort, known as "Lean production" will
significantly reduce working capital tied up in inventory and reduce
manufacturing costs (See the Toyota Production System).
Role of inventory accounting
By helping the organization to
make better decisions, the accountants can help the public sector to change in
a very positive way that delivers increased value for the taxpayer’s
investment. It can also help to incentive's progress and to ensure that reforms
are sustainable and effective in the long term, by ensuring that success is
appropriately recognized in both the formal and informal reward systems of the
organization.
To say that they have a key role to play is an understatement. Finance is
connected to most, if not all, of the key business processes within the
organization. It should be steering the stewardship and accountability systems
that ensure that the organization is conducting its business in an appropriate,
ethical manner. It is critical that these foundations are firmly laid. So often
they are the litmus test by which public confidence in the institution is
either won or lost.
Finance should also be providing the information, analysis and advice to enable
the organizations’ service managers to operate effectively. This goes beyond
the traditional preoccupation with budgets – how much have we spent so far, how
much do we have left to spend? It is about helping the organization to better
understand its own performance. That means making the connections and
understanding the relationships between given inputs – the resources brought to
bear – and the outputs and outcomes that they achieve. It is also about
understanding and actively managing risks within the organization and its
activities.
FIFO vs. LIFO accounting
Main article: FIFO and LIFO
accounting
When a merchant buys goods from
inventory, the value of the inventory account is reduced by the cost of
goods sold (COGS). This is simple where the cost has not varied across
those held in stock; but where it has, then an agreed method must be derived to
evaluate it. For commodity items that one cannot track individually,
accountants must choose a method that fits the nature of the sale. Two popular
methods in use are: FIFO (first in – first out) and LIFO (last in – first out).
FIFO treats the first unit that arrived in inventory as the first one sold.
LIFO considers the last unit arriving in inventory as the first one sold. Which
method an accountant selects can have a significant effect on net income
and book value and, in turn, on taxation. Using LIFO accounting for
inventory, a company generally reports lower net income and lower book value,
due to the effects of inflation. This generally results in lower taxation. Due
to LIFO's potential to skew inventory value, UK GAAP and IAS have
effectively banned LIFO inventory accounting. LIFO accounting is permitted in
the United States subject to section 472 of the Internal Revenue Code.[18]
Standard cost accounting
Main article: Standard cost
accounting
Standard cost accounting
uses ratios called efficiencies that compare the labour and
materials actually used to produce a good with those that the same goods would
have required under "standard" conditions. As long as actual and
standard conditions are similar, few problems arise. Unfortunately, standard
cost accounting methods developed about 100 years ago, when labor comprised the
most important cost in manufactured goods. Standard methods continue to
emphasize labor efficiency even though that resource now constitutes a (very)
small part of cost in most cases.
Standard cost accounting can hurt managers, workers, and firms in several ways.
For example, a policy decision to increase inventory can harm a manufacturing
manager's performance evaluation. Increasing inventory requires increased
production, which means that processes must operate at higher rates. When (not
if) something goes wrong, the process takes longer and uses more than the
standard labor time. The manager appears responsible for the excess, even
though s/he has no control over the production requirement or the problem.
In adverse economic times, firms use the same efficiencies to downsize,
rightsize, or otherwise reduce their labor force. Workers laid off under those
circumstances have even less control over excess inventory and cost
efficiencies than their managers.
Many financial and cost accountants have agreed for many years on the
desirability of replacing standard cost accounting. They have not, however,
found a successor.
Theory of constraints cost
accounting
Eliyahu M. Goldratt developed
the Theory of Constraints in part to address the cost-accounting
problems in what he calls the "cost world." He offers a substitute,
called throughput accounting, that uses throughput (money for
goods sold to customers) in place of output (goods produced that may sell or
may boost inventory) and considers labor as a fixed rather than as a variable
cost. He defines inventory simply as everything the organization owns that it
plans to sell, including buildings, machinery, and many other things in
addition to the categories listed here. Throughput accounting recognizes only
one class of variable costs: the truly variable costs, like materials and
components, which vary directly with the quantity produced
Finished goods inventories remain balance-sheet assets, but
labor-efficiency ratios no longer evaluate managers and workers. Instead of an
incentive to reduce labor cost, throughput accounting focuses attention on the
relationships between throughput (revenue or income) on one hand and controllable
operating expenses and changes in inventory on the other.
National accounts
Inventories also play an
important role in national accounts and the analysis of the business
cycle. Some short-term macroeconomic fluctuations are attributed to
the inventory cycle.
Distressed inventory
Also known as distressed or
expired stock, distressed inventory is inventory whose potential to be sold at
a normal cost has passed or will soon pass. In certain industries it
could also mean that the stock is or will soon be impossible to sell. Examples
of distressed inventory include products which have reached their expiry
date, or have reached a date in advance of expiry at which the planned market
will no longer purchase them (e.g. 3 months left to expiry), clothing which is
out of fashion, music which is no longer popular and old newspapers or
magazines. It also includes computer or consumer-electronic equipment which is
obsolete or discontinued and whose manufacturer is unable to support it, along
with products which use that type of equipment e.g. VHS format
equipment and videos.[19]
In 2001, Cisco wrote off inventory worth US $2.25 billion due to
duplicate orders.[20] This is considered one of the biggest inventory
write-offs in business history.[citation needed]
Stock rotation
Stock rotation is the practice of changing the way inventory is displayed on a regular basis. This is most commonly used in hospitality and retail - particularity where food products are sold. For example, in the case of supermarkets that a customer frequents on a regular basis, the customer may know exactly what they want and where it is. This results in many customers going straight to the product they seek and do not look at other items on sale. To discourage this practice, stores will rotate the location of stock to encourage customers to look through the entire store. This is in hopes the customer will pick up items they would not normally see.
Inventory credit
Inventory credit refers to the
use of stock, or inventory, as collateral to raise finance. Where
banks may be reluctant to accept traditional collateral, for example in developing
countries where land title may be lacking, inventory credit is a
potentially important way of overcoming financing constraints. This is not a
new concept; archaeological evidence suggests that it was practiced in Ancient
Rome. Obtaining finance against stocks of a wide range of products held in
a bonded warehouse is common in much of the world. It is, for
example, used with Parmesan cheese in Italy.[22] Inventory credit on the
basis of stored agricultural produce is widely used in Latin American countries
and in some Asian countries.[23] A precondition for such credit is that
banks must be confident that the stored product will be available if they need
to call on the collateral; this implies the existence of a reliable network of
certified warehouses.[24] Banks also face problems in valuing the
inventory. The possibility of sudden falls in commodity prices means that they
are usually reluctant to lend more than about 60% of the value of the inventory
at the time of the loan.
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