Inventory Management: Techniques and Costing Methods
Inventory Management
Inventories represent property for sale in the ordinary course of business. The range of functions and services of inventories depends on the nature and type of enterprise, the importance of the cost of materials and equipment, and the organization of the company. Inventory management focuses on four basic issues: the number of units to be produced in a given time, when inventory items deserve special attention, and how to protect against changes in inventory costs.
Inventory
Inventory is the set of goods or items a company trades, allowing purchase and sale or manufacture before selling in a specific economic period. It should appear in the group of assets.
Inventory is one of the greatest assets of an enterprise, listed on both the balance sheet and the income statement. On the balance sheet, inventory is often the largest current asset. On the income statement, ending inventory is subtracted from the cost of goods available for sale to determine the cost of goods sold during a given period.
Factors in Inventory Minimization
The minimum inventory is zero; a company can have none and produce on demand. However, this is not possible for most companies, as they must meet customer demands immediately or risk losing orders to competitors. Companies seek to minimize inventory because maintenance is expensive. For example, having a million invested in inventory means capital has been obtained at a cost, including salaries and accounts payable. If the cost is 10%, the cost of inventory financing will be 100,000 per year, plus storage costs.
Meeting Demand
If the purpose of inventory management were only to minimize and instantly satisfy demand, companies would store large quantities of products. However, this is extremely expensive due to static capital that could be used more advantageously. Companies must determine the appropriate inventory level, balancing the benefits of avoiding shortages with the cost of maintaining inventory.
Importance of Inventory Administration
Inventory management generally focuses on four basic aspects:
- How many units to order or produce at a given time.
- When to order or produce inventory.
- Which inventory items deserve special attention.
- How to protect against changes in inventory costs.
Success is framed within the policies of inventory management:
- Establish exact relations between likely needs and supplies.
- Define categories for each commodity and classify appropriately.
- Keep supply costs at the lowest possible level.
- Maintain an adequate inventory level.
- Satisfy demand quickly.
- Utilize computer systems.
Features and Analysis of Inventory
It is necessary to analyze inventory items, identifying stages in the production process. Common stages include:
- Raw materials
- Work in process
- Finished goods
- Supplies and parts
Inventory Management Techniques
Common methods include the ABC system and the Economic Order Quantity (EOQ) model.
ABC System
Companies divide inventory into three groups: A, B, and C. Group A products represent the highest investment and require careful control. Group B items follow A on the investment scale. Group C consists of many products requiring a small investment, subject to less stringent control procedures.
Economic Order Quantity (EOQ) Model
The EOQ model determines the optimal order quantity to minimize total inventory cost, considering operational and financial costs. It is useful for controlling Group A items.
Production Control
Key variables for inventory control include:
- Sales levels
- Length and nature of production processes
- Durability of finished products
Production directors must distribute production capacity based on demand and inventory policy, determining the number of each component needed.
Inventory Control
Inventory responsibility affects many departments. Control measures range from budgeting and sales forecasting to cost accounting. General functions include planning, purchasing, receiving, storage, production, shipping, and accounting.
Planning
Production planning and inventory needs estimation are based on the sales budget, developed by the sales department.
Purchasing
Purchasing involves determining material types and quantities, placing orders, and ensuring timely delivery.
Receiving
Receiving includes accepting materials after inspection, recording receipts, and delivering items to warehouses.
Types of Inventories
Types of Inventories
Raw Material Inventory
Basic elements used in product development. Materials significantly involved in production are considered raw materials.
Work-in-Process Inventory
Partially completed products in the production process, with value increasing as they transform into finished goods.
Finished Goods Inventory
Completed items transferred to the warehouse, awaiting sale. Inventory levels depend directly on sales demand.
Materials and Supplies Inventory
Includes secondary raw materials and consumer goods used in operations, such as fuels and lubricants.
Inventory Costs
Inventory Costs
Costs Associated with Flow
Include costs for normal operations, depreciation, amortization, and supply flow (transport).
Costs Associated with Stock
Include storage, deterioration, degradation, and financial costs of inventory.
Costs Associated with Process
Inventory Costing Methods
Inventory Costing Methods
Methods include Specific Unit Cost, Weighted Average Cost, First-In, First-Out (FIFO), and Last-In, First-Out (LIFO).
Specific Unit Cost
Used for individually identifiable items like cars and jewelry.
Weighted Average Cost
Based on the weighted average cost of inventory during the period.
First-In, First-Out (FIFO)
Assumes the first items purchased are the first sold.
Last-In, First-Out (LIFO)
Assumes the last items purchased are the first sold.