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Subject BUSINESS ECONOMICS
Paper No and Title 4: Principles of Business Finance and Accounting
Module No and Title 16: Inventory Management
Module Tag BSE_P4_M16
BUSINESS PAPER NO. 4 : PRINCIPLES OF BUSINESS FINANCE AND
ECONOMICS ACCOUNTING
MODULE NO. 16: INVENTORY MANAGEMENT
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Types of Inventory
3.1. Raw Material
3.2. Work in Progress
3.3. Finished Goods Inventory
3.4. Stores and Spares
4. Objectives of inventory Management
5. Reasons of optimal Inventory management
6. Costs of Inventory
6.1. Carrying costs
6.2. Ordering Costs
7. Techniques of Inventory Management
7.1. ABC Technique of Analysis
7.2. Economic order Quantity (EOQ)
8. Graded illustrations
9. Summary
BUSINESS PAPER NO. 4 : PRINCIPLES OF BUSINESS FINANCE AND
ECONOMICS ACCOUNTING
MODULE NO. 16: INVENTORY MANAGEMENT
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1. Learning Outcomes
After studying this module, you shall be able to
Know the meaning of types of inventory.
Learn various techniques of inventory management.
Analyze the impact of various inventory policies on the costs of inventory.
Evaluate the various policies and choose the optimal level of inventory.
2. Introduction
Inventories are one of the important current assets of the firm. They require certain investment.
The funds of the organization are blocked in inventories. Therefore, loosing interest on this fund
becomes the opportunity cost of holding inventories. However, there should still be an optimum
level of inventory. If the level of inventory is too low, the firm may lose opportunity of sales and
may be goodwill. If the level of inventories is too high, it entails unnecessary blocking of funds.
That is why inventory management constitutes important segment of working capital
management.
3. Types of Inventory
The term inventory does not include goods and services being sold only but also includes raw
materials or other components being used in manufacturing of such goods. The type of inventory
depends upon the fact whether it is the case of retailer or a manufacturing concern. It is quite
obvious that retail shopkeeper will keep inventory of finished goods only whereas the
manufacturing concern will maintain inventory of raw materials also. The Inventories for most of
the business firms may be classified as:-
1. Raw material
2. Work-in-progress
3. Finished goods
4. Stores & supplies
3.1 Raw material
It includes material which the firm uses in the production process. A firm must hold certain
stocks of raw material in its stores so that production process goes on smoothly without any
interruption. These units of raw materials are regularly issued to the production department. The
quantity of raw materials to be kept by a manufacturing firm depends upon many factors e.g.
Availability of raw material
Price of the raw material
Consumption pattern of the raw material
Lead time (Time taken to replenish the stock)
BUSINESS PAPER NO. 4 : PRINCIPLES OF BUSINESS FINANCE AND
ECONOMICS ACCOUNTING
MODULE NO. 16: INVENTORY MANAGEMENT
___________________________________________________________________________________
3.2 Work-in-progress – The raw material which is engaged in various stages of production
schedule on which certain degree of labor and overheads have been employed is known as work
in progress inventories. The degree of completion may vary for various units. Some units might
have been just introduced in the production process while others may be near completion. It refers
to partly produced goods. The quantity and value of work in progress depends upon the length of
the production cycle. The shorter the length, work in progress inventories would be small and if
the production cycle is lengthy the value of the work in progress inventory would be large.
3.3 Finished goods - There are goods which are complete and ready for sale to the customers.
They may be purchased or produced. The level of finished goods depends on how promptly the
customer requires his demand to be met. In competitive markets the firm must hold large level of
finished goods so that it may not loose sales.
3.4 Stores and supplies – Stores and supplies include fuel, coal, cotton, chemical etc. They do
not enter the production process directly but are needed to run the production process smoothly.
4. Objective of Inventory management
Through efficient management of inventory the wealth of owners will be maximized. To reduce
the requirement of cash in business, inventory turnover should be maximized and there should be
no loss of production and sales, arising from its beings out of stocks.
The main purpose of inventory management is to keep inventories at appropriate level. If
inventory levels are high there would be no loss of production and sales. Both the functions
would be carried without interpretations. But there is always a cost involved in the inventories.
The cost would include the capital cost of the stock and the costs of storing i.e. rent, insurance
premium etc. On the other hand if stocks are kept at low levels the cost of capital and storing
costs would be avoided but there can be stock out costs. The cost of stock out may be sales loss or
customers dissatisfied. It may also cause delay or hold ups in the production process.
Thus there has to be a balance between the two. There is a level of stock which is optimum or
most appropriate. Inventory management seeks to determine this level and maintain it.
Thus, the objectives of inventory management are two fold:
1. To ensure continuous supply of raw material in adequate manner.
2. To minimize the investment of funds in the inventories.
5. Reasons for maintaining optimum inventory level
The optimum level of inventory depends upon the features of a particular firm. If it is a trading
firm it procures goods and sells them. So if the firm has stocks with it, it can sell goods even if
supply of goods has stopped. But if the firm has no stocks with it, sales will stop as soon as
procurement stops. Therefore the firm must maintain optimum level of inventory if it does not
want to lose its share in the market to its competitors.
Similarly, if it is manufacturing firm, it process raw material and converts it into finished goods to
sell. It must maintain optimum level of raw material as well as optimum stocks of finished goods
BUSINESS PAPER NO. 4 : PRINCIPLES OF BUSINESS FINANCE AND
ECONOMICS ACCOUNTING
MODULE NO. 16: INVENTORY MANAGEMENT
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