What is Inventory ?
Besides cash and receivables, the third major current asset is inventory. The term inventory refers to the aggregate of the products that the firm offers for sales, or trades in,and the components that make up the products. That is, inventory is composed of assets that will be sold in future in the normal course of business. For the construction industry,it is the total of items on which bills will be raised by the contractor or tenderer on the client or the customer for eventual payment to be received. Looked at in this perspective,it is the aggregate of usable (having economic value) but idle resources. The assets or resources which the firm keeps in its stock in anticipation of need (or for eventual billing on the client on completion of work items) are : (i) raw materials; (ii) work-in-progress (or semi-finished goods); and (iii) finished goods. Besides these, which actually would be eventually transferred (for cost through sale) to the client, the firm also needs (iv) supplies for operations, maintenance and repairs, and packaging, and also (v) spares on its store/stocks. Cost of fuels and lubricants is included in (iv), alongwith other consumables.
How Inventory Differs from Other Current Assets
Rather than any particular individual or unit of the organisation, the organisation as a whole has to be involved in Inventory Management. Cash as well as receivables are characterised by their "monetary value", which immediately takes care of the quantity statement also; and, except for bad debts, quality aspect is not involved. When shortage is felt, it is only the finance controlling department that has to mobilise itself and the other departments can be unconcerned. Inventory management on the other hand has to be by an integrated systems approach - using every feasible productivity technique regarding the use, design, development, processing, marketing, distribution, acquisition, flow,handling, storage, maintenance, inspection, auditing and financing of the inventory items within the whole organisation and its interaction with its environment. Taking particularly the functional areas of finance, marketing, production, design and purchasing, as a typical set of functional areas involved, their views regarding inventory are likely to be different for each area. If the designer reduces on the material specifications, finance unit may be agreeable, but production unit will find the going difficult; and so marketing unit will find it more difficult to promote the product in the market. If the purchasing department goes for discounts, the finance may agree but the stores and security units will have problems on hand in terms of space and personnel needed. If finance suggests that the purchases may be made since cash will be available at a certain time, the purchasing unit may find the right quality and righ quantity of materials needed are not then available and if certain items get purchased because of then availability, even if these items do not deteriorate, design and production units may not approve of the items purchased for their purposes. Production-in-charge wants minimum stock-out; on the contrary, finance wants to minimise inventory. Designers and architects may prescribe costly and difficult-to-produce materials, also with much variety and, may be, even non-standard dimensions - leading to wastage and irreplaceability. When the ultimate user requires RAM - Reliability, Availability and Maintainability - these introduce further problems by themselves.In short, inventory management requires an integrated systems approach if low productivity is to be avoided.
Importance of Inventory Management
In any business venture, and particularly so in the construction industry, materials constitute the biggest single element of cost - generally around 40% of total cost and even upto 50% to 70% of total cost. Optirnising material related costs will definitely increase productivity and this is very much feasible if the hidden costs are reduced.Let us assume that current profits are 20% and it is desired to increase these to, say, 22%.Then, either sales will have to be increased from, say, 100 to 102.56, i.e. by 2.56%, or costs have to be reduced by 2% as seen herewith.
(a)Sales at 100; profits at 20; so costs at 80 at the current status; at the desired changed status : Sales at 100; profits at 22; so costs to be 78. This is the cost reduction alternative.
(b) Sales at 102.56; profits at 22%, i.e. to be 22.56, so costs remain at 80. This is the income expansion alternative.In the income expansion case, income has to increase by 2.56 units, but, in the cost reduction case, costs have to be decreased by 2 units. Besides having to produce 2.56 more units (assuming that manufacturing capacity need not be expanded), more advertisement, more sales personnel, etc., would also be needed for income expansion alternative. For the cost reduction alternative, it would be much easier to reduce costs by 2 units, of which material costs to be reduced would be, say, 50% thereof, i.e. 1 unit only and other expenses by 1 unit. This is, at any time, the more feasible alternative.Inventory is also necessary to improve production efficiency and also morale.Non-availability of materials as resource inputs leads to delays in production and/or implementation, hence schedule slippages, hence penalties, hence loss of image in the public domain and reduced benefits (both due to delay in implementation and the associated increased costs).
Reasons for Holding Inventory
Any time lag in delivery of materials by suppliers would hold up production and construction activity. There has to be adequate inventory on hand as a buffer to keep production and construction going on uninterrupted.Even the lead times for delivery are variable and the rate of demand for use of materials may vary during this lead time. Also, demand (as well as supply) for materials may even be uncertain. Moreover, by holding inventory, one guards against delays arising from rejection of items of supply or of production -substitutions are possible.
Due to batch processing, or the necessary sequence of operations in any item of work and the delays between the stagesfsequences for reason of specifications,materials properties, etc., what is called cycle stock gets built up unavoidably.Economy of scale of operation too requires additional materials and that interruption of operations must be avoided.Since production and transportation delivery to customers may often differ in the time-rates, in-process (or pipeline) inventory is unavoidable.If damand or supply is seasonai, stock must have to be accumulated during low demand period to be later able to meet peak demand - otherwise, other resources,like personnel, machinery, etc. will be unevenly loaded over time.On the same lines, discontinuities due to strikes, lockouts, monsoons, etc.necessitate inventory management. Same is true under circumstances of cartelling by suppliers or any trade malpractices of suppliers - either by monopolies or by cartels.
The firm itself has to respond to offers of discount for bulk purchases (which exceed the rate of consumption), to prospects of short supply and to projections of potential or forthcoming inflation and controls.Stockouts would result in closing down the production and construction activity and would lead to loss of sales. Moreover, holding inventory aids in standardisation since production will not be disrupted.Inventory Flow Cycle and Decoupling Function of Inventories Recalling in part the Figure given under previous Section , the inventory flow cycle can be redrawn as under.
Besides cash and receivables, the third major current asset is inventory. The term inventory refers to the aggregate of the products that the firm offers for sales, or trades in,and the components that make up the products. That is, inventory is composed of assets that will be sold in future in the normal course of business. For the construction industry,it is the total of items on which bills will be raised by the contractor or tenderer on the client or the customer for eventual payment to be received. Looked at in this perspective,it is the aggregate of usable (having economic value) but idle resources. The assets or resources which the firm keeps in its stock in anticipation of need (or for eventual billing on the client on completion of work items) are : (i) raw materials; (ii) work-in-progress (or semi-finished goods); and (iii) finished goods. Besides these, which actually would be eventually transferred (for cost through sale) to the client, the firm also needs (iv) supplies for operations, maintenance and repairs, and packaging, and also (v) spares on its store/stocks. Cost of fuels and lubricants is included in (iv), alongwith other consumables.
How Inventory Differs from Other Current Assets
Rather than any particular individual or unit of the organisation, the organisation as a whole has to be involved in Inventory Management. Cash as well as receivables are characterised by their "monetary value", which immediately takes care of the quantity statement also; and, except for bad debts, quality aspect is not involved. When shortage is felt, it is only the finance controlling department that has to mobilise itself and the other departments can be unconcerned. Inventory management on the other hand has to be by an integrated systems approach - using every feasible productivity technique regarding the use, design, development, processing, marketing, distribution, acquisition, flow,handling, storage, maintenance, inspection, auditing and financing of the inventory items within the whole organisation and its interaction with its environment. Taking particularly the functional areas of finance, marketing, production, design and purchasing, as a typical set of functional areas involved, their views regarding inventory are likely to be different for each area. If the designer reduces on the material specifications, finance unit may be agreeable, but production unit will find the going difficult; and so marketing unit will find it more difficult to promote the product in the market. If the purchasing department goes for discounts, the finance may agree but the stores and security units will have problems on hand in terms of space and personnel needed. If finance suggests that the purchases may be made since cash will be available at a certain time, the purchasing unit may find the right quality and righ quantity of materials needed are not then available and if certain items get purchased because of then availability, even if these items do not deteriorate, design and production units may not approve of the items purchased for their purposes. Production-in-charge wants minimum stock-out; on the contrary, finance wants to minimise inventory. Designers and architects may prescribe costly and difficult-to-produce materials, also with much variety and, may be, even non-standard dimensions - leading to wastage and irreplaceability. When the ultimate user requires RAM - Reliability, Availability and Maintainability - these introduce further problems by themselves.In short, inventory management requires an integrated systems approach if low productivity is to be avoided.
Importance of Inventory Management
In any business venture, and particularly so in the construction industry, materials constitute the biggest single element of cost - generally around 40% of total cost and even upto 50% to 70% of total cost. Optirnising material related costs will definitely increase productivity and this is very much feasible if the hidden costs are reduced.Let us assume that current profits are 20% and it is desired to increase these to, say, 22%.Then, either sales will have to be increased from, say, 100 to 102.56, i.e. by 2.56%, or costs have to be reduced by 2% as seen herewith.
(a)Sales at 100; profits at 20; so costs at 80 at the current status; at the desired changed status : Sales at 100; profits at 22; so costs to be 78. This is the cost reduction alternative.
(b) Sales at 102.56; profits at 22%, i.e. to be 22.56, so costs remain at 80. This is the income expansion alternative.In the income expansion case, income has to increase by 2.56 units, but, in the cost reduction case, costs have to be decreased by 2 units. Besides having to produce 2.56 more units (assuming that manufacturing capacity need not be expanded), more advertisement, more sales personnel, etc., would also be needed for income expansion alternative. For the cost reduction alternative, it would be much easier to reduce costs by 2 units, of which material costs to be reduced would be, say, 50% thereof, i.e. 1 unit only and other expenses by 1 unit. This is, at any time, the more feasible alternative.Inventory is also necessary to improve production efficiency and also morale.Non-availability of materials as resource inputs leads to delays in production and/or implementation, hence schedule slippages, hence penalties, hence loss of image in the public domain and reduced benefits (both due to delay in implementation and the associated increased costs).
Reasons for Holding Inventory
Any time lag in delivery of materials by suppliers would hold up production and construction activity. There has to be adequate inventory on hand as a buffer to keep production and construction going on uninterrupted.Even the lead times for delivery are variable and the rate of demand for use of materials may vary during this lead time. Also, demand (as well as supply) for materials may even be uncertain. Moreover, by holding inventory, one guards against delays arising from rejection of items of supply or of production -substitutions are possible.
Due to batch processing, or the necessary sequence of operations in any item of work and the delays between the stagesfsequences for reason of specifications,materials properties, etc., what is called cycle stock gets built up unavoidably.Economy of scale of operation too requires additional materials and that interruption of operations must be avoided.Since production and transportation delivery to customers may often differ in the time-rates, in-process (or pipeline) inventory is unavoidable.If damand or supply is seasonai, stock must have to be accumulated during low demand period to be later able to meet peak demand - otherwise, other resources,like personnel, machinery, etc. will be unevenly loaded over time.On the same lines, discontinuities due to strikes, lockouts, monsoons, etc.necessitate inventory management. Same is true under circumstances of cartelling by suppliers or any trade malpractices of suppliers - either by monopolies or by cartels.
The firm itself has to respond to offers of discount for bulk purchases (which exceed the rate of consumption), to prospects of short supply and to projections of potential or forthcoming inflation and controls.Stockouts would result in closing down the production and construction activity and would lead to loss of sales. Moreover, holding inventory aids in standardisation since production will not be disrupted.Inventory Flow Cycle and Decoupling Function of Inventories Recalling in part the Figure given under previous Section , the inventory flow cycle can be redrawn as under.
 |
| Inventory Flow Cycle |
At each of the processing stages, viz. A, B, C and D, the firm is holding inventory-in-transition between externalities I and V andlor internal nomenclature (11, I11 and IV). Inventory in the form of raw materials (11) decouples the processes on either side, viz. supply/procurement/purchases (A) on the backward side and design and production processes (B) on the forward side, thereby protecting B
from the uncertainties in (A). Likewise I11 decouples B and C and protects C from the uncertainties in B. Likewise IV decouples C and D and protects D from the uncertainties in C. Thus, inventory, in its three forms, acts like springs/dashpots, shock absorbers and buffers in mechanical analogy and the operations in the firm (in its several units/departments) are reasonably well dissociated from each other.Also, flexibility is provided in all the stages A, B, C and D. That is, inventory on hand permits efficient production scheduling and utilisation of resources and enhances effectiveness everywhere in the firm.
Objectives of Inventory Management
The illustrative examples thereunder have all emphasised the role of turnover of the current assets to minimise their requirement and also thereby to maximise the owners' wealth. Likewise, in the case of inventories also, inventory must be turned over as quickly as possible,ensuring at the same time that sufficient inventory is available to meet production or construction and sales demands. That is, the policy adopted for inventory management should optimally reconcile and counterbalance between two conflicting requirements, viz. (i) to minimise the firm's investments in inventory,and (ii) to meet the demand for the products by efficiently organising the functions and operations of its various units/departments.
These conflicting requirements, or objectives, can also be expressed in terms of costs and benefits associated with the inventory. To minimise investments in inventory pre-ordains the maintenance of certain inventory which, in turn, involves costs (either for inventory on hand, or by loss of sales due to lack of inventory on hand). In any case, the lower the inventory, the lower the cost to the firm [though in case of loss of sales, it will be loss of profit on the sales, which is as good as a cost (being negative profit)]. But inventories also provide benefits since they help in the decoupled and flexible functioning of the units/departments of the fm; that is to say, the larger the inventory, the better the decoupling and flexibility and hence, it is better from the firm's viewpoint.The optimal level of inventory then would depend on the trade-off between costs and benefits associated with levels of inventory. For this purpose, both inventory management techniques (based on inventory models) and selective inventory control (based on inventory classification) are used. Essentially, these directly apply for raw materials only.
The further description of inventory management techniques based on inventory models and inventory classification techniques have already been covered in detail in ET 581 (Part B) and ET 525 , respectively. However, a brief description of inventory management techniques is presented .
Costs Associated with Inventory
There are two major categories of costs associated with materials. These are costs OF materials and costs ON materials.
Costs of Material
Costs of material include their price (and taxes, if appropriate). Besides.this simple concept, which goes towards the primary cost (whether the f m buys it or not),there are other types of costs in relation to profitability of the firm.
These include following :
(a) Shortage or Stockout Costs : This relates to the opportunity loss due to non-availability of material when required. Non-availability of material when required results in delays in production/construction/project implementation, in idling (and the associated cost thereof) of other resources and their wearing out (if their running cannot be stopped just for this reason of non-availability of material). There results inconvenience to the customer with the risk of loss of goodwill, incidence of other social costs and even penalties for the delay (if so provided for under the terms of the contract). Either sales are lost (under extreme conditions, the owner may insist on, or resort to, getting the job done by another contractor at the risk and cost of the currently defaulting contractor) or they can be attended to as back-orders or back-logs. If substitution is done, there will be penal costs and also problems related to labour and wastages. On the other hand, if expeditious and emergency procurements have to be made, then suppliers may hike their prices and the cost paid will be distress-dependent.
Stock-out cost as described hereinabove relates to situations when "supply" is "dynamic" (i.e. repetitive supplies are possible depending upon the situation of residual stock) and "demand" is "certain" - these are discussed . However, in situations where supply is "static" (i.e. only once, or periodically, the period not at all relatable to the available inventory position on hand) and the demand is "risk-described" (these too are discussed later), it is called undenstocking cost. In this latter case, loss of goodwill and of customer may occur; but substitution or emergency procurement is not characteristically into the situation.
(b) Over-stocking Cost : This arises under conditions contrary to the incidence of under-stocking cost. When supply is static and demand is risk-distributed, if the inventory level is higher than the optimum, the extra inventory in excess of the optimum is not sold. Also, since the "static" supply may again be available though at its own schedule on the next occasion, this currently unsold inventory may not be picked up by the customers; or, if it has not deteriorated, the firm may be able to sell it, may be at a lesser unit price only, and the firm would,anyway, have incurred a "over-the-season carrying cost" also, till the next cycle of sales begins. (Bread, Diwali crackers, etc., are common examples, though production and construction firms may also realise its incidence.)
(c) Other Incidences : These are not, in reality, costs of materials, but are associated with their purchase depending upon the discretion andlor commodity under sale. Included in this are : discounts, effects of inflation; associated purchases (or gifts); complementary/bonus items (or commodities).
Costs on Materials
These are also called the hidden costs. Inventory has, obviously to be purchased;and this requires certain activities. Also, as the definition and concept of inventory go, inventory has to be the buffer decoupling demand for use from procured supply, i.e. inventory, after its purchase, has to be handled and preserved for issue as and when required by the production process. Accordingly, two types of costs form this category of costs on materials, viz. (i) ordering, acquisition, or set-up, costs; and (ii) carrying or holding costs. In as much as these costs are largely borne by unitsldepartments of the firm other than the production/construction unitl department, and given that every individual will (like to) justify his being on the rolls of the firm, meaning that these costs could not be wished out, these costs are shown separately as overheads, administrative, stores or other expenses, rather than as superposed on the cost of materials. For this reason, the firm is not triggered (or alerted) to the possibility of reduction in these costs by integrated inventory management.
These include following :
(a) Ordering (or Replenishing) costs refers to the monetisation of the efforts expended in procurement of stock. It includes : Order generation andprocessing; stationery, transport, postage and clerical expenses; expenses in follow-up by letters, telegrams, telex, telephone, fax, e-mail, etc. and also by journeys; and the related salaries, wages, allowances, etc. On receipt, the material has to be inspected for quality, quantity and specifications, for quality control, for information processing, etc. till the material is sent to stores.Expenses or return, if any, of the goods is also to be included. It must be remembered that only incremental costs should be recognised as pertinent to each individual order. To explain, if Rs. 10,000 has been booked as ordering costs so far, and one fresh order thereafter brings up the booked cost on ordering to Rs. 11,200, the ordering cost for this order is to be reckoned only as Rs. 1,200. If 6 orders had been processed earlier and this is the seventh order, it is not the practice to attribute Rs. 1,600 to each of the seven orders.
(b) Carrying (or holding) costs arise because of maintaining (or carrying or holding) of the inventory till issued. There are two major classes of costs in this,viz. those that arise due to the physical presence of the inventory and those that are the opportunity cost of funds. Costs related to the physical presence of the inventory include : rental cost of the space, salaries and wages of personnel,cost of process of keeping accounts/issues, etc., power, rent, insurance against fire and theft, propery taxes, security and lighting, packaging and handling,internal transport within the firm's premises including from godown to godown, protection from vagaries of weather and climate, termite proofing, etc. Cost of delays in transport is also to be included. The phenomenon called as enhanced stock-dependent consumption has also to be provided for - e.g., people take the car just because it is there and do not walk; stationery is used as table spread for lunch just because it is more handily available; lights and fans are on just because one cannot care, and so on. There are also costs arising from pilferage,breakage, technical obsolescence, style obsolescence and price decline. The other class of holding cost, viz. opportunity cost of funds, consists of expenses in raising the funds to finance the acquisition of the inventory (cost in acquiring the funds and the interest on capital). If these funds had not been locked up in inventory, they could have earned a return. This is the financial cost component of the holding cost.
There is a third group of costs (other than ordering costs and holding cost) on materials, viz. wastage costs. These include losses due to : perishability of goods,evaporation of liquids, expiry of goods, crumbling, buckling, rusting, shrinkage, mixing up, chemical reaction, etc., and also for reason of having to produce or set apart test samples (for destructive testing, particularly). These are non-apportionable costs, in the sense, they cannot be attributed to particular job items : say, cement, which is usable for Cement Concrete foundation, RCC beams and lintel, plinth protection course, damp-proofing course, etc., and any loss of cement cannot be apportioned to any of these job items specifically. However, it is a general practice to include these wastage costs within carrying (or holdiag) costs.
Inventory Management Techniques
It is the non-matching of the supply to the demand of materials needed for the business purposes of the firm that necessitates the keeping of inventory. This mismatch can be in quantity terms or in terms of timing or both. If no, or very little, mismatch can be managed as a nation-wide mission, one can possibly practise what has been called JIT, JUST IN TIME, materials handling. That the Japanese firms have been able to practise this is crucially dependent upon successful (and, more importantly, unsuspected) efforts having been expended on : Value analysis, source development, vendor rating, standardisation, variety reduction, purposeful logistics, good materials planning (including forecasting and trend analysis) and faith in individuals and in the system. The very practice of inviting quotations and tenders for every occasion of purchase and limiting the validity period of the rates offered and the procedural labyrinth to be followed for settling the bills for the supply (be it materials, or labour, or consultancy) is contra-indicative of JIT type of materials management.
The other alternative is what gets labelled as JIC materials management, with JIC standing for JUST-IN-CASE. The hesitations and apprehensions leading to JIC attitude span over a whole lot of details - JIC materials are not available, JIC funds are not available, JIC the climate is non-conducive, JIC the power fails or the,supply does not reach, JIC labour goes on go-slow or strike. JIC any one step in the procedure followed is held to be flawed. etc.
However, one aspect of JIC is the reason for holding inventory, viz. the mismatch between supply of and demand for the materials. This mismatch is not merely in terms of quantity but also in terms of the lead time for the supply and the variations (over time) of the demand. As discussed under Section 20.9.3, supply can be static or dynamic.Demand, on the other hand, can be either certain, or risk-distributed or uncertain (uncertain referring to unpredictability or non-amenability to specifying a risk pattern, like, for instance, the burning out of a bulb, or the bursting of the tyre of a bulldozer, etc.).Accordingly, one way of classification of the techniques (and the corresponding mathematical models) for inventory management and control is the Supply-Demand based classifications. The two possibilities of supply conditions, viz. static and dynamic, can each go with each of the three possibilities of demand conditions, viz. certain,risk-distributed and uncertain. Of these, the interaction between static supply and certain demand is too trivial and does not need any modelling or technique; just go and buy what you need when it is available. The interaction between dynamic supply and uncertain demand is quite complicated. The classification is presented in Table.
from the uncertainties in (A). Likewise I11 decouples B and C and protects C from the uncertainties in B. Likewise IV decouples C and D and protects D from the uncertainties in C. Thus, inventory, in its three forms, acts like springs/dashpots, shock absorbers and buffers in mechanical analogy and the operations in the firm (in its several units/departments) are reasonably well dissociated from each other.Also, flexibility is provided in all the stages A, B, C and D. That is, inventory on hand permits efficient production scheduling and utilisation of resources and enhances effectiveness everywhere in the firm.
Objectives of Inventory Management
The illustrative examples thereunder have all emphasised the role of turnover of the current assets to minimise their requirement and also thereby to maximise the owners' wealth. Likewise, in the case of inventories also, inventory must be turned over as quickly as possible,ensuring at the same time that sufficient inventory is available to meet production or construction and sales demands. That is, the policy adopted for inventory management should optimally reconcile and counterbalance between two conflicting requirements, viz. (i) to minimise the firm's investments in inventory,and (ii) to meet the demand for the products by efficiently organising the functions and operations of its various units/departments.
These conflicting requirements, or objectives, can also be expressed in terms of costs and benefits associated with the inventory. To minimise investments in inventory pre-ordains the maintenance of certain inventory which, in turn, involves costs (either for inventory on hand, or by loss of sales due to lack of inventory on hand). In any case, the lower the inventory, the lower the cost to the firm [though in case of loss of sales, it will be loss of profit on the sales, which is as good as a cost (being negative profit)]. But inventories also provide benefits since they help in the decoupled and flexible functioning of the units/departments of the fm; that is to say, the larger the inventory, the better the decoupling and flexibility and hence, it is better from the firm's viewpoint.The optimal level of inventory then would depend on the trade-off between costs and benefits associated with levels of inventory. For this purpose, both inventory management techniques (based on inventory models) and selective inventory control (based on inventory classification) are used. Essentially, these directly apply for raw materials only.
The further description of inventory management techniques based on inventory models and inventory classification techniques have already been covered in detail in ET 581 (Part B) and ET 525 , respectively. However, a brief description of inventory management techniques is presented .
Costs Associated with Inventory
There are two major categories of costs associated with materials. These are costs OF materials and costs ON materials.
Costs of Material
Costs of material include their price (and taxes, if appropriate). Besides.this simple concept, which goes towards the primary cost (whether the f m buys it or not),there are other types of costs in relation to profitability of the firm.
These include following :
(a) Shortage or Stockout Costs : This relates to the opportunity loss due to non-availability of material when required. Non-availability of material when required results in delays in production/construction/project implementation, in idling (and the associated cost thereof) of other resources and their wearing out (if their running cannot be stopped just for this reason of non-availability of material). There results inconvenience to the customer with the risk of loss of goodwill, incidence of other social costs and even penalties for the delay (if so provided for under the terms of the contract). Either sales are lost (under extreme conditions, the owner may insist on, or resort to, getting the job done by another contractor at the risk and cost of the currently defaulting contractor) or they can be attended to as back-orders or back-logs. If substitution is done, there will be penal costs and also problems related to labour and wastages. On the other hand, if expeditious and emergency procurements have to be made, then suppliers may hike their prices and the cost paid will be distress-dependent.
Stock-out cost as described hereinabove relates to situations when "supply" is "dynamic" (i.e. repetitive supplies are possible depending upon the situation of residual stock) and "demand" is "certain" - these are discussed . However, in situations where supply is "static" (i.e. only once, or periodically, the period not at all relatable to the available inventory position on hand) and the demand is "risk-described" (these too are discussed later), it is called undenstocking cost. In this latter case, loss of goodwill and of customer may occur; but substitution or emergency procurement is not characteristically into the situation.
(b) Over-stocking Cost : This arises under conditions contrary to the incidence of under-stocking cost. When supply is static and demand is risk-distributed, if the inventory level is higher than the optimum, the extra inventory in excess of the optimum is not sold. Also, since the "static" supply may again be available though at its own schedule on the next occasion, this currently unsold inventory may not be picked up by the customers; or, if it has not deteriorated, the firm may be able to sell it, may be at a lesser unit price only, and the firm would,anyway, have incurred a "over-the-season carrying cost" also, till the next cycle of sales begins. (Bread, Diwali crackers, etc., are common examples, though production and construction firms may also realise its incidence.)
(c) Other Incidences : These are not, in reality, costs of materials, but are associated with their purchase depending upon the discretion andlor commodity under sale. Included in this are : discounts, effects of inflation; associated purchases (or gifts); complementary/bonus items (or commodities).
Costs on Materials
These are also called the hidden costs. Inventory has, obviously to be purchased;and this requires certain activities. Also, as the definition and concept of inventory go, inventory has to be the buffer decoupling demand for use from procured supply, i.e. inventory, after its purchase, has to be handled and preserved for issue as and when required by the production process. Accordingly, two types of costs form this category of costs on materials, viz. (i) ordering, acquisition, or set-up, costs; and (ii) carrying or holding costs. In as much as these costs are largely borne by unitsldepartments of the firm other than the production/construction unitl department, and given that every individual will (like to) justify his being on the rolls of the firm, meaning that these costs could not be wished out, these costs are shown separately as overheads, administrative, stores or other expenses, rather than as superposed on the cost of materials. For this reason, the firm is not triggered (or alerted) to the possibility of reduction in these costs by integrated inventory management.
These include following :
(a) Ordering (or Replenishing) costs refers to the monetisation of the efforts expended in procurement of stock. It includes : Order generation andprocessing; stationery, transport, postage and clerical expenses; expenses in follow-up by letters, telegrams, telex, telephone, fax, e-mail, etc. and also by journeys; and the related salaries, wages, allowances, etc. On receipt, the material has to be inspected for quality, quantity and specifications, for quality control, for information processing, etc. till the material is sent to stores.Expenses or return, if any, of the goods is also to be included. It must be remembered that only incremental costs should be recognised as pertinent to each individual order. To explain, if Rs. 10,000 has been booked as ordering costs so far, and one fresh order thereafter brings up the booked cost on ordering to Rs. 11,200, the ordering cost for this order is to be reckoned only as Rs. 1,200. If 6 orders had been processed earlier and this is the seventh order, it is not the practice to attribute Rs. 1,600 to each of the seven orders.
(b) Carrying (or holding) costs arise because of maintaining (or carrying or holding) of the inventory till issued. There are two major classes of costs in this,viz. those that arise due to the physical presence of the inventory and those that are the opportunity cost of funds. Costs related to the physical presence of the inventory include : rental cost of the space, salaries and wages of personnel,cost of process of keeping accounts/issues, etc., power, rent, insurance against fire and theft, propery taxes, security and lighting, packaging and handling,internal transport within the firm's premises including from godown to godown, protection from vagaries of weather and climate, termite proofing, etc. Cost of delays in transport is also to be included. The phenomenon called as enhanced stock-dependent consumption has also to be provided for - e.g., people take the car just because it is there and do not walk; stationery is used as table spread for lunch just because it is more handily available; lights and fans are on just because one cannot care, and so on. There are also costs arising from pilferage,breakage, technical obsolescence, style obsolescence and price decline. The other class of holding cost, viz. opportunity cost of funds, consists of expenses in raising the funds to finance the acquisition of the inventory (cost in acquiring the funds and the interest on capital). If these funds had not been locked up in inventory, they could have earned a return. This is the financial cost component of the holding cost.
There is a third group of costs (other than ordering costs and holding cost) on materials, viz. wastage costs. These include losses due to : perishability of goods,evaporation of liquids, expiry of goods, crumbling, buckling, rusting, shrinkage, mixing up, chemical reaction, etc., and also for reason of having to produce or set apart test samples (for destructive testing, particularly). These are non-apportionable costs, in the sense, they cannot be attributed to particular job items : say, cement, which is usable for Cement Concrete foundation, RCC beams and lintel, plinth protection course, damp-proofing course, etc., and any loss of cement cannot be apportioned to any of these job items specifically. However, it is a general practice to include these wastage costs within carrying (or holdiag) costs.
Inventory Management Techniques
It is the non-matching of the supply to the demand of materials needed for the business purposes of the firm that necessitates the keeping of inventory. This mismatch can be in quantity terms or in terms of timing or both. If no, or very little, mismatch can be managed as a nation-wide mission, one can possibly practise what has been called JIT, JUST IN TIME, materials handling. That the Japanese firms have been able to practise this is crucially dependent upon successful (and, more importantly, unsuspected) efforts having been expended on : Value analysis, source development, vendor rating, standardisation, variety reduction, purposeful logistics, good materials planning (including forecasting and trend analysis) and faith in individuals and in the system. The very practice of inviting quotations and tenders for every occasion of purchase and limiting the validity period of the rates offered and the procedural labyrinth to be followed for settling the bills for the supply (be it materials, or labour, or consultancy) is contra-indicative of JIT type of materials management.
The other alternative is what gets labelled as JIC materials management, with JIC standing for JUST-IN-CASE. The hesitations and apprehensions leading to JIC attitude span over a whole lot of details - JIC materials are not available, JIC funds are not available, JIC the climate is non-conducive, JIC the power fails or the,supply does not reach, JIC labour goes on go-slow or strike. JIC any one step in the procedure followed is held to be flawed. etc.
However, one aspect of JIC is the reason for holding inventory, viz. the mismatch between supply of and demand for the materials. This mismatch is not merely in terms of quantity but also in terms of the lead time for the supply and the variations (over time) of the demand. As discussed under Section 20.9.3, supply can be static or dynamic.Demand, on the other hand, can be either certain, or risk-distributed or uncertain (uncertain referring to unpredictability or non-amenability to specifying a risk pattern, like, for instance, the burning out of a bulb, or the bursting of the tyre of a bulldozer, etc.).Accordingly, one way of classification of the techniques (and the corresponding mathematical models) for inventory management and control is the Supply-Demand based classifications. The two possibilities of supply conditions, viz. static and dynamic, can each go with each of the three possibilities of demand conditions, viz. certain,risk-distributed and uncertain. Of these, the interaction between static supply and certain demand is too trivial and does not need any modelling or technique; just go and buy what you need when it is available. The interaction between dynamic supply and uncertain demand is quite complicated. The classification is presented in Table.
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| Inventory Models |
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