Question

- Analyze inventory costs using an example?

- Generally, how does a firm manage its inventory efficiently?

Answer 1

Inventory means stock of goods. It includes raw materials, work-in progress, consumables, finished goods and spares. Although it may appear that the holding of inventories is blocking the funds of the firm, it should be understood that unless a firm has required amount of inventory, it will not be able to carry out its production activities. However, it is true that there are certain costs that are incurred by the firm when it is holding inventory. Such cost is known as inventory cost. It includes Capital cost and Storage and Handling cost. Capital cost indicates the opportunity cost of investment. In other words, the amount of money that the firm is spending on the inventory could have been used as an investment. The benefit foregone by investing in inventory and not in any investment is known as capital cost. Apart from this, the inventory has to stored properly, maintained and handled properly. This will also lead to incurring some costs i.e. Storage and Handling cost.

For example: A company uses wood as its raw material. The inventory costs of the company will include the cost incurred in buying the wood, storing the wood properly such that it does not get spoilt, handling and transporting the wood from one place to another for carrying out the production process such that it is not damaged. All these will together constitute the inventory cost of the company.

A firm manages its inventory efficiently, by following an effective inventory management technique. These techniques help to balance the problem of liquidity as well as availability of inventory when required. Some of the techniques are:

a) ABC Analysis: In this the inventory is classified as category A, B and C based on its percentage value in consumption. Category A consists of those materials that are more valuable in terms of price and used in less quantity in the manufacturing process. Category B consists of materials that are average in price and average in quantity. Category C consists of materials that are used in large quantity and have less value.

b) VED analysis: This is similar to ABC analysis as it also categorizes the materials into different categories i.e. Vital, Essential and Desirable.

c) EOQ Analysis: This is known as Economic Order Quantity analysis. EOQ is the quantity of materials purchased that is economically viable to the company. It is the point where the inventory carrying costs and ordering costs are same.

d) JIT: It stands for Just-in-time. It involves the purchase of materials in such a way that the material is received just before its use or demand in the production process.