Inventory: Meaning, Classification and Need

In this article we will discuss about:- 1. Meaning of Inventory 2. Classification of Inventory 3. Need 4. Nature 5. Motives of Holding 6. Market Structure and Inventories 7. Costs of Holding 8. Methods of Evaluating Inventory.

Meaning of Inventory:

Inventory is the life blood of the industries. But an excess or shortage of inventory is harmful. It is the most important component of working capital.

The term inventory is used to denote the stock on hand at a particular time comprising raw materials, goods in the process of manufacture and finished goods. An inventory has a primary significance for accounting purposes to ascertain the correct income for a particular period. Inventory plays a very important part in the determination of profit of a business.

In the financial sector, inventory is defined as “the sum of the value of raw materials, fuels and lubricants, spare parts, maintenance consumables, semi-processed materials and finished goods stock at any given point of time”.

S.E. Walters states, “The term inventory refers to the stockpiles of the product a firm is offering for sales and the components that make up the product”.

James H. Green observed, “An inventory refers to the movable articles of the business which are eventually expected to go into the flow of trade.”

Classification of Inventory:

The inventory may be classified into the following categories:

(a) Raw Materials Inventory:

This consists of basic materials that have not yet been committed to production in a manufacturing firm. Raw materials that are purchased from firms to be used in the firm’s production operations. The aim of maintaining raw material inventory is to uncouple the produc­tion function from the purchasing function so that delays in shipment of raw materials do not cause production delays.

(b) Stores and Spares:

This includes those products which are accessories to the main products produced for the purpose of sale. Examples of stores and spares are bolts, nuts, clamps, screws, etc. These spare parts are generally bought from outside.

(c) Works in Process Inventory:

This includes those materials that have been committed to the production process but have not been completed. The more complex and lengthy the production proc­ess, the larger will be the investment in work in process inventory.

(d) Finished Goods Inventory:

These are completed products awaiting sale. The purpose of finished goods inventory is to uncouple the production and sale functions so that it is no longer neces­sary to produce the goods before a sale can occur.

On the basis of functions, inventory may be classified into the following four types:

(i) Lot-size Inventories:

Some business firms prefer to purchase materials in bulk because they receive a discount on bulk purchases. Big business firms can afford to buy in large quantities. To produce the goods in exact amount of their demand is not generally possible and practical. Some inventories accumulate. The inventories accumulated as a result are known as lot-size inventories.

(ii) Fluctuation Inventories:

Because of the demand and supply factors, the market for certain commodities or raw materials generally fluctuates. This fluctuation is marked in respect of agro-based products.

When the availability of raw materials is seasonal, bulk stocks are purchased and stocked throughout the year in order to meet the high demand during the season. Since demand fluctuates over time and cannot be forecasted accurately, some reserve stocks are necessary. Those safety stocks are fluctuation inventories.

(iii) Transportation Inventories:

The inventory manager of the business firm favours low in­ventories to reduce inventory cost. However, this policy increases stock-outs, back orders, paper work, special production runs and high cost fast-freight transportation.

Raw materials are transported from its place of production to the business firm which needs it. Since the goods and raw materials in transit cannot serve those for whom these have been sent, these goods or resources in transit represent transportation inventories.

(iv) Anticipation Inventories:

When a business firm anticipates a price rise or introduces the business promotion tools, it will need to accumulate inventories. The raw materials may be stored in the form of semi-finished goods or stored in their original form. These inventories are known as anticipation inventories.

Need for Inventory:

A businessman needs inventory to carry on the day-to-day operations of his business. Now busi­ness activity has increased and the problem of inventory has also become more complex. The business­man needs more cash to conduct his daily business activities. Therefore, the higher the level of inven­tory, the lower the level of cash.

One of the causes for the failure of a business is a huge inventory. The existence of large quantities of inventories is naturally a cause for alarm. The need for inventory must be balanced against the preference for liquidity. If we can stock the required inventory well in advance, we are able to save the cost of idle time of machinery and the cost of idle time of men.

Nature of Inventories:

1. Safety Inventory:

Safety inventory provides for failures in supplies, unexpected spurt in demand, i.e. an insurance cover.

2. Excessive Inventory:

Management is compelled to build up excessive inventory for reasons beyond its control as a measure of government price support of commodity as in the case of strategic import.

3. Normal Inventory:

It is based on production plan and the time of supplies and economic ordering quantity levels. It also includes a reasonable factor of safety.

4. Flabby Inventory:

It includes finished goods, raw materials and stores held because of poor working capital management and inefficient distribution.

5. Profit Making Inventory:

It represents stock of raw materials and finished goods held for realising stock profit. It is a must for every concern to make inventory profitable for adequacy of business operations.

Motives of Holding Inventory:

The decision to hold the inventories is based on certain basic motives.

The motives behind the holding of inventories can be broadly classified as under:

1. For Speculative Purposes:

In a situation of inflation, it may happen that the value of stock increases overtime at a rate which is higher than the cost of holding stocks. The motive to hold inventories for speculative purposes would depend upon the expectations of the price increase as against the holding cost of inventory which includes the prevalent market rate of interest or capital cost, the cost of storage and handling, and the cost of deterioration and obsolescence.

2. To Facilitate a Constant Rate of Output Flow:

The ordinary motive for holding inventories is to enable a constant rate of output flow of the business firm for the uninterrupted supply for which every firm should hold stock of raw materials and semi-finished goods. In business, it is always advisable to hold some precautionary stock to overcome the special problems, like power shortages, transport bottlenecks, labour unrest, etc.

3. To Meet Demand:

The motive to hold inventories to meet demand is quite important for a firm. It is essential to note that demand varies in an unpredictable manner. The changes in the demand for the commodity are not under the control of the firm.

Market Structure and Inventories:

The firm operates in a market, the decision to hold inventories is an important managerial function. The decision to hold inventories depends on the market structure within which the firm is operating.

On the basis of competition, markets are classified into:

1. Perfectly Competitive Market:

In a perfectly competitive market, the individual firm is only a ‘price taker’ and not ‘price maker’ and the individual firm cannot have a price policy of its own. The individual firm will pay attention to the production side to reduce the cost of production. It will adjust output to the market price. There is no need of incurring any expenditure on advertisement and publicity.

The firm need not keep the inventories of finished goods because all output can be sold at a given price. The sellers know the potential sales at various price levels in the market. The firm need not bother about future expectations of prices.

2. Imperfect Market:

Imperfect competition is a term denoting a market situation which is not perfect. Each firm produces basically the same product but endeavours to distinguish it from its rivals by product differen­tiation. There will be no unique price, instead there will be a cluster of prices. The firm gains and retains his customers by competitive advertising and sales promotion.

In case of imperfect competition, the demand is uncertain and the firm needs to keep inventories to take advantage of profitable sales oppor­tunities. The optimum level of inventory will depend upon the variability of sales and the relationship between revenue and cost.

Pricing is not the problem, but product differentiation is the problem, and competition is not on prices but on products. Greater the difference between price and marginal cost, the greater will be the level of inventory stock.

Oligopoly refers to that form of imperfect competition where there will be only a few sellers. Another feature of oligopolist market with product differentiation is price rigidity. The price will be kept unchanged due to fear of retaliation and prices tend to be sticky and inflexible. No firm would indulge in price-cutting and there is a tendency for price stability.

The stocks of finished goods provide the adjustment mechanism necessary when demand does not equal supply. An oligopolist relies more on the short run adjustments in its level of stocks than on price changes. When stocks fall quickly, they exert a pressure for price increase, similarly when stocks grow quickly, the cost of holding inventories would grow to force the firm for a price decrease.

Cost of Holding Inventory:

Holding of inventories has considerable costs. The burden of the cost of inventory is expressed in terms of money.

These costs are divided into the following:

(i) Set up Cost:

These costs include clerical cost on orders and discount rates on quantity of goods purchased. The costs are included in the cost of material at two stages. Firstly, when material is purchased and stored, and secondly, when goods manufactured are stored from the said material. Every company has to store its goods that it wants to be sold. Storage function is necessary because produc­tion and consumption cycles rarely match.

(ii) Cost of Spoilage and Obsolescence:

The next is the cost of spoilage and obsolescence. It refers to loss of goods while in stock. Any product or material is bound to spoil if stored for a long time. The risk of spoilage is an open risk. The cost of spoilage is bound to be taken into account.

Similarly the cost of obsolescence, some spare parts and machine components may become obsolete if they are stored for a long time. This is true when there are rapid technological changes. As a result, the cost of spoilage and obsolescence gives rise to the accountability of inventory cost.

(iii) Cost of Placing an Order:

This cost may be for placing order on outside suppliers for procuring raw goods to be manufactured inside the firm. Depending upon the type of stock, this cost may vary.

Cost of placing an order includes the following:

(i) Set up cost of machines,

(ii) Cost involved in follow-up,

(iii) Cost involved in receiving the order, and

(iv) Paper work costs.

(iv) Cost of Carrying Stock:

This is the cost which a firm actually incurs for carrying the stock.

Cost of carrying stock is calculated by taking into consideration the following items:

(i) Interest on capital,

(ii) Tax and insurance charges,

(iii) Storage cost,

(iv) Allowance for spoilage, and

(v) Obsolescence.

(v) Cost of Running out of Stock:

Whenever stock exhausts for any item, this cost is incurred. These costs are different in nature.

The cost of running out of stock for a raw material or spare part is made up of plant down time and possible special delivery costs. For a finished good, such costs are known as dissatisfaction to custom­ers or lost customers.

Methods of Evaluating Inventories:

The commonly practised methods of evaluating inventories are listed below:

(i) First in First Out:

It is commonly known as the recent purchase method. The method as­sumes that the goods first purchased are the goods first sold or the units that are the first to enter the plant are also the first to leave it. This method ensures that materials should be issued at actual cost and no profit or loss should occur on this account.

This system goes smooth if the prices are stable. During inflation, operating statements reflect inventory profits, which do not represent disposable income. However during deflation, it results in narrowing of profits.

(ii) Last in First Out:

It is generally called as the ‘replacement cost’ method. The method is based on the theory that the goods sold are those most recently purchased. It works in the reversal order to first in first out. The main advantage of this method is that materials are issued at cost and relate as closely as possible to current price levels. This method tends to level profits and losses during inflation and deflation.

Thus it maintains the real capital intact. During inflation, the recent requisitions tend to lower the margin of profit because of their higher costs. However, during deflation the fall in profit is reduced because of the lower cost of the last units acquired.

(iii) Base Stock Method:

This method works more or less similar to the first in first out method, with the addition of a fixed minimum quantity of stock which is always maintained and carried forward at the end of each year at actual cost. In practice, many concerns maintain a minimum stock inventory in store.

When emergency arises, it is released. This method minimises violent fluctuations in the gross profit. This method is prevalent in extractive industries and also applied to those industries where a variety of raw materials are used.

(iv) Average Method:

There are different types of averages. They are the simple average, weighted average, periodic simple average and periodic weighted average. Under simple average method, materi­als are not charged at actual cost but an approximate figure is calculated by dividing the total of the prices by the number of prices which may result in profit or loss.

The weighted average method is similar to simple average. However, weighted average is calculated each time a purchase is made. To eliminate the effect of earlier prices, the total quantities and total costs are considered.

The periodic simple average is also similar to simple average price except that the issue price is calculated at the end of the period. It can be calculated by dividing the total prices of the materials by the number of prices periodically.

The periodic weighted price is calculated at the end of the period by dividing the total cost of purchases by the total quantities purchased. This method is more accurate than the previous one because of the inclusion of total quantities and total cost.

(v) Standard Price Method:

In the light of the various variations, with a view to showing what it should be at the expected level of efficiency, the pre-determined price is ascertained for each material in advance of the accounting period. Thus the standard price is compared with the actual price. When this method is followed the figures of profit are more realistic.