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In this article we cover the following topics:

  1. what is Inventory Management
  2. Techniques
  3. Ratios

 1. what is Inventory Management

Inventory management is the process through which an entity can maintain and manage its inventory. This involves activities which allow an entity to have a better control over various inventory items right from receipt to the point of sale. The term inventory management techniques include series of activities like ordering, receipt, storage, refill, issue etc.

The main objective of inventory management is to provide uninterrupted production, sales, customer-service levels at the minimum cost. For many companies, inventory is the major item in the current assets category and inventory losses are an important contributor to business failures.

2. Techniques

Some of the common inventory management techniques are discussed below: Inventory Management - techniques

 

2.I. Just in Time

Just in Time is an inventory management technique which helps with better management of an entity’s inventories. It allows you to purchase the inventories as and when to get a sales order.

The main advantage of this method is an entity can purchase the exact amount of inventory to satisfy the current customer demand and it decreases the wastage. This method best suits for retailers and service-based industries than manufacturers.

2.II. ABC Analysis

ABC analysis is a process by which inventories are categorized based on their value, volume etc and used for production/sales. This analysis helps in cost reduction and managing the availability of stock without any disruption to the production process.

Following are the classification:

Classification- A: These are high-value items which are priority stock of the entity. These are the item which provides a major contribution to the revenue.

Classification- B:  These are items in the middle of value, volume, the frequency of stock reviews and re-orders

Classification- C: These are low values items but generally their volume is huge

2.III. Minimal Stock Level

The minimal stock is the minimum quantity of stock an entity should maintain at any point in time. This stock level is never the same and should be managed as and when needed. Making such adjustments ensures that the production process is not paused because of non-availability of stock.

This stock level enables more cash flow due to better inventory management and reduces dead stock. More monitoring is required for using minimal stock as a control measure.

2.IV. First-In-First-Out (FIFO) & Last-In-First-Out (LIFO)

FIFO is the most popular method under which goods are issued in their order of purchase. This is majorly used for goods with a limited shelf-life which has to be used within an expiry date.

Best practice for FIFO is to have proper warehousing procedures and documentation. One important disadvantage of FIFO method is that cost is not matched to the current income per income statement.

Another common method is LIFO which is used for heavy raw materials; pipes etc one main advantage of LIFO method is that the cost flow actually matches the physical flow of the goods in and out of inventory. 

2.V. Safety Stock

Safety stock is the additional inventory maintained by the entity beyond its expected demand. Safety stocks are important to handle stockouts and seasonal customer demand.

Maintaining safety stock is an essential technique for retaining customers and developing the market. The aim is to never lose a customer sale due to inventory stock-outs.

Safety stock level must be high enough to cover vendor’s delivery times but not so high which might end up in high carrying costs.

3. Ratios

Asset management ratio also called for efficiency or activity ratio indicates the return generated from a particular type of asset using the sales, cost and asset data. This ratio helps the business to identify effective utilization of the assets and thereby facilitates efficient management.

Inventory turnover ratio is one of the most important asset management ratios for an entity selling physical goods. Ratios related to inventory are given below:

3.I. Inventory turnover ratio

Inventory turnover ratio is used to ascertain the rate at which the company’s inventory is converted to cash. A company with higher inventory ratio is considered to have the effective sales strategy. It is generally measured using inventory period which is the average inventory divided by average cost of goods is sold

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*Average Inventory is the opening balance of the inventory plus the closing balance divided by 2.

A high inventory turnover ratio indicates efficient management of inventory and goods are fast moving.

3.II. Inventory Outstanding Days

Inventory Outstanding days represent the average number of days it takes for an entity to sell the inventory. It is the number of days the inventory stored in the warehouse before it is sold to the customer.

Capture43.III. Operating Cycle

Operating cycle is the number of days it takes for an entity to sell the inventory and collect cash from the customers. This is termed as operating cycle because it is the process of purchasing inventories, selling them, recovering cash from customers, using that cash to purchase inventories and so on is repeated as a cycle

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*It is the average days taken to sell the inventory i.e (365/ Inventory Turnover ratio)

+ This is the number of days for realizing the receivables i.e. (365/ account receivable turnover ratio)

A short operating cycle is good as it ensures the entity’s cash is held up for a shorter period.

 

Illustration:

Cost of goods sold is Rs. 300,000 opening inventory is Rs 40,000 and closing inventory is Rs. 80,000, we shall calculate the inventory ratio as follows:

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So the entity’ inventory management is 5 times efficient and fast

moving.

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The entity’s inventory outstanding days is 73 meaning, on an average, the inventory is stored in the warehouse for 73 days in a year.

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