INVENTORY MANAGEMENT

13.1.0 Definition Of Inventory :

The Dictionary meaning of Inventory is 'a list of goods'. In a wider sense, inventory can be defined as an idle resource which has an economic value. It is however, commonly used to indicate various items of stores kept in stock in order to meet future demands.

• In any organization, there may be following four types of inventory:

(a) Raw materials & parts-- These may include all raw materials, components and assemblies used in the manufacture of a product;

(b) Consumables & Spares -- These may include materials required for maintenance and day-to-day operation;

(c) Work in progress -- These are items under various stages of production not yet converted as finished goods;

(d) Finished Products -- Finished goods not yet sold or put into use.

13.1.1 Need For Inventory : Many of the items we need for our day-to-day maintenance and operation are required to be specially manufactured for the Railways. The time to procure these materials, therefore, is longer due to various reasons and it is not possible to procure these materials when instantaneously required. It is, therefore, necessary to keep stocks of such items.

• Even for those items which are readily available in the market, it may not be economical to buy these items every time as buying in piecemeal involves additional costs to the administration. Therefore, we may find it cheaper to buy in bulk and to stock some of these items and supply our indentors through such stocks. 
• There are always some fluctuations in demand as well as fluctuations in the time within which material can be procured. It is therefore, not possible to forecast our requirements exactly and time the purchases in such a way so that the materials will arrive just when they are physically required. It, therefore, becomes necessary to maintain stocks of these items.

13.1.2 Basic Problems of Inventory Management : From the above discussions, it will be seen that on the one hand inventories are idle and valuable resource i.e. capital remains locked up in the inventories which can be used for other productive purposes but on the other hand, they are desirable to satisfy manufacturing, maintenance or operation requirement of the organization. Hence basic problem of inventory management is to optimize the stock levels of different materials so that their stocks are maintained at optimum levels without affecting the production or day-to-day maintenance . Three basic problems associated with this optimization of stocks are ;

(a) When to initiate purchase of the materials

(b) How much quantities are to be purchased at a time and

(c) What should be the stock levels of different items.

• For getting answers to these questions, we have to investigate various types of costs related to inventory management.

13.2.0 Various Costs Related To Inventory Management :

13.2.1 Costs Of Ordering Or Costs Of Acquisition : For a large organization, it becomes necessary to have a separate purchase office to purchase thousands of items. The demands received are technically scrutinized and for purchasing them, inquiries are issued, tenders are received and evaluated, orders are progressed, materials are received and inspected and lastly, the payments are arranged. All these mean additional costs to the organization. All these costs together constitute what is called cost of ordering or cost of acquisition.

• In the Railways, we do not have a system of working out these costs. But it is necessary that for a given stores organization, total number of purchases are ascertained and average cost per purchase order worked out. When we work out the costs, we may find that some costs are fixed while some are variable. We should be interested in knowing the variable costs.
• As we are using 3 major systems of purchasing viz., advertised tender, limited tender and cash purchase systems, it is advisable to work out the ordering costs for these three different procedures of purchasing.
• Based on some of the studies made ordering costs may be as follows: 

1. Cash Purchase Rs.50 to Rs.100 per purchase
2. Limited Tender Purchase Rs.300 to Rs.600 "
3. Advertised Tender Purchase Rs.1000 to Rs.2000 "

• These are just approximate and may vary considerably depending upon various factors. It is repeated that every Railway should establish these costs from time to time so that they can be used in designing proper inventory models.

13.2.2 Inventory Carrying Costs : The very fact that the items are required to be kept in stock means additional expenditure to the organization. The different elements of costs involved in holding inventory are as follows:

(a) Interest on capital / cost of capital / opportunity costs : When materials are kept in stock money representing the value of materials is blocked. In a developing economy, capital is extremely scarce and as such, the real value of capital is much higher than the nominal rate of interest which the organization like Railways may be paying. The ,money which is blocked up is not available to the organization to do more business or to use it for alternative productive investment. This opportunity to earn more profits which we loose can be expressed asopportunity cost. o While working out the inventory carrying cost in an organization, the higher of the three factors viz., interest, cost of capital or opportunity cost should, be taken into consideration. This may be roughly 20% per annum.

(b) Obsolescence and depreciation : The costs because of obsolescence and depreciation, are very important even though they are very difficult to assess. This factor is relatively higher for spare parts inventory as against raw material inventory. Larger the stock we keep more the risk of obsolescence and as such, the costs are expressed as the percentage costs to the average inventory holding and can be between 2 to 5%.

(c) The cost of storage, handling and stock verification : There are additional costs because of the clerical work involved in handling of materials in the ward, in stock verification, in preservation of materials as well as the costs because of various equipments and facilities created for the purpose of materials. A part of this cost is of a fixed nature. The major portion of the cost including the cost of staff, however, can be treated as variable costs at least in the long run. This cost can be roughly 3 to 5% of the inventory holding.

(d) Insurance Costs : Materials in stocks are either insured against theft, fire etc., or we may have to employ watch & ward organization and also fire fighting organizations. Cost of this may also be 1 to 2%. The average inventory carrying costs can, therefore, be as follows: Interest/costs of capital/opportunity cost 15 to 25% Obsolescence and depreciation cost 2 to 5% Storage, handling etc. 3 to 5% Insurance costs 1 to 2% Total 21 to 37%

 In the Indian Railways, the reasonable assessment of inventory carrying costs shall be about 20 to 25% per year of the average inventory holding. It is again clarified here that these costs are not normally reflected in our accounting system and as such are required to be established by individual Railway.

13.2.3 Shortage Or Stock Out Costs : Whenever an item is out of stock and as such cannot be supplied, it means that some work or the other is delayed and this, in turn, leads to financial loss associated with such stoppage or delay of work.

o For example, if a locomotive remains idle for want of spare parts, the earning capacity of the locomotive is lost for the duration of this period. On the other hand, the spare parts required will have to be purchased on emergency basis or have to be specially manufactured resulting in additional costs.

o Stock out costs can vary from item to item and from situation to situation depending upon the emergency action possible. No attempt therefore, is normally made to evaluate a stock out cost of an item. Nevertheless, it is important to understand the concept of stock out costs, even though the actual quantification is not possible. We should have a rough grading of the items depending upon the possible stock out costs.

13.2.4 Systems Costs : These are the costs which are associated with the nature of the control systems selected. If a very sophisticated model of the relationship between stockout costs, inventory holding cost and cost of ordering is used and operated with the help of a computer, it may give the theoretical minimum of the other costs but the cost of such control system may be sufficiently high to offset the advantages achieved.

• In most of the situations, however, there is no substantial increase in costs because of the proposed control system and in such cases, these costs can be overlooked.

13.3.0 Inventory Management - Constrains & Problems : Problems of inventory management vary from organization to organization depending upon various variables, some of them are as under:

(a) Whether the demand for the goods is one time (static) or of repetitive nature (dynamic). In Railways, all the non-stock items are treated of static nature and stock items of dynamic nature.

(b) In case of demands of dynamic (repetitive) items, whether future requirements can be assessed with certainty or uncertainty or under risk (probability). Also, whether the demand is fixed over a time or is variable.

(c) Whether the material is manufactured in house or is to be purchased through outside suppliers.

(d) Whether the lead time during which material can be arranged is fixed or is variable.

13.4.0 Economic Order Quantity : Depending upon various variables, different inventory models have been developed. Different models take different costs into account. One of the popular model developed for items of repetitive nature (dynamic), future demands for which can be projected with certainty is Economic Order Quantity (EOQ) model.

• In addition to factors mentioned above, this model assumes that price of the material remains constant with time and also does not vary with order quantity. This model can be developed mathematically by differentiating total cost of inventory (ordering cost + inventory carrying cost) with respect to Quantity. The formula so derived is given below :

Economic Order Quantity (EOQ) = Sq. Rt. { 2xAxCo / (Cu x Ci)

}

Where,

A = Annual Consumption

Quantity

Co = Cost of placing one

order

Ci = Annual inventory

carrying cost represented as

fraction

Cu = Unit Cost (Rate/Unit) of

the material

13.4.1 EOQ model and various other models and systems of recoupments as explained in Chapter 5 are the answers of two basic questions of inventory management

--When to purchase ?

--How much to purchase?

13.5.0 Measuring Efficiency Of Inventory Management :

13.5.1 Efficiency of an inventory management system is generally measured by two measures ;

(a) Service level : This is the percentage of compliance of demands of user. This level is set by the top management who knows that cost of providing 100% service level (i.e. meeting with all demands for materials at all times) is prohibitively high.

o Therefore, it is attempted to attain a service level between 90 to 98% depending upon criticality of the items. In Railways, we try to comply demands of vital and safety items up to 97 to 98%, recoup imprest items and supply all ferrous and non-ferrous raw materials up to 95% and give compliance of all other items between 90 to 95%.

(b) Inventory turnover ratio : This is a measure of average stocks held in stock at a time. This is measured in percentage by the following formula :

                     

                     Average value of stock of all materials held in stock

T/O ratio = ---------------------------------------------------------------------- 

                   Total value of issues made during the year

In Railways, Stores Balances are reflecting in various capital suspense head e.g., Purchase Suspense (7110, 7120, 7130), Sale Suspense (7140), Stock Suspense (7150, 7160).

o As per accounting system for working out inventory turnover ratio, we divide debit balances outstanding in all above suspense heads on 31st March of the year by total issues made from 1st April to 31st March. This ratio is multiplied by 100 to get percentage. In Railways, we try to achieve turnover ratio of about 27%.

(c) As overstock and inactive items are not contributing towards inventory turnover, we should control their balances. In Railways, total balances of inactive stores (items not moved for past 12 months or more) and overstocks should not be more than 5% of total Stores Balances.

13.6.0 Inventory Control : Inventory Control is the art and science of maintaining the stock level of a given group of items, incurring the least total cost, consistent with other relevant targets and objectives set by the management. Generally, this is measured in terms of service level which is measured in terms of percentage of compliance of demands (requisitions for materials) of user departments and Inventory Turnover ratio as explained above.

13.6.1 Inventory Control Techniques : Various techniques employed for controlling stock levels are ;

(a) Selective Management :- In this technique, various items of stores are classified in various classifications depending upon their consumption, value, unit price, criticality for the organization, source of supply, purchasing problems, rate of drawal from stores, seasonality and stores balances on a particular date. Different approaches of control are being followed for different types of items. Two such classifications ABC & VED are described in paragraphs 13.6.2 & 13.6.3.

(b) Management by exception-- In this technique, items with certain exceptions are tackled on different points of time. For example, overstock items, surplus items and inactive items may require more attention.

(c) Designing of recoupments policies -- Recoupments policies are designed in such a manner that average stocks of materials are optimum.

(d) Rationalization :- Techniques of standardization and variety reduction are used to minimize lead time of the material, and reduce unnecessary inventory carrying costs.

(e) Value Analysis :- Functions performed by the materials are analyzed and alternative designs/raw materials are suggested to achieve the same function at minimum cost.

(f) Computerization :- Computer Outputs can be used for scientific forecast of demand to solve many inventory models, providing optimum safety stocks and for controlling funds.

13.6.2 A-B-C Analysis :This analysis is based upon Pareto Principle according to which in many situations, majority of the activity (70 to 80%) is governed by very few (10 to 20) attributes.

 Hence if all the stock items are analyzed in terms of their annual consumption value, major part of total consumption value on a Railway (about 70-80%) is of only few high consumption value items (say 10 to 20%). These items may be classified as A category. 

 15 to 20% of total consumption is represented by another 15 to 20% items which may be classified as B category . 

 Remaining 5 to 10% consumption is represented by a large no. of small consumption value items which may be classified as C category. 

o Actual ABC classification depends upon management decision. In Railways, we have decided that

 All high consumption value items which represent 70% of total issues, will be classified as A category, 

 Items which represent 20% of total issue will be classified as B category . 

 All remaining items will be C category.

o This analysis is done on the computer as explained below:

(a) First of all annual issue values of all the items which were issued from all the depots are added together to find total issues (in rupees) of the Railway;

(b) Then all the items are sorted in descending sequence of their issue value on the entire Railway (i.e. after adding issues of individual depots);

(c) Then we go on counting the items adding issue value of the item to a 'cumulative issue value' counter. When the value in this counter represents 70% of total issue- value worked out in step (a), after reading a particular item, all the items from top to this item are classified as 'A' category items;

(d) The reading of items is further continued when after reading a particular item and adding its issue value to 'cumulative issue value' counter, value in the counter is equal to 90% of total issues, we mark all items from item next to last A category item to this item as B category item;

(e) All remaining items are classified as C category items.

• For the purpose of Inventory Control, A category items are most important. Therefore, they are closely monitored at highest level at very frequent intervals.
• In Railways, their stock levels, consumption forecast etc. are monitored at the level of COS/CMM every month. B category items are monitored at the level of CMM/Dy. COS every quarter or every six month.
• Stock verification

1. of A category items is carried out every six months; 
2. for B category items every year and
3. once in two years for C category items.

o To achieve better inventory turn over ratio, we intend to keep average stocks of 3 months, 6 months and 12 months of A, B and C category items respectively.

13.6.3 V-E-D Classification : A-B-C Classification is on the basis of consumption value of an item and does not give any importance to the criticality of the item and therefore, only A-B-C Classification is not adequate. Classification done on the basis of criticality of the item is known as V-E-D, where the items are classified as Vital, Essential and Desirable.

• Vital items are those items which are very critical for the operations and do not permit any corrective time i.e. they cannot be procured off the shelf if they are not available.
• Essential items are comparatively less vital and work without them cannot be managed for few days. All remaining items are known as Desirable items.

13.6.4 A-B-C / V-E-D Matrix : Tackling the items on the basis of their consumption value and also criticality improves the service to the customer as well as we are able to control the inventory.

We can design the stock levels in such a manner that

• Maximum service is provided for C category vital items
• While for A category Desirable items service can be minimum desirable . 
• For remaining items, service levels can be in between these two levels and average stock holdings can be designed accordingly. 
• Tackling the items on the basis of their consumption value and also criticality improves the service to the customer as well as we are able to control the inventory.

Numbers indicate the focus priority for best results both in terms of service as well as resources required We can design the stock levels in such a manner that maximum service is provided for C category vital items which provide high satisfaction levels at very little cost, while for A category Desirable items service can be minimum desirable as the require largeresources and provide very low satisfaction. For remaining items, service levels can be in between these two levels and average stock holdings can be designed accordingly.