Accounting Standard (AS) 2: Valuation of Inventories:

Objectives of (AS)2:
A primary issue in accounting for inventories is the determination of the
value at which inventories are carried in the financial statements until the
related revenues are recognised.
This Standard deals with the determination of such value, including the
ascertainment of cost of inventories and any write-down thereof to net
realisable value.

INVENTORY MANAGEMENT:
Introduction:
Inventories constitute the most significant part of current assets of the
business concern. It is also essential for smooth running of the business activities.
A proper planning of purchasing of raw material, handling, storing and recording is
to be considered as a part of inventory management. Inventory management means
management of raw materials and related items. Inventory management
considers:

what to purchase?
how to purchase?
how much to purchase?
from where to purchase?
where to store? and
when to use for production?, etc.

Meaning:The dictionary meaning of the inventory is stock of goods or a list of

goods. In accounting language, inventory means stock of finished goods. In a

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manufacturing point of view, inventory includes, raw material, work in process,
stores, etc.

TYPES OF INVENTORIES

Inventories can be classified into 4 major categories namely;

1. Raw Material:
It is basic and important part of inventories. These are goods which have not yet
been committed to production in a manufacturing business concern.
2. Work in Progress:

These include those materials which have been committed to production

process but have not yet been completed.
3. Finished Goods:
These are the final output of the production process of the business
concern. It is ready for consumers.
4) Stores & Supplies:
It is that part of inventory which does not become a part of final product,
but are required by the firm for production process. These involve cotton waste, oil
and lubricants, soaps, brooms, light bulbs, etc. They form a very minor part of
inventory, which do not involve significant investment.

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OBJECTIVES OF INVENTORY MANAGEMENT:
Inventory occupy 3080% of the total current assets of the business
concern. It is also very essential part not only in the field of Financial Management
but also it is closely associated with production management. Hence, in any
working capital decision regarding the inventories, it will affect both financial and
production function of the concern.
Hence, efficient management of inventories is an essential part of any
kind of manufacturing process concern.
The major objectives of the inventory management are as follows:
To efficient and smooth production process.
To maintain optimum inventory to maximize the profitability.
To meet the seasonal demand of the products.
To avoid price increase in future.
To ensure the level and site of inventories required.
To plan when to purchase and where to purchase
To avoid both over stock and under stock of inventory.

COSTS OF HOLDING INVENTORIES:

The holding of inventories involves blocking of a firms funds and
incurrence of capital and other costs. It also exposes the firm to certain risks. The
various costs involved in holding inventories are as follows:

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(I) ORDERING/ACQUISITION/SET-UP COSTS:

These are the costs of placing an order for the goods. Orders are placed by
the firm with suppliers to replenish inventory of raw materials.
Ordering costs include the cost of: requesting, purchasing, ordering,
transporting, receiving, inspecting and storing.
The ordering costs vary in proportion to the number of orders placed. They
also include clerical costs(such as invoice processing, accounting,
and communication costs, etc.) and stationery costs.(That is why it
is called as set-up cost.).

Although these costs are almost fixed in nature, the larger the
order placed, or the more frequent the acquisition of inventory made, the higher are
such costs. Similarly, the fewer the orders, the lower the order cost will be for the
firm. Thus, the ordering/acquisition costs are inversely related to the level of
inventory.

(II)STOCK OUT/SHORTAGE COST :

The stock out or shortage cost occurs when the demand for an item exceeds its
supply. When a stock out or shortage occurs, a company faces two possibilities:

It can meet the shortage with some type of rush, special handling or priority
shipment.
It cannot meet the shortage at all.
*MATERIAL COST: This includes the cost of purchasing the goods,
transportation & handling charges less any discount allowed by the
suppliers of goods.

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(II) CARRYING COST:

These are the expenses of storing goods, i.e., they are involved in carrying
inventory.

The cost of holding inventory may be divided into:

(i) COST OF STORING THE INVENTORY:This includes

(a) Storage Cost (i.e., tax, depreciation, insurance, maintenance of building, etc.,)

(b) Insurance (for fire and theft);

(c) Obsolescence and Spoilage;

(d) Damage or Theft;

(e) Servicing Costs (i.e., clerical, accounting costs etc.)

(ii) OPPORTUNITY COST OF FUNDS:

This includes the expenses in raising funds (i.e., Interest on Capital) which are
used for financing the acquisition of inventory.

The level of inventory and the carrying costs are positively related and move in the
same direction, i.e., if inventory level decreases, the carrying costs also decrease,
and vice versa.

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BENEFITS/REASONS FOR HOLDING INVENTORIES

Inventories serve a number of important functions in various companies.

Among the major reasons for holding inventories are:

To satisfy expected demand:

Companies use anticipation stock ( buffer stock) to satisfy expected demand,
and it is particularly important for products that exhibit marked seasonal
demand but are produced at uniform rates. Air conditioner, rain suit
manufacturers and children's toy manufacturers build up anticipation stock,
which is depleted during peak demand periods.
To protect against stock outs: Manufacturers use safety stock to protect
against uncertainties in either the demand or supply of an item. Delayed
deliveries and unexpected increases in demand increase the risk of shortages.
Safety stock provides insurance that the company can meet anticipated
customer demand without backlogging orders.
To allow for smooth and flexible production operations: A
production-distribution system needs flexibility and a smooth flow of
material, but production cannot be instantaneous so work-in-process
inventory relieve pressure on the production system. Similarly,
manufacturers use in-transit or pipeline inventory to offset distribution
delays. Both work-in-process inventories and pipeline inventories are part of
a broader classification, called movement inventories.
To guard against price increases: Manufactures sometimes use large
purchase, or large production runs, to achieve savings when they expect
price increases for raw materials or component parts.

TECHNIQUES OF INVENTORY MANAGEMENT:

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 Effective Inventory management requires an effective control system
for inventories. A proper inventory control not only helps in solving the acute
problem of liquidity but also increases profits and causes substantial reduction in
the working capital of the concern. The following are the important tools and
techniques of inventory management and control:

INVENTORY MANAGEMENT
TECHNIQUES

Techniques Based on Techniques Based on

Order Quantity Classification

Determination Economic Order ABC VED HML FNSD

of Stock Level Quantity (EOQ) Analysis Analys Analy Analys
is sis is

A. Techniques based on the order quantity of Inventories:

Order quantity of inventories can be determined with the help of the following
techniques:

i)Stock Level:Stock level is the level of stock which is maintained by the

business concern at all times. Therefore, the business concern must maintain
optimum level of stock to smooth running of the business process. Different level
of stock can be determined based on the volume of the stock as follows:

a)Minimum Level :The business concern must maintain minimum level of stock
at all times. If the stocks are less than the minimum level, then the work will stop
due to shortage of material.

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Formula:

Minimum level = Re-order level - (Normal consumption Average delivery

period)

b)Re-order Level:

Re-ordering level is fixed between minimum level and maximum level. Re-
order level is the level when the business concern makes fresh order at this level.

Formula:

Re-order level=Maximum Consumption Maximum Re-order period.

c)Maximum Level:

It is the maximum limit of the quantity of inventories, the business

concern must maintain. If the quantity exceeds maximum level limit then it will be
overstocking.

Formula:
Maximum level = Re-order level + Re-order quantity

- (Minimum consumption Minimum delivery period)

d) Danger Level:
It is the level below the minimum level. It leads to stoppage of the production
process.

Formula:
Danger level=Average consumption Maximum re-order period for emergency
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purchase
Lead Time:
Lead time is the time normally taken in receiving delivery after placing orders
with suppliers. The time taken in processing the order and then executing it is
known as lead time.

ECONOMIC ORDER QUANTITY (EOQ)/ REORDER

QUANTITY:
A decision about how much to order has great significance in inventory
management. The quantity to be purchased should neither be small nor big
because costs of buying and carrying materials are very high.
Economic order quantity is the size of the lot to be purchased which is
economically viable. This is the quantity of materials which can be
purchased at minimum costs.
Generally, economic order quantity is the point at which inventory carrying
costs are equal to order costs.

In determining economic order quantity it is assumed that cost of a

managing inventory is made of solely of two parts i.e. ordering costs and carrying
costs viz;

(A) Ordering Costs:

These are costs that are associated with the purchasing or ordering of materials.
These costs include:

Inspection costs of incoming materials.

Cost of stationery, typing, postage, telephone charges etc.

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 Expenses incurred on transportation of goods purchased.

These costs are also known as buying costs and will arise only when some
purchases are made.

(B) Carrying Costs:

These are costs for holding the inventories. These costs will not be incurred if
inventories are not carried. These costs include:

The cost of capital invested in inventories. An interest will be paid on the

amount of capital locked up in inventories.
Cost of storage which could have been used for other purposes.
Insurance Cost
Cost of spoilage in handling of materials

I)Mathematical formula for calculation of EOQ:

EOQ = 2AO/PI

Where; A = Annual Consumption of inventories (units)

O = Cost of Placing Order

P = Purchase price per unit of Inventory &

I = Inventory Carrying Cost

There are some assumptions on which EOQ is calculated. These assumptions

are:-

i. There is known and constant holding cost.

ii. There is a known and constant ordering cost.

iii. The rates of demand are known.

iv. There is known constant price per unit.

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v. No stock-outs are allowed.

vi. Replenishment is made instantaneously.

GRAPHICAL REPRESENTATION OF EOQ:

Minimum
Total Cost

Carrying Cost

Cost

Ordering Cost

Q Order Size

Economic Order Quantity

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Just-In-Time (JIT) Inventory System:-
Japanese firms popularized this technique in order to reduce the
inventory level up to zero to eliminate the inventory costs. According to this
system, the materials arrive at the manufacturing sites just few hours before they
are going to use. This system also eliminates the necessity of carrying large
inventories.

In JIT, a firm keeps only enough inventory on hand to meet immediate

production needs. The JIT system reduces inventory carrying costs by requiring
that the raw materials are procured just in time to be placed into production.
Additionally, the work in process inventory is minimized by eliminating the
inventory buffers between different production departments. If JIT is to be
implemented successfully there must be high degree of coordination and
cooperation between the suppliers and manufacturers and among different
production centers.

INVENTORY TURNOVER RATIO:

Inventory turnover is an efficiency ratio which calculates the number of

times per period a business sells and replaces its entire batch of inventories. It is
the ratio of cost of goods sold by a business during an accounting period to the
average inventories of the business during the period.

Dividing the total cost of inventories sold during a period (which equals
cost of goods sold) by the cost of average inventories balance maintained by a
business gives us dollars of sales made per dollar of cash tied up in inventories

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Formula:
Cost of Goods Sold
Inventory Turnover =
Average Inventories

Where;

Cost of goods sold = Opening Inventories + Cost of Goods Manufactured

Closing Inventories

Beginning Inventories + Ending Inventories

Average Inventories =
2

(II)TECHNIQUES BASED ON CLASSIFICATION OF

INVENTORIES

1)A-B-C Analysis:

It is the inventory management technique that divides inventory into three

categories based on the value and volume of the inventories namely;

A Category:

10% of the inventorys item contributes to 70% of value of consumption and this
category is known as A category.

B Category:

About 20% of the inventory item contributes about 20% of value of consumption
and this category is called category B &

C Category:
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About 70% of inventory item contributes only 10% of value of consumption and
this category is called C category.

WORKING OF ABC ANALYSIS:

CATEGORY COMPOSITION DEGREE OF

CONTROL
A Those Items which are Higher Degree of
Costly they require Control
huge investment
B Those Items which Moderate Degree of
require moderate Control
investment
C Those Items which are Lower Degree of
Cheapest they require Control
smaller investment

IMPORTANCE OF ABC ANALYSIS:

Investment in inventory is minimized because of close control over Items

A.
Cost of Ordering & Carrying Cost is reduced.
The technique cuts down the cost of the system.
Fulfillment of objectives of inventory control.

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2)VED ANALYSIS

This technique is ideally suited for spare parts in the inventory management liken
ABC analysis. Inventories are classified into three categories on the basis of usage
of the inventories namely;

V = Vital item of inventories

E = Essential item of inventories
D = Desirable item of inventories

The VED analysis is used generally for spare parts. The requirements
and urgency of spare parts is different from that of materials. A-B-C analysis may
not be properly used for spare parts. Spare parts are classified as Vital (V),
Essential (E) and Desirable (D).

*Vital item V:

The vital spares are a must for running the concern smoothly and these
must be stored adequately. The non-availability of vital spares will cause havoc in
the concern.

*Essential item E:

The E type of spares are also necessary but their stocks may be kept at
low figures.

* Desirable item D:

The stocking of D type of spares may be avoided at times. If the lead

time of these spares is less, then stocking of these spares can be avoided.

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3)HML ANALYSIS:

Under this analysis, inventories are classified into three categories on the basis of
the value of the inventories viz;

H = High value of inventories

M = Medium value of inventories
L = Low value of inventories

Items are classified into three groups labeled as High Medium Low.
The HML analysis is very similar to the ABC Analysis, the difference being
instead of usage value, the price criterion is used. In their classification, the items
used by the company are arranged in descending orders of their unit price. After
this, the management of the company uses its discretion and judgment to decide
the cut off lines for deciding the three categories.

For example, the management may decide that all items of unit price
value above Rs 500 should be categorized as H items, items whose, unit price
falls between Rs 50 and Rs 500 should be categorized as M items and items
whose unit price falls below Rs 50 should be categorized as L items. The
categorization therefore is decided by the management.

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FNSD ANALYSIS:Inventories are classified according to the period of their
holding and also this method helps to identify the movement of the inventories.
Hence, it is also called as, FNSD analysis Where;

F = Fast moving inventories N = Normal moving inventories

S = Slow moving inventories D = Dead moving inventories

Fast Moving Items F:

It stands for Fast moving items. Such inventory is consumed in a short

period, It is a stock of fast moving items. In order to avoid stock-out position, the
items in this category must be observed constantly.

Normal Moving Items N:

It stands for Normal moving items. Such stock is exhausted over a period
of year. In order to avoid surplus stock the inventory levels should be fixed on the
basis of new estimates.

Slow Moving Items S:

It stands for Slow moving items. Such items lasts for two or more years.
Such items should be reviewed very carefully before placement of any order.

Dead Stock D:

It stands for dead stock. No further demand is seen for the existing stock.
It implies that money spent cannot be realised but it requires some useful space.
Such items should be identified and efforts should be made to find alternative uses.

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SOME MAJOR RISKS ASSOCIATED WITH INVENTORY
MANAGEMENT:

Market Value of Inventory:

The main risk in inventory management is that market value of

inventory may fall below what firm paid for it, thereby causing inventory losses.
The sources of market value of risk depend on type of inventory. Purchased
inventory of manufactured goods is subject to losses due to changes in technology.
Such changes may sharply reduced final prices of goods when they are sold or may
even make the goods unsaleable.

Agricultural Commodities:

Agricultural commodities are a type of inventory subject to risks due

to unpredictable changes in production and demand.

Risk of Obsolescence:
The inventories may become obsolete due to improved
technology, changes in requirements, change in customers tastes, etc.

Risk of Price Decline:

There is always a risk of reduction in the prices of inventories by

the suppliers in holding inventories. This may be due to increased market supplies,
competition or general depression in the market.

Risk of Deterioration in Quality:

The quality of the materials may also deteriorate while the
inventories are kept in stores.
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 CONCLUSIONS:

After analyzing the project thoroughly, it can be concluded that

inventory is the most important part of any business; especially for manufacturing
companies. It is hidden costs which are to be controlled for sustaining in present
competitive market. Apart from costs, customer satisfaction is also the most
important factors for the businesses. Inventory management also improves the
level of customer satisfaction because customer wants product at least time as
possible.

Inventory management deals with proper planning of purchasing of raw

material, handling, storing and recording. The purpose of inventory management is
to keep the stocks in such a way that neither there is over-stocking nor under-
stocking. The over-stocking will mean reduction of liquidity and starving of other
production processes; under-stocking, on the other hand, will result in stoppage of
work.

There are various risks associated with inventory management such as

Risk of Deterioration in Quality, Risk of Price Decline, Risk of Obsolescence,
Spoilage, Shrinkage, Theft, Changing Trends & Styles, etc. In order to overcome
this, a manufacturing firm must install the optimal inventory control techniques or
improve their asset turnover as much as possible. Also, by different analysis it is
concluded that inventory turnover ratio is correlated with the net profit of the
companies.

Lastly, it can be concluded that it is a responsibility financial manager

to implement proper inventory controlling techniques whenever and wherever
demanded; so that business firms will succeed and excel not only in the short-run
but also in the long-run.

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 REFERENCES:

BIBLIOGRAPHY :

1) Financial Policy & Management Accounting) {Pg. No. 493}[7th

Edition]
- Bhabatosh Banerjee

2) Advanced Financial Management(Sheth Publication){Pg. No. 161,

167, 173}

-L.N. Chopde

-Kishore M. Mehta

-Dhiren Kanabar

WEBLIOGRAPHY:
http://www.referenceforbusiness.com
http://www.yourarticlelibrary.com
http://www.careerride.com
http://www.iosrjournal.org
http://ecr-all.org

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