Accounting for materials? Types of inventories

Accounting for materials
Concept of material/ inventory management
A manufacturing company requires many types of material to produce any goods or render services. If a company does not get the required materials as needed then the production system will get disturb and fail to produce and sale required quantity of products on time. The over stock of inventory is unsuitable due to the large amount of investment on it as well as other cost associated with it. On their hand, the lower stock of inventory might create the problem of shortage resulting in the disturbance on production. Therefore, inventory management included the requirement of different types of inventory, period of stock and cost associated on it.

Inventory is the stock that a firm maintains to meet its future requirements for production and selling. The basic reason for holding inventory is to keep up the production activities unhampered. Inventories are a part of current assets, which are used within one year. In a normal course of business operation manufacturing organizations maintain the inventory of raw materials, work-in-progress, finished goods, spare parts, suppliers etc. in case of manufacturing concern, inventories link the production and sales. Trading organizations involve in buying and selling of goods. Therefore, inventory of trading organization is unsold good i.e. finished goods.

Hence, inventory may be defined as storage of the combination of raw materials, work-in-progress, finished goods and other suppliers required for the smooth operation of production and sales of an organization. Managing the stock at lowest cost without compromising on the production and sales activities is called inventory management.

Types of inventories
1.    Raw material: raw material is a very important and investable factor of production includes physical commodities used to manufacture the final product.
2.    Work-in-progress: work-in-progress inventories are semi-manufactured products, the products that need more work before they are converted to finished products for sales. In other words goods partially worked on but fully completed goods are called work-in-progress.
3.    Finished goods: inventory of finished products are the stock of goods which are ready for sales. Stock of finished goods is required for smooth marketing operations of the products.

Inventory on inventory depends on certain risk and costs. Therefore, the inventory manager should try to maintain optimal size of inventory without disturbing the production and sales needs.

Inventory control/management
Inventory may be defined as the stock of raw material, work-in-progress and finished goods maintained for smoothing the production and sales in a business concern. Inventory control may be defined as the practice directed towards availing inventory as and when needed. It is also concerned with minimizing inventory as much as possible. It is also related to bringing the annual cost of carrying or holding and ordering cost to minimum as much as possible. Inventory control always attempts to reduce losses, damages and misappropriation materials.

Importance or objective of inventory control/management
The importance or objective of inventory control may be explained thought the following points.
1.    To supply the required materials continuously: there should be a continuous availability of materials in the factory or finished goods for trade. The main objective of inventory control is to maintain required inventory so that production and sales process run smoothly.

2.    To minimize the risk of under and over stocking of material: if a company keeps inventory without proper analysis, there will be a change of overstocking, which will increase the cost of carrying the inventories or under stocking of inventories that create problem in smooth operation of a business. So one of the main objectives of the inventory control is to minimize the risk caused due to under and over stocking of inventory.

3.    To reduce losses, damages and misappropriation of materials: inventory control aims to reduce or remove the losses and misappropriation of materials. This is done by maintaining the proper stock of materials with utmost care.
4.    To maintain systematic record of inventory: management needs different information regarding inventory for planning and decision-making. A systematic record of inventory helps provided such information to the management. It also assists to evaluate the current inventory management policy.

5.    To minimize the costs associated with inventory: the proper maintenance of the information regarding inventory helps to make decisions like whether to take discounts or not. The size of order to be placed, when to order etc. the total costs associated with inventory may be minimized by analyzing the to be acquired the offer of discount on various lot sizes and the timing of order. Such analysis helps to reduce the unnecessary inventory in inventors.
6.    To make stability in price: an effective inventory control system minimizes the effects of regular price fluctuations. This in turn helps to gain the stability in selling price.


Reasons or motives or objective of holding material/inventory
The main objective or reason or objective of holding inventory is to supply the required quantity of inventory to different departments as needed so that production/sales process does not get hampered. The reasons or motive or objective of holding inventories are:
1.    Transaction motive: the manufacturing concerns need inventories or raw material and work-in-progress so as to maintain regular production activities. Similarly, the trading organization need the inventories of finished goods for supplying the goods and services to the customers regularly, in this way, holding of invoices helps to have regular transaction.
2.    Precautionary motive: die to different reasons, like shortage of inventory with the supplier, weak relation with the suppliers, disturbance in transportation, delay in inventory supply etc. might take place. It is also an important objective of holding the inventory to take precaution from the above.

3.    Speculative motive: generally the price of inventory rise, so the companies may keep additional amount of inventory to get benefit by selling the surplus inventory at higher price than purchase price. It creates risk when the price of inventory falls.

Techniques of inventory control
To achieve the objective of the inventory control, different techniques are used. Some of them are mentioned below:
a.    Economic order quantity
b.    Stock level:
•    Re-order level
•    Maximum stock level
•    Minimum stock level
•    Danger stock level
•    Average stock level
•    Safety stock
c.    Just in time purchase
d.    Perpetual inventory system
e.    ABC analysis
Economic order quantity EOQ
Meaning and assumption of economic order quantity
Economic order quantity is defined as the quantity of inventory to be ordered each time that minimizes the total inventory cost. Inventory cost comprises the ordering or set-up cost and carrying or holding cost less discount if any. In this way, EOQ is an inventory management tool, which shows quantity to be ordered each time that involves the minimum cost. Normally, the ordering cost and carrying cost are equal at the point of EOQ. Thus, EOQ is the quantity that minimum the total inventory cost. It is also known as 'standard order quantity','Economic Lot Size' or Economic ordering quality' or 'Optimum ordering Quantity.'

There are some assumptions of economic order quantity. They are:
a.    Annual requirements should be certain.
b.    Ordering cost per order should be fixed and known.
c.    Carrying cost of inventory per unit should be fixed and known.
d.    Purchase price of the inventory should be known.
e.    Demand of the inventory should be uniform through the year.

Types of inventory cost
They are two types of inventory cost. They are:
a.    Carrying cost
It is the cost of holding a unit of inventory. Carrying cost is calculated on the bass of average inventory. When the number of order increase, then total amounts of carrying cost decrease and vice-versa. Average carrying costs per unit remain constant and are denoted by 'C'.

Carrying cost is also called storage cost or materials holding cost or possession cost that included the following items.

a.    Internet of investment in inventory or opportunity cost.
b.    Rent, insurance and tax of warehouse
c.    Safety and supervision cost
d.    Depreciation
e.    Maintenance and inspection cost.
f.    Insurance
g.    Interest on capital
h.    Loss by deterioration obsolesce

Since, the carrying cost is a per unit cost, the higher stocking of inventories results in higher carrying cost and vice versa.

The carrying cost is calculated as follows:
Carrying cost = Average inventory X carrying cost per unit

b.    Ordering cost
The cost of placing and receiving an order is called ordering cost. It is also called procurement cost or processing cost of materials or set up cost. The ordering cost depends on number of orders, when the number of order increase, the total amount of ordering cost also increases and vice-versa. However, ordering costs per order remains constant and is denoted by 'O'.

Ordering costs included the following items:
a.    Cost of staff associated with the purchasing department.
b.    Cost of inspection for materials control.
c.    Clerical and administrative cost of purchasing department.
d.    Transaction and shipping costs.
e.    Tooling and set-up costs.
f.    Fax, telephone, email charge etc.

Ordering cost = No. of orders x ordering cost per order

c.    Total cost
The total cost is the sum of ordering and carrying cost. Hence,
Total cost = A/Q X O +Q/2 X C

Determination of Economic order Quantity
Economic order quantity can be computed by using difference methods. Among them some  importance methods are as follows:
a.    Formula method
b.    Trial and error method or tabular method
c.    Graphic method


a.    Formula method
The formula has been development considering that the total carrying cost is always equal with the total carrying cost.
Total ordering costs = total carrying costs

b.    Tabular or trial and error method
Under this approach, the total cost is calculated under different order sizes. The economic order quantity is that inventory level that minimizes the total of ordering and carrying cost.  Under trial and error approach, we prepare a table and try to find out the total costs at different order sizes.

c.    Graphic method
Under this method, the carrying cost, ordering cost and total cost are shown in graph. Cost data are plotted on Y-axis and quantity on X-axis. It is based on the principle that the total carrying cost increase as the order size increases. However, the ordering cost decrease as the order size increase. The ordering cost curve slops don from the left to the right but the carrying cost curve slops upwards from the left to right as the carrying cost increase with the number of orders. The point where ordering and carrying cost curve intersect each other, total cost is minimum and the point is called the economic order point.

Discount and economic order quantity
Sometimes, the suppliers offer certain quantity discount if the purchase are made in large quantity. Such discount reduces the total cost. The offer of discount is profitable when the discount exceeded the increased carrying cost due to bulky purchase. To accept or reject the offer of discount, the total cost under EOQ and offer both are calculated. The cost under offer is calculated by subscripting the discount from the sum of carrying and ordering cost. If the total cost under offer is less than the of EOQ, the offer should be accepted; otherwise not.

Total cost of discount offer = A/Q x O + Q/2 X C-A x purchase price x discount rate

Economic order quantity and re-order quantity
Economic order quantity and re-order quantity both convey the same meaning i.e. the quality of material ordered each time. Economic order quality is the order quantity in which the total cost is the least. But, re-order quantity is the quantity of materials that is actually ordered. The total cost at re-order quantity may not be the minimum. In this way, it can be concluded that an economic order quantity is a re-order quantities but re-order may be not be an economic order quantity.

 Stock level
Stock level is said to the different levels of stock that an organization maintains to run its activities without any obstruction. Under it, different types of stock levels are calculated as per the requirements and purposes. The stock level can be calculated under two situations as given in the following table:

Re-ordering level
It is level of stock at which the storekeeper initiates the purchase requisition for fresh suppliers of material. The fresh order must be made before the actual stock reaches to the minimum level. This level should be fixed by taking into account as abnormal usage of material; unexpected delay in procuring the material etc. the following factors should be taken into consideration while fixing re-ordering level.

a.    Minimum quantity of the item to be maintained.
b.    Rate of consumption
c.    Lead time

Minimum stock level
It is also known as 'Buffer Stock', minimum limit or minimum stock'. This represented the minimum quantity of the material which must be kept in hand at all the times. Such level of material is fixed so that production may not be held up due to shortage of material. The following points should be considered to determine the minimum stock level:
a.    Lead time: it is a time long between the points of placing an order and receiving the material.
b.    Consumption rate: the consumption rate of material during the lead time should also be considered.
c.    Re-order level: the level at which initiation to purchase requisition for new purchase of material is taken store in-charge is the re-order level. It should also be consisted.
d.    Disruption of supply: the possibility of any disruption is supply of material in near future should be taken into mind.
e.    Nature of material: it is another factor, which should be considered while fixing minimum level. Minimum level is not needed in the case of the material that is required against customer's specific order.

Minimum stock level = reorder level – (Normal consumption x normal reorder period)

Maximum stock level
It is a peak level of the material in stock. It is also called as 'Maximum Limit' or 'Maximum Stock'. It represents the maximum quantity of an item of material which may be held in stock. The stock should not exceed this quantity. The purpose of fixing this quantity is to avoid overstocking. Overstocking unnecessarily blocks working capital, but needs to utilize in some profitable activities. Similarly, overstocking also increase the cost due to the requirements of more space in good won. There may be more chances of having obsolescence and deterioration of quality when the actual stock exceeds the maximum stock levels.

The following points are to be considered while determining the maximum stock level:

a.    Working capital: sufficient amount of working capital should be kept for maintaining the maximum level of stock.
b.    Godown space: for putting the material safely, there is a need to have sufficient space in godown.
c.    Maximum requirement: there is a need to keep maximum stock of material since maximum requirement may arise at any time.
d.    Time lag: the time lead-time should be considered.
e.    Rate of consumption: while fixing maximum level of material, the rate of consumption of material during the lead-time should be determined.
f.    Cost of managing the store: it is another importance factor, which should be kept in mind while fixing maximum level of material.
g.    Loss in store: the maximum quantity of material will be fixed at a lower level in as of store, which deteriorates in quantity and quality if they are stored over a lag period.
h.    Seasonal nature of material: some of materials are available only during specific season in a year. Such materials should be stored beyond the maximum level during specific season.
i.    Change in fashion and habit: possibility of changes in fashion and habit, which may necessitable change in the requirement of materials, should also be considered.
j.    Flections in price: the fluctuation in the price of material may have effect on the fixation of maximum stock level. For instance, if it is anticipated that the price of the material will increase in future, a comparatively large maximum stock level can be fixed. On the other hand, if there is a fixed at a comparatively lower level.
k.    Restrictions of government: if government has imposed some restriction on stock e.g. fire explosion this may have effect on the fixation of maximum stock level.

 Maximum stock level = reorder level + recorder quantity – (minimum consumption x minimum recorder period)

Re-order quantity
Re-order quantity is the quantity of material that is purchased each time. This is termed as order size quantity. The re-order quantity is also termed as economic order quantity if it can be acquired at the minimum cost. The re-order quantity can be calculated as under.

Re-order quantity = (maximum stock level – re-order level) + (minimum consumption x minimum re-order period)

Average stock level
Average stock level refers the normal or moderate stock level. It is calculated as under,

Average stock level = minimum stock level + ½ 0f reorder quantity or EOQ

Danger level
This is level of material at which the issue of material is temporarily stopped due to shortage of stock. Form this level, material are issued for some abnormal situations only. The issue of material can be made against the special order from the top level. Since it is a damage level, some serious actions should be taken to acquire materials.

Danger level = normal consumption x maximum re-order period for emergency purchase

Perpetual inventory system
 Meaning of perpetual inventory system
The perpetual inventory system is the way of maintaining the record of inventory in such a ways that the stock on hand can be ascertained at any time. It emphasizes the day to day checking of stocks a d maintains the up to date records. It is a method of recording inventory after every receipt and issue to facilitate regular checking and obviate the stocktaking. It provided the perfect stock control as we can easily find out and verify the level and position of stock lying in the store at any moment by physical counting. Some definitions of perpetual inventory system are given below.

Charted institute of management accounts (CIMA), London, 'a system of records maintain by the controlling, which department, which reflect the physical movement of stock and their current balance.'

Mr. Weldon, 'it is a method of recording stores balance after every receipt and issue, to facilitate regular checking and to obviate closing for stock taking.'

Perpetual inventory system helps to ascertain the balance of each and every stock in terms of physical quantity as well as monetary value held in store at all time. For this, a company may maintain bin card, in which separate receipt and issue of material and balance of stock are recorded.

a.    Bin card
A bin card is a document maintained by the storekeeper to keep the record of the receipt and issue of inventory. It records the materials received, issued and balance in store in quantitative terms. Bin is a palace, rack or cupboard where materials are kept. A separate bin card is prepared for each item of material and attached or hung on the shelf; rack of pigeonholed etc. bin card gives quantitiave information about maximum level, minimum level and re-order level of material. It is a detailed statement of material received, issued and balance.

b.    Two bin card
Under two-bin card system, two-bin (i.e. bin and small bin) are maintained for every items of the store. The bin card is used for regular transactions that records the inventories issued to difference departments. It is called the big bin. The bin that is used for recording the issued made from the minimum stock or safety stock is called small bin. The issue from the small bin card is made when there is no sufficient stock in the big bin. The verification of stock is made through the regular bin.

c.    Store ledger
It is the ledger that maintains the records of stock both in quantity and value. It is maintained by the cost accounting department. It provided the information of material received. Issued, returned and balance. It is used for making decision regarding the inventory.

The difference between bin card and store ledgers are presented in the following table.

Advantage and disadvantages of perpetual inventory system
The advantages of the perpetual inventory system are as follows:

a.    Objective the necessary of physical verification of all items: it objective the necessity for the physical checking of all items of stores at end of the year.
b.    Easy to prepare final accounts: it is possible to prepared the profit and loss account and balance sheet without checking the inventory because the figure of closing stock can be taken from bin card or stores ledger.
c.    Reliable check: A perpetual inventory system is able to provide more reliable check on the store.
d.    Up-to-date and accurate records: continuous stock taking will make the storekeeper and stores accounts more vigilant toward their work and they make efforts to ensure that there is no ledge of the stock.
e.     Planning of production is easy: production planning can be one according to the availability of material in stores, since the management is constantly informed about the stores position.
f.    Continuity in internal check: a system of internal check remains in operation all the times.
g.    Easy to discover error and shortage of stock: error and shortage of stock and readily discovered and efforts can be made to avoid the shortage of stock in future.
h.    Control over capital investment in store: the capital investment in stores can be controlled since the actual stock can be compared with the maximum and minimum levels.
i.    Easy to make claim with insurance company: perpetual inventory system provided correct stock figures for claims to be made with the insurance company for loss of stock destroyed by fire or others.

The disadvantages of perpetual inventory system are as follows:

a.    It is possible maintaining stock cards, bin card and store ledger. So it is expensive.
b.    Small level organization cannot use it.
c.    In right time and in right place the information about actual stock of goods may not be avoidable.
d.    Accurate costing, measure, counting and weighing are difficult regularly.

Stock control through ABC Analysis
Concept of ABC analysis
ABC analysis is a way of categorizing the material on the quantity of consumption and their relative values. Some materials might be consumed in lower quantities but their price may be very high. Such materials are kept in group 'A' similarly, some materials may be consumed in large quantities but their values may be lower. Such materials are kept in group 'C' in between these two; some materials may be consumed in moderate quantity with the moderate price. Such materials are kept in group 'B'. Under ABC analysis, very close control is excursed over the materials in group 'A' whereas a very little control is exercised over the materials in group 'C'.

Techniques of ABC analysis
The above figure shows that material in group 'A' covers a small portion on the basis of quantity but it covers a very large portion on the basis of value. The materials in group 'B' have moderate value as well as quantity. The materials in group 'C' cover a large quantity but it has been presented below.

Advantages of ABC analysis
The advantages of ABC analysis are as follows:
a.    Strict control: under ABC analysis, strict control can be exercised to the materials in group 'a' that have higher value.
b.    Reduction in investment: under ABC analysis, the materials from group 'A' are purchased in lower quantities as much as possible. With this, the effort to reduce the delivery period is also made. These in turn help to reduce the investment in material.
c.    Minimum storage cost: since, the materials from group 'a' are purchase in lower quantities as much as possible the storage cost as well.
d.    Saving in time: since a significant effort is made for the management of the materials from group 'A', it helps to save time as well.
e.    Economy: this method is economical, since equal time and labour is not needed for all types of materials.

Disadvantage of ABC analysis
The disadvantages of ABC analysis are as follows:
•    ABC analysis will not be effective if the materials are not classified into the group property.
•    It is not suitable for the organizations where the costs of materials do not vary significantly.
•    There is no any scientific base for the classification of materials under ABC analysis.
•    The classification of the materials into different groups may lead to extra cost. Hence, it may not be suitable for small organizations.

Just in time (JIT) inventory system
Concept of JIT
Just-in-time inventory system is one of the recently developed inventory management concepts, which assumes that the purchase of inventory has to be made just in time of use. JIT refers to process of acquiring materials (inventory) as they are needed. JIT reduces investment by purchasing and touring lower quantities of inventories as much as possible. The objective of JIT is to maintain as low as possible. Sometimes, it may even be at zero level. Thus under JIT, the inventories are received in time or purchased in time of use. it is only possible when the suppliers can be relied for making the delivery of goods on time without compromising the suppliers can be relied for making the delivery of good on time without compromising the quality. Generally, in developed counties where communalization and transportation system are very efficient, the use if JIT is common.

Advantages of JIT
The advantages of JIT are as follows.
a.    Just in time inventory system reduces the amount of money tied up in inventory of raw materials and finished goods.
b.    This system create saving of space.
c.    It does not require maintaining large inventory storage facilities.
d.    Just in time inventory system minimum wastage.
e.    It helps to improve the labour efficiency.

Disadvantages
The disadvantes of JIT are as follows.
a.    The effectiveness of this system depends on the co-operation and faith with the supplier.
b.    This system works well when there is proper knowledge of quality and quantity of materials needed.
c.    The must become alternative suppliers as the regular suppliers may not be able to dispatch the materials all the times.

Inventory control systems design
The process followed regarding the purchase, store and issue of material for controlling the production cost is called the inventory control system design. The purchase process of material included the preparation of the purchase requisition, selection of the suppliers; placing the structure and location of the store as well as recoding of the investors are included. Issue of materials involved availing the inventory, evaluating the inventory and recording the issue. 

The main objectives of the inventory control system design are as follows:
•    To purchase the inventories by the authorized persons.
•    To purchase the inventories according to the quality needed.
•    To avail the suitable space and facilities for store-keeping.
•    To stop the unauthorized use of materials.
•    To ensure that the materials as per the recode's reconcile with the materials that actually exist in store.