Inventory types

1. CONTENTS
1. INTRODUCTION
2. INVENTORY TYPES
*RAW MATERIALS
*WORK-IN-PROGRESS
*FINISHED GOODS
*TRANSIT INVENTORY
*BUFFER INVENTORY
*DECOUPLING INVENTORY
3. MOTIVE OF HOLDING INVENTORY
4. REASONS AND BENEFITS OF INVENTORY
5. INVENTORY MANAGEMENT
6. TECHNIQUES OF INVENTORY MANAGEMENT

2. INTRODUCTION
Inventories are assets of the firm and require investment and
hence involve the commitment of firm’s resources. The
inventories need not be viewed as an idle asset rather these
are an integral part of firm’s operations. If the inventories
are too big, they became a strain on the resources, however,
if they are too small the firm may loose the sales. Therefore,
the firm must have an optimum level of inventories.
INVENTORY TYPES
Inventory is defined as a stock or store of goods. These goods are
maintained on hand at or near a business's location so that the firm may
meet demand and fulfill its reason for existence. If the firm is a retail
establishment, a customer may look elsewhere to have his or her needs
satisfied if the firm does not have the required item in stock when the
customer arrives. If the firm is a manufacturer, it must maintain some
inventory of raw materials and work-in-process in order to keep the factory
running. In addition, it must maintain some supply of finished goods in order
to meet demand.
Sometimes, a firm may keep larger inventory than is necessary to meet
demand and keep the factory running under current conditions of demand. If
the firm exists in a volatile environment where demand is dynamic (i.e., rises

3. and falls quickly), an on-hand inventory could be maintained as a buffer
against unexpected changes in demand. This buffer inventory also can serve
to protect the firm if a supplier fails to deliver at the required time, or if
the supplier's quality is found to be substandard upon inspection, either of
which would otherwise leave the firm without the necessary raw materials.
Other reasons for maintaining an unnecessarily large inventory include
buying to take advantage of quantity discounts (i.e., the firm saves by buying
in bulk), or ordering more in advance of an impending price increase.
Generally, inventory types can be grouped into four classifications: raw
material, work-in-process, finished goods, and MRO goods.
RAW MATERIALS
Raw materials are inventory items that are used in the manufacturer's
conversion process to produce components, subassemblies, or finished
products. These inventory items may be commodities or extracted materials
that the firm or its subsidiary has produced or extracted. They also may be
objects or elements that the firm has purchased from outside the
organization. Even if the item is partially assembled or is considered a
finished good to the supplier, the purchaser may classify it as a raw material
if his or her firm had no input into its production. Typically, raw materials
are commodities such as ore, grain, minerals, petroleum, chemicals, paper,
wood, paint, steel, and food items. However, items such as nuts and bolts,
ball bearings, key stock, casters, seats, wheels, and even engines may be
regarded as raw materials if they are purchased from outside the firm.

4. The bill-of-materials file in a material requirements planning system (MRP)
or a manufacturing resource planning (MRP II) system utilizes a tool known
as a product structure tree to clarify the relationship among its inventory
items and provide a basis for filling out, or "exploding," the master
production schedule. Consider an example of a rolling cart. This cart consists
of a top that is pressed from a sheet of steel, a frame formed from four
steel bars, and a leg assembly consisting of four legs, rolled from sheet
steel, each with a caster attached. An example of this cart's product
structure tree is presented in Figure 1.
Figure 1
Generally, raw materials are used in the manufacture of components. These
components are then incorporated into the final product or become part of a
subassembly. Subassemblies are then used to manufacture or assemble the
final product. A part that goes into making another part is known as a
component, while the part it goes into is known as its parent. Any item that
does not have a component is regarded as a raw material or purchased item.

5. From the product structure tree it is apparent that the rolling cart's raw
materials are steel, bars, wheels, ball bearings, axles, and caster frames.
WORK-IN-PROCESS
Work-in-process (WIP) is made up of all the materials, parts (components),
assemblies, and subassemblies that are being processed or are waiting to be
processed within the system. This generally includes all material raw
materials that has been released for initial processing up to material that
has been completely processed and is awaiting final inspection and
acceptance before inclusion in finished goods.
Any item that has a parent but is not a raw material is considered to be
work-in-process. A glance at the rolling cart product structure tree example
reveals that work-in-process in this situation consists of tops, leg
assemblies, frames, legs, and casters. Actually, the leg assembly and casters
are labeled as subassemblies because the leg assembly consists of legs and
casters and the casters are assembled from wheels, ball bearings, axles, and
caster frames.
FINISHED GOODS
A finished good is a completed part that is ready for a customer order.
Therefore, finished goods inventory is the stock of completed products.
These goods have been inspected and have passed final inspection

6. requirements so that they can be transferred out of work-in-process and
into finished goods inventory. From this point, finished goods can be sold
directly to their final user, sold to retailers, sold to wholesalers, sent to
distribution centers, or held in anticipation of a customer order.
Any item that does not have a parent can be classified as a finished good. By
looking at the rolling cart product structure tree example one can determine
that the finished good in this case is a cart.
Inventories can be further classified according to the purpose they serve.
These types include transit inventory, buffer inventory, anticipation
inventory, decoupling inventory, cycle inventory, and MRO goods inventory.
Some of these also are know by other names, such as speculative inventory,
safety inventory, and seasonal inventory. We already have briefly discussed
some of the implications of a few of these inventory types, but will now
discuss each in more detail.
TRANSIT INVENTORY
Transit inventories result from the need to transport items or material from
one location to another, and from the fact that there is some transportation
time involved in getting from one location to another. Sometimes this is
referred to as pipeline inventory. Merchandise shipped by truck or rail can
sometimes take days or even weeks to go from a regional warehouse to a
retail facility. Some large firms, such as automobile manufacturers, employ
freight consolidators to pool their transit inventories coming from various
locations into one shipping source in order to take advantage of economies of

7. scale. Of course, this can greatly increase the transit time for these
inventories, hence an increase in the size of the inventory in transit.
BUFFER INVENTORY
As previously stated, inventory is sometimes used to protect against the
uncertainties of supply and demand, as well as unpredictable events such as
poor delivery reliability or poor quality of a supplier's products. These
inventory cushions are often referred to as safety stock. Safety stock or
buffer inventory is any amount held on hand that is over and above that
currently needed to meet demand. Generally, the higher the level of buffer
inventory, the better the firm's customer service. This occurs because the
firm suffers fewer "stock-outs" (when a customer's order cannot be
immediately filled from existing inventory) and has less need to backorder
the item, make the customer wait until the next order cycle, or even worse,
cause the customer to leave empty-handed to find another supplier.
Obviously, the better the customer service the greater the likelihood of
customer satisfaction.
ANTICIPATION INVENTORY
Oftentimes, firms will purchase and hold inventory that is in excess of their
current need in anticipation of a possible future event. Such events may
include a price increase, a seasonal increase in demand, or even an impending

8. labor strike. This tactic is commonly used by retailers, who routinely build up
inventory months before the demand for their products will be unusually
high (i.e., at Halloween, Christmas, or the back-to-school season). For
manufacturers, anticipation inventory allows them to build up inventory when
demand is low (also keeping workers busy during slack times) so that when
demand picks up the increased inventory will be slowly depleted and the firm
does not have to react by increasing production time (along with the
subsequent increase in hiring, training, and other associated labor costs).
Therefore, the firm has avoided both excessive overtime due to increased
demand and hiring costs due to increased demand. It also has avoided layoff
costs associated with production cut-backs, or worse, the idling or shutting
down of facilities. This process is sometimes called "smoothing" because it
smoothes the peaks and valleys in demand, allowing the firm to maintain a
constant level of output and a stable workforce.
DECOUPLING INVENTORY
Very rarely, if ever, will one see a production facility where every machine in
the process produces at exactly the same rate. In fact, one machine may
process parts several times faster than the machines in front of or behind
it. Yet, if one walks through the plant it may seem that all machines are
running smoothly at the same time. It also could be possible that while
passing through the plant, one notices several machines are under repair or
are undergoing some form of preventive maintenance. Even so, this does not
seem to interrupt the flow of work-in-process through the system. The
reason for this is the existence of an inventory of parts between machines,

9. a decoupling inventory that serves as a shock absorber, cushioning the
system against production irregularities. As such it "decouples" or
disengages the plant's dependence upon the sequential requirements of the
system (i.e., one machine feeds parts to the next machine).
The more inventory a firm carries as a decoupling inventory between the
various stages in its manufacturing system (or even distribution system), the
less coordination is needed to keep the system running smoothly. Naturally,
logic would dictate that an infinite amount of decoupling inventory would not
keep the system running in peak form. A balance can be reached that will
allow the plant to run relatively smoothly without maintaining an absurd level
of inventory. The cost of efficiency must be weighed against the cost of
carrying excess inventory so that there is an optimum balance between
inventory level and coordination within the system.
CYCLE INVENTORY
Those who are familiar with the concept of economic order quantity (EOQ)
know that the EOQ is an attempt to balance inventory holding or carrying
costs with the costs incurred from ordering or setting up machinery. When
large quantities are ordered or produced, inventory holding costs are
increased, but ordering/setup costs decrease. Conversely, when lot sizes
decrease, inventory holding/carrying costs decrease, but the cost of
ordering/setup increases since more orders/setups are required to meet
demand. When the two costs are equal (holding/carrying costs and
ordering/setup costs) the total cost (the sum of the two costs) is minimized.

10. Cycle inventories, sometimes called lot-size inventories, result from this
process. Usually, excess material is ordered and, consequently, held in
inventory in an effort to reach this minimization point. Hence, cycle
inventory results from ordering in batches or lot sizes rather than ordering
material strictly as needed.
MRO GOODS INVENTORY
Maintenance, repair, and operating supplies, or MRO goods, are items that
are used to support and maintain the production process and its
infrastructure. These goods are usually consumed as a result of the
production process but are not directly a part of the finished product.
Examples of MRO goods include oils, lubricants, coolants, janitorial supplies,
uniforms, gloves, packing material, tools, nuts, bolts, screws, shim stock, and
key stock. Even office supplies such as staples, pens and pencils, copier
paper, and toner are considered part of MRO goods inventory.
THEORETICAL INVENTORY
In their book Managing Business Process Flows: Principles of Operations
Management, Anupindi, Chopra, Deshmukh, Van Mieghem, and Zemel discuss
a final type of inventory known as theoretical inventory. They describe
theoretical inventory as the average inventory for a given throughput
assuming that no WIP item had to wait in a buffer. This would obviously be
an ideal situation where inflow, processing, and outflow rates were all equal
at any point in time. Unless one has a single process system, there always will

11. be some inventory within the system. Theoretical inventory is a measure of
this inventory (i.e., it represents the minimum inventory needed for goods to
flow through the system without waiting). The authors formally define it as
the minimum amount of inventory necessary to maintain a process
throughput of R, expressed as:
Theoretical Inventory = Throughput Theoretical Flow Time
Ith = R Tth
In this equation, theoretical flow time equals the sum of all activity times
(not wait time) required to process one unit. Therefore, WIP will equal
theoretical inventory whenever actual process flow time equals theoretical
flow time.
Inventory exists in various categories as a result of its position in the
production process (raw material, work-in-process, and finished goods) and
according to the function it serves within the system (transit inventory,
buffer inventory, anticipation inventory, decoupling inventory, cycle
inventory, and MRO goods inventory). As such, the purpose of each seems to
be that of maintaining a high level of customer service or part of an attempt
to minimize overall costs.
What is "Inventory Management"
Inventory management is the active control program which allows the
management of sales, purchases and payments.
Inventory management software helps create invoices, purchase orders,
receiving lists, payment receipts and can print bar coded labels. An
inventory management software system configured to your warehouse,

12. retail or product line will help to create revenue for your company. The
Inventory Management will control operating costs and provide better
understanding. We are your source for inventory management information,
inventory management software and tools.
A complete Inventory Management Control system contains the following
components:
·Inventory Management Definition
·Inventory Management Terms
·Inventory Management Purposes
·Definition and Objectives for Inventory Management
·Organizational Hierarchy of Inventory Management
·Inventory Management Planning
·Inventory Management Controls for Inventory
·Determining Inventory Management Stock Levels
MOTIVE OF HOLDING INVENTORY:-
·Transaction Motive:- Every firm has to maintain some fuel of
inventory to meet the day to day requirements of sale production
process, customer demand etc.
·Precautionary Motive:- The firm should keep some inventory for
unforeseen circumstances also. For eg. The fresh supply of raw

13. materials may not reach the factory due to strike by the transports
or due to natural calamities in a particular area.
·Speculative Motive:- It may be required to keep some inventory in
order to capitalize an opportunity to make profits. Example,
sufficient level of inventory may help the firm to earn profit in case
of expected shortage in market.
REASONS AND BENEFITS OF
INVENTORY
The inventory has cost as well as benefits associated with it. While
determining the optimum level of inventories, the financial manager must
consider the necessity of holding inventory & cost thereof. The optimum
level of inventory is a subjective matter and depends upon the features of a
firm. The following are some of the benefits or reasons for holding
inventories.
1) Trading firm:
If the firm has some stock of goods then the sale activity can be
undertaken even if the procurement as stopped due to one reason or the
other . Otherwise ,if stock is not there , there is likelihood that the ale will

14. stop as soon as there is an interruption in procurement. Moreover , it is not
always possible to procure goods whenever there is a sales opportunity , as
there is always a time gap required between the purchase & sale of the
goods. Thus , a trading concern should have some stock of finished goods in
order to undertake sales activities independent of each other. A firm may
have several incentives being offered in terms of quantity discount or lower
price etc. the inventory so purchased, at a discount/lower cost, will result in
lowering the total cost resulting in higher to the firm. So , in case of trading
concern, the inventory helps in de-linking the sales activity from purchase
activity and also to capitalize a profit of opportunity.
2) Manufacturing firm:
A manufacturing firm should have inventory of not only the finished goods,
but also, of raw material and work-in-progress for obvious reason as follows:

i) Uninterrupted production schedule:
Every firm must have sufficient stock of raw material in order to have
regular & uninterrupted production schedule. If there is stock-out of raw
material at any stage of production process , then the whole production
process may come to a halt. This may result in customer satisfaction as the
goods can not be delivered in time. The firm may have to incur heavy cost to
restart the production process.
Further, sufficient work-in-progress would let the production process to run

15. smoothly. The work-in-progress helps in fulfillment of sales orders even if
the supply of raw material has stopped.
ii) Independent sales activity:
The production schedule is generally a time consuming process & in most
cases goods cannot be produced just after receiving orders. Every
manufacturing concern therefore, maintains a minimum level of finished
goods in order to deliver the goods as soon as the order is received.
COST OF INVENTORY: Every firm maintains some stock of raw materials,
work in progress and finished goods depending upon the requirement and
other features of the firm. It is benefited by holding inventory no doubt,
yet it must also consider various costs involved in holding inventories. The
cost of holding inventories may include the following:
1.Carrying cost: This is the cost incurred in keeping or maintaining an
inventory of one unit of raw material or work in progress or finished
goods. Two basic costs are associated with holding a unit in inventory.
These are:
(a)Cost of storage- This means and includes the cost of storing
one unit of raw material by firm .This cost may be in relation to
rent of space occupied by the stock ,the cost of people
employed for the security of the stock , cost of infrastructure
required e.g., air conditioning ,etc ., cost of insurance , cost of
pilferage , warehousing cost , handling cost ,etc..
(b)Cost of financing: This cost includes the cost of funds invested
in the inventories. The funds used in the purchase / production

16. of inventories have an opportunity cost i.e. the income which
could have been earned by investing these funds elsewhere.
Moreover, if the firm has to pay interest on borrowings made
for the purchase of materials / goods, then there is an explicit
cost of financing in the form of interest.
It may be noted that total carrying cost is entirely variable and
rise in direct proportion to the level of inventories carried. The
total carrying cost move in the same direction as the annual
average inventory.
2. Cost of Ordering: The cost include the cost of acquisition of
inventories .it is the cost of preparation and execution of an order,
including cost of paper work and communicating with the supplier.
There is always minimum cost involved whenever an order for
replenishment of goods is placed. The total annual cost of ordering
is equal to the cost per order multiplied by the number of order
placed in a year. The number of orders determines the average
inventory being held by the firm. Therefore, the total order cost
is inversely related to the average inventory of the firm. The
ordering cost may have a fixed component which is not affected by
the order size; and a variable component which changes with the
order size. For example, transportation charges may be payable
per unit subject to a minimum charge per trip.

17. 3.Cost of stock outs- A stock out is a situation where the firm is not
having units of an item in store but there is a demand for that either
from the customers or the production department. The stock out refer
to demand for an item whose inventory level has already reduced to zero
or insufficient level. It may be noted that the stock out does not appear
if the item is not demanded even if inventory level is fallen to zero. The
whole theory of inventory management can be summarized as follows-
1. Maintaining sufficient stock of raw materials ensuring continuous
supply to production schedule.
2. Maintaining sufficient supply of finished goods for achieving smooth
sales operations, and
3. Minimizing the total annual cost of maintaining inventories.
TECHNIQUES OF INVENTORY MANAGEMENT
ABC ANALYSIS-ABC analysis is a type of analysis of material dividing in
three groups called A-group items, B-Group items and C-group items For the
purpose of exercising control over materials. Manufacturing concerns find it
useful to divide materials into three categories.
An analysis of the annual consumption of materials of any organisation would
indicate that a handful to top high value items (less than 10 per cent of the
total number) will account for a substantial portion of about 70 per cent of
total consumption value.
Remember: 10% of total number of items carries 70% of value. - "A" group

18. items
Similarly, a large number bottom items (over 70 per cent of the total
number of items) account for only about 10 percent of the consumption
value.
Remember: 70% of total number of items account for only about 10% of
consumption value - "C"-group items.
Between these two extremes will fall those items the percentage number of
which is more or less equal to their consumption value.
Remember: 20% of total number of items account for only about 20%
consumption value - "B" group items.
Items in the top category are treated as "A" items, items in the bottom
category are called as "C" category items and the items that lie between the
top and the bottom are called "B" category items. Such an analysis of
materials is known as ABC analysis or Proportional parts value analysis.
Classification of items into A, B and C
categories
The logic behind this kind of analysis is that the management should study
each item of stock in terms of its usage, lead time, technical or other
problems and its relative money value in the total investment in inventories.

19. Critical items i.e., high value items deserve very close attention and low value
items need to be devoted minimum expense and effort in the task of
controlling inventories.
The Material Manager by concentrating on "A" class items is able to control
inventories and show visible results in a short span of time. By controlling
"A" items and doing a proper inventory analysis, obsolete stocks are
automatically pinpointed.
ABC analysis also helps in reducing the clerical costs and results in better
planning and improved inventory turnover. ABC analysis has to be resorted to
because equal attention to A, B and C items will not be worthwhile and would
be very expensive.
The following steps will explain to you the classification of items into A, B
and C categories.
The following steps will explain to you the classification of items into A, B
and C categories.
1. Find out the unit cost and and the usage of each material over a given
period.
2. Multiply the unit cost by the estimated annual usage to obtain the net
value.
3. List out all the items and arrange them in the descending value. (Annual

20. Value)
4. Accumulate value and add up number of items and calculate percentage on
total inventory in value and in number.
5. Draw a curve of percentage items and percentage value.
6. Mark off from the curve the rational limits of A, B and C categories.
Stock Levels
Maintenance of proper stock of each item of materials is one of the main
functions of stores department. Large quantity of material in store lead to
huge investments, deterioration in quality, large space requirement etc. Less
stock also leads to higher costs, frequent purchases and loss of production
etc. Therefore, it is important to maintain stock level. One of the best way
to maintain stock is to determine the minimum and maximum stock levels as
per the necessity and maintain it regularly.
Store keepers usually use scientific technique of material management to
ensure optimum quantity of material in store and make purchases
accordingly. In order to do that following levels are fixed in advance:
1.Maximum Stock Level

21. 2.Minimum Stock level
3.Re-ordering level
4.Danger level
Reordering Level
Re-ordering level is a level at which the storekeeper will initiate the steps to
purchase fresh supplies. This level is called re-ordering level or ordering
level. This level usually lies between minimum and maximum stock level. This
level will usually be higher than the minimum stock level to cover unexpected
delay in delivery of fresh supplies or abnormal usage of materials. Following
points need to be taken into consideration while fixing the re-ordering level
1. Economic ordering quantity
2. Rate of consumption
3. Time required for the delivery of fresh supply.
Following formulas can be used for calculating the re-ordering level.
Reorder level = Maximum consumption x Maximum re-order period
or
Reorder level = Minimum level + consumption during the time required to get
fresh deliveries

22. Example 1
Calculate the reorder level from the following information:
Maximum Consumption = 100 units per week
Minimum Consumption = 50 units per week
Maximum reorder period = 4 weeks
Solution:
Reorder level = Maximum consumption x Maximum reorder period
= 100 x 4 = 400 units.
Example 2
Find out the order level from the following information:
Maximum Stock: 250 units
Minimum stock: 100 units
Time required for receiving fresh supplies: 10 days
Daily consumption of material : 5 units
Solution:
Reorder level = Minimum level + consumption during the time required to get

23. fresh deliveries
= 100 + (5 x 10)
= 150 units.
Minimum Stock Level
Minimum stock level is a level of stock which must be kept in store at all
times. This is a level of an item of material below which the stock in hand is
not allowed to fall. The objective of this limit is to avoid the possibility of
interruption of production due to shortage of material. The following points
needs to be taken into consideration while fixing the minimum stock level.
1.Time required for the fresh supply of material - Lead time
2.Rate of consumption of material during the lead time.
3.Reorder level
Following formula can be used for determine the minimum stock level
Minimum stock level = Reorder level - (Normal consumption x Normal
reorder period)
Example:
Calculate the minimum stock level from the following data:
Net normal consumption = 500 units per day
Normal reorder period = 10 days
Reorder level = 8000 units

24. Solution:
Minimum stock level = Reorder level - (Normal consumption x Normal reorder
period)
= 8000 - (500 x 10)
= 3000 units
Maximum stock level
Maximum stock level is a quantity of material above which the stock of any
item should not be allowed. To avoid blocking of working capital and making
undue investments in stock, maximum stock level is to be fixed. It also helps
to maintain proper quality of raw materials. Following points must be taken
into consideration while fixing maximum stock level:
1.Availability of storage space
2.Cost of carrying the inventory
3.Amount of working capital available
4.Economic ordering quantity
5.Possibility of change in market trend
6.Normal rate of consumption of material during the reordering
process.
7.Time necessary for fresh delivery of materials.
8.Possibility of loss due to deterioration/evaporation etc.
9.Price fluctuation.
10.Insurance costs if any.

25. Following formula is normally in use for calculating Maximum stock level.
Maximum stock level = Reorder level + reorder quantity - (maximum
consumption X minimum re-order period)
Example:
Find out the Maximum stock level from the following information:
Reorder Level = 32000 units
Reorder quantity = 30000 units
Minimum Consumption = 3000 units per month
Minimum reorder period = 2 months.
Solution:
Maximum stock level = Reorder level + reorder quantity - (maximum
consumption X minimum re-order period)
Maximum stock level = 32000 + 30000 - (3000 x 2)
=62000 - 6000 = 56000 units.
Danger Level
Danger level is a level below the minimum level. This is a level at which urgent
action must be taken to procure new stock otherwise the stock may exhaust
and could affect the production. This level is calculated by taking into
account the time required to get the materials by the shortest possible
means. Generally following formula is used to calculate the Danger level:

26. Danger level = average consumption x Maximum reorder period for
emergency purchase.
Average stock level
Average stock level can be determined by using the following formula:
Average Stock Level = 1/2 of (Maximum stock level + Minimum Stock level)
or
Average Stock Level = Minimum stock level + half of reorder quantity)
Reorder Quantity or Economical order Quantity
It is better to determine in advance how much is to be purchased when the
material reaches reorder level. This quantity is called reorder quantity. It is
the quantity when it received, it will not exceed the maximum stock level. It
is also called Economic Order Quantity because purchase of this quantity of
material is most economical as well. Frequent purchase will result in increase
in cost of transportation. Too much of goods may block the working capital
for a long time. Following points needs to be taken into consideration while
fixing the reorder quantity.

27. 1.Cost of transportation
2.cost of storage (warehouse rent, insurance, heating and lighting
expenses)
3.cost of ordering
4.Availability of working capital
5.Minimum and maximum consumption for the lead time.
6.Time necessary to obtain deliveries
7.Possibility of loss due to evaporation or deterioration
8.Changes in the fashion trend.
9.Interest on investment
10.Obsolescence losses,