Glossary

11.3 Inventory Management

3 min read•july 18, 2024

Inventory management is crucial for businesses to balance costs and meet customer demand. It involves tracking , , , and maintenance supplies. Effective management optimizes stock levels, minimizes costs, and ensures smooth operations.

Key concepts include , reorder points, and inventory control systems. Just-in-time techniques and ABC classification help businesses streamline processes and focus on high-value items. Understanding these principles is essential for efficient inventory management.

Inventory Management

Types of inventory in production

Top images from around the web for Types of inventory in production

  • Investigar en tiempos extraños: PhD in progress! View original

    Is this image relevant?

  • 2.3 Job Costing Process with Journal Entries | Managerial Accounting View original

    Is this image relevant?

  • Investigar en tiempos extraños: PhD in progress! View original

    Is this image relevant?

1 of 3

Top images from around the web for Types of inventory in production

  • Investigar en tiempos extraños: PhD in progress! View original

    Is this image relevant?

  • 2.3 Job Costing Process with Journal Entries | Managerial Accounting View original

    Is this image relevant?

  • Investigar en tiempos extraños: PhD in progress! View original

    Is this image relevant?

1 of 3
  • Raw materials inventory
    • Unprocessed materials used to create finished products (lumber, steel, plastics)
    • Serve as inputs for the production process
    • Must be purchased and stored until needed for production
  • Work-in-progress (WIP) inventory
    • Partially completed products in various stages of the production process
    • Represents the value of materials, labor, and overhead incurred but not yet turned into finished goods
    • Ties up capital and requires storage space until completion
  • Finished goods inventory
    • Completed products ready for sale to customers
    • Represents the final output of the production process
    • Must be stored and managed until sold and delivered to customers
  • Maintenance, repair, and operating (MRO) inventory
    • Supplies and materials used to support production but not directly incorporated into finished products (spare parts, lubricants, cleaning supplies)
    • Ensures smooth operation of production equipment and facilities
    • Requires regular monitoring and replenishment to avoid production disruptions

Economic order quantity calculation

  • Economic order quantity (EOQ)
    • Optimal order quantity that minimizes total inventory costs
    • Balances the trade-off between ordering costs and holding costs
    • Formula: EOQ=2DSHEOQ = \sqrt{\frac{2DS}{H}}
      • DD = Annual demand in units
      • SS = Fixed cost per order (setup costs, transportation costs)
      • HH = Annual holding cost per unit (storage, insurance, opportunity cost)
  • Reorder point (ROP)
    • Inventory level at which a new order should be placed to prevent stockouts
    • Considers lead time and to ensure continuous supply
    • Formula: ROP=(Daily demand×Lead time)+Safety stockROP = (Daily\ demand \times Lead\ time) + Safety\ stock
      • Daily demand = Average number of units sold per day
      • Lead time = Time between placing an order and receiving the inventory
      • Safety stock = Extra inventory held to prevent stockouts due to unexpected demand or supply delays

Inventory control system analysis

    • Inventory levels are reviewed and orders placed at fixed intervals (weekly, monthly)
    • Benefits: simplicity, less frequent ordering, suitable for low-value items
    • Costs: higher average inventory levels, increased risk of stockouts
    • Inventory levels are continuously monitored and updated with each transaction
    • Benefits: real-time inventory tracking, lower risk of stockouts, better decision-making
    • Costs: higher setup and maintenance costs for technology and systems
  • ABC inventory classification
    • Categorizes inventory items based on their value and importance
      1. A items: high value, critical to production (20% of items, 80% of value)
      2. B items: moderate value, less critical (30% of items, 15% of value)
      3. C items: low value, least critical (50% of items, 5% of value)
    • Benefits: focuses management attention on high-value items, optimizes inventory control efforts
    • Costs: time and resources required for classification and differentiated management

Just-in-time inventory techniques

  • Just-in-time (JIT) inventory management
    • Production and inventory strategy that aims to minimize inventory holding costs by receiving materials just as they are needed
    • Key principles:
      1. Pull system: production is triggered by customer demand, not forecasts
      2. Small, frequent deliveries from suppliers
      3. Continuous improvement to reduce waste and inefficiencies (lean manufacturing)
    • Benefits:
      • Lower inventory holding costs
      • Reduced space requirements
      • Improved cash flow
    • Challenges:
      • Requires strong supplier relationships and reliable deliveries
      • Increased risk of stockouts if supply chain disruptions occur (natural disasters, labor strikes)
      • Higher transportation costs due to frequent deliveries

Key Terms to Review (18)

Abc analysis: ABC analysis is an inventory categorization method that divides items into three categories (A, B, and C) based on their importance and value to the business. This approach helps businesses prioritize their inventory management efforts, ensuring that the most critical items receive the most attention, while less important items are managed with a lighter touch.
Carrying Cost: Carrying cost refers to the total cost of holding inventory over a specific period of time. This includes expenses such as storage, insurance, depreciation, and opportunity costs associated with the capital tied up in the inventory. Understanding carrying costs is crucial for businesses as it directly impacts inventory management strategies and financial performance.
Days Sales of Inventory: Days Sales of Inventory (DSI) is a financial metric that indicates the average number of days a company takes to sell its entire inventory during a specific period. It helps businesses assess their inventory management efficiency, revealing how quickly products move through the supply chain. A lower DSI suggests better inventory turnover, which can lead to reduced holding costs and improved cash flow.
Drop shipping: Drop shipping is a retail fulfillment method where a store does not keep the products it sells in stock. Instead, when a store sells a product, it purchases the item from a third party and has it shipped directly to the customer. This method allows retailers to offer a wide range of products without the need for inventory management and reduces overhead costs.
Economic Order Quantity: Economic Order Quantity (EOQ) is a formula used to determine the optimal order quantity that minimizes total inventory costs, which include ordering costs and holding costs. This model helps businesses maintain sufficient stock levels while reducing excess inventory and associated costs, making it a crucial component of effective inventory management.
FIFO: FIFO stands for 'First In, First Out,' which is an inventory management method where the oldest inventory items are sold or used first. This technique ensures that products are rotated, minimizing spoilage and obsolescence, and is particularly important for businesses dealing with perishable goods or items with a limited shelf life.
Finished goods: Finished goods are products that have completed the manufacturing process and are ready for sale to customers. They represent the final stage in the production cycle, indicating that all necessary processes, from raw materials to assembly, have been completed. Understanding finished goods is crucial for effective inventory management, as it helps businesses determine stock levels, production planning, and sales forecasting.
Inventory turnover: Inventory turnover is a financial metric that measures how efficiently a company manages its inventory by indicating how many times inventory is sold and replaced over a specific period. This ratio is crucial for understanding the effectiveness of inventory management practices, as a higher turnover rate often signals efficient inventory control and sales performance, while a lower rate may suggest overstocking or weak sales.
Just-in-time inventory: Just-in-time inventory is a management strategy that aligns raw-material orders from suppliers directly with production schedules. This approach reduces inventory costs and minimizes waste by receiving goods only as they are needed in the production process, effectively optimizing the supply chain. The strategy relies on strong relationships with suppliers and precise demand forecasting to ensure that materials are available just in time for production, which is essential for improving efficiency and reducing excess stock.
Lifo: LIFO, or Last In, First Out, is an inventory valuation method where the most recently purchased items are assumed to be sold first. This method impacts financial statements and tax calculations, as it can lead to lower taxable income during periods of rising prices due to higher costs associated with the latest inventory.
Periodic Inventory System: The periodic inventory system is an accounting method used to value inventory and determine the cost of goods sold at specific intervals, rather than continuously tracking inventory levels. This system involves counting inventory at the end of an accounting period, allowing businesses to calculate their total stock on hand and adjust financial records accordingly. It contrasts with the perpetual inventory system, which maintains continuous records of inventory transactions.
Perpetual inventory system: A perpetual inventory system is an inventory management method that continuously updates inventory records in real-time as transactions occur. This approach allows businesses to maintain accurate and up-to-date information about stock levels, helping to reduce discrepancies and improve overall efficiency in managing inventory.
Raw materials: Raw materials are the basic, unprocessed resources that are used in the production of goods and services. These materials serve as the foundational inputs for manufacturing and can include anything from metals and minerals to agricultural products. Understanding raw materials is essential for effective inventory management as it influences production schedules, costs, and supply chain dynamics.
Safety Stock: Safety stock is an extra quantity of inventory kept on hand to prevent stockouts caused by uncertainties in supply and demand. It acts as a buffer against unexpected spikes in customer demand or delays in supplier deliveries, ensuring that a business can continue to operate smoothly without interruptions. Proper management of safety stock is crucial for maintaining customer satisfaction and optimizing inventory levels.
Stockout cost: Stockout cost refers to the financial impact and potential loss incurred when a company runs out of inventory and is unable to meet customer demand. This cost encompasses various aspects such as lost sales, customer dissatisfaction, and the potential harm to a company's reputation. Managing stockout costs is crucial for businesses, as it directly influences their ability to maintain sales and retain customers.
Vendor-managed inventory: Vendor-managed inventory (VMI) is a supply chain practice where the vendor or supplier takes responsibility for managing and replenishing the inventory for a retailer or buyer. This approach allows for more efficient inventory management, as the vendor uses real-time data and insights to maintain optimal stock levels, reducing stockouts and excess inventory while improving overall supply chain performance.
Weighted average cost: Weighted average cost is a method used to calculate the average cost of inventory by assigning different weights to various costs based on their significance in the total inventory. This approach is particularly useful for businesses that have fluctuating purchase costs, allowing them to reflect the true cost of goods sold more accurately. By using weighted averages, companies can better manage their inventory valuation and make informed pricing and production decisions.
Work-in-progress: Work-in-progress (WIP) refers to the partially finished goods in a manufacturing process that have not yet been completed. This term is crucial in inventory management as it represents a significant component of a company's total inventory costs and reflects the resources consumed in the production process. Proper management of WIP is essential for optimizing production efficiency and ensuring timely delivery of finished goods to customers.
© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.
Back
Practice QuizGlossary
Practice QuizGlossary
Next guide