Inventory Management Meaning, Elements, Types

Table of Contents:-

  • Meaning of Inventory
  • Definition of Inventory
  • Elements of Inventory
  • Motives for Holding Inventories
  • Types of Inventory

Meaning of Inventory

In the dictionary, inventory means ‘stock of goods’. Authors interpret the term “Inventory” in different ways. In accounting terminology, it may refer solely to the stock of finished goods. A manufacturing concern may include raw materials, work in process and stores, etc.

Definition of Inventory

The International Accounting Standard Committee (L.A.S.C) defines inventories as “Tangible property

1) Held for sale in the regular course of business,

2) In the process of production for such sale or,

3) To be consumed in the process of production of services or goods for sale”.

The American Institute of Certified Public Account (AICPA) defines “inventory in the sense of tangible goods, which are held for sale, in the process of production and available for ready consumption”.

According to Bolten S.E., “Inventory refers to stock-pile of product, a firm is offering for sale and components that make up the product”.

Elements of Inventory

Inventory includes the following things:

  1. Raw Material
  2. Consumable
  3. Work-in-Progress
  4. Stores and Spares
  5. Finished Goods

1) Raw Material

It includes direct material used in the manufacturing process of a product. The purpose of holding raw materials is to ensure uninterrupted production in the event of delayed delivery. The amount of raw materials to be kept by a firm depends on various factors such as the speed with which raw materials are to be ordered and procured and uncertainty in the supply of these raw materials.

i) Direct Material: Direct material is the primary classification for raw materials in manufacturing operations. It has a direct correlation to the end product.It is only the material that, after manufacturing processes are applied, is exported out to a distributor or the final customer. If, e.g., the company manufactures hammers, then steel would be its primary direct material.

ii) Indirect Material: Indirect material is the class of materials in the manufacturing process that does not ship to the customer as part of the final product. For example, the gas used to beat the furnaces that melt the steel in the manufacture of hammers is an indirect material. Similarly, the water that cools the metal can also be classified as an indirect material.

2) Consumable

Consumables are products that consumers frequently purchase, such as items that are used up or disposed of. For example, consumable office supplies encompass items like paper, pens, file folders, post-it notes, computer disks, and toner or ink cartridges. This category does not include capital goods such as computers, fax machines, other business machines, or office furniture.

3) Work-in-Progress

It includes partly finished goods and materials held between manufacturing stages. It can also be stated that those raw materials which are used in the production process but are not finally converted into the final product are work-in-progress.

4) Stores and Spares

This category includes those products, which are accessories to the main products produced for sale. For example, stores and spare items are bolts, nuts, clamps, screws, etc. These spare parts are usually bought externally, although there are cases where the company manufactures them in-house as well.

5) Finished Goods

The goods ready for sale or distribution come under this class. It helps to reduce the risk associated with a stoppage in output on account of strikes, breakdowns, shortage of material, etc.

Elements of Inventory

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Motives for Holding Inventories

The motives for holding inventories are given as follows:

1) Speculative Motive

The firm may be tempted to keep some inventory to capitalize on an opportunity to make a profit e.g., a sufficient level of inventory may help the firm to earn extra profit in case of an expected shortage in the market.

2) Transaction Motive

Every company needs to maintain a certain level of inventory to meet daily sales, production demands, customer requirements, and so on. This motive makes the firm keep an inventory of finished goods as well as raw materials. Maintaining an appropriate inventory level ensures the smooth operation of the company. A business firm exists for business transactions which require a stock of goods and raw materials.

3) Precautionary Motive

A company should keep some inventory for unforeseen possibilities. For example, the fresh supply of raw material may not reach the factory due to strikes by the transporters or due to natural calamities in a particular area. The factory may have labour problems, and the production process may halt. Therefore, the company should maintain inventories of both raw materials and finished goods to address such unexpected situations.

Types of Inventory

There are various types of inventory which are given as follows:

1) Anticipation Inventories

Anticipation inventories are held for the reason that a future demand for the product is anticipated. Production of specialized times like crackers well before Diwali, umbrellas and raincoats before rains set in, fans while summers are approaching, or the piling up of inventory stocks when a strike is on the anvil are all significant examples of anticipation inventories.

2) Cycle Inventories

Cycle inventories are held for the reason that purchases are usually made in lots rather than for the exact amounts which may be needed at a point in time. Certainly, if all purchases are made precisely when the item is needed, there would be no cycle inventories. But, practically, purchases are made in lots because if purchases are made frequently and in small numbers, the cost of obtaining the items would be huge.

3) Movement Inventories

Movement inventories are also called pipeline or transit inventories. They exist because there is a transportation time required when moving significant quantities of resources. For example, when coal is transported from the coalfields to an industrial town by trains, the coal, while in transit, cannot provide any service to the customers for power generation or for burning in furnaces.

4) Buffer Inventories

Buffer inventories are maintained to protect against the uncertainties of demand and supply. An organization generally knows the average order for various items that it needs. However, the actual demand may not precisely align with the average and could even surpass it. To meet this kind of situation, inventories may be held more than the average for expected demand. Similarly, the average delivery time (that is, the time elapsing between placing an order and having the goods in stock ready for use, technically called the lead time) may be known.

However unpredictable events could cause the delivery time to exceed the average. Thus, excess stocks might be kept to meet the demand during the time for which the delivery is delayed. These inventories which are more than those necessary just to meet the average demand (during the average lead period), held for protecting against the fluctuations in demand and lead-time are known also by the term safety stocks.

5) Decoupling Inventories

The idea of decoupling inventories is to decouple, or disengage, different parts of the production system. As we can observe, different machines/equipment and people usually work at different rates, some slower and some faster. A machine, for example, might be producing half the output of the machine on which the item being handled is to be processed the Inventories in between the various machines are held to disengage the processing on those machines. In the absence of such inventories, different machines and people cannot work simultaneously continuously. When maintaining these inventories, even in the event of a machine breakdown, work on other machines would not come to a halt.

6) Dependent Demand Inventory

Inventory item whose demand is is linked to or dependent upon the a higher-level item. The demand for such items is typically considered as derived demand. Dependent demand inventory items are usually considered the materials, components, parts, and assemblies that make up the finished product.

7) Independent Demand Inventory

Inventory item whose demand is not related to or dependent upon a higher-level item. The demand for such items is often referred to as forecasted demand, while independent demand inventory items are typically considered as finished products.

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