Cost of inventory can be lowered by–
– Entering into long term arrangements for the supply of raw materials at market-driven prices.
– Arranging for direct supply of raw material at manufacturing locations.
– Promoting ex-factory sales of the finished goods.
– Availing quantity discounts and spot payment discounts if the carrying cost and financing cost is less than the discounts.
– Apart from these general steps, a technique called ABC analysis is also used for monitoring inventory costs.
Managing the Inventory Level
1. Economic Order Quantity (EOQ) Model
Inventory level can be managed by adopting the Economic Order Quantity (EOQ) model. This model determines the order size that will minimize the total inventory cost. According to this model, three parameters are fixed for each item of the inventory:
- The minimum level of that inventory to be kept after accounting for the usage rate of that item and time lag in procuring that item and contingencies.
- The level at which the next order for the item must be placed to avoid the possibility of a stock-out.
- The quantity of the item for which the re-order must be placed.
In addition to the determination of the above parameters, the EOQ model is based on the following assumptions:
– The total usage of that particular item for a given period is known with certainty and the usage rate is even throughout the period.
– There is no time gap between placing an order and receiving supply.
– The cost per order of an item is constant and the cost of carrying inventory is also fixed and is given as a percentage of the average value of inventory.
– There are only two costs associated with the inventory and these are the cost of ordering and the cost of carrying the inventory.
2. The various forms of cash holding
Cash is considered to be the most liquid of current assets. It is held either as cash balances with the firms or in bank accounts. There are two ways of holding bank balances – first as current accounts through which the day to day transactions of the firm are carried out and secondly as fixed deposits in which balances are held for a specified twice period. Current account balances are most liquid. Fixed account balances are convertible into cash by adjustment downwards of the rate of interest even before maturity. Hence even fixed deposit balances should be treated at par as regards liquidity. But there is a catch here. Quite a few fixed deposits are not held perse, but as margin money deposits for availing the facilities like letters of credit and guarantee from banks. To the extent of such margin money deposits, the liquidity of bank balances of the firm is impaired.
Cash balances are also held as an unraveled portion of the working capital facilities granted by the banks. All such balances earn money for the firm in terms of the interest that is saved on unveiled portion. Yet the money remains available to the firm almost on call. Such balances are most suitable to a firm for enhancement of liquidity provided the firm has the policy of availing bank finance for its working capital requirements.