Inventory Policy Controlling Inventory Is a Control Term Paper

Excerpt from Term Paper :

Inventory Policy

Controlling inventory is a control of 45% to 90% of all expenses related to business is very important also to see that the business has the correct goods on hand so that it does not get into stock-outs, or shrinkage of inventory due to spoilage or theft, and helps in providing a correct accounting. When inventory is not maintained properly, then the major part of the assets of a retailer gets tied up into inventory, and probably these are the wrong types of inventory that do not sell easily. The reason for low sales may be due to the age of stock, worn out, being spoilt through storage in the shop, out of date for the users, wrong in sizes or colors, or may be stored in a wrong type of products that are not liked by customers. (Inventory Control) The importance of controlling capital is recognized even by the big companies, and it was stated by the Chairman of Berkshire Hathaway "Four years ago I told you that we needed profits of $3.9 billion to achieve a 15% annual return over the decade then ahead. Today, for the next decade, a 15% return demands profits of $10.3 billion" to be made. (Berkshire Hathaway INC) Thus all retailers have to look at the correct policy of maintaining their inventory.

The first system that is used by most retailers is the eyeball system and this is also the system used for many small manufacturing units. In this the decision making authority stands in the middle of the store and decided what items are short in supply. The items that are seen to be in short supply are ordered for supply. This system has the problem that somebody may not notice that an item has been out of stock for quite some item before the order is placed again, and this will lead to loss of sale. The loss of sale starts at the time the product goes out of stock and continues till it comes into stock again. This had led to the Reserve Stock or Brown bag system. In this system, a brown bag is kept at the back of the store, and this is used to supply material when the item in the open area has been exhausted and cannot be supplied to customers. The process of reordering takes place when the stock in the open area is finished, and the brown bag is opened. The new stock when it comes in is placed in the brown bag at the back. (Inventory Control)

This makes it essential that the reserve stock is calculated correctly so that the new stock arrives when the last of the quantities in the brown bag are being used up. These systems are for use by small retailers and for bigger companies, there are perpetual inventory systems. These systems can be manual, card oriented or computer controlled. Today the computer-based systems are used the most and this ensures that an order is placed the minute the stock falls below a certain level as has been decided earlier. The control system for stock should keep track of the quantities of each item on hand. For the system to be effective there will be guides for what and when and how much of each product is to be purchased. The descriptions of purchase will be in terms of styles, colors, sizes, prices and brands. The objective of the system will be to reduce the loss of sales that arise from stock outs. The system should also be able to tell the managers of the speed of movement of items and thus indicate the preferences of customers. (Inventory Control)

As has been mentioned earlier, inventory is one of the major components of cost for retail industry organizations. One of the methods to evaluate this has been LIFO. As on date, this method is not viewed as really reflecting the commercial position of the stock that is kept in the company. The only case where it may be viewed as really taking place may be in a large heap of coal where the stocks are dumped on top and also taken out from top. This has made the procedure as banned under UK GAAP and IAS. The procedure is permitted under U.S. GAAP and is found to be useful when the prices of items in stock are rising. This helps the companies to save on the taxes that they have to pay. The advantage of LIFO is in terms of the savings in tax and through that procedure, increase of profits. (LIFO) The other regular method for deciding on the value of inventory is called FIFO. This is useful where there are stocks which are similar in nature as they come from different batches of the production for the same material. The logic behind this method is that it believes the oldest batch of that type will be sold out first. This is generally the practice that takes place in most organizations. (FIFO)

With modernization new methods for the calculation of the value of inventory to organizations have come up. One of them is called GMROI or the Gross Margin Return on Investment. This can be stated in mathematical terms as gross margin divided by average inventory. Here the correct figures must be used for the right positions to be reached. The meaning of gross margin here is the margin on sales from stock. This means that margins on sales from out of stock in the store, or direct sales have to be removed. The figure of gross margin is to be calculated from the figure of gross sales figure less the gross purchase figure. The average inventory is the annual figure and should reflect the on hand inventory that was available throughout the year. The net figure that is reached will be compared to 1. If the figure is less than 1, then the item is considered not to be paying for itself, and if it is over 1 then the item has paid for itself. The other important concept is turn and earn. (GMROI and Turn & Earn)

This is the concept that is used by supply companies more than retailers. The basic understanding is that if an item sells more, then the return to the seller has to be less for the item to be carried by the seller on his list. As an example let us take the case of a pound of sugar. If the sales price is 0.69 cents and the buying price is 0.60 cents then the profit per pound can be seen to be working out to 0.09 on the pound of sugar that is being sold. At the same time, putting that pound of sugar in the shop involves the shelf space, clerks at the shop, and all other expenses of keeping that shop running. The point here is that the shop does not sell only one pound of sugar, but sells many more. Then the return to him will be the margin multiplied by the number of pounds, or turns that are being sold. This will determine the margin and the help that the item is providing to keep the store running. (GMROI and Turn & Earn) It is important that all benefits of carrying the items should be measured before it is decided to carry any item.


One of the major problems that retail organizations face is that their capital base keeps growing as the profits keep getting stored in the form of capital. This 'increase problem' has been discussed earlier, and probably there are very few ways to reduce it. The opportunities for reducing this problem sometimes arise from the method of arbitrage and the advantage can be taken by the retail organization concerned. There was a time when cocoa was being sold for 50 cents a pound and the manufacturers had to keep large quantities of cocoa in stock. In 1954, there was a sudden shortage of cocoa and the price rose to more than 60 cents a pound. There was a chocolate manufacturer in New York which had bought cocoa at 50 cents and adopted that as the price of cocoa for their stock in the LIFO system. (Berkshire Hathaway INC)

When the price rose, the companies had a choice of selling off the stock and thus earn a killing, but this would have resulted in a 50% tax on the earnings that they got. There was a Tax code which helped them and they used the provision that the LIFO profits could be eliminated if it was distributed to shareholders for the purpose of reduction of the business of the company. This permitted the company to put an end of its business in part and sell off 13 million pounds of cocoa which was left for that work. As a result, the company gave 80 pounds of cocoa beans for each share as the beans were no longer needed. (Berkshire Hathaway…

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