IntroductionIn the previous lesson, we looked at how to monitor inventory using service level, accuracy, turnover and days of supply. But a company’s inventory is not all the same. It includes raw materials waiting to enter production, parts moving through the production line, finished goods in a warehouse, goods on trucks, and spare parts for maintenance. Each is held for a different reason. In this lesson, we’ll look at inventory in two ways: where it sits in the flow of materials and what purpose it serves. Then we’ll look at how materials are classified, including the distinction between consumable and permanent materials, which is governed by law.Types of inventory by position in the flowInventory along the supply chain: from supplier to customerRaw materials and components: everything purchased for use in a product but not yet used. For a clothing manufacturer, that means fabric, thread, buttons and zippers.Work in process (WIP): materials that have entered production but have not yet become finished goods. At a clothing manufacturer, this includes cut pieces waiting to be sewn.Finished goods: products ready for sale and waiting in a factory warehouse or distribution center. Packaged shirts are one example.Auxiliary materials: materials used in production that either do not become part of the product or do so only in negligible amounts, such as packaging, labels, lubricants and cleaning supplies.Maintenance, repair and operations supplies (MRO): replacement machine parts, tools, personal protective equipment and office supplies. They do not go into the product, but a missing spare part can bring the factory to a halt.Inventory in transit: materials that have left one location but have not reached another, whether traveling from a supplier to a factory or from a factory to a distribution center. The inventory exists and has been paid for (or will be), but it is not available for use.The same material can fall into different categories depending on the company: fabric is a finished good for a textile mill but a raw material for a clothing manufacturer.A furniture manufacturer has the following in inventory: MDF boards, assembled drawers waiting to be fitted into cabinets, packaged cabinets, glue and sandpaper, and replacement bearings for a saw. Which item is work in process?Answer: The assembled drawers waiting to be fitted into cabinets — they have been worked on but are not yet finished goods. The boards are raw materials, the glue and sandpaper are auxiliary materials, and the bearings are MRO supplies.Types of inventory by functionThe question now is: why is this inventory held?Cycle stock (or lot stock): inventory held because a company buys or produces in batches larger than it needs immediately. If a company buys 1,000 units at once and uses 100 a week, it holds an average of about 500 units simply because of the batch size. The ideal batch size is covered in the lesson on economic order quantity.Safety stock: a buffer against uncertainty, whether demand exceeds the forecast or a supplier delivers late. See the lesson on lead time and safety stock.Seasonal or anticipation stock: inventory built up ahead of a predictable surge in demand or a planned shutdown. A chocolate factory starts producing months before Easter because it could not make everything in March.Inventory in transit (or pipeline inventory): inventory tied up during transportation. The longer the journey, the more material is on the road or at sea.Decoupling inventory: stock placed between two production stages so that one can keep running if the other encounters a problem or operates at a different pace.Speculative inventory: extra stock purchased in anticipation of a price increase or a shortage. It may pay off, but it is a gamble that ties up capital.Obsolete (or dead) stock: material that is no longer useful, has expired or has been discontinued. It serves no purpose; it costs money and takes up space, so it must be identified and sold, donated or disposed of.What if the company does not own the inventory?Not everything in a warehouse belongs to the company storing it. Under a consignment arrangement, a supplier leaves goods with a customer and bills only for what the customer uses or sells. The customer has the goods on hand without tying up capital. With VMI (vendor-managed inventory), which we covered in the lesson on the history of logistics, the customer may own the stock, but the supplier decides when to replenish it.In September, a distributor bought three times its usual quantity of a product because the manufacturer announced a 15% price increase for October. What type of inventory is the excess?Answer: Speculative inventory — it was bought to guard against a price increase, not to cover uncertain demand (safety stock) or because of the usual batch size (cycle stock). It pays off if the savings on the purchase price exceed the cost of holding the extra inventory.Classifying materials“Classification is the process of grouping materials with similar characteristics”- FENILI, RenatoClassification gives materials managers a way to focus on categories rather than trying, in vain, to manage thousands of items one by one. Without a well-defined classification system, managing inventory would be nearly impossible. [1]A good classification system has three attributes: [1]Comprehensiveness: it covers a range of material characteristics (physical, financial, accounting-related…) and describes items fully.Flexibility: it connects different classifications to provide a broad view of inventory management and can be adapted and improved when needed. Comprehensiveness concerns the characteristics of the material; flexibility concerns the links between classifications.Practicality: it is straightforward, requires no complicated procedures and provides clear information.ComprehensivenessFlexibilityPracticalityConsumable or permanent material?MaterialFinishDimensionsForm suppliedPackagingStocked or non-stocked material?Critical or noncritical material?Class A, B or C material?Example of a well-described item:Code: 33800Dimensions: 5/16 in x 2 inType: hex-head bolt, fully threaded, property class 8.8, UNF 24 thread (24 threads per inch)Finish: yellow zinc-platedPackaging: original factory packaging, with material identification and quality informationThe most common ways to classify materials are:By source: can the item be produced in-house, or must it be purchased?By consumption value: ABC classification.By operational importance: XYZ classification (how much a shortage would disrupt operations).By use: raw material, work in process, finished goods, auxiliary materials or MRO, as discussed earlier.By hazard: flammable, corrosive or toxic materials that require special storage and transportation.By shelf life: materials with expiration dates, which require batch tracking and first-in, first-out handling.By accounting treatment: consumable or permanent material.ABC and XYZ classification have a lesson of their own, while coding systems (item codes, barcodes and RFID) are covered in the lesson on materials classification and coding.Consumable and permanent materialsThis is primarily an accounting distinction, and Brazil’s public sector has its own rules for it. Law 4.320/1964, which governs public budgets, states in Article 15, § 2º, that material lasting more than two years is considered permanent. On that basis:Consumable material: material that normally loses its physical identity through ordinary use and/or has a useful life of no more than two years. Examples include paper, toner, fabric and cleaning supplies.Permanent material: material that does not lose its physical identity through ordinary use, even when incorporated into another asset, and/or lasts more than two years. Examples include machinery, furniture, computers and vehicles.Because the two-year rule alone leaves room for doubt, the National Treasury Secretariat issued Ordinance nº 448/2002, which public agencies still use as a reference when classifying expenditure. Article 3 sets out five criteria: if a material meets at least one of them, it is consumable, not permanent.“Article 3. In classifying expenditure, the following exclusionary criteria shall be considered together to identify permanent material: I – Durability, when material under normal use loses or has reduced functionality within a maximum of two years; II – Fragility, when its structure is subject to change because it is breakable or deformable, making it irreparable and/or causing it to lose its identity; III – Perishability, when it is subject to changes (chemical or physical), deteriorates or loses its normal characteristics of use; IV – Incorporation, when it is intended to be incorporated into another asset and cannot be removed without impairing the characteristics of the main asset; and V – Transformability, when it is purchased for transformation”- Portaria STN nº 448/2002A drinking glass can last for years, but it is fragile and loses its identity when it breaks, so it is consumable material. A light bulb installed in a building is also consumable because it is incorporated into the main asset. Fabric purchased by a clothing manufacturer is consumable because it is transformed, even if it can be stored for a long time.For private companies, the corresponding concept is property, plant and equipment: assets held for use over more than one accounting period (CPC 27 pronouncement). For income tax purposes, Article 15 of Decree-Law 1.598/1977, as amended by Law 12.973/2014, allows an asset with a unit value of up to R$ 1,200.00 or a useful life of up to one year to be expensed immediately. Above those limits, it is recorded as a fixed asset and depreciated.A municipal government bought 200 LED bulbs with a useful life of 5 years to install in school light fixtures. Under Ordinance STN 448/2002, how should they be classified?Answer: Consumable material, because they will be incorporated into another asset — the ordinance’s criteria are exclusionary: meeting just one is enough to classify material as consumable, even if it lasts more than two years. Unit price matters under the income tax rule for companies, not under this rule.References[1] FENILI, Renato Ribeiro. Gestão de materiais. Brasília: ENAP, 2015.[2] BRASIL. Lei nº 4.320, de 17 de março de 1964, art. 15, § 2º.[3] BRASIL. Secretaria do Tesouro Nacional. Portaria nº 448, de 13 de setembro de 2002, art. 3º.[4] BRASIL. Decree-Law No. 1.598 of December 26, 1977, art. 15 (as amended by Law No. 12.973/2014).ExercisesEasy1) How can inventory be classified by use? What is the difference between finished goods and work in process? Give real-world examples.2) (Logistics exam, CEFET/RJ, 2018) Give 5 real-world examples of permanent materials and 5 of consumable materials in a textile factory.3) For each situation, name the type of inventory by function:a) a toy store doubles its stock in November;b) an automaker keeps 2 more days' worth of parts than it needs because its supplier is sometimes late;c) 40 containers of components are on a ship coming from China;d) boxes of a phone model discontinued two years ago.4) What is the difference between the supply chain and logistics? (review of lesson 1)Hard5) A company uses 600 units of a component per month, at a steady rate, and currently buys 1,200 units every 2 months. Each unit costs R$ 8.00, and holding inventory costs 20% a year of the value of average inventory.a) What is the average cycle stock today?b) If it switches to buying 300 units every 15 days, what will the new average cycle stock be?c) How much does the company save per year in holding costs?d) How many orders a year did it place before, and how many will it place now? Why is the answer to item c not enough to make the decision?6) A factory imports a component of which it uses 2,000 units a week, at a cost of R$ 30.00 each. By ship, the journey takes 5 weeks; by air, 1 week, but air freight costs R$ 0.50 more per unit. The company's cost of capital is 15% a year (assume 52 weeks a year).a) What is the average inventory in transit, in units and in reais, for each mode?b) How much does the company save per year in cost of capital by switching to air?c) How much more does it spend per year on freight?d) Is it worth switching modes just because of inventory in transit?7) A municipal government bought the items below. Under Law 4.320/1964 and Ordinance STN 448/2002, classify each one as consumable or permanent material and, when it is consumable, name the criterion in the ordinance that decides it:a) tires to replace on the garbage trucks;b) office chairs;c) glassware (beakers and test tubes) for the school laboratory;d) laptops for the municipal department;e) wood bought by the school workshop to make benches;f) vaccines for the health clinic.8) A private company bought: (a) a drill for R$ 900.00, with a useful life of 5 years; (b) a laptop for R$ 4,500.00, with a useful life of 4 years; (c) a toner cartridge for R$ 1,500.00 that lasts about 4 months. Under the income tax rule covered in the lesson (Article 15 of Decree-Law 1.598/1977), which can be expensed immediately and which go to property, plant and equipment? Justify each one.9) A clothing manufacturer currently has in its inventory: (a) rolls of fabric bought in excess in August because the supplier announced a price increase; (b) cut pieces waiting to be sewn; (c) packaged shirts from the current collection; (d) shirts from the collection of two summers ago, which nobody buys anymore; (e) needles and oil for the sewing machines; (f) a shipment of buttons that left the supplier yesterday and arrives next week. Classify each item by position in the flow and, where possible, also by function.Answer key1) By use, inventory is divided into raw materials, work in process, finished goods, auxiliary materials and MRO. Work in process has begun to be transformed but cannot yet be sold, like a painted car body without an engine at an automaker; finished goods are ready for sale, like the car in the lot. Other examples: flour (raw material), rising dough (work in process) and packaged bread (finished goods) at an industrial bakery.2) Possible answer: permanent, the looms, industrial sewing machines, boiler, forklifts and office computers; consumable, the cotton yarn, dyes, machine needles, lubricating oils and packaging. Note that a needle, although made of metal, is consumable: it breaks and wears out quickly.3) a) Seasonal or anticipation stock, for Christmas; b) safety stock; c) inventory in transit; d) obsolete stock.4) Logistics plans and controls the flow and storage of materials, products and information from origin to consumption; supply chain management is broader and coordinates several companies, including suppliers' suppliers, purchasing, partnerships and distributors. Logistics is part of supply chain management.5) a) Inventory goes from 1,200 to zero over each cycle; the average is 1,200 ÷ 2 = 600 units.b) 300 ÷ 2 = 150 units.c) Reduction of 600 − 150 = 450 units; in value, 450 × R$ 8 = R$ 3,600; savings = 20% × 3,600 = R$ 720 a year.d) Annual consumption: 600 × 12 = 7,200 units. Before: 7,200 ÷ 1,200 = 6 orders a year; after: 7,200 ÷ 300 = 24 orders a year. Each order has a cost (issuing, receiving, inspecting, freight). If 18 more orders cost more than R$ 720, the change does not pay off. This trade-off is the subject of the lesson on economic order quantity.6) a) Inventory in transit = weekly consumption × weeks of travel. Ship: 2,000 × 5 = 10,000 units, or 10,000 × 30 = R$ 300,000. Air: 2,000 × 1 = 2,000 units, or 2,000 × 30 = R$ 60,000.b) Capital freed up: 300,000 − 60,000 = R$ 240,000; savings = 15% × 240,000 = R$ 36,000 a year.c) Units per year: 2,000 × 52 = 104,000; extra freight: 104,000 × 0.50 = R$ 52,000 a year.d) No: air freight costs R$ 52,000 − R$ 36,000 = R$ 16,000 a year more than is saved in capital. The switch would only be justified for other reasons, such as also reducing safety stock (the shorter lead time reduces uncertainty) or meeting an urgent need.7) a) Consumable, by incorporation: the tire is incorporated into the truck (and it also wears out).b) Permanent: it lasts more than two years and fits none of the five criteria.c) Consumable, by fragility: it breaks and loses its identity.d) Permanent: it lasts more than two years and does not lose its identity through use.e) Consumable, by transformability: it was bought to be transformed into benches.f) Consumable, by perishability (and because it is used up).8) a) Drill: unit value of R$ 900, up to R$ 1,200, so it can be expensed immediately, even though it lasts 5 years (one of the two conditions is enough).b) Laptop: R$ 4,500 is more than R$ 1,200 and the useful life exceeds one year, so it goes to property, plant and equipment and is depreciated.c) Toner: the value exceeds R$ 1,200, but the useful life is no more than one year, so it can be expensed immediately.9) a) Raw material; by function, speculative inventory (bought to avoid the price increase).b) Work in process.c) Finished goods (by function, cycle stock, if it is the collection's normal batch).d) Finished goods; by function, obsolete stock: it should be identified and sold at a discount, donated or disposed of.e) Maintenance, repair and operations supplies (MRO): they do not go into the shirt, but without them the machines stop.f) Raw material (component) in inventory in transit: it has left the supplier and is not yet available.
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