The term ‘inflation’ refers to rise in general ( on an average basis) price level of goods and services in the economy .i. e. fall in purchasing power of money. It creates a number of uncertainties because of rising prices in raw materials, semi-finished and finished goods. Inflation also muddies inventory planning, The management should consider the following points for effective management of inventories under the inflationary conditions :
(i) EOQ : We use inventory carrying cost to determine how much inventory we will keep on-hand. Inflation affects the EOQ model by increasing carrying costs ( because the inflation pushes up the interest rate ) (C) which results in a small EOQ level. This small quantity is misleading and results in increase in inventory related costs. Hence, to calculate the optimum order size, cost to carry should be reduced by inflation’s impact on interest cost. To understand this let’s have an example : Cost per unit Rs.5. Cost to order Rs.100 per order. Annual demand 10000 units. Cost to carry 12% p.a. of cost of inventory carried ( this is made of 10% interest cost and 2 % storage etc cost). Cost to carry per unit p.a. = Re.0.60. Now suppose inflation is there and data is : Cost per unit Rs. 6, cost to order Rs.110 per order, Cost to carry 14% ( including 11.50 % interest cost and 2.50 % other cost like storage etc. Had the inflation not been there, the interest cost would have been 10.50 %). Now for the purpose of calculation of EOQ, cost to carry should be taken as 13% of Rs.6. ( otherwise the inflation’s impacted on cost to carry per unit be considered twice; once as increased price and other time as increased % of cost to carry )
(ii) NIFO as the basis of valuation of inventory: NIFO assumes that the inventory we sell is purchased at the time of its sale. Generally, this inventory costs more than earlier layers of inventory. As a result, ending inventory is smaller than it otherwise would be. Since ending inventory is smaller, COGS is higher. ( COGS is calculated on the basis of replacement cost ) Higher COGS means reporting the lower profit, this helps in lower dividend, higher retained profit for replacement of assets and maintaining the capital intact. If inventory is valued on FIFO basis, the profit reported by the books of accounts will contain an element what is referred as inventory profit, “Inventory profits” are never real profits. If inflation continues, the inventory will have to be replaced at tomorrow’s higher prices. If inflation stops, inventory profits immediately turn into an inventory loss. Some authorities call inventory gains “Phantom profits,” which disappear the moment inventory is replaced.
(iii) Ideally, the inventory-sales ratio should be kept as low as feasible so as to minimize the cost of storage and the cost of money tied up in inventory. But As these prices rise, purchasing managers naturally tempted to buying for forward requirements.. The purchasing manager of course realizes that his cost of storage and tied up money will thereby go up. But he may hold that these costs are more than offset by being able to obtain inventory at lower prices than he could later. Such decisions , for buying for future requirements should be taken after considering the both ( i) possible further price movements and (ii) cost to carry including the cost of obsolescence.