Inventory Control

Materials Management
The component of the integrated materials management can be classified into the following modules:
 Materials planning;
 Inventory control;
 Purchase management;
 Stores management.
Inventory
Inventory is the physical stock of goods, which is kept in reserve for a certain period of time for the
smooth and efficient running of future affairs of an organization. Ex. – Tools (spare parts), raw
materials, goods in the process (semi fished goods), finished goods, etc.

Inventory Control
Inventory is essential to provide flexibility in the operating system.
―Inventory is the stock of any item or resource used in an organization‖ - Richard B. Chase and
Nicholas J. Aquilano.
APICS (American Production and Inventory Control Society) defined as ―The technique of
maintaining stock keeping items at desired levels, whether they be raw materials, work-in-process, or
finished products.‖
The inventory can be classified into raw materials inventory, in-process inventory and finished goods
inventory.
 The raw materials inventories remove the dependency between suppliers and plants.
 The work-in-process inventories remove the dependency between machines of the product line.
 The finished goods inventory removes dependency between the plant and its customers/market.
The main functions of inventory are summarized below:
 smoothing out irregularities in supply
 minimizing the production cost
 allowing organizations to cope with perishable materials.
The primary objectives of inventory control are to minimize the cost of the materials inventory. The
inventory control function of materials management is presented in Figure-1 as consisting of three
departments: raw materials inventory, production and finished goods inventory.
Figure-1 The Inventory Control Function of Materials Management

INVENTORY CONTROL
Raw Finished
In from Receiving Production Out to Shipping
Materials Goods
Inventory Inventory

Source: S. M. Lee and M. J. Schniederjans, Operations Management, Boston: Houghton Mifflin Co. 1997, p.245.
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Objectives of Inventory Control

The primary objective of inventory control is to minimize the cost of the materials inventory.
1. Raw Materials: Provides the materials needed to make the product;
2. Work-in-process: Enables overall production to be divided into stages of manageable size;
3. Financial Goods: Provides ready supply of products upon customer demand and enables
long, efficient production runs;
4. In-transit (pipeline): Distributes products to customers.

Inventory Costs
In making any decision that will affect inventory size, the following costs must be considered.
a. Holding (or carrying) costs: Carrying costs are the costs, which are incurred deterioration in
connection with holding the inventory. They included-
i. Interest on capital investment;
ii. Storage facilities, handling charges;
iii. Taxes and insurance expenses;
iv. Physical deterioration, depreciation, obsolescence
High holding costs tend to favor low inventory levels and frequent replenishment.
b. Production change (or setup) costs: To make each different product involves obtaining the
necessary materials, arranging specific equipment setups, filling out the required papers,
appropriately charging time and materials and moving out the previous stock of material. Also, other
costs may be involved in hiring, training, or layoff of workers and in idle time or overtime.
c. Ordering costs: These costs refer to the managerial and clerical costs entailed in preparing the
purchase or production order. Common terminology subdivides these into two categories:
(1) header cost, which is the cost of identifying and issuing an order to a single vendor and
(2) line cost, which is the cost of computing each separate item order from the same vendor.
Thus, ordering three items from a vendor entails one header cost and three-line costs.
Or, ordering costs are the costs, which are incurred in connection with ordering and procurement.
They include—
i. cost of sending requisition to the purchasing office
ii. placing the order
iii. receiving the goods
iv. placing them into inventory
v. paying the supplier
vi. salaries
vii. stationary

d. Shortage costs: When the stock of an item is depleted, an order for that item must either wait until
the stock is replenished or be canceled. There is a trade-off between carrying stock to satisfy demand
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and the costs resulting from stock out. This balance is sometimes difficult to obtain since it may not
be possible to estimate lost profits or the effects of lost customers or lateness penalties. Frequently,
the amount of the shortage cost is little more than a guess, although it is usually possible to specify
the likely range of such costs.

Models of Inventory
There are different models of inventory. The inventory models can be classified into deterministic
models and probabilistic models. The various deterministic models are as given below:
 Purchase model with instantaneous replenishment and without shortages.
 Manufacturing model without shortages.
 Purchase model with instantaneous replenishment and with shortages.
 Manufacturing model with shortages.
These models are explained in the following sections.
a. Purchase model with instantaneous replenishment and without shortages:
In this model of inventory, orders of equal size
Q= order size
are placed at periodical intervals. The items
against an order are replenished
instantaneously and the items are consumed at
Unit

a constant rate. The purchase price per unit is Q

the same irrespective of order size.
tt
Time
Fig.: Purchase model without stockoutQ Q

b. Manufacturing model without shortages:

R= annual demand
If a company manufacturing its component, r K= no. of units produced/year
which is required for its main product, then T=time

the corresponding model of inventory is called

the ―Manufacturing Model‖. This model is
Units

with shortages or without shortages. The rate k-r r k-r r

of consumption of items is uniform

throughout the year. The cost of production
t1 t2
per unit is the same irrespective of production Time
lot size. Fig.: Manufacturing model without stockout
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c. Purchase model with instantaneous replenishment and with shortages:

In this model, the items on order will be Q Q Q Q= EOQ
Q1=Maximum Inventory
received instantaneously and they are Q2=Maximum stock out

consumed at a constant rate. The purchase

price per unit remains the same irrespective of
Q1
order size. If there is no stock at the time of
Q
receiving a request for the items, it is assumed
that it will be satisfied at a later date with a Q2 t1
penalty. This is called the back-ordering. t2 Time
Fig.: Purchase model of inventory with stock out

r= annual demand of an item

d. Manufacturing model with shortages: k= no. of units produced/year
Q=EOQ
In this model, the items are produced and c c Q1= Maximum inventory
Q2= maximum stock out
consumed simultaneously for a portion of the
cycle time. The rate of consumption of items is
uniform throughout the year. The cost of r
r
Q1 k-r
Q t4
production per unit is the same irrespective of t3
k-r

production lot size. In this model, stock out is Q2 t1 t2

permitted. It is assumed that the stock out units

Time
Fig. 4 Manufacturing model with shortages
will be satisfied with the units, which will be
produced at a later date with a penalty. This is
called the back-ordering.

TYPES OF INVENTORY
Another perspective on inventory is to classify it by how it is created. In this context, there are four
types of inventory for an item: cycle, safety, anticipation, and pipeline. They cannot be identified
physically, that is an inventory manager can't look at a pile of widgets and identify which ones are
cycle inventory and which ones are pipeline inventory. However, conceptually, each of the four types
comes into being in an entirely different way. Once you understand these differences, you can
prescribe different ways to reduce inventory, which we discuss in the next section.
Cycle Inventory: The portion of total inventory that varies directly with lot size is called cycle
inventory. Determining how frequently to order, and in what quantity, is called lot sizing. Two
principles apply.
1. The lot size, Q, varies directly with the elapsed time (or cycle) between orders. If a lot is
ordered every five weeks, the average lot size must equal five weeks' demand.
2. The longer the time between orders for a given item, the greater the cycle inventory must be.
At the beginning of the interval, the cycle inventory is at its maximum, or Q. At the end of the
interval, just before a new lot arrives, cycle inventory drops to its minimum, or 0. The average cycle
inventory is the average of these two extremes:
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Q0 Q
Average cycle inventory = 
2 2
This formula is exact only when the demand rate is constant and uniform. However, it does provide a
reasonably good estimate even when demand rates are not constant. Factors other than the demand
rate (e.g., scrap losses) also may cause estimating errors when this simple formula is used.

Safety Stock Inventory: To avoid customer service problems and the hidden costs of unavailable
components, companies hold safety stock. Safety stock inventory protects against uncertainties in
demand, lead time, and supply Safety stocks are desirable when suppliers fail to deliver the desired
quantity on the specified date with acceptable quality or when manufactured items have significant
amounts of scrap or rework. Safety stock inventory ensures that operations are not disrupted when
such problems occur, allowing subsequent operations to continue.
To create safety stock, a firm places an order for delivery earlier than when the item is typically
needed. The replenishment order therefore arrives ahead of time, giving a cushion against
uncertainty. For example, suppose that the average lead time from a supplier is three weeks but a firm
orders five weeks in advance just to be safe. This policy creates a safety stock equal to a two weeks'
supply.
Anticipation Inventory: Inventory used to absorb uneven rates of demand or supply, which
businesses often face, is referred to as anticipation inventory. Predictable, seasonal demand patterns
end themselves to the use of anticipation inventory Manufacturers of air conditioners, for example,
can experience 90 percent of their annual demand during just three months of a year. Such uneven
demand may lead a manufacturer to stockpile anticipation inventory during periods of low demand so
that output levels do not have to be increased much when demand peaks. Smoothing output
rates with inventory can increase productivity because varying output rates and workforce size can be
costly. Anticipation inventory also can help when supply, rather than demand, is uneven. A company
may stock up on a certain purchased item if its suppliers are threatened with a strike or have severe
capacity limitations.

Pipeline Inventory: Inventory moving from point to point in the materials flow system is called
pipeline inventory. Materials move from suppliers to a plant, from one operation to the next in the
plant, from the plant to a distribution center or customer, and from the distribution center to a retailer.
Pipeline inventory consists of orders that have been placed but not yet received. For example,
NUMMI, the joint venture between General Motors and Toyota in California, uses parts produced in
the Midwest. Shipments arrive daily at the plant, but the transportation lead time requires a pipeline
inventory of parts in rail cars enroute from the Midwest at all times. Pipeline inventory between two
points, for either transportation or production, can be measured as the average demand during lead
time, D L , which is the average demand for the item per period (d) times the number of periods in the
item's lead time (L) to move between the two points, or
Pipeline inventory = DL  dL
Note that the lot size does not directly affect the average level of the pipeline inventory. Increasing
inflates the size of each order, so if an order has been placed but not received, there is more pipeline
inventory for that lead time. But that increase is canceled by a proportionate decrease in the number
of orders placed per year. The lot size can indirectly affect pipeline inventory, however, if increasing
causes the lead time to increase. Here D, and therefore pipeline inventory, will increase.
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Types of Inventory (Shortly)

There are four types of inventory for an item: cycle, safety, anticipation/expectation and pipeline.
1. Cycle Inventory: The portion of total inventory that varies directly with lot size is called cycle
inventory.
Q0 Q
Average cycle inventory = = Where,
2 2 Beginning of the interval = Maximum or Q
End of the interval = Minimum or 0
The formula is exact only when the demand rate is constant and uniform.

2. Safety stock Inventory: Surplus inventory that a company holds to protect against uncertainties in
demand, lead-time and supply.
3. Anticipation Inventory: Inventory used to absorb uneven rates of demand or supply, which
business often face, is referred to as anticipation inventory.
4. Pipeline Inventory: Inventory moving from point to point in the materials flow system is called
pipeline inventory.
Pipeline Inventory = D L = dL
Where D L = Average demand during lead time
d = Average demand for the item per period
L = The number of periods in the items lead time.

Some Key Words:

* Economic Lot Size (ELS): ELS is that size which is to be produced in a single run so that the total
set-up cost and carrying cost is minimized. Or ELS is that lot size that minimizes the total cost of
setup and carrying inventories.
* Lead Time: Lead time is the time gap between placing an order and receiving the goods in stock.
* Re-order point: It is the critical stock level at which the next order has to be placed.
* Economic Order Quantity (EOQ): EOQ is the size of the order, which minimizes the total
ordering and carrying costs.
There are three methods for determining EOQ:
i. Trial and Error method
ii. Algebraic method and
iii. Graphically.
The algebraic method is generally used and is taken more dependable on the trial and error method.
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Formula: (Algebraic Method)

1. Total annual cost = Annual purchase cost + Annual ordering cost/Setup cost + Annual holding
cost/ Carrying cost
D Q
or, TC = DC + S+ H
Q 2
or, Total cost / minimum total cost = 2SHD
where, D = Annual demand
C = Purchase cost per unit / cost of production per unit
Q = EOQ = Economic Order Quantity
S = Cost of placing an order / making a production setup
H = Annual holding cost / storage cost / carrying cost per unit of average inventory
R = Reorder point
L = Lead time

2 DS
2. EOQ = Q =
H
3. Reorder point is, R = d L
Annual demand
where, d = Average daily demand =
365
D
4. Number of orders per time period =
EOQ
EOQ
5. Time interval between two consecutive orders =  1 year (or, no. of working day in a year)
D
EOQ EOQ D
or, Cycle time = t1 + t2 = + (1- ) [here, P = Production rate of the item]
P D P
6. Holding cost = C  I (rate of return/ interest)

Problem 1
Find the economic order quantity and the reorder point and total cost given the following data:
Annual demand = 1,000 units per year (D)
Ordering cost = Tk. 5 per order (S)
Holding cost = Tk. 1.25 per unit per year (H)
Lead time = 5 days (L)
Cost per unit = Tk. 12.50 (C) or (P)

Solution:
The optimum economic order quantity is
2 DS 2  1000  5
Q = EOQ = = = 8,000 = 89.4 units (more than 89 order) (Answer)
H 1.25
The reorder point is
R= dL
Annual demand 1000
Where, d = Average daily demand = =
365 365
1000
R =  5 = 13.7 units (14 units approx.) (Answer)
365
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The total annual cost is

D Q
TC = DC + S+ H
Q 2
1000 89.4
= 1000  12.50 + 5 +  1.25
89.4 2
5000 111.75
= 12500 + +
89.4 2
= 12500 + 55.928 + 55.875
= Tk. 12611.80 (Answer)

Problem 2
Given, Annual demand, D = 20000 units per year
Cost of placing an order, S = Tk. 100 per order per year
Holding cost, H = 16% of average inventory per unit per year
Determine-
EOQ, minimum total cost and optimum no. of orders per year.

Solution:
2 DS 2  20000  100
We know, EOQ = = = 25000000 = 5000 units (Answer)
H 0.16
16
Here, H = 16% of average inventory per unit per year = = 0.16
100
D Q
Minimum total cost = DC + S+ H
Q 2
20000 5000 16
= 20000  0 +  100 + 
5000 2 100
= 0 + 400 + 400
= Tk. 800 (Answer)
D 20000
Optimum no. of orders per year = = = 4 times (Answer)
EOQ 5000

Problem 3
A company requires 1200 units every year of materials costing Tk. 125 per unit. The ordering cost is
Tk. 3 and carrying cost per year is 15% of the average inventory value. Find EOQ and optimum no.
of orders per year.

Solution:
Here, Total demand / requirement, D = 1200 units
Ordering cost, S = Tk. 3
Carrying cost, H = 15% of the average inventory per unit per year
= CI = 0.15  125
= Tk. 18.75
2 DS
We know, EOQ =
H
2  1200  3 7200
= = = 384 = 19.60 units (20 approx.) (Answer)
18.75 18.75
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D 1200
Optimum no. of orders per year = = = 61.22 =61 times (Answer)
EOQ 19.6

Problem 4
A company uses annually 24000 units of a raw material, which cost Tk. 1.25 per unit. Placing each
ordering cost Tk. 22.50 and the carrying cost is 5.4% per year of the average inventory. Find the
EOQ and total inventory cost (including the cost of material)

Solution:
We have, Total annual requirement, D = 24000 units
Ordering cost, S = Tk. 22.50
Materials cost, C = Tk. 1.25 per unit
Carrying cost, H = 5.4% per year of the average inventory
= CI = 0.054  1.25 = Tk. 0.0675
2 DS 2  24000  22.50
We know, EOQ = = = 4000 units
H 0.054  1.25
D Q
Now, Total cost (including the cost of material) = ( S + H ) + DC ( C = Tk. 1.25)
Q 2
24000 4000
=  22.50 +  .0675 + 24000 1.25
4000 2
= 622.50 + 2000  0.0675 + 30000
= 135 + 135 + 30000
= Tk. 30270 (Answer)

Problem 5
A company requires 1000 units per month. Ordering cost is estimated to be Tk. 50 per order. In
addition to Tk. 1 the carrying cost is 10% of average inventory per unit per year. The purchase price
is Tk. 10 per unit.
Find out the EOQ and the minimum total cost.

Solution:
We have, the company’s monthly requirement is 1000 units
Total annual requirement, D = 1000  12 = 12000 units
Ordering cost, S = Tk. 50 per order
Carrying cost, H = 1 + .10  10
= 1 + 1 = Tk. 2
2 DS 2  12000  50
We know, EOQ = = = 60000 0 = 774.596 units = 775 units (approx.)
H 2
D Q
Now, the minimum total cost, TC = DC + S+ H
Q 2
12000 774.60
= 12000  10 + 50 + +  2 ( C= Tk. 10)
774.60 2
600000
= 120000 + + 774.60
774.60
= 120000 + 774.60 + 774.60
= Tk. 1,21,549.20 (Answer)
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Problem 6
A manager has decided to place an order for a minimum quantity of 500 units of a particular item an
order to get a discount of 10%. From the records, it was found out that in the last year 8 orders each
size 200 units have been placed. Given ordering cost Tk. 500 per order, carrying cost Tk. 160 per
order and cost per unit Tk. 400. Is the manager justified in his decision?

Solution:
Where, Annual demand / requirement, D = 200 × 8 = 1600 units per year
Ordering cost, S = 500 per order
Carrying cost, H = 160 per order
Price of the product, C = Tk. 400

2 DS 2  1600  500
We know, EOQ = Q = = = 10000 = 100 units
H 160
D Q
 Total cost as per EOQ approach, TC = DC + S+ H
Q 2
1600 100
= 1600  400 +  500 +  160
100 2
= 640000 + 4000 + 16000
= Tk. 6,56,000 -------------------- 
D Q
 Total cost as per present policy (i.e., lot size is 200 units), TC = DC + S+ H
Q 2
1600 200
= 1600  400 +  500 +  160 (Q = 200)
200 2
= 640000 + 4000 + 16000
= Tk. 6,60,000 -------------------- 
D Q
And, the total cost (when lot size is 500 units), TC = DC + S+ H
Q 2
1600 500
= [1600  (400 – 10% discount)] +  500 +  160 (Q = 500)
500 2
= 1600  360 + 1600 + 40000
= 576000 + 41600 = Tk. 6,17,600 -------------------- 

If the manager has decided to place the order 500 units each, then the company gains Tk. (6,60,000
- 6,17,600) = Tk. 42,400. Also, he will save Tk. (6,56,000 - 6,17,600) = Tk. 38,400 over the policy
of placing an order of economic lot size, i.e., an order of size 100 numbers. So, the manager’s
decision is justified and it will save Tk. 42,400. (Answer)