Inventory Management

Production and Operations Management

 Inventory
• An inventory is a stock or store of goods.
• The amounts and dollar values of inventories carried by different types of firms vary widely. A typical
firm probably has 30% of its current asset and 90% of its working capital invested in inventory.

Return On Investment (ROI) = Profit After Tax / Total Asset

Different kinds of inventories -

Raw materials and purchased parts (Clay used in tiles production firms)
Work in Progress - WIP (Tiles under production)
Finished good inventories (Ready tiles)
Replacement parts, tools and supplies (Replacing defective tiles)
Goods in transit to warehouses or customers - Pipeline inventory (Tiles for sale)
 Functions of Inventory (Why we need it)
❑ To meet anticipated customer demand
❑ To smooth production requirements
❑ To decouple operations
❑ To protect against stockout
❑ To take advantage of order cycles
❑ To hedge against price increase
❑ To permit operations
❑ To take advantage of quantity discount
 Inventory Counting System

❑ Periodic System – Under this system a physical count of the items in inventory is made at
periodic intervals (e.g. – weekly, monthly) to determine how much to order.
❑ Many small retailers use this approach.
❑ An advantage of this system is that orders for many items occur at the same time and helps
to save ordering and shipping cost.
❑ One of the major disadvantage is the shortages between review periods.

❑ Perpetual Inventory System – This system keeps track of removals from inventory on a
continuous basis, so the system can provide information on the current level of inventory for
each item.
❑ An obvious advantage is continuous monitoring of inventory withdrawals. Also helps to
order optimum quantity.
❑ One disadvantage of this system is added cost of record keeping.

❑ Two-Bin System: Two Containers of inventory; reorder when the first is empty.
 Inventory Counting System

Universal Product Code or Bar Code – Universal product code or bar code printed on a label
that has information about the item to which it is attached.

Identifies Product
Category
0

32087768
Indicates the specific
214800
Item

Radio Frequency
Identification
System will replace
UPC in near future Identifies
Manufacturer
 Requirements for Effective Inventory Management
❑ A system to keep track of the inventory on hand and on order.
❑ A reliable forecast of demand that includes an indication of possible forecast error.
❑ Knowledge of lead times and lead time variability.
❑ Reasonable estimates of inventory holding costs, ordering costs and shortage costs.
❑ A classification system for inventory requirements.

ABC classification and inventory analysis

❑ ABC classification, based on Pareto’s principle or the 80/20 rule, assumes that 20% of the items in a list will
account for 80% of the significant measurement.
❑ For example, in a shopping list, 80% of the cost will be due to only a few high-cost purchases such as oil,
milk. Other items such as bread, vegetable, pasta etc. will be relatively low in cost.
A Category Items Comprise 20% of SKU & Contribute to 70% of $ spend.
B Category Items Comprise 30% of SKU & Contribute to 25% of $ spend.
C Category Items Comprise 50% of SKU & Contribute to 5% of $ spend.
 ABC Classification Example
Item Annual Unit Cost ($) Annual Dollar Classification Annual Dollar Classification
No. Demand Value ($) Value ($)
8 1000 4000 4,000,000 A
5 3900 700 2,730,000 A
3 1900 500 950,000 B
6 1000 915 915,000 B
1 2500 330 825,000 B
4 1500 100 150,000 C
12 400 300 120,000 C
11 500 200 100,000 C
9 8000 10 80,000 C
2 1000 70 70,000 C
7 200 210 42,000 C
10 9000 2 18,000 C
 ABC Classification Example
Annual unit Percentage of total Item Usage Unit Cost($)
Item Unit cost ($) Usage in dollar
usage dollar usage
K34 50 1200
PA 01 5,000 1.50 7,500 2.94
PA 02 1,500 8.00 12,000 4.71 K35 20 400

PA 03 10,000 10.50 105,000 41.22 K36 72 300

PA 04 6,000 2.00 12,000 4.71 M10 160 400

PA 05 7,500 0.50 3,750 1.47 M20 40 600
PA 06 6,000 13.60 81,600 32.03 Z45 60 1600
PA 07 5,000 0.75 3,750 1.47 F14 40 160
PA 08 4,500 1.25 5,625 2.21
PA 09 7,000 2.50 17,500 6.87
PA 10 3,000 2.00 6,000 2.36
Do it Home
Total 254,725 100
 Benefits of ABC Classification
Area of use Benefit of ABC classification system

Cycle Counting Using ABC classification in cycle counting, A class items will be counted more frequently than B
Frequency or C class items.

Order quantity and safety stock levels are established according to the criticality and cost of each
Customer Service
item.

The engineering department may use ABC classification to identify items of high cost or high
Engineering Priorities usage and concentrate their efforts accordingly. There is little point re-engineering products of little
value or low usage.
Inventory replenishment systems will vary according to the importance of the inventory items. For
Replenishment example, C class items may be controlled with a simple two-bin system if they are not particularly
Systems bulky. This minimizes the cost of control and replenishment and does not significantly increase
inventory carrying costs.

As A class items form a larger investment in inventory, these items are closely analyzed to ensure
appropriate order quantities and safety stocks are used. A class items are always the focus of
Investment Decisions
attempts to improve inventory turns as changes in the way A class items are procured and managed
will have the most significant effect on the overall inventory investment level
 Inventory Costs
Three basic costs are associated with inventories:

Holding or Carrying Cost – The cost to carry an item in inventory for a length of time.
Holding or carrying cost is a variable cost. Costs include warehousing cost (heat, light, rent,
security), insurance, spoilage, breakage cost etc.
Typically annual holding costs range from 20% to 40% of the value of an item.

Ordering Cost – Ordering costs are the costs of ordering and receiving inventory.
Ordering cost is a fixed type cost. Costs include invoice cost, shipping cost, inspection cost etc.

Shortage Cost – Costs resulting when demand exceeds the supply of inventory (Result – Not making a
sale, loss of customer goodwill etc.).

e - time
Lead Tim
tween
interval be
nd
ordering a
e c e i v i n g t he order
r
 Inventory Costs
  Holding costs
are linearly
related to
order size

Ordering costs
are inversely and
nonlinearly
related to order
size
 Economic Order Quantity (EOQ)
Economic Order Quantity (EOQ) - EOQ is
a fixed order size that will minimize the sum
of the annual costs of holding inventory and
ordering inventory.

  The total cost curve reaches

its minimum where the
carrying and ordering costs
are equal.
 Math on EOQ
A local distributor of National Tire company expects to sell 9600 tires next year. Annual carrying
cost is $16 per tire and ordering cost is $75. The distributor operates 288 days a year.

a) Calculate the EOQ.

b) How many times per year does the store reorder?
c) What is the length of the order cycle.
d) Calculate the total annual cost.