Chapter

INVENTORY MANAGEMENT
7

CONCEPT OF INVENTORY
Inventory is defined as a usable resource which is physical and tangible such as materials. In this
sense, our stock is our inventory, but even then the term inventory is more comprehensive. Though
inventory is a usable resource, it is also an idle resource, unless it is managed efficiently and
effectively.
Inventory management boils down to maintaining an adequate supply of something to meet the
expected demand pattern subject to budgeting considerations. Inventory could be raw materials, work-
in-progress (WIP), finished products or the spare parts and other indirect materials. Effectiveness of
the materials and production functions depend to a large extent upon inventory management.

IMPORTANCE OF INVENTORY
Inventories constitute the largest component of current assets in many organizations. Poor
management of inventories therefore may result in business failures. A stock-out creates an unpleasant
situation for the organization. In case of a manufacturing organization, the inability to supply an item
from inventory could bring production process to a halt. Conversely, if a firm carries excessive
inventories, the added carrying cost may represent the difference between profit and loss. Efficient
inventory control, therefore, can significantly contribute to the overall profit position of the organization.

FUNCTIONS OF INVENTORY
In any organization, inventories add an operating flexibility that would otherwise be lost. In
production, work-in-process inventories are an absolute necessity unless each individual part is to be
carried from machine to machine and those machines set up to produce that single part.
The many functions inventory performs can be summarized as follows:

(a) Regularizing Demand and Supply

Harvest of tobacco is carried out during the concluding part of the summer, but the manufacture
of tobacco products such as cigarettes and cigars continues throughout the entire year. In cases like
this, sufficient raw materials must be purchased during the tobacco-producing period to last the entire
year. It compels the manufacturer to carry inventory.
Inventory Management 65

In a simple sense, because a commercial vehicle can be driven 100 miles without passing a petrol
pump, its tanks must carry enough petrol to avoid run-outs.

(b) Economizing Purchases or Productions by Lot Buying or Batch Production

If the product does not have the demand sufficient to sustain its continuous production round the
year, it is usually produced in batches or lots, on an intermittent basis. During the time when the item
is not being produced, sales are made from inventory which is accumulated while the item is being
produced. Similarly, a super bazaar selling men’s clothing does not purchase a new shirt from Double
Bull each time they sell one. Rather they choose to carry with them an inventory of these shirts so that
purchasing can be done in larger quantities, thereby allowing lower costs and less paperwork.

(c) Allowing Organizations to Cope with Perishable Materials

Organizations selling canned foods, particularly fruits and vegetables, operate at peak production
capacity only for a few months each year. They must store up inventory to supply sufficient to last
them through a year’s anticipated demand until the next season. They give thoughtful consideration to
the rate of inventory accumulation and depletion throughout the peak production and sales periods
each year.

(d) Inventory can Store Labour

Though it may sound abstract to talk of “Inventorying” labour, it has been done as a matter of
routine. Levin and Kirkpatrick illustrate this by a lively example. “The peak demand for the
installation of replacement heating units comes in the fall, just after the old units have been operated
for the first time. The manufacturers of heating units store up excess labour by having their workers
produce at a designated rate all year long, then having converted labour into finished heating units;
they hold them in inventory until the point when demand increases rapidly. Even if demand exceeds
current productive capacity, a manufacturer can supply the difference out of inventory at that time.”

PURPOSE OF INVENTORY
There are several reasons to carry inventory.
1. To protect against uncertainties in supply, demand and lead time
2. To maintain independence of operations, e.g., a supply at work centre allows it flexibility of
operations.
3. To allow flexibility in production scheduling.
4. To allow economic production and purchase.
5. To provide for transit.

INVENTORY CONTROL TECHNIQUES

(i) ABC Analysis
ABC analysis underlines the very important Pareto principle of “Vital few: trivial many”.
Statistics reveal that only a handful of items account for bulk of the annual expenditure on materials.
These few items called “A” items therefore hold the key to business. The other items known as
“B” and “C” items are numerous in number but their contribution is less significant. ABC analysis,
66 Production and Total Quality Management

thus, tends to segregate all items into three categories: A, B and C on the basis of their annual usage.
The categorization so made enables one to pay the right amount of attention as merited by the items.
“A” Items: It is found that 5-15% of items account for 70-80% of the total money spent on
materials. These items require detailed and rigid control and need to be stocked in smaller quantities.
These items should be procured regularly, the quantity per occasion being small. A healthy approach
would be to enter into contract with the manufacturers of these items and have their supply in
staggered lots according to production programme of the buyer. This, however, will be possible when
the demand is steady. Alternatively, the inventory can be kept at minimum by frequent ordering.
“B” Items: These items are generally 30% of all items and represent 15% of the total
expenditure on the materials. These are intermediate items. The control on these items need not be as
detailed and as rigid as applied to “C” items.
“C” Items: There are numerous (as many as 50-60% of the total items), inexpensive (represent
hardly 5-10% of the total expenditure on materials) and hence insignificant (do not require close
control) items. The procurement policy for these items is exactly the reverse of “A” items. “C” items
should be procured infrequently and in sufficient quantities. This enables buyer to avail price
discounts and reduce workload of the concerned departments.
The ABC system of classification should, however, be used with caution. For example, an item
of inventory may be very inexpensive. Under the ABC system, it should be classified as “C” category.
But it may be very critical to the production process and may not be easily available. It deserves the
special attention of management. But in terms of the ABC framework, it would be included in the
category, which requires the least attention. This is a limitation of the ABC analysis.
100

90

80

70

60

50 Mid Value
Total Mid Volume
Percentage Class (B)
40 Low Value, Low
of Annual
Volume: Class (C)
Cost in
Inventory 30

20 High Value
Low Volume
Class (A)
10

0
10 20 30 40 50 60 70 80 90 100

Total Percentage of Number of Items

Inventory Management 67

(ii) HML Analysis

HML analysis is similar to ABC analysis except for the difference that instead of “usage value”,
“price” criterion is used. The items under this analysis are classified into three groups, which are
called “High”, “Medium” and “Low”. To classify, the items are listed in the descending order of their
unit price. The cut-off-lines are then fixed by the management for deciding three categories. For
example, the management may decide that all items of unit price above ` 1,000 will be of “H”
category, those with units price between ` 100 and ` 1,000 will be of “M” category and those having
unit price below ` 100 will be of “L” category.
HML analysis helps to:
● Assess storage and security requirements (e.g., high priced items like bearings, worm shafts,
worm wheels, etc. require to be kept in the cupboards).
● To keep control over consumption at the departmental head level (e.g., indents of high and
medium priced items are authorized by the departmental head after careful scrutiny of the
consumption figures).
● Determine the frequency of stock verification (e.g., high priced items are checked more
frequently than low priced items).
● To evolve buying policies to control purchases (e.g., excess supply than the order quantity
may not be accepted for “H” and “M” groups while it may be accepted for “L” group).
● To delegate authorities to different buyers to make petty cash purchase (“H” and “M”
category of items may be purchased by senior buyers and “L” category of items by junior
buyers).

(iii) VED Analysis

VED analysis represents classification of items based on their criticality. The analysis classifies
the items into three groups called Vital, Essential and Desirable.
“Vital” category encompasses those items for want of which production would come to halt.
“Essential” group includes items whose stock-outs cost is very high. And “Desirable” group comprises
of items which do not cause any immediate loss of production or their stock-out entail nominal
expenditure and cause minor disruptions for a short duration.
VED (Vital – Essential – Desirable) analysis is carried out to identify critical items. An item,
which usage-wise belongs to C-category, may be critical from production point of view if its stock-out
cause heavy production loss.
An item may be vital for a number of reasons, namely
1. If the non – availability of the item can cause serious production losses.
2. Lead-time for the procurement is very large.
3. It is non – standard item and is procured to buyer’s design.
4. The sources of supply are only one and are located far off from the buyer’s plant.

(iv) GOLF Analysis

GOLF analysis like S – D – E analysis based on the nature of the suppliers which determine
quality, lead time, terms of payment, continuity or otherwise of supply and administrative work
involved. The analysis classifies the items into four groups namely GOL and F.
68 Production and Total Quality Management

“G” group covers items procured from “Government” suppliers such as the STC, the MMTC and
the public sector undertakings. Transaction with this category of suppliers involve long lead time and
payments in advance or against delivery
“O” group comprises of items procured from Nongovernment or “Ordinary” suppliers.
Transactions with this category of suppliers involve moderate delivery time and availability of credit,
usually in the range of 30 to 60 days.
“L” group contains items bought from “Local” suppliers. The items bought from local suppliers
are those which are cash purchased on blanket orders.
“F” group contains those items, which purchased from “Foreign” suppliers.

(v) S – OS Analysis
S – OS analysis is based on seasonality of the items and it classifies the items into two groups S
(seasonal) and OS (Off Seasonal). The analysis identifies items, which are:
● Seasonal and are available only for a limited period. Example: agriculture produce like raw
mangoes, raw materials for cigarette and paper industries, etc. are available for a limited
time and therefore such items are procured to last the full year.
● Seasonal but are available throughout the year. Their prices, however, are lower during the
harvest time. The quantity of such items requires to be fixed after comparing the cost
savings due to lower prices if purchased during season against higher cost of carrying
inventories if purchased throughout the year.
● Non – seasonal items whose quantity is decided on different considerations.

(vi) F – S – N Analysis
F – S – N analysis is based on the consumption figures of the items. The items under this analysis
are classified into three groups:
F (Fast moving)
S (Slow moving)
N (Non – moving)
To conduct the analysis, the last date of receipt or the last date of issue whichever is later is taken
into account and the period, usually in terms of number of months that has elapsed since the last
movement is recorded.
Such an analysis helps to identify:
1. Active items, which require to be reviewed regularly.
2. Surplus items whose stocks are not being consumed. The last two categories are reviewed
further to decide on disposal action to deplete their stocks and thereby release company’s
productive capital
3. Non – moving items which are not being consumed. The last two categories are reviewed
further to decide on disposal action to deplete their stocks and thereby release company’s
productive capital.
Further detailed analysis is made of the third category in regards to their year – wise stocks and
items can be sub –classified as non – moving for 2 years, non – moving for 3 years, non – moving for
5 years and so on.
Inventory Management 69

(vii) X – Y – Z Analysis
X – Y – Z analysis is based on value of the stocks on hand (i.e., inventory investment). Items
whose inventory values are high are called X items while those inventory values are low are called Z
items. And Y items are those, which have moderate inventory stocks.
Usually X – Y – Z analysis is used in conjunction with either ABC analysis or HML analysis.

INVENTORY CONTROL IN SERVICES

We shall examine how inventory control works in service organizations such as a big retail outlet
having many inventory items called stock-keeping-units (SKUs). SKUs of each item run into a large
number, say socks are available in two fabric varieties — cotton and synthetic, three sizes (extra-large,
medium, small) and four colors. Thus, there are 24 (2×3×4) different items. SKUs run into thousands
in a big departmental store.
Manually EOQ cannot be computed for each item. How then is the inventory managed? The
department is divided into major product lines — say shirts and trousers. Items are classified
according to prices. The items are sourced from the distributor who handles the products of many
manufacturers. This way orders and dispatch time are minimized. The distributor’s salespeople visit
the store and take the count of inventory available.
The distributor's salespeople take the order as per the replenishment level decided by the buyer.
This saves time. The typical lead time is 2-3 days. The safety stock is therefore low. The lead time
demand plus expected demand are covered by the replenishment level.
There is no formal method of assessing the stock out and establishing safety stock. It is because
the items are far too many. The department's items are counted in terms of value. The replenishment
level is set as rupee allocation.
Each department plans monthly values for inventory. Inventory balance, monthly sales, items on
order is tabulated. That gives us open-to-buy figure — the unspent figure of the budget. This is the
amount available to the buyer for the following months. When seasonal increases are expected in
demand, there is a large open-to-buy position. The replenishment levels are raised creating a higher
stock of goods on hand.

INVENTORY COSTS
The following two types of costs are considered in calculating inventory size:
(i) Ordering / Set up Costs
This is the sum of the costs that are incurred each time an item is ordered. It is important to
understand that these are costs associated with the frequency of the orders and not the
quantities ordered.
It Includes:
● Cost of order processing i.e., use of stationary and services, cost of staff etc.
● Cost of transmission of an order i.e., cost of postage & follow-up messages through
telephone, fax, etc.
● Cost of Invoice Pricing i.e., checking, approval, book entries & payment procedures.
70 Production and Total Quality Management

● Cost of Goods receiving, handling, inspecting and entry in the stock register/computer.
● Cost of final feeding of data in Logistics information system.
(ii) Holding Cost
● It is the cost associated with holding one unit of an item in stock for a period of time.
● It includes rent, labor; insurance; security and other direct expenses.
● Thus it varies with number of units.

ECONOMIC ORDER QUANTITY (EOQ)

This celebrated model was developed by F.W. Harris in 1915 and came to be extensively used
through the efforts of a consultant named Wilson. It is known after Wilson, though it is originally
developed by Harris. EOQ and its variations are still popular for independent-demand inventory
management.
The EOQ is a concept which determines optimal order quantity on the basis of ordering and
holding cost.

Annual
Total cost
cost

Holding
costs

Ordering costs

EOQ Reorder quantity

The Economic Order Quantity can be calculated by using the following formula:
EOQ = √ 2*D*S
H
D = Annual demand (units)
S = Cost per order (`)
C = Cost per unit (`)
I = Holding cost (%)
H = Holding cost (`) = I × C

Numerical Example:
Your Company needs 1,000 parts per year. The cost of each part is ` 78. Ordering cost is ` 100
per order. Carrying cost is 40% of per unit cost. Your Company is open 365 days/yr.
What is the optimal order quantity?
Inventory Management 71

Sol:
D = 1,000; S = ` 100; C = ` 78; I = 40%;
H = C × I; H = ` 31.20
EOQ = √ 2*D*S = 80 parts
H
Assumptions
(i) Production is instantaneous. There is no capacity constraint and the entire lot is produced
simultaneously.
(ii) Delivery is immediate. There is no time lag between production and availability to satisfy
demand.
(iii) Demand is constant over time. In fact, it can be represented as a straight line, so that if
annual demand is 365 units this translates into a daily demand of one unit.
(iv) A production run incurs a constant setup cost. Regardless of the size of the lot or the status
of the factory, the setup cost is the same.

Limitations
(i) Erratic changes usages – the formula presumes the usage of materials is both predictable and
evenly distributed. When this is not the case, the formula becomes useless.
(ii) Faulty basic information – order cost varies from commodity to commodity and the carrying
cost can vary with the company’s opportunity cost of capital. Thus the assumption that the
ordering cost and the carrying cost remains constant is faulty and hence EOQ calculations
are not correct.
(iii) Costly calculations – the calculation required to find out EOQ is extremely time consuming.
More elaborate formulae are even more expensive. In many cases, the cost of estimating the
cost of possession and acquisition and calculating EOQ exceeds the savings made by buying
that quantity.
(iv) No formula is a substitute for common sense – sometimes the EOQ may suggest that we
order a particular commodity every week (six-year supply) based on the assumption that we
need it at the same rate for the next six years. However we have to order it in the quantities
according to our judgement. Some items can be ordered every week; some can be ordered
monthly, depends on how feasible it is for the firm.

IMPORTANT TERMS USED IN INVENTORY MANAGEMENT

Lead Time
Lead time is the amount of time from the point at which you determine the need to order to the
point at which the inventory is on hand and available for use. It should include supplier or
manufacturing lead time, time to initiate the purchase order or work order including approval steps,
time to notify the supplier, and the time to process through receiving and any inspection operations.
If a supplier cannot supply the required goods on demand, then the client firm must keep an
inventory of the needed goods. The longer the lead time, the larger the quantity of goods the firm must
carry in inventory.
72 Production and Total Quality Management

A just-in-time (JIT) manufacturing firm, such as some automobile manufacturing firms, can
maintain extremely low levels of inventory. Some of these companies take delivery of some goods as
many as 18 times per day. However, steel mills may have a lead time of up to three months. That
means that a firm that uses steel produced at the mill must place orders at least three months in
advance of their need. In order to keep their operations running in the meantime an on-hand inventory
of three months' steel requirements would be necessary.

Reorder Level (or reorder point)

Reorder level (or reorder point) is the inventory level at which a company would place a new
order or start a new manufacturing run.
Reorder Level = Lead Time in Days × Daily Average Usage
Lead time is the time it takes the supplier or the manufacturing process to provide the ordered
units. Daily average usage is the number of units used each day.
If a business is holding a safety stock to act as buffer if daily usage accelerates the reorder level
would increase by the level of safety stock.
Reorder Level = Lead Time in Days × Daily Average Usage + Safety Stock
Examples
Example 1: ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily.
Its supplier takes a week to deliver the order.
The inventory manager should place an order before the inventories drop below 3,500 units (500
units of daily usage multiplied with 7 days of lead time) in order to avoid a stock-out.
Example 2: ABC Ltd. has decided to hold a safety stock equivalent to average usage of 5 days.
Calculate the reorder level.
Safety stock which ABC Ltd. has decided to hold equals 2,500 units (500 units of daily usage
multiplied by 5 days).
In this scenario reorder level would be 6,000 units (2,500 of safety stock plus 3,500 units based
on 7 days of lead time), inventory level at which a company would place a new order or start a new
manufacturing run.

Safety Stock
Safety stock (also called buffer stock) is a term used to describe a level of extra stock that is
maintained to mitigate risk of stock outs (shortfall in raw material or packaging) due to uncertainties in
supply and demand. Adequate safety stock levels permit business operations to proceed according to
their plans. Safety stock is held when there is uncertainty in demand, supply, or manufacturing yield; it
serves as an insurance against stock outs.
The amount of safety stock an organization chooses to keep on hand can dramatically affect their
business. Too much safety stock can result in high holding costs of inventory. In addition, products
which are stored for too long a time can spoil, expire, or break during the warehousing process. Too
little safety stock can result in lost sales and, thus, a higher rate of customer turnover. As a result,
finding the right balance between too much and too little safety stock is essential.
Inventory Management 73

APPENDIX – I

LEAN DOES NOT MEAN ZERO INVENTORY

Daniel T. Jones and James P. Womack wrote a book on Toyota ‘The Machine that Changed the
World’ in 1990. It first introduced lean to the world. Lean is practiced more in auto industry as Toyota
spread in every other country. In the U.S., the aerospace industry has practiced it successfully.
Supermarkets are also practicing it. In Canada and Denmark, post offices practice it. Lean is not
restricted to factories. It can be extended to services and retailing.
Though lean does not mean zero inventories, there are organizations that make purchases on the
basis of the sales the day before, e.g., a brewery in South Africa which makes beer. Every day one can
buy what one needs. Here demand is highly predictable. In a supermarket, there are inventories at
various levels, as they cannot predict demand. But it is not possible to have an inventory-less business.

Fig. 7.1: Lean Evangelists: Jim Womack (left) and Dan Jones
Lean has grown fast over the last five years, since it helps an organization to become a global
manufacturer. Indian companies like SRF, Sundaram Brake Linings, and Sona Koyo Steering are also
practicing Lean.
74 Production and Total Quality Management

APPENDIX – II

JUST-IN-SEQUENCE (JIS) OR
JIT (JUST-IN-TIME) SYSTEM OF INVENTORY
Just-In-Time Philosophy
Just In Time (JIT) is a production and inventory control system in which materials are purchased
and units are produced only as needed to meet actual customer demand. It is a strategy to increase
efficiency and decrease waste by receiving goods only as they are needed in the production process,
thereby reducing inventory costs. In other words, JIT inventory refers to an inventory management
system with objectives of having inventory readily available to meet demand, but not to a point of
excess where you must stockpile extra products.

Just-in-Time at Maruti Suzuki

Storage is an obsolete term at Maruti Suzuki plant at Gurgaon. The company has 230 plus
vendors. Their transport vehicles e.g., trucks and tempos line up outside the shed. They bring in the
exact quantity of components required for the day’s production. These are hauled inside in bins, which
go back to the vendors. This is the supply just-in-time, eliminating the storage completely. The plant is
directly responding to daily shifts in demand.

Samsung, Noida
At Noida plant of Samsung, there was no perfect supply chain prior to 2003-04. If it were to
make 5000 TV sets a day, and an assortment to be made, it would decide on the process 24 hours in
advance and inform the vendors accordingly. Today, the company has a three-day fixed plan in place.
It is globally accepted, and none has the authority to change the three-day sequence. This keeps the
people on their toes, and enable the plant to carry on with the minimum required inventory on the
production line.

Just in Time in TVS-Lucas

Lucas-TVS embarked upon JIT in 1985. Their operations are based at Padi. It had a fat workforce
of 3105 in those days. It turned out components worth about ` 61 crores. The rejection rate was 10 per
cent. JIT was pioneered by Toyota Motor Company in the late 50s. After introducing JIT, TVS- Lucas
has made surprising gains. Sales per employee shot up to 13.80 lakhs from 1.96 lakhs then. The
workforce is downsized to 2230. Rejection rate is down to 1 per cent from the previous 10 per cent.
Scrap has almost been eliminated at 0.8 per cent. Sales have quintupled to ` 308.6 crores.
Lucas-TVS has become the first company outside Japan and Korea to bag the prestigious
Japanese award, JIT Grand Prix, from JIT Management Laboratory Co.
Inventory Management 75

QUESTIONS
1. Define the term “Inventory” and explain its importance in business.
2. Elaborate on the reasons for carrying the raw materials, work in progress and finished goods
inventory.
3. Explain the following Inventory Control techniques:
(i) ABC
(ii) VED
(iii) GOLF
4. Write a short note on the EOQ model.
5. Explain the assumptions and limitations of the EOQ model.
6. Define the following terms:
(i) Ordering Cost
(ii) Reorder Level
(iii) Safety Stock
7. An auto company purchases sparkplugs at the rate of ` 25 per piece. The annual
consumption of sparkplugs is 18,000 nos. If the ordering cost is ` 250 per order and carrying
cost is 25% pa; what would be the EOQ?

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