210

Operations Management
LESSON

9
INVENTORY CONTROL

CONTENTS
9.0 Aims and Objectives
9.1 Introduction
9.2 Inventory Management
9.3 Types of Inventory
9.3.1 Manufacturing Inventory
9.3.2 Types of Inventory by Function
9.4 Safety Stock
9.5 Importance of Inventory
9.5.1 Manufacturing of Inventory
9.5.2 Functions of Inventory
9.6 Inventory Costs
9.6.1 Holding (or Carrying) Costs
9.6.2 Cost of Ordering
9.6.3 Setup (or Production Change) Costs
9.6.4 Shortage or Stock-out Costs
9.7 Inventory Classification
9.7.1 ABC Classification
9.7.2 Other Models
9.8 Fundamental Approaches to Manage Inventory
9.9 Fixed-order Quantity Approach
9.9.1 Fixed-order Quantity Modeling
9.9.2 Inventory Model with Uncertainty
9.9.3 Fixed-order Interval Approach
9.10 Inventory Control
9.10.1 Reasons for Maintaining Inventory
9.10.2 The Eyeball System
9.10.3 Reserve Stock (or Brown Bag) System
9.10.4 Perpetual Inventory Systems
9.10.5 Stock Control
9.10.6 Inventory Control Records
Contd...
 9.11 Controlling Inventory 211
Inventory Control
9.12 Just-in-Time
9.13 Kanban
9.13.1 The Two-card System
9.13.2 Attributes of JIT
9.14 Let us Sum up
9.15 Lesson End Activity
9.16 Keywords
9.17 Questions for Discussion
9.18 Suggested Readings

9.0 AIMS AND OBJECTIVES

After studying this lesson, you will be able to:
Define inventory
Know the importance of coordinated flow of inventory through the supply chain
Describe associated costs of inventory
Some EOQ models for fixed-order quantity approach (under conditions of
certainty and uncertainty)
Explain fixed-order interval approach to inventory management.

9.1 INTRODUCTION
The term inventory means any stock of direct or indirect material (raw materials or
finished items or both) stocked in order to meet the expected and unexpected demand
in the future. A basic purpose of inventory management is to control inventory by
managing the flows of materials. It sets policies and controls to monitor levels of
inventory and determine what levels should be maintained, when stock should be
replenished, and how large orders should be.

9.2 INVENTORY MANAGEMENT

Inventories are materials and supplies carried on hand either for sale or to provide
material or supplies to the production process. They provide a buffer against the
differences in demand rates and production rates.
Inventory Management involves the control of current assets being procured or
produced in the normal course of the company's operations i.e. or "how many" parts,
pieces, components, raw material and finished goods the firm should hold and when
should it replenish the stock. What should be the trigger points for action?
The purpose of holding inventories is to allow the firm to separate the processes of
purchasing, manufacturing, and marketing of its primary products. In other words, the
inventory forms a buffer that ensures the flow of the goods and services of the firm is
maintained on a continuing basis, based on the customer’s requirements.
Inventories not only separate processes, but also reduce risk of production shortages.
For example, manufacturing firms frequently produce goods with hundreds or even
thousands of components. If any of these components are not available on time, the
212 entire production operation can be halted. This would mean a heavy loss to the firm.
Operations Management
To avoid starting a production run and then discovering the shortage of a vital raw
material or other component, firms maintain inventories.
The goal of effective inventory management is to minimize the total costs - direct and
indirect - that are associated with holding these assets. However, the importance of
inventory management to the company depends upon the extent of investment in
inventory. As the value of the inventory goes up, the criticality of the function in
Inventory Management enables an organization to meet or exceed customers'
expectations of product availability while maximizing net profits or minimizing costs.

What is Inventory?
The term inventory means any stock of direct or indirect material (raw materials or
finished items or both) stocked in order to meet the expected and unexpected demand
in the future. A basic purpose of inventory management is to control inventory by
managing the flows of materials. It sets policies and controls to monitor levels of
inventory and determine what levels should be maintained, when stock should be
replenished, and how large orders should be.

9.3 TYPES OF INVENTORY

There are two basic types: merchandising and manufacturing. Manufacturing is further
divided into three more components: raw material, work in process and finished
goods.
1. Merchandise inventory: If you buy items from other artists and crafters to sell in
your own gallery or shop, you'll have a merchandise inventory. Remember
though - any items in your shop on consignment are not part of your inventory.
2. Manufacturing inventory: If you make your own arts and crafts, you'll have a
manufacturing inventory. The term 'manufacturing' might not seem to fit a hand
crafted type of business, but a quick review of the classifications within the term,
will make the relationship clearer.

9.3.1 Manufacturing Inventory

A manufacturing inventory consists of three different parts: raw materials, work in
process and finished goods. Using a leather crafting business as my sample craft
company, here are definitions and examples of the three:
1. Raw materials: Everything the crafter buys to make the product is classified as
raw materials. That includes leather, dyes, snaps and grommets. The raw material
inventory only includes items that have not yet been put into the production
process.
2. Work in process: This includes all the leather raw materials that are in various
stages of development. For the leather crafting business, it would include leather
pieces cut and in the process of being sewn together and the leather belts and
purse etc. that are partially constructed.
In addition to the raw materials, the work in process inventory includes the cost of
the labor directly doing the work and manufacturing overhead. Manufacturing
overhead is a catchall phrase for any other expenses the leather crafting business
has that indirectly relate to making the products. A good example is depreciation
of leather making fixed assets.
3. Finished goods: When the leather items are completely ready to sell at craft 213
Inventory Control
shows or other venues, they are finished goods. The finished goods inventory also
consists of the cost of raw materials, labor and manufacturing overhead, now for
the entire product.

9.3.2 Types of Inventory by Function

Input Process Output
Raw Materials Work In Process Finished Goods
Consumables required for Semi Finished Production in various Finished Goods at
processing. E.g. : Fuel, stages, lying with various Distribution Centers through
Stationary, Bolts & Nuts departments like Production, WIP out Supply Chain
etc. required in Stores, QC, Final Assembly, Paint
manufacturing Shop, Packing, Outbound Store, etc.
Maintenance Production Waste and Scrap Finished Goods in transit
Items/Consumables
Packing Materials Rejections and Defectives Finished Goods with
Stockiest and Dealers
Local purchased Items Spare Parts Stocks & Bought
required for production Out items
Defectives, Rejects and Sales
Returns
Repaired Stock and Parts
Sales Promotion & Sample
Stocks

9.4 SAFETY STOCK

It is the amount of inventory carried in addition to the average demand to take care of
fluctuations in demand.
The basic issue associated with P and Q systems of inventory is to determine safety
stock, which is influenced by the criteria we choose, the method of calculation and the
nature of demand distribution. Silver, et al. has suggested four criteria to determine
safety stock, which are summarized below:
Safety stock established through the use of a simple minded approach, "supplies
for a fixed-time period and equal safety factor for all items."
Safety stock based on minimization of cost (cost per unit short, cost per stock out,
etc).
Safety stock based on customer service (specified probability of no stock out per
replenishment cycle, specified fraction of demand to be met, etc).
Safety stock based on aggregate consideration "allocation of total safety stocks for
items to minimize the expected total cost of stock out per year, etc."
Regarding calculation of safety stock, we have two approaches – approximate method
and optimal method. Approximate method independently calculates the safety stock.
It is less involved computationally and offers a near optimal solution. Optimal method
is computationally more complex and faced with the problem of data availability.
In a large number of situations, demand follows normal distribution. However, when
level of demand is low, discrete distribution, such as Poisson, is more appropriate.
214 Here, we shall present the calculation of safety stock of P and Q systems using
Operations Management
approximate method and considering the criteria as given below:
Specified probability of no stock out
Specified Fraction of demand fulfillment.

9.5 IMPORTANCE OF INVENTORY

Inventory is a stock of materials used to satisfy customer demand or support the
production of goods or services. By convention, inventory generally refers to items
that contributes to or becomes part of an enterprise’s output. There are different types
of inventory, however the most commonly identified types of inventory are:
Raw Materials Inventory: Parts and raw materials obtained from suppliers that
are used in the production process.
Work-in-process (WIP) Inventory: This constitutes partly-finished parts,
components, sub-assemblies or modules that have been started into the production
process but not yet finished.
Finished Goods Inventory: Finished product or end-items.
Replacement Parts Inventory: Maintenance Parts meant to replace other parts in
machinery or equipment, either the company’s own or that of its customers.
Supplies Inventory: Parts or materials used to support the production process, but
not usually a component of the product.
Transportation (Pipeline) Inventory: Items that are in the distribution system but
are in the process of being shipped from suppliers or to customers.
Though the description above focuses on manufacturing inventory, wholesalers and
retailers have corresponding inventory types. The different types of inventories are
given below and each type has different risks depending upon the firm’s position in
the distribution channel.

9.5.1 Manufacturing of Inventory

Manufacturing inventory is typically classified into raw materials, finished products,
component parts, supplies, and work-in-process. Independence of workstations is
desirable in intermittent processes and on assembly lines a well. As the time that it
takes to do identical operations varies from one unit to the next, inventory allows
management to reduce the number of setups. This results in better performance.
In the case of seasonal items, any fluctuation in demand can be met if possible, by
either changing the rate of production or with inventories. However, if the fluctuation
in demand is met by changing the rate of production, one has to take into account the
different costs. The cost of increasing production and employment level involves
employment and training; additional staff and service activities; added shifts; and
overtime costs. On the other hand, the cost of decreasing production and employment
level involves unemployment compensation costs; other employee costs; staff, clerical
and services activities; and idle time costs. By maintaining inventories the average
output can be fairly stable. The use of seasonal inventories can often give a better
balance of these costs.
In addition, the firm also has to have in-services inventory. This generally refers to
finished goods, the tangible goods that must often be transferred to warehouses in
close proximity to wholesalers and retailers to be sold, and the supplies necessary to
administer the service.
Wholesale: The wholesaler purchases large quantities from manufacturers and sells 215
Inventory Control
small quantities to retailers. He provides the capability to provide retail customers
with assorted merchandise from different manufacturers in smaller quantities.
Expansion of product lines has increased the width and inventory risk. Where products
are seasonal, the wholesaler has to take an inventory position far in advance of selling.
Retail: For a retailer, inventory management is fundamentally a matter buying and
selling. The retailer purchases a wide variety of products and markets them. The prime
emphasis in retailing is on inventory turnover and direct product profitability.
Turnover measures inventory velocity and is calculated as the ratio of annual sales
divided by average inventory.
Not all types of inventories are held by all businesses. Table 9.1 summarizes the
inventory types held by different kinds of business organizations. Retail service
organizations hold only supplies. Retail sales organizations, wholesalers and
distributors hold both supplies and finished products. Projects and intermittent
processes in manufacturing hold supplies, raw materials and in-process inventory.
However, most continuous manufacturing organizations hold all the different types of
inventory.
Table 9.1: Organizational Inventories
Type of Inventory
Type of Organization Raw In-Process Finished
Supplies
Materials Inventory Goods
A. Retail systems
1. Sale of services *
2. Sale of goods * *
B. Wholesale/Distribution * *
C. Manufacturing systems
1. Projects * * *
2. Intermittent process * * *
3. Continuous process * * * *

9.5.2 Functions of Inventory

To maintain independence of operations, a supply of materials at a work center allows
that center flexibility in operations. Consider the case - an enterprise that does not
have any inventory. Clearly, as soon as the enterprise receives a sales order, it will
have to order for raw materials to complete the order. This will keep the customers
waiting. It is quite possible that sales may be lost. Also the enterprise may have to pay
high price for some other reasons. If the demand for the product is known precisely, it
may be possible (though not necessarily economical) to produce the product to exactly
meet the demand. However, in the real world this does not happen and inventories
become essential. It is almost essential to keep some inventory in order to promote
smooth and efficient running of business.
Inventory comprises physical stock of goods that is kept by an enterprise for future
purposes. Functional inventory categories are:
Working Stock: Also known as ‘work-in-progress’, is the inventory associated
with manufacturing/production. Significant amounts of inventory can be
accumulated between processes or at the assembly line.
Safety Stock: It is the stock that is always kept in store to protect against
uncertainties. It is a buffer.
216 Anticipation Stock: Stock kept at hand to meet seasonal fluctuations in demand or
Operations Management
to meet the shortfall caused by erratic production. Also called build stock or
seasonal stock.
Pipeline Stock: This is stock that is on the books of the firm but is not physically
available, e.g., stock in transit.
Decoupling Stock: A buffer stock used between productions processes to make
one process independent of the other.
Psychic Stock: Used in retail, it is retail display inventory used for stimulating
demand.

Figure 9.1: Functions of Inventory

Broadly speaking, the functions of inventory have been shown in Figure 9.1. Raw
materials flow in from the supplier and finally are sold to the customer. During the
process of providing goods to the customer, the inventory is required for use,
transformation and for distribution. A part of the inventory is in transit connecting the
different transformation and distribution activities.
The build-up of inventory takes place at different points during this flow from the
supplier to the final customer. It is desirable to maintain inventories in order to
provide time utility, guard against discontinuity and uncertainty, enhance stability of
production, protect employment levels and to provide economic advantage to the
organization.
Broadly speaking some of the functions of inventories are:
1. To protect against unpredictable variations (fluctuations) in demand and supply;
2. To take the advantage of price discounts by bulk purchases;
3. To take the advantage of batches and longer production run;
4. To provide flexibility to allow changes in production plans in view of changes in
demands, etc; and
5. To facilitate intermittent production.
Formulating inventory policy requires understanding the inventory’s role in the firm.
Inventories permit production planning for smoother flow and lower – cost operation
through larger lot-size production. They allow a buffer when delays occur. These
delays can be for a variety of reasons: a normal variation in shipping time, a shortage
of material at the vendor’s plant, an unexpected strike in any part of the supply chain,
a lost order, a climatic catastrophe like a hurricane or floods, or perhaps a shipment of
incorrect or defective materials.
In simple terms, inventory is an idle resource of an enterprise comprising physical 217
Inventory Control
stock of goods that is kept by an enterprise for future purposes. You do not want to
hold it, but cannot do without it.
The inventory decision gets complicated due to the different relationships between
inventory and the objectives of different functional departments. These conflicting
objectives are reflected in the contradictory viewpoints of different parts of the
organization.
Table 9.2: Conflicting Organizational Objectives
Area Typical Response
Marketing/Sales I can't sell from an empty wagon. I can't keep our customers if we
continue to stock out and there is not sufficient product variety

Production If I can produce larger lot sizes, I can reduce per unit cost and function
efficiency.
Purchasing I can reduce the per unit cost if I buy large quantities in bulk.
Warehousing I am out of space. I can't fit anything else in the building.
Finance Where am I going to get the funds to pay for the inventory? The levels
should be lower.

These comments in Table 9.2 place the focus on the functional significance of
inventory for different departments in the organization.
Marketing would like to have a large inventory so that customer service can be
improved and sales can increase.
Production would like to minimize set-up costs and increase worker productivity by
having large production runs adding on to the in-process inventory (work-in-progress
and finished goods).
Purchasing can bring down prices by buying in bulk and obtaining quantity discounts.
Stores or warehousing has storage constraints in storing and moving large quantities
of stock.
But the bottom line is equally important. All these requirements can be met at a cost.
Larger inventories mean more capital investment, lower cash flows, idle inventory,
and lower profitability. This is reflected in the comments made by Finance.
All this is clearly seen below in Table 9.3 the whole picture of inventory becomes
clear when seen in the context of the different functional objectives of departments
within the organization.
Table 9.3: Functional Significance of Inventory
Functional Functional Inventory
Inventory Goal
Area Responsibility Inclination
Maximize customer
Marketing Sell the Product High
service
Production Make the Product Efficient lot sizes High
Purchasing Buy required materials Low cost per unit High
Finance Provide working capital Efficient use of capital Low
Engineering Design the product Avoid obsolescence Low

As will be apparent from Table 9.3, some functional areas find inventory desirable,
while others do not. What is important to note is that both the inclination to hold
inventory and the inventory goals of the different functions are significantly different.
For example, inventory can be used to promote sales by reducing customer’s waiting
time, improve work performance by reducing the number of setups, or protect
218 employment levels by minimizing the cost of changing the rate of production.
Operations Management
Therefore, it is desirable to maintain inventories in order to enhance stability of
production and employment levels.
The functionality of inventory becomes clear only when it is considered in light of all
quality, customer service and economic factors - from the viewpoints of purchasing,
manufacturing, sales and finance. Inventory build-up is important as it is meant to
permit them to meet their functional objectives.
The major issue in inventory decisions is how to reconcile the differences between the
different functional requirements of the different parts of the organization and the
goals of the organization as a whole. No matter what the viewpoint of each department
is or what each function desires, in the ultimate analysis; effective inventory
management has to provide an economic advantage that is essential to organizational
competitiveness.
A significant percentage of assets of many firms are tied up in inventories. This could
range from fifteen per cent to nearly fifty percent of the capital utilized in a typical
firm. Holding of inventory, therefore, reflects a type of risk to the firm, these are risks
related to the capital investment and the potential for obsolescence of the inventory.
For the manufacturer, inventory risk has a long-term dimension. Although retailers or
wholesalers have a wider product line than the manufacturer, the manufacturer's
inventory commitment is relatively deep and of long duration. Wholesaler risk
exposure is narrower but deeper and of longer duration than that of retailers. Although
retailers assume a position of risk on a variety of products, the position on anyone
product is not deep. This does not mean that their risk is lesser; due to the variety of
merchandise the risk is wider. For example, a typical supermarket carries more than
10,000 SKUs. This variety of merchandise reflects the risk of the retailer. If an
individual enterprise plans to operate at more than one level of the distribution
channel, it must be prepared to assume additional inventory risk.
Only when considered in light of all quality, customer service and economic factors—
from the viewpoints of purchasing, manufacturing, sales and finance—does the whole
picture of inventory functionality become clear. No matter the viewpoint, effective
inventory management is essential to organizational competitiveness as excessive
inventory is a drain to the profitability of the organization. This is discussed in the
next section.
Check Your Progress 1
Broadly speaking, some other functions of inventories are:
1. To protect against unpredictable variations in demand and supply
2. To take the advantage of price discounts by bulk purchases
3. To take the advantage of batches and longer production run
4. To provide slack to allow changes in marketing plans, etc; and
5. To facilitate intermittent production.
Which of these statements are true?
 219
9.6 INVENTORY COSTS Inventory Control

The heart of inventory decisions lies in the identification of inventory costs and
optimizing the costs relative to the operations of the organization. Therefore, an
analysis of inventory is useful to determine the level of stocks. The resultant stock
keeping decision specifies:
1. When items should be ordered,
2. How large the order should be?
3. “When” and “how many to deliver”?
It must be remembered that inventory is costly and large amounts are generally
undesirable. Inventory can have a significant impact on both a company’s productivity
and its delivery time. Large holdings of inventory also cause long cycle times which
may not be desirable as well. What are the costs identified with inventory?
The costs generally associated with inventories are shown in Figure 9.2. The different
components of cost are discussed below:

Figure 9.2: Total Inventory Costs

9.6.1 Holding (or Carrying) Costs

It costs money to hold inventory. Such costs are called inventory holding costs or
carrying costs. This broad category includes the costs for storage facilities, handling,
insurance, pilferage, breakage, obsolescence, depreciation, taxes, and the opportunity
cost of capital. Obviously, high holding costs tend to favor low inventory levels and
frequent replenishment.
There is a differentiation between fixed and variable costs of holding inventory. Some
of the costs will not change by increase or decrease in inventory levels, while some
costs are dependent on the levels of inventory held. The general break down for
inventory holding costs has been shown in Table 9.4.
220 Table 9.4: Fixed and Variable Holding Costs
Operations Management
Fixed costs Variable cost
Capital costs of warehouse or store Cost of capital in inventory
Cost of operating the warehouse or store Insurance on inventory value
Personnel costs Losses due to obsolescence, theft, spoilage
Cost of renting warehouse or storage space

9.6.2 Cost of Ordering

Although it costs money to hold inventory, it also, unfortunately, to replenish
inventory. These costs are called inventory ordering costs. Ordering costs have two
components:
1. One component that is relatively fixed, and
2. Another component that will vary.
It is good to be able to clearly differentiate between those ordering costs that do not
change much and those that are incurred each time an order is placed. The general
breakdown between fixed and variable ordering costs is a follows:
Table 9.5: Fixed and Variable Ordering Costs
Fixed costs Variable costs
Staffing costs (payroll, benefits, etc.) Shipping costs
Fixed Costs on IT systems Cost of placing and order (phone, postage,
order forms)
Office Rental and equipment costs Running costs of IT systems
Fixed Costs of Vendor Development Receiving and inspection costs
Variable Costs of Vendor Development

One major component of cost associated with inventory is the cost of replenishing it.
If a part or raw material is ordered form outside suppliers, and places orders for a
given part with its supplier three times per year instead of six times per year, the costs
to the organization that would change are the variable costs, and which would
probably not are the fixed costs.
There are costs incurred in maintaining and updating the information system,
developing vendors, evaluating capabilities of vendors. Ordering costs also include all
the details, such as counting items and calculating order quantities. The costs
associated with maintaining the system needed to track orders are also included in
ordering costs. This includes phone calls, typing, postage, and so on.
Though Vendor development is an ongoing process, it is also a very expensive
process. With a good vendor base, it is possible to enter into longer-term relationships
to supply needs for perhaps the entire year. This changes the “when” to “how many to
order” and brings about a reduction both in the complexity and costs of ordering.

9.6.3 Setup (or Production Change) Costs

In the case of subassemblies, or finished products that may be produced in-house,
ordering cost is actually represented by the costs associated with changing over
equipment from producing one item to producing another. This is usually referred to
as setup costs.
Set-up costs reflect the costs involved in 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 materials, in making each
different product. If there were no costs or loss of time associated in changing form 221
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one product to another, many small lots would be produced, permitting reduction in
inventory levels and the resultant savings in costs.

9.6.4 Shortage or Stock-out 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 and the costs resulting from stock out. The costs that are incurred as
result of running out of stock are known as stock out or shortage costs. As a result of
shortages, production as well as capacity can be lost, sales of goods may be lost, and
finally customers can be lost.
In manufacturing, inventory requirements are primarily derived from dependent
demand, however, in retailing the requirements are basically dependent on
independent demand. Inventory systems are predicated on whether demand is derived
from an end item or is related to the item itself. Because independent demand is
uncertain extra inventory needs to be carried to reduce the risk of stocking out. To
determine the quantities of independent item that must be produced, firms usually use
a variety of techniques, including customer surveys, and forecasting. However, a
balance is sometimes difficult to obtain, because it may not be possible to estimate lost
profits, the effects of lost customers, or lateness penalties.
If the unfulfilled demand for the items can be satisfied at a later date (back order case),
in this case cost of back orders are assumed to vary directly with the shortage quantity
(in rupee value) and the cost involved in the additional time required to fulfill the
backorder ( / /year). However, if the unfulfilled demand is lost, the cost of shortages
is assumed to vary directly with the shortage quantity ( /unit shortage). Frequently,
the assumed shortage cost is little more than a guess, although it is usually possible to
specify a range of such costs.

9.7 INVENTORY CLASSIFICATION

It is useful to visualize the inventory of a medium sized business organization. The
inventory would comprise thousands of items, each item with different usage, price,
lead time and specifications. This makes planning and co-ordination extremely
difficult, if not impossible. There could be different procurement and technical
problems associated with different items and many a time the firm has to deal with the
inability of the entire chain of suppliers to respond promptly.
As the number of departments and users increase different types of issues arise. For
example, an electric company had as many as 118 names for a simple screw with a
width of 3/8 inches and length of 6 inches, depending upon the type of usage and the
department using the screw. This type of issue would finally result in confusion and
tend to duplicate ordering or result in overstocking.
In order to escape this quagmire many selective inventory management techniques are
used based on thorough analysis of the items that constitute the inventory. It is often
prudent to classify inventory so as to improve response time and bring the relevant
issues within the capability of the supply chain partners.
The use of class systems make the effort to manage inventory more effective and
efficient than if the organization managed each individual item independently. Some
of the classifications that facilitate this process of improving the management of
inventory are described above.
222 9.7.1 ABC Classification
Operations Management
ABC classification, or the alphabetical approach, is based on the annual consumption
value. Typically only 20 percent of all the items account for 70 to 80 percent of the
total rupee usage, while the remaining 80 percent of the items typically account for
remaining 20 to 30 percent of the rupee value. The ABC classification is based on
focusing efforts where the payoff is highest; i.e. high-value, high-usage items must be
tracked carefully and continuously. As these items constitute only 20 percent, the
ABC analysis makes the task relatively easier.
After calculating the rupee usage for each inventory item, the items are ranked by
rupee usage, from highest to lowest. The first 20 percent of the items are assigned to
class ‘A’. These are the items that warrant closest control and monitoring through a
perpetual inventory system.
One of the major costs of inventory is annual carrying costs, and your money is
invested largely in class ‘A’. Tight control, sound operating doctrine, and attention to
security on these items would allow you to control a large rupee volume with a
reasonable amount of time and effort.
The next 30 percent of the items are classified as ‘B’ items. These deserve less
attention than ‘A’ items. Finally, the last 50 percent of items are ‘C’ items. These have
the lowest rupee usage and can be monitored loosely, with larger safety stocks
maintained to avoid stock outs. They should have carefully established but routine
controls.

Figure 9.3: ABC Analysis

This classification is commonly used by companies, as very often they need not keep
extremely accurate track of all inventory items. Through performing 80/20 analysis,
many companies are optimizing their investment in inventory, and production,
procurement and distribution assets. These companies are able to analyze their
inventory network as well as policies and able to add inventory where there are
opportunities for winning additional market share and reduce inventory where they are
not needed. They do not trim inventories across the board to reduce cost.
Through this approach, organizations are able to increase their overall customer
service levels while simultaneously reducing their total inventory carrying costs. Thus
these companies are able to improve other key metrics like customer retention, gross
margin and inventory turns.
The importance of each item is determined while procuring and storing it to improve
the purchase efficiency. The fundamental idea behind selective control techniques is
to put the efforts where the results are worth it. Even if an organization uses millions
of items, only a few items become important - from the finance view, availability
considerations, seasonality, criticality of performance, etc. The materials are classified
according to their importance and increased attention is paid to the items that are more 223
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important. For instance, high-value, high-usage items must be tracked carefully and
continuously but certain parts with a relatively low value or infrequent use can be
monitored loosely.
The ABC Analysis is also a guide to physical count of items of inventory. Counts are
conducted depending on the importance of inventory items. ‘A’ items are counted
frequently, ‘B’ items less frequently and ‘C’ items are counted the least frequently.
Accuracy of the count also depends on the classification. APICS recommends ± 0.2
percent for ‘A’ items, ± 1 percent for ‘B’ items and ± 5 percent for ‘C’ items.
However, ABC analysis should be used prudently. It cannot always be applied across
the board. Some categories of items where the application of ABC analysis is fraught
with high risk are identified below:
Difficult Procurement Items
Short Shelf Life
Large Storage Space Requirements
Item’s Operational Criticality
Likelihood of Theft
Difficult Forecast Items

9.7.2 Other Models

The ABC classification has limitations when applied to items that are scarce, where
lead time analysis is difficult and purchasing strategies can be critical. Purchase
strategies can also be critical for a number of items that may have to be imported and
in addition to normal transportation times, time required for clearance through
customs may not be highly predictable. In such cases, there is a tendency to hold too
little inventory for items with lumpy demand and too much for items with steady
demand.
However, organizations deal with a large number of items with varying degrees of
characteristics in terms of size, shape, physical characteristics, sources of supply,
modes of handing, user departments, etc. Inventory can also be classified using any of
differences between the items.
Items may belong to more than one class depending upon the criteria used. Any of
these criteria could be the basis of classification. The criterion could be the nature of
the materials, e.g. raw materials, machinery and equipment, consumable items,
chemicals, packaging materials, inflammable items, fuel stock, furniture and fixtures,
scrap, general materials, etc. Another could be, on the basis of usability of the material
e.g. finished, semi-finished items, dead stock items, unused items, serviceable,
unserviceable, and dead stock items, etc. Still another criterion could be the critically
of the component, e.g. vital, essential, desirable, etc.
There are, therefore, a number of classification systems besides the ABC classification
that are used in industry. Most of these systems operate in a similar manner to the
ABC Classification. A brief description and comparison of these classifications are
given in Table 9.6.
224 Table 9.6: Comparison of Different Classification Systems
Operations Management
S. No. Title Basis Main Uses
1. ABC (Level of Usage) Value of To control raw material components
consumption and work-in progress inventories in
the normal course of business
2. HML (High, medium, Unit price of the Mainly to control purchase.
low usage) material
3. FSND (Fast moving, Consumption To control obsolescence.
Slow moving, Non- pattern of the
moving, dead items) component
4. SDE (Scarce, difficult, Problems faced in Lead time analysis and purchasing
easy to obtain items) procurement strategies
5. Golf (Government, Source of the Procurement strategies
Ordinary, Local, Foreign material
Sources)
6. VED (Vital, Essential, Criticality of the To determine the stocking levels of
Desirable) component spare parts.
7. SOS (Seasonal, Off- Nature of suppliers Procurement/ holding strategies for
seasonal) seasonal items like agriculture
products
8. XYZ ( Value of Stock) Value of items in To review the inventories and their
storage use scheduled intervals.

Other similar types of classifications are the XYZ Classification, VED Classification,
and the HML classification of inventory. The basic difference between the ABC
Classification and the XYZ Classification is that it is based on the inventory in stock
rather than usage.
The VED Classification is based on the criticality of the inventory item. In normal
practice, items in the ‘V’ category are often monitored manually; in addition to the
computer monitoring that may be in place. The HML reflects a classification based on
the unit price of the item. Obviously, the ‘H’ category items require additional
attention, especially if the lead times are long, as it may often be in imported
components. The ‘time’ triggered reorder system has some advantages in production
cycling, in such high value items.
All these techniques are used to focus management attention in deciding on the degree
of control necessary for different items in the inventory. However, it should be kept in
mind that changes in the business environment, e.g. customer demand patterns or
material costs, can cause material item classifications to change. This in turn can
affect key planning & scheduling decisions.

9.8 FUNDAMENTAL APPROACHES TO MANAGE

INVENTORY
Managing inventory involves four fundamental questions: how much to order, when
to reorder, where inventory should be held, and what specific line items should be
available at specific locations. The first two questions can be answered by performing
a few simple calculations. However, questions regarding the other two still challenge
the creativity and analytical capabilities of inventory decision makers.
Managing inventory in today's business environment usually involves selecting an
overall strategy from a range of alternatives and to structure logistics systems to
manage inventories more effectively and to lower cost and improve service as well.
Selecting an acceptable approach depends on the circumstances under which the
company operates and the simplifying assumptions that can be made.
Inventory decisions are made on issues relating to cost and to customer service 225
Inventory Control
requirements. Increasing investments in inventory generally result in higher levels of
customer service, but can options be identified that will result in higher levels of
customer service along with reduced investments in inventories. That is the challenge.
However, several factors make this an achievable objective:
1. More responsive order-processing and order-management systems;
2. Enhanced ability to strategically manage logistics information;
3. More capable and reliable transportation resources; and
4. Improvements in the ability to position inventories so that they will be available
when and where they are needed.

Key Differences among Approaches to Managing Inventory

Given the various approaches to managing inventory that are available and used today,
it is important to know the key ways in which they differ. These differences include
dependent versus independent demand, pull versus push, and system wide versus
single-facility solutions to inventory management issues.
Dependent Demand: The risk of carrying additional inventory depends on the nature
of the demand. Each type of demand carries with it a different type of risk. And this
adds to the cost and the quantum of inventory held by the organization.
For example, marketing experts hold the Edsel designed by Ford Motor Co. as a
supreme example of corporate America’s failure to understand the nature of consumer
demand. The Edsel was created as an automobile that would meet consumer demands
for a new generation of Americans. It was the hot new car that everybody was talking
about. It turned out to be a major failure. The company suffered greatly because it did
not consider the risks associated with getting the figures wrong.
Inventory items can be divided into two main types: Independent demand, and
dependent demand items. In inventory management it is important to distinguish
between dependent and independent demand.
An item has independent demand when we can’t control it or tie it directly to another
item’s demand. The Ford example was an example of independent demand. Though
Ford tried to manipulate demand through pricing incentives and other marketing
efforts, the Edsel failed. As the results of the Edsel show, the firm can try to predict or
influence independent demand, but independent demand for the product is ultimately
determined by the marketplace.
In order to predict independent demand firms use different types of forecasting
methods. Forecasting looks at the market place to determine how much of the product
the consumers want.
In forecasting, both accuracy of data as well as the method, are important. It is not
only important to know where the data comes from but also if it is useful. There are
many different applications to consider when deciding which method is best. Not only
is the input important but also the quality of output is very important. Feedback on the
output creates the ability to go back and correct any errors that may have been made
during the initial input of data. The first item to look at is different methods used in
different situations. We will be looking at this issue in greater detail the next unit on
forecasting.
Manufacturing requirements are primarily derived from dependent demand, while
retailing requirements basically depend on independent demand. Dependent demand is
by far the most common type of demand. An item has dependent demand when the
demand for an item is controlled directly, or tied to the production of something else.
226 Continuing with the Edsel example, Suppose, Ford decided to manufacture 15,000
Operations Management
units of the automobile for the first year based on a forecast of the independent
demand. Based on this, Ford knew exactly how many steering wheels are needed and
when. This is because the demand for these items is dependent on the production
schedule of 15,000 automobiles for the year. The steering wheels are dependent
demand items because:
1. The firm controls their demand through the production schedule, and
2. Their demand is tied to the production of automobiles.
Dependent demand, in a manufacturing unit, is based on the sub-assemblies or
components or raw materials that are part of the BOM for the end items. The demand
for these items is indirect or comes from the finished products demand when we
explode the BOM (Bill of Material).
Material Planning: Materials Planning has been automated, to a large extent, in many
organizations through the use of ‘MRP I’ and ‘MRP II’. MRP I, is also called
‘Materials Requirement Planning’, and MRP II is called ‘Manufacturing Resource
Planning’. These are software solutions that integrate many areas of the manufacturing
enterprise into a single entity for planning and control purposes in order to minimize
inventory when the demand is dependent. It uses the basic principal that external
demand is generally independent and internal demand is generally dependent. This
genre of planning starts with aggregate planning and includes ‘MRP I’ and ‘MRP II’.

Dependent Demand Dependent Demand

Figure 9.4: Independent and Dependent Demand in MRP Models

As shown in Figure 9.4, Material Planning, MRP I and MRP II get the independent
demand and calculate the total demand by working downwards at the highest level of
the Bill of Materials after deducting on hand quantities. Once this is done for high
level items, the bills of material are exploded to calculate the components required.
This process is repeated further down the levels till the raw material requirements are
arrived at.
Managing Independent Demand: It must be remembered that inventory is costly and
large amounts are generally undesirable. As inventory can have a significant impact
on both a company’s productivity and its delivery time, different methods have to be
found to reduce inventory. One approach is through ‘demand management’. Another
is to reduce the risks associated with inventory. If risks are reduced, inventory levels
can be are also reduced.
Push-Pull Concept: It has been found that the risks due to independent demand can
be reduced through process design. Process design can minimize the risk if we reduce
demand uncertainty of independent demand by positioning the process from the push-
pull point of view. What is the push-pull view?
The push/pull relationship is that between a product or piece of information and who 227
Inventory Control
is moving it. Customers "pull" things towards themselves, while a producer "pushes"
things toward customers.
Another way of looking at the transformation operations of any product is whether
they are executed in response to a customer order or in anticipation of customer
orders. Pull processes are initiated by a customer order whereas push process are
initiated and performed in anticipation of customer orders. Engineered-to-Order
(ETO) and Made-to-Order (MTO) are based on pull processes, whereas Made-to-
Stock (MTS) is based on a push process. Assembled-to-Order (ATO) is a combination
of pull and push processes.
For example, Tata Steel collects orders that are similar enough to enable it to
consolidate demand and produce specific products in large quantities. In this case, the
manufacturing cycle is reacting to customer demand (referred to as a pull process).
The other example is Hindustan Lever Ltd, a consumer products firm, which must
produce in anticipation of demand. In this case the manufacturing cycle is anticipating
customer demand (referred to as a push process).
A push/pull view of the transformation processes is very useful when considering
strategic decisions relating to planning for material requirements. This view forces a
more global consideration of operations as they relate to fulfilling the customer’s
order.
Push is a planning based approach and is more appropriate for dependent demand,
scale economies, supply uncertainties, source capacity limitations, or seasonal build-
ups. In general, push systems are more prevalent in organizations having greater
logistics sophistication.

Customer
Order PULL
Cycle PROCESS Customer Order Cycle Customer

Retailer
Customer Replenishment and
Order Manufacturing Cycle
Arrives
Manufacturer

Procurement PUSH
Procurement Cycle
Manufacturing, PROCESS Supplier
Replenishment Cycle

Figure 9.5: Push/Pull Processes for a Retail Network

Figure 9.5 shows graphically the push/pull system in a retail network. It can be clearly
seen from the figure that in the pull processes, customer demand is known with
certainty at the time of execution i.e. it is executed after the customer order arrives.
Whereas for a push process demand is not known and must be forecast as the
customer order is yet to arrive.
Therefore, pull processes may also be referred to as reactive processes because they
react to customer demand. Push processes may also be referred to as speculative
processes because they respond to forecasted rather than actual demand. The push/pull
boundary separates push processes from pull processes.
228 A process or market orientation that has more pull processes has a significant impact
Operations Management
on reducing the requirement of inventory in the system. Just like in the case of
collaborative forecasting, more pull processes can help eliminate excess inventory as
it minimizes the inventory carried to cover uncertainty due to independent demand.
Just-in-Time (JIT) is, in a sense, a pull system. The firm places an order for an item
only when the amount on hand reaches a certain level, thus pulling inventory through
the system as needed. There is a time phased approach to inventory scheduling and
inventory receipt. The Economic Order Quantity (EOQ) approach, which we will
study in this lesson, on the other hand is generally pull based, but is quite often a
hybrid system.

System wide versus Single Facility Solution

A major inventory management issue is whether to take a system wide approach to
inventory management or to provide solutions on a facility wise basis. Generally, JIT,
EOQ-based approaches are applicable to single facility decision making. The MRP or
DRP solutions are more suited to system wide applications.
The single facility approach is simpler and less expensive. The MRP or DRP approach
is expensive and it takes time, effort and systemic change of the mental framework to
make it successful. The choice is a trade-off.
Check Your Progress 2
Identify which of these statements are true:
1. An item has independent demand when we can’t control it or tie it directly
to another item’s demand.
2. Manufacturing requirements are primarily derived from dependent
demand.
3. As the lead time reduces, it reflects an increase in inventory requirements.
4. Push processes are initiated by a customer order whereas pull process are
initiated and performed in anticipation of customer orders.
5. A market orientation that has more pull processes reduces the requirement
of inventory in the system.

9.9 FIXED-ORDER QUANTITY APPROACH

Multi-period inventory systems are designed to ensure that an item will be available
on an ongoing basis throughout the year. Fixed-order quantity models are “event
triggered”. In other words, at an identified level of the stock the fixed-order quantity
model initiates an order. This event may take place at any time, depending on the
demand for the items considered. Generally, the Fixed-order Quantity models are
favored when:
1. Items are more expensive items because average inventory is lower.
2. Items are critical, e.g. repair parts, because there is closer monitoring and
therefore quicker response to potential stock out.
The models that emanate from this are similar to batch processing systems, counting
takes place only at the review period. The Fixed-Time Period models are “time
triggered” i.e. the model initiates an order after a fixed-time. These models require a
larger average inventory because they must also protect against stock out during the
review period; while the fixed-order quantity mode has no review period.
These differences and the nature of operations tend to influence the choice of the 229
Inventory Control
inventory system that is more appropriate.

9.9.1 Fixed-order Quantity Modeling

In this lesson we will consider Fixed-Order Quantity i.e. inventory models in which
demand is assumed to be fixed and completely predetermined. The heart of inventory
analysis resides in the identification of relevant costs. The basic approach to
determining fixed-order sizes – are the Economic Order Quantity (EOQ) models. The
basic EOQ model is concerned primarily with the cost of ordering and the cost of
holding inventory.

Waiting for demand

Demand occurs, units

withdrawn from
inventory or backorder

No Is position
< Recorder point?

Yes

Issue an order for

exactly 'Q' units

Figure 9.6: Fixed-order Quantity System

A Fixed-Order Quantity system is shown in Figure 9.6. The notations that are used in
the models for this system are given below:
‘D’ – Annual demand
‘v’ – Unit purchase cost or unit cost of production ( /unit)
‘A’ – Ordering or Set-up cost ( /year)
‘r’ – Holding cost per per year ( / /year) (Inventory carrying charges factor)
‘b’ – Shortage cost per short per unit time ( / /year)
‘Q’ – Order quantity (to be determined)
The basic assumptions in the model are as follows:
1. The rate of demand for the item is deterministic and is a constant ‘D’ units per
annum independent of time.
2. Production rate is infinite, i.e. production is instantaneous.
3. Shortages are not allowed.
230 4. Lead time is zero or constant and it is independent of both demand as well as the
Operations Management
quantity ordered.
5. The entire quantity is delivered as a single package (or produced in a single run).
The objective of the model is to minimize the average annual variable costs. And it
provides a solution to the problem of determining when an order should be placed and
how much should be ordered. The schematic representation of the EOQ Model is
given in Figure 9.7. It shows the ‘inventory level’ vs. ‘time’ relationship.

Inventory Level ‘Q’

Time T T

Figure 9.7: Schematic Representation of the EOQ Model

In developing the EOQ model, we will attempt to minimize total annual costs by
varying the order quantity, or lot size. From the figure it is obvious that since the
inventory is consumed at uniform rate and since maximum inventory level is Q, the
average inventory will be ‘Q / 2’.
Hence, average Investment in Inventory will be = ‘Q × v / 2’
And the Average Inventory Holding Cost will be = ‘(Q × v × r) / 2
Hence the total annual variable cost (TC) = Ordering cost + Inventory Holding Cost.
Therefore,
TC = (A × D) / Q + (Q × v × r) / 2
If ‘QEOQ’ is the order quantity at which the total cost is minimum, then mathematically
the relationship can be expressed as:
Q = QEOQ = √ (2 × A × D /r × v),
This equation is known as the EOQ formula. From this formula, the optimal time
between orders can be derived.
TEOQ = D/Q = (1/D) × √ (2 × A × D/ r × v)
The Minimum Total Annual Cost (TC) of holding inventory is given by the formula:
TC = √ 2 × A × D × r × v
Ordering cost and holding cost can be imagined as two children on a see saw. When
one goes up, the other goes down, and vice versa. This way out of this dilemma is to
combine the two costs as total annual variable costs and worry only about minimizing
that cost.
1. EOQ Model with ‘Lead Time’: In the above discussion we considered that lead 231
Inventory Control
time is zero. However, if lead time is constant the above results can be used
without any modification.
Inventory Level

Reorder Level, R0

L L L
Time
T T T

Figure 9.8: EOQ with a Fixed Lead Time Reorder Level

If lead time is say constant and equal to ‘L’ (in weeks). Then during lead time, the
consumption is L × D units. This means order will have to be released for quantity
QEOQ, the new order will arrive exactly after time period ‘L’ at which time inventory
level will be zero and the system will repeat it self.
The inventory level at which the order is released is known as reorder level is shown
in Figure 9.8. It can be mathematically expressed by the equation:
Reorder Level = Ro = L × D
Let us work out an example to understand the EOQ Model and all that has been said
earlier in this section on fixed-order quantity policies:
A company, for one of its class ‘A’ items, placed 8 orders each for a lot of 150
numbers, in a year. Given that the ordering cost is 5,400.00, the inventory holding
cost is 40 percent, and the cost per unit is 40.00. Find out if the company is making a
loss in not using the EOQ Model for order quantity policies.
What are your recommendations for ordering the item in the future? And what should
be the reorder level, if the lead time to deliver the item is 6 months?
‘D’ = Annual demand = 8 × 150 = 1200 units
‘v’ = Unit purchase cost = 40.00
‘A’ = Ordering Cost = 5400.00
‘r’ = Holding Cost = 40%
Using the Economic Order Equation:
QEOQ = √ (2 × A × D /r × v)
= √ (2 × 5400 × 1200)/(0.40 × 40) = 900 units.
232 Minimum Total Annual Cost (TC) = √ 2 × A × D × r × v
Operations Management
= √ 2 × 5400 × 1200 × 0.40 × 40
= 14,400.00
The Total annual Cost under the present system
= (1200 × 5400/150 + 0.40 × 40 × 150/2)
= (43,800 + 1200) = 45,000.00
The loss to the company = 45,000 – 14,400 = 30,600.00
Reorder Level = Ro = L × D = (6/12) × 1200 = 600 units
The company should place orders for economic lot sizes of 900 units in each order. It
should have a reorder level at 600 units.

Economic Order Quantity Model with Shortages

This model considers the situation when back orders are allowed, i.e. stock-out is
allowed for some period in the system. In case of shortage, demand is assumed to
reflect as a back-order and is not lost. The model assumes three costs, unlike the
earlier model that assumed only the first two costs shown below:
(a) Ordering or set-up cost,
(b) Inventory holding cost, and
(c) Shortage or stock-out cost.
The shortage cost is denoted by ‘b’ rupees per short per unit time i.e. / /Year.
The total average annual cost (TC) can be written as,
TC = Ordering cost +Inventory holding cost + Cost of back orders
Assuming order quantity to be ‘Q’, then the number of orders per annum equals ‘D/Q’
And hence ordering cost equals ‘A* (D/Q)’.
Total Annual Cost (with backorders permitted) = [(Q-S) 2 *v*r /2Q] + A* (D/Q) +
S*2 *b/2* QEOQ
The average inventory and stock out can be derived using Figure 9.9. The average
inventory during period T1 will be ‘I’ (as consumption is at uniform rate) and the
inventory level during T 2 us negative and hence in practice on hand inventory will be
zero.
Thus, average inventory through period T will be
Average Inventory = (Q – S)2 / 2Q
Average Inventory Holding Cost = [(Q-S)2 /2Q] *v*r
And,
QEOQ = √(2*A*D/ r*v)*((r*v + b)/ b)
If shortages are not allowed, then b = ∞
The above equation will be reduced to: Q = QEOQ = √2*A*D/r*v
 233
Inventory Control

T1 T1 T1 Time

T2 T2 T2
T T T

Figure 9.9: EOQ Model with Shortages

This is the same equation that we had derived earlier, i.e. optimal order quantity for
the EOQ model.
Let us try another exercise to demonstrate the EOQ model. The demand for an item is
equal to 600 units per year. The per unit cost of the item is ` 50 and the cost of placing
an order is ` 5. The inventory carrying cost is 20% of inventory per annum and the
cost of shortage is ` 1 per unit per month. Find the optimum ordering quantity if stock
outs are permitted. If stock outs are not permitted what would be the loss to the
company?
‘D’ = Annual demand = 600 units
‘v’ = Unit purchase cost = ` 50.00
‘A’ = Ordering Cost = ` 5.00 per order
‘r’ = Holding Cost = 20% per annum
‘b’ = Shortage Cost = ` 12 per annum
QEOQ = √(2×A×D/ r×v)×((r×v + b)/ b)
= √ (2×5×600/0.20×50)×((0.20×50 +12)/12)
= √ 600*1.833 = 33.16 units = say 33 units
Max. Number of backorders = (S*) = QEOQ (r×v/(r×v) + b)
= 33×(0.20×50/((0.20×50) +12) = 15 units
Total Annual Cost (with backorders permitted)
= [(Q-S)2 × v × r /2Q ] + A × (D/Q) + S × 2 × b/2 × QEOQ
= [(33 -15) 2 × (0.20 × 50) / (2 × 33)] + (600 × 5)/33 + 15 ×15 × 12/ (2 × 33)
= ` 181
If stock outs and backorders are not permitted, the economic order quantity is:
Q = QEOQ = √2 × A × D/r × v
= √ 2 × 600 × 5/ (0.20 × 50) = 24.5 units
TC = Ordering Cost + Ave. Holding Cost = [D × A/ QEOQ] + QEOQ × r × v/2
= [600 × (5/ 24.5)] + 24.5 × 0.20 × 50/2 = ` 254.00
234 Therefore, additional cost when backordering is not allowed
Operations Management
= 254.00 – 181.00 = 64.00.

9.9.2 Inventory Model with Uncertainty

Inventory models with uncertainty have been developed that can be used to determine
how much inventory should be kept on stock, what service levels should be met, and
how to design inventory layout. Such models consider that risks have geometrically-
distributed probabilities and demand to be either deterministic or normally distributed.

Figure 9.10: Working Stock and Safety Stock

Figure 9.10 shows the relationship between working stock and safety stock, where the
demand is uncertain. In the Figure Ss represents the safety stock. B is the reorder point
and the working stock is shown as the difference between the total stock and safety
stock.
In re-order point models with risk, the probability distribution of demand during the
lead-time is an important characteristic in inventory management. We can, generally,
assume the lead time demand as a normal distribution as shown in Figure 9.11. The
‘Y’ axis shows the frequency of occurrence i.e. the probability, and the ‘X’ axis shows
the demand during the lead time.
The different relationships shown in Figure 9.10 are reflected in Figure 9.11 also. The
reason that we can represent the inventory model shown in Figure 9.10 with the
distribution shown in Figure 9.11 is because of the central limit theorem. Suppose we
repeat an experiment many times, where the lead time demand is ‘M’, and ‘Mi’ is the
result of the ith experiment. In general, we won't know what the distribution of ‘M i’ is,
and it may be discrete or continuous. The central limit theorem says that the
distribution of the average of the Mi's is normal.

Figure 9.11: Realistic Lead Time Demand

Using these concepts, we can tackle problems with constant lead time and variable 235
Inventory Control
demand. Data has been provided in Table 9.7 to illustrate such a problem. In the
problem, it is assumed that the weekly demand is variable and the lead time is
constant at 2 weeks.
Table 9.7: Calculation of Lead Time Demand
Demand Probability Demand Probability Lead time Probability
first week p(D) second week p(D) demand (col. 2)(col. 4)
(D) (D) (col. 1)(col. p(M)
3) (M)
1. 0.60 1 0.60 2 0.36
3 0.30 4 0.18
4 0.10 5 0.06
2. 0.30 1 0.60 4 0.18
3 0.30 6 0.09
4 0.10 7 0.03
3. 0.10 1 0.60 5 0.06
3 0.30 7 0.03
4 0.10 8 0.01

The basic data in Table 9.7, in columns 1 to 3 are used to calculate the lead time
demand and the probability of lead time demand, which are given in columns 5 and 6.
The lead time demand obtained and the probability of lead time demand obtained in
Table 9.7 have been rearranged in Table 9.8 to obtain the distribution.
Table 9.8: Lead Time Demand and Probability
Lead time demand (M) Probability P(M)
0 0
1 0
2 0.36
3 0
4 0.36
5 0.12
6 0.09
7 0.06
8 0.01
Total 1.00

We have worked out the example of constant lead time and variable demand above.
A reasonable approximation method for determining model parameters is to use the
EOQ model to solve for the order size. The time between orders is then simply the
order quantity divided by annual demand. The standard deviation of demand during
the order interval is found by determining the daily standard deviation of demand and
multiplying by the square root of the length of the order interval. Different
relationships emerge when there is:
1. Variable demand and constant lead time,
2. Constant demand with variable lead time, and
3. Variable demand with variable lead time.
236 Each of these relationships is shown below. The notations that are used are as follows:
Operations Management
‘B’= Reorder point in units.
‘M’ = Lead time demand in units (a random variable).
‘f (M)’ = Probability density function of lead time demand.
‘p (M)’= Probability of a lead time demand of M units.
‘L’ = Expected lead time
‘Lm’ = Maximum lead time
‘ ’ = Standard deviation of lead time demand
‘Q’ = Lot size
‘S’ = Set-up cost or Ordering Cost ( /year)
‘SS’ = Safety Stock
‘D’ = Annual Demand
‘P’ = Unit Price ( /unit)
‘H’ = Holding or Carrying cost per Unit ( /Unit)
‘F’ = Inventory Carrying Charges Factor
‘Q*’ = Economic Order Quantity (to be determined)

Figure 9.12: Inventory Risk: Variable Demand and Constant Lead Time
The relationships that emerge when Demand is variable and Lead Time is constant are
shown in Figure 9.12. The figure shows the relationships that are given below:
B – SS = Expected lead time demand
B - J = Minimum lead time demand
B + W = Maximum lead time demand
p(M>B) = Probability of a stock out

Figure 9.13: Inventory Risk: Variable Demand and Variable Lead Time
The relationships when there is constant demand with variable lead time are shown in 237
Inventory Control
Figure 9.13. The relationships that emerge from this configuration are given below:
p (M > B) = Probability of a stock out
B – S = Expected lead time demand
B + W = Maximum lead time demand
The lot order size is given by the expression:
Q* = 2DS / H …(1)
And the reorder point is given by:
B = M + SS …(2)
When both demand and lead times are probabilistic, the basic procedure for finding
operating doctrines is a convergence procedure. This is a directed trial an error
method. For the quantity/reorder point model, the order quantity is computed
assuming constant demand. Then the reorder point is calculated using the computed
order quantity. This value is then used to recalculate the order quantity and recalculate
the reorder point. Eventually, the order quantity the reorder point coverage to their
optimal values. The example of ABC Ltd. illustrates the method.
ABC Ltd. for one of its class ‘A’ items, has an ordering cost is 5,400.00, the
inventory holding cost is 40 percent, and the cost per unit is 40.00.
‘D’ = Annual demand = 8 × 150 = 1200 units
‘P’ = Unit purchase cost = 40.00
‘S’ = Ordering Cost = 5400.00
‘F’ = Holding Cost = 40%
The lead time to deliver the item is 10 days. The Lead time demand is given in the
table below.
Lead time demand Probability P(M) Lead time demand Probability P(M)
(M) (M)
0 0 1 0
2 0.36 3 0
4 0.36 5 0.12
6 0.09 7 0.06
8 0.01 Total 1.00

What is the lowest cost reorder point if the stock out cost is 5 per unit?
Using the Economic Order Equation:
Q* = √(2DS/H) = √(2DS/FP) = EOQ
= (2 × 5400 × 1200)/(0.40 × 40) = 900 units.
Reorder Level: (RB) = L × D = (10/365) × 1200 ≈ 33 units
238 Let us now determine the lowest cost reorder point.
Operations Management
M max 8
B = 34 E(M > B) = (M – B) p(M ) or ( M – 33) p ( M )
M B 1 1 1

= (34 – 33) × 0.36 + (34 – 33) × 0.00 + (34 – 33) × 0.36 + (34 – 33) × 0.12 +
(34 – 33) × 0.09 + (34 – 33) × 0.06 + (34 – 33) × 0.01
= 1 unit
TCS = Holding Cost + Stock out Cost
= (B – M) H + SCS E (M>B)/ Q
TCS = (34 - 33) × 1 + 5400 × 2 × 1/ 900
= 1 + 12 = 13.00
8
B = 35 E (M > B) = ( M – 33) p ( M )
2 1

= (35 – 33) × 0.36 + (35 – 33) × 0.12 +

(35 – 33) × 0.09 + (35 – 33) × 0.06 + (35 – 33) × 0.01
= 1.28 units
TCS = (35 – 33) × 1 + 5400 × 2 × 1.28/ 900
= 2 + 15.36 = 17.36
8
B = 36 E (M > B) = ( M – 33) p ( M )
4 1

= (36 – 33) × 0.12 + (36 – 33) × 0.09 + (36 – 33) × 0.06 + (36 – 33) × 0.01
= 1.12 units
TCS = (36 – 33) × 1 + 5400 × 2 × 1.12/ 900
= 4 + 13.44 = 17.44
8
B = 37 E (M > B) = ( M – 33) p ( M )
5 1

= (37 – 33) × 0.09 + (37 – 33) × 0.06 + (37 – 33) × 0.01

= 0.80 units
TCS = (37 – 33) × 1 + 5400 × 2 × 0.80/ 900
= 5 + 9.60 = 14.60
8
B = 38 E (M > B) = ( M – 33) p ( M )
6 1

= (38 – 33) × 0.06 + (38 – 33) × 0.01

= 0.42 units
TCS = (38 – 33) × 1 + 5400 × 2 × 0.42/ 900
= 6 + 5.04 = 11.04
8
B = 39 E (M > B) = ( M – 33) p ( M )
7 1
 = (39 – 33) × 0.01 239
Inventory Control
= 0.07 units
TCS = (39 – 33) × 1 + 5400 × 2 × 0.07/ 900
= 7 + 0.84 = 7.84
Therefore, the lowest cost of reorder point is 39 units with an expected annual cost of
safety stock of 7.84.
In the example that we worked out above and in this section, we have considered the
single period inventory problem when there is a fixed-order or setup cost including the
point at which the marginal revenue of an additional unit of initial inventory just
equals the marginal cost of a unit of inventory.

9.9.3 Fixed-order Interval Approach

Another approach is called the fixed period or fixed review period approach.
In essence, this technique involves ordering inventory at fixed or regular intervals; and
generally the amount ordered depends on how much is in stock and available at the
time of review. Firms customarily count inventory near the interval's end and base
orders on the amount on hand at the time.
The basic difference between the two systems, the ‘fixed order’ and the ‘fixed period’
is that the fixed-order quantity models are “event triggered” and fixed-time period
models are “time triggered.” In other words, at an identified level of the stock the
fixed-order quantity model initiates an order. This event may take place at any time,
depending on the demand for the items considered. In contrast, the fixed-time period
models review the stocks at time intervals that are fixed and orders are placed at the
end of predetermined time periods. In these models, only the passage of time triggers
action.
Table 9.9 makes a comparison of the two systems and brings out the significant
differences.
Table 9.9: Fixed-order Quantity and Fixed-Time Period Differences
Feature Fixed-Order Quantity Model Fixed-Time Period Model
Order quantity The same amount ordered each time Quantity varies each time order is
placed
When to place Reorder point when inventory Reorder when the review period
order position dips to a predetermined level arrives
Record keeping Each time a withdrawal or addition is Counted only at review period.
made
Size of inventory Less than fixed-time period model Larger than fixed-order quantity
model
Time to maintain Higher due to perpetual record
keeping
Type of items Higher-priced, critical, or important
items.

The models that emanate from fixed-order system are for perpetual systems that
require continual monitoring of inventory. Every time a withdrawal from inventory or
an addition to inventory is made, records must be updated.
In comparison with the basic EOQ approach: the fixed interval model does not require
close surveillance of inventory levels; thus, monitoring is less expensive. The fixed-
time models are similar to batch processing systems, counting takes place only at the
review period. The firm can order low-valued items infrequently and in large
240 quantities, checking only infrequently to determine exactly how much is on hand at
Operations Management
any particular time.
In many retail merchandising systems, a fixed-time period system is used. Sales
people make routine visits to customers and take orders for their complete line of
products. Inventory, therefore, is counted only at particular times, such as every week
or every month or when the supplier’s visit is due. Sometimes, this is also resorted to
in order to combine orders to save transportation costs.

Figure 9.14: Fixed-Time Period Model System

The way in which a Fixed-Period Quantity system works, is shown in Figure 9.14.
Fixed-time period models generate order quantities that vary from period to period,
depending on the usage rates. They generally require a higher level of safety stock
than fixed-order quantity systems. They also require continual tracking of inventory
on hand and replenishing stock when the reorder point is reached, while the fixed-
order quantity mode has no review period.
Like the fixed-order quantity approach to inventory management, the fixed-order
interval approach typically combines elements of both the pull and push philosophy.
These differences and the nature of operations tend to influence the choice of the
inventory system that is more appropriate.
The inventory models analyzed represents a small subset of the inventory models.
Other models including infinite horizon models continuous review and periodic
review models are outside the scope of this book.

9.10 INVENTORY CONTROL

Control of inventory, which typically represents 45% to 90% of all expenses for
business, is needed to ensure that the business has the right goods on hand to avoid
stock-outs, to prevent shrinkage (spoilage/theft), and to provide proper accounting.
Many businesses have too much of their limited resource, capital, tied up in their
major asset, inventory. Worse, they may have their capital tied up in the wrong kind of
inventory. Inventory may be old, worn out, shopworn, obsolete, or the wrong sizes or
colors, or there may be an imbalance among different product lines that reduces the
customer appeal of the total operation.
Inventory control involves the procurement, care and disposition of materials. There 241
Inventory Control
are three kinds of inventory that are of concern to managers:
1. Raw materials,
2. In-process or semi-finished goods, and
3. Finished goods.
If a manager effectively controls these three types of inventory, capital can be released
that may be tied up in unnecessary inventory, production control can be improved and
can protect against obsolescence, deterioration and/or theft.

9.10.1 Reasons for Maintaining Inventory

The various reasons of maintaining inventory are:
1. Anticipation Inventory or Seasonal Inventory: Inventory are often built in
anticipation of future demand, planned promotional programs, seasonal demand
fluctuations, plant shutdowns, vacations, etc.
2. Fluctuation Inventory or Safety Stock: Inventory is sometimes carried to protect
against unpredictable or unexpected variations in demand.
3. Lot-Size Inventory or Cycle Stock: Inventory is frequently bought or produced in
excess of what is immediately needed in order to take advantage of lower unit
costs or quantity discounts.
4. Transportation or Pipeline Inventory: Inventory is used to fill the pipeline as
products are in transit in the distribution network.
5. Speculative or Hedge Inventory: Inventory can be carried to protect against some
future event, such as a scarcity in supply, price increase, disruption in supply,
strike, etc.
6. Maintenance, Repair, and Operating (MRO) Inventory: Inventories of some
items (such as maintenance supplies, spare parts, lubricants, cleaning compounds,
and office supplies) are used to support general operations and maintenance.
Three major approaches can be used for inventory control in any type and size of
operation. The actual system selected will depend upon the type of operation, the
amount of goods.

9.10.2 The Eyeball System

This is the standard inventory control system for the vast majority of small retail and
many small manufacturing operations and is very simple in application. The key
manager stands in the middle of the store or manufacturing area and looks around.
If he or she happens to notice that some items are out of stock, they are reordered.
In retailing, the difficulty with the eyeball system is that a particularly good item may
be out of stock for sometime before anyone notices. Throughout the time it is out of
stock, sales are being lost on it. Similarly, in a small manufacturing operation, low
stocks of some particularly critical item may not be noticed until there are none left.
Then production suffers until the supply of that part can be replenished. Such
unsystematic but simple retailers and manufacturers to their inherent disadvantage.

9.10.3 Reserve Stock (or Brown Bag) System

This approach is much more systematic than the eyeball system. It involves keeping a
reserve stock of items aside, often literally in a brown bag placed at the rear of the
stock bin or storage area. When the last unit of open inventory is used, the brown bag
of reserve stock is opened and the new supplies it contains are placed in the bin as
242 open stock. At this time, a reorder is immediately placed. If the reserve stock quantity
Operations Management
has been calculated properly, the new shipment should arrive just as the last of the
reserve stock is being used.
In order to calculate the proper reserve stock quantity, it is necessary to know the rate
of product usage and the order cycle delivery time. Thus, if the rate of product units
sold is 100 units per week and the order cycle delivery time is two weeks, the
appropriate reserve stock would consist of 200 units (100u x 2w). This is fine as long
as the two-week cycle holds. If the order cycle is extended, the reserve stock
quantities must be increased. When the new order arrives, the reserve stock amount is
packaged again and placed at the rear of the storage area.
This is a very simple system to operate and one that is highly effective for virtually
any type of organization. The variations on the reserve stock system merely involve
the management of the reserve stock itself. Larger items may remain in inventory but
be cordoned off in some way to indicate that it is the reserve stock and should trigger a
reorder.

9.10.4 Perpetual Inventory Systems

Various types of perpetual inventory systems include manual, card-oriented, and
computer-operated systems. In computer-operated systems, a programmed instruction
referred to commonly as a trigger, automatically transmits an order to the appropriate
vendor once supplies fall below a prescribed level. The purpose of each of the three
types of perpetual inventory approaches is to tally either the unit use or the dollar use
(or both) of different items and product lines. This information will serve to help avoid
stock-outs and to maintain a constant evaluation of the sales of different product lines
to see where the emphasis should be placed for both selling and buying.

9.10.5 Stock Control

A stock control system should keep you aware of the quantity of each kind of
merchandise on hand. An effective system will provide you with a guide for what,
when, and how much to buy of each style, color, size, price and brand. It will reduce
the number of lost sales resulting from being out of stock of merchandise in popular
demand. The system will also locate slow selling articles and help indicate changes in
customer preferences. The size of your establishment and the number of people
employed are determining factors in devising an effective stock control plan. Can you
keep control by observation? Should you use on-hand/on-order/sold records?
Detachable ticket stubs? Checklists? And/or physical inventory? If so, how often?
With the observation method (the eyeball system), unless the people using it have an
unusually sharp sense of quantity and sales patterns, it is difficult to keep a
satisfactory check on merchandise depletion. It means that you record shortages of
goods or reorders as the need for them occurs to you. Without a better checking
system, orders may only be placed at the time of the salesman's regular visit,
regardless of when they are actually needed. Although it may be the simplest system,
it also can often result in lost sales or production delays. Detachable stubs or tickets
placed on merchandise provide a good means of control. The stubs, containing
information identifying the articles, are removed at the time the items are sold. The
accumulated stubs are then posted regularly to the perpetual inventory system by hand
or through the use of an optical scanner.
A checklist, often provided by wholesalers, is another counting tool. The checklist
provides space to record the items carried, the selling price, cost price, and minimum
quantities to be ordered of each. It also contains a column in which to note whether the
stock on hand is sufficient and when to reorder. This is another very simple device
that provides the level of information required to make knowledgeable decisions about 243
Inventory Control
effective inventory management.
Most smaller operations today, except for the very smallest, are using some form of a
perpetual online system to record the movement of inventories into and out of their
facilities. In a retail operation, the clerk at the register merely scans the ticket with a
reader, and the system shows the current price and removes the item from the
inventory control system. A similar process occurs in a manufacturing operation,
except that the "sale" is actually a transfer of the inventory from control to production.
This is a particularly critical system in a large operation such as a grocery store where
they regularly maintain 12,000 plus items. Often a vendor will provide on-site or
computerized assistance needed to help their smaller customers maintain a good
understanding of their own inventory levels and so keep them in balance.

9.10.6 Inventory Control Records

Inventory control records are essential to making buy-and-sell decisions. Some
companies control their stock by taking physical inventories at regular intervals,
monthly or quarterly. Others use a dollar inventory record that gives a rough idea of
what the inventory may be from day to day in terms of dollars. If your stock is made
up of thousands of items, as it is for a convenience type store, dollar control may be
more practical than physical control. However, even with this method, an inventory
count must be taken periodically to verify the levels of inventory by item.
Perpetual inventory control records are most practical for big-ticket items. With such
items it is quite suitable to hand count the starting inventory, maintain a card for each
item or group of items, and reduce the item count each time a unit is sold or
transferred out of inventory.
Periodic physical counts are taken to verify the accuracy of the inventory card.
Out-of-stock sheets, sometimes called want sheets, notify the buyer that it is time to
reorder an item. Experience with the rate of turnover of an item will help indicate the
level of inventory at which the unit should be reordered to make sure that the new
merchandise arrives before the stock is totally exhausted.
Open-to-buy records help to prevent ordering more than is needed to meet demand or
to stay within a budget. These records adjust your order rate to the sales rate. They
provide a running account of the dollar amount that may be bought without departing
significantly from the pre-established inventory levels. An open-to-buy record is
related to the inventory budget. It is the difference between what has been budgeted
and what has been spent. Each time a sale is made, open-to-buy is increased
(inventory is reduced). Each time merchandise is purchased; open-to-buy is reduced
(inventory is increased). The net effect is to help maintain a balance among product
lies within the business, and to keep the business from getting overloaded in one
particular area.
Purchase order files keep track of what has been ordered and the status or expected
receipt date of materials. It is convenient to maintain these files by using a copy of
each purchase order that is written. Notations can be added or merchandise needs
updated directly on the copy of the purchase order with respect to changes in price or
delivery dates.
Supplier files are valuable references on suppliers and can be very helpful in
negotiating price, delivery and terms. Extra copies of purchase orders can be used to
create these files, organized alphabetically by supplier, and can provide a fast way to
determine how much business is done with each vendor. Purchase order copies also
244 serve to document ordering habits and procedures and so may be used to help reveal
Operations Management
and/or resolve future potential problems.
Returned goods files provide a continuous record of merchandise that has been
returned to suppliers. They should indicate amounts, dates and reasons for the returns.
This information is useful in controlling debits, credits and quality Issues.
Price books, maintained in alphabetical order according to supplier, provide a record
of purchase prices, selling prices, markdowns, and markups. It is important to keep
this record completely up to date in order to be able to access the latest price and profit
information on materials purchased for resale.

9.11 CONTROLLING INVENTORY

Controlling inventory does not have to be an onerous or complex proposition. It is a
process and thoughtful inventory management. There are no hard and fast rules to
abide by, but some extremely useful guidelines to help your thinking about the
subject. A five step process has been designed that will help any business bring this
potential problem under control to think systematically thorough the process and allow
the business to make the most efficient use possible of the resources represented. The
final decisions, of course, must be the result of good judgment, and not the product of
a mechanical set of formulas.

Step 1: Inventory Planning

Inventory control requires inventory planning. Inventory refers to more than the goods
on hand in the retail operation, service business, or manufacturing facility. It also
represents goods that must be in transit for arrival after the goods in the store or plant
are sold or used. An ideal inventory control system would arrange for the arrival of
new goods at the same moment the last item has been sold or used. The economic
order quantity, or base orders, depends upon the amount of cash (or credit) available
to invest in inventories, the number of units that qualify for a quantity discount from
the manufacturer, and the amount of time goods spend in shipment.

Step 2: Establish Order Cycles

If demand can be predicted for the product or if demand can be measured on a regular
basis, regular ordering quantities can be setup that take into consideration the most
economic relationships among the costs of preparing an order, the aggregate shipping
costs, and the economic order cost. When demand is regular, it is possible to program
regular ordering levels so that stock-outs will be avoided and costs will be minimized.
If it is known that every so many weeks or months a certain quantity of goods will be
sold at a steady pace, then replacements should be scheduled to arrive with equal
regularity. Time should be spent developing a system tailored to the needs of each
business. It is useful to focus on items whose costs justify such control, recognizing
that in some cases control efforts may cost more the items worth. At the same time, it
is also necessary to include low return items that are critical to the overall sales effort.
If the business experiences seasonal cycles, it is important to recognize the demands
that will be placed on suppliers as well as other sellers.
A given firm must recognize that if it begins to run out of product in the middle of a
busy season, other sellers are also beginning to run out and are looking for more
goods. The problem is compounded in that the producer may have already switched
over to next season’s production and so is not interested in (or probably even capable
of) filling any further orders for the current selling season. Production resources are
likely to already be allocated to filling orders for the next selling season. Changes in
this momentum would be extremely costly for both the supplier and the customer.
On the other hand, because suppliers have problems with inventory control, just as 245
Inventory Control
sellers do, they may be interested in making deals to induce customers to purchase
inventories off-season, usually at substantial savings. They want to shift the carrying
costs of purchase and storage from the seller to the buyer. Thus, there are seasonal
implications to inventory control as well, both positive and negative. The point is that
these seasonable implications must be built into the planning process in order to
support an effective inventory management system.

Step 3: Balance Inventory Levels

Efficient or inefficient management of merchandise inventory by a firm is a major
factor between healthy profits and operating at a loss. There are both market-related
and budget-related issues that must be dealt with in terms of coming up with an ideal
inventory balance:
Is the inventory correct for the market being served?
Does the inventory have the proper turnover?
What is the ideal inventory for a typical retailer or wholesaler in this business?
To answer the last question first, the ideal inventory is the inventory that does not lose
profitable sales and can still justify the investment in each part of its whole.
An inventory that is not compatible with the firm’s market will lose profitable sales.
Customers who cannot find the items they desire in one store or from one supplier are
forced to go to a competitor. Customer will be especially irritated if the item out of
stock is one they would normally expect to find from such a supplier. Repeated
experiences of this type will motivate customers to become regular customers of
competitors.

Step 4: Review Stocks

Items sitting on the shelf as obsolete inventory are simply dead capital. Keeping
inventory up to date and devoid of obsolete merchandise is another critical aspect of
good inventory control. This is particularly important with style merchandise, but it is
important with any merchandise that is turning at a lower rate than the average stock
turns for that particular business. One of the important principles newer sellers
frequently find difficult is the need to mark down merchandise that is not moving
well.
Markups are usually highest when a new style first comes out. As the style fades,
efficient sellers gradually begin to mark it down to avoid being stuck with large
inventories, thus keeping inventory capital working. They will begin to mark down
their inventory, take less gross margin, and return the funds to working capital rather
than have their investment stand on the shelves as obsolete merchandise. Markdowns
are an important part of the working capital cycle. Even though the margins on
markdown sales are lower, turning these items into cash allows you to purchase other,
more current goods, where you can make the margin you desire.
Keeping an inventory fresh and up to date requires constant attention by any
organization, large or small. Style merchandise should be disposed of before the style
fades. Fad merchandise must have its inventory levels kept in line with the passing
fancy. Obsolete merchandise usually must be sold at less than normal markup or even
as loss leaders where it is priced more competitively. Loss leader pricing strategies
can also serve to attract more' consumer traffic for the business thus creating
opportunities to sell other merchandise as well as well as the obsolete items.
Technologically obsolete merchandise should normally be removed from inventory at
any cost.
246 Stock turnover is really the way businesses make money. It is not so much the profit
Operations Management
per unit of sale that makes money for the business, but sales on a regular basis over
time that eventually results in profitability. The stock turnover rate is the rate at which
the average inventory is replaced or turned over, throughout a pre-defined standard
operating period, typically one year. It is generally seen as the multiple that sales
represent of the average inventory for a given period of time.
Turnover averages are available for virtually any industry or business maintaining
inventories and having sales. These figures act as an efficient and effective benchmark
with which to compare the business in question, in order to determine its effectiveness
relative to its capital investment. Too frequent inventory turns can be as great a
potential problem as too few. Too frequent inventory turns may indicate the business
is trying to overwork a limited capital base, and may carry with it the attendant costs
of stock-outs and unhappy and lost customers.
Stock turns or turnover, is the number of times the "average" inventory of a given
product is sold annually. It is an important concept because it helps to determine what
the inventory level should be to achieve or support the sales levels predicted or
desired. Inventory turnover is computed by dividing the volume of goods sold by the
average inventory. Stock turns or inventory turnover can be calculated by the
following equations:
Cost of Goods Sold
Stock Turn =
Average Inventory at Cost
Or
Sales
=
Average Inventory at Sales Value
If the inventory is recorded at cost, stock turn equals cost of goods sold divided by the
average inventory. If the inventory is recorded at sales value, stock turn is equal to
sales divided by average inventory. Stock turns four times a year on the average for
many businesses. Jewelry stores are slow, with two turns a year, and grocery stores
may go up to 45 turns a year.
If the dollar value of a particular inventory compares favorably with the industry
average, but the turnover of the inventory is less than the industry average, a further
analysis of that inventory is needed. Is it too heavy in some areas? Are there reasons
that suggest more inventories are needed in certain categories? Are there conditions
peculiar to that particular firm? The point is that all markets are not uniform and
circumstances may be found that will justify a variation from average figures.
In the accumulation of comparative data for any particular type of firm, a wide
variation will be found for most significant statistical comparisons. Averages are just
that, and often most firms in the group are somewhat different from that result.
Nevertheless, they serve as very useful guides for the adequacy of industry turnover,
and for other ratios as well. The important thing for each firm is to know how the firm
compares with the averages and to determine whether deviations from the averages
are to its benefit or disadvantage.

Step 5: Follow-up and Control

Periodic reviews of the inventory to detect slow-moving or obsolete stock and to
identify fast sellers are essential for proper inventory management. Taking regular and
periodic inventories must be more than just totaling the costs. Any clerk can do the
work of recording an inventory. However, it is the responsibility of key management
to study the figures and review the items themselves in order to make correct
decisions about the disposal, replacement, or discontinuance of different segments of 247
Inventory Control
the inventory base.
Just as an airline cannot make money with its airplanes on the ground, a firm cannot
earn a profit in the absence of sales of goods. Keeping the inventory attractive to
customers is a prime prerequisite for healthy sales. Again, the seller's inventory is
usually his largest investment. It will earn profits in direct proportion to the effort and
skill applied in its management.
Inventory quantities must be organized and measured carefully. Minimum stocks must
be assured to prevent stock-outs or the lack of product. At the same time, they must be
balanced against excessive inventory because of carrying costs. In larger retail
organizations and in many manufacturing operations, purchasing has evolved as a
distinct new and separate phase of management to achieve the dual objective of higher
turnover and lower investment. If this type of strategy is to be utilized, however,
extremely careful attention and constant review must be built into the management
system in order to avoid getting caught short by unexpected changes in the larger
business environment.

9.12 JUST-IN-TIME
‘Just-in-Time’ (JIT) is a term that has often been used interchangeably with Lean
Manufacturing. Some say it is a predecessor to Lean Manufacturing, but in any case, it
is an essential part of lean manufacturing.
JIT is a management philosophy that strives to eliminate sources of manufacturing
waste by producing the right part in the right place at the right time. Waste results
from any activity that adds cost without adding value such as moving and storage. JIT
improves profits and return on investment by reducing inventory levels, reducing
variability, improving product quality and reducing production and delivery lead
times. In a JIT system, underutilized (excess) capacity is used instead of buffer
inventories to hedge against problems that may arise.
Just-in-time is a movement and idea that has gained wide acceptance over the past
decade. As companies became more and more competitive and the pressures from
Japan's continuous improvement culture mounted, other firms were forced to find
innovative ways to cut costs and compete. The notion of pushing materials in large
quantities no longer made sense. Both the financial costs and the required resources of
doing so are counter productive in the long run. It is wiser to deliver materials only
just before they are needed and only in the quantity required.
A firm cannot implement a JIT system by itself; it must have the complete cooperation
of its entire Supply Chain. A large amount of information is needed for a JIT system
to operate well. It demands partnerships to be formed and nurtured, almost to the point
at which an entire supply chain operates as one firm. Examples of these kinds of
partnerships are everywhere in today’s business world.

9.13 KANBAN
Kanban is a Japanese word meaning flag or signal and is a visual aid to convey the
message that action is required. The Kanban inventory control system was an integral
part of TPS and some aspects of the Kanban have been discussed in the 'pull concept'.
JIT uses a Kanban system. It works on the basis that each process on a production line
pulls just the number and type of components the process requires, at just the right
time. Kanban is usually a physical card but other devices can be used. A Kanban is a
card that is attached to a storage and transport container. It identifies the part number
248 and container capacity along with other information. There are two common types of
Operations Management
Kanban systems used; the one-card system and the two-card system.

9.13.1 The Two-card System

The two-card system is the more popularly used Kanban system. It uses two kinds of
Kanban cards:
1. Conveyance Kanban (C-Kanban), signals the need to deliver more parts to the
next work center. It specifies the kind and quantity of product which a
manufacturing process should withdraw from a preceding process. The C-Kanban
in Figure 9.15 shows that the preceding process which makes this part is forging,
and the person carrying this Kanban from the subsequent process must go to
position B-2 of the forging department to withdraw drive pinions. Each box of
drive pinions contains 20 units and the shape of the box is ‘B’. This Kanban is the
4th of 8 issued. The item back number is an abbreviation of the item.
2. Production Kanban (P-Kanban), signals the need to produce more parts.
It specifies the kind and quantity of product which the preceding process must
produce. The P-Kanban on the right in Figure 9.15 shows that the machining
process SB-8 must produce the crankshaft for the car type SX50BC-150. The
crankshaft produced should be placed at store F26-18. The production-ordering
Kanban is often called an in-process Kanban or simply a production Kanban.

Figure 9.15: C-Kanban and P-Kanban

Each process (area, cell) on the production line has two Kanban ‘post-boxes’, one for
C-Kanbans and one for P-Kanbans. At regular intervals a worker takes C-Kanbans
that have accumulated in his process post-box, and any empty pallets, to the location
where finished parts (components, assemblies) from the preceding process are stored.
Each full pallet has attached to it one or more P-Kanbans which he removes and puts
in the appropriate post-box belonging to the process that produced the parts. The
worker now attaches a P-Kanban to the pallet and takes it back to his own process
area. When this new pallet begins being used it’s C-Kanban is put back into the
post-box. At each process on the line P-Kanbans are periodically removed from their
post-box and used to define what parts and quantities to produce next. There are three
rules that must be followed:
1. No parts to be made unless P-Kanban authorizes production
2. Exactly one P-Kanban and one C-Kanban for each container
3. Only standard containers are used and they are always filled with the prescribed
quantity.
The number of kanban card sets required in a particular location can be calculated as:
K = (Expected demand during lead time + Safety stock)/(Size of the container)
If rounding is necessary, K must be rounded up to the next highest integer.
Lean Manufacturing strives to maximize long-term profitability and growth. Kanbans 249
Inventory Control
help simplify planning and to fine-tune production to meet changing customer demand
of up to ± 10%. The system requires planned monthly and weekly production
schedules. Kanbans simplify day-to-day flexibility, hence changes to the production
schedule only need to be given to the final assembly process and then automatically
work their way back up the line.
Kanban systems can be tightened by removing cards or by reducing the number of
parts on a pallet. The effect will be to speed the flow through the process and hence
reduce lead times. However, it also makes the system more vulnerable to breakdowns
and other causes of dislocation. By identifying the areas within the line that are
causing disruption, efforts can be made to improve them. Thus, the overall efficiency
of the line is raised by tackling the key points.
A Kanban system is a pull system, in which the Kanban is used to pull parts to the
next production stage when they are needed; an MRP system (or any schedule based
system) is a push system, in which a detailed production schedule for each part is used
to push parts to the next production stage when scheduled. The weakness of a push
system (MRP) is that customer demand must be forecast and production lead times
must be estimated accurately. The weakness of a pull system (Kanban) is that
following the Lean Manufacturing philosophy is essential, especially concerning the
elements of short setup times and small lot sizes.
Single Card Kanban Systems: In a single-card Kanban system, parts are produced and
bought according to a daily schedule and deliveries to the user are controlled by a
C-Kanban. In effect, the single-card system is a push system for production coupled
with a pull system for delivery to the point of use.
Single-card Kanban controls deliveries very tightly so that the using work center never
has more than a container or two of parts and the stock points serving the work center
are eliminated. Single-card systems work well in companies in which it is relatively
easy to associate the required quantity and timing of component parts with the
schedule of end products. These are usually companies with a relatively small range of
end products or products which are not subject to rapid, unexpected changes in
demand levels.

9.13.2 Attributes of JIT

Just-in-time has been discussed as a way to control flows of material through
sequential processes, with particular emphasis on the pacing by downstream processes
of the production and delivery work done by upstream processes. While this and
associated issues of inventory control are important aspects of JIT as used in practice,
this emphasis misses attributes of JIT that contribute to problem solving, process
improvement and the operations-based sustainable competitive advantage often
associated with Toyota and its affiliates. These attributes are explained through a real
life example.
The Aisin JIT System is shown in Figure 9.16 Aisin is a first-tier, auto-parts supplier
to Toyota. It also manufactures consumer products such as mattresses, sewing
machines and computerized bathroom scales.
250
Operations Management

Figure 9.16: Aisin JIT System

Customer orders (item 1) determine production mix, volume and delivery timing for
the plant. Production control creates printed manifests establishing the production
mix, volume, and sequence with one manifest for every mattress and sends the
individual manifest to the start of the quilting line (item 2). It also sends one that
corresponds to the same mattress to the start of the framing line (item 3).
For every mattress for which a manifest-set was sent to the start of quilting and
framing, a separate signal was sent to the end of the assembly line (item 4), indicating
that the next mattress was to be taken to shipping.
This signal continued through the system and established for each worker when to
produce and deliver one more unit and thereby determined each person's correct
production pace.
Stores, which separated process-stages in the plant, were located between quilting and
assembly (item 5) and framing and assembly (item 6). These stores were the only way
to transfer units between the feeder and the assembly lines. They operated on a
first-in, first-out basis. Therefore, the stores protected the unambiguous production
mix and sequence established at the start of quilting and framing. Stores also protected
the production rate across process-stages because of their capacity limitations.
As materials were depleted, individual 'Kanban' cards were sent to the person who
ordered material thereby automatically authorizing delivery of small batches of
replacement supplies. Kanban cards were the only way of reordering certain materials
and were used every time a specific customer had to reorder material of a particular
type. They went to a specific supplier and established the criteria for a good response
(i.e., the card for fabric-1 was different than that for fabric-2 and indicated a
pre-agreed quantity, such as 20 meters worth of cloth). The person who received the
individual Kanban cards reordered materials by sending a shipment worth of Kanban
cards to the external supplier, on an established schedule. By extending the rate and
sequence with which customer orders were filled from within the Aisin plant to
external suppliers as well, the entire system was linked to the mass customization
effort.
The plant transitioned from mass production to mass customization in 1986. The
impact of using JIT in spite of continued increases in volume and variety is shown in
Table 9.10. One can see the increases in productivity and simultaneous reductions in 251
Inventory Control
lead-time and inventory.
Table 9.10: Aisin Mattress Production: Historical Mix, Volume and Inventory

This transition was achieved despite challenges characteristic of making complex

items more general such as multiple process stages, imbalanced and variable process
times, product variety and fluctuations in the mix, volume, and timing of demand.
Thus, rather than facing static trade-offs along a fixed 'production possibilities frontier'
the plant repeatedly improved its manufacturing process and continued to achieve
much better frontiers.
Manifests traveled with mattresses at each step. The information on each manifest
established fully the criteria of what each worker had to do to achieve a good
outcome. Linking individual, customer orders to the end of production initiated a pull
that extended upstream to external suppliers. Each batch of Kanban cards also had an
unambiguous meaning. A batch of cards was the only way to specify the mix and
volume of the next shipment and was sent for every order.
The example shows the JIT system at work. The process established the production
rhythm for the entire plant by structuring information unambiguously between
external customers and the plant, within the assembly line, between assembly and its
feeder process-stages and between the feeder processes and their external suppliers.
Check Your Progress 3
The basic difference between the two inventory ordering systems is:
1. The fixed-order quantity models are “time triggered”, and
2. Fixed-time period models are “event triggered”.
Which of these statements are false?

9.14 LET US SUM UP

The term inventory means any stock of direct or indirect material (raw materials or
finished items or both) stocked in order to meet the expected and unexpected demand
in the future. Formulating inventory policy requires understanding the inventory’s role
in the firm. Though inventory is an idle resource and adds to the risk of the firm, it is
almost essential to keep some inventory in order to promote smooth and efficient
running of business.
The different types of inventories have different risks depending upon the firm’s
position in the distribution channel. If an individual enterprise plans to operate at more
than one level of the distribution channel, it must be prepared to assume additional
inventory risk. In light of all quality, customer service and economic factors—from
the viewpoints of purchasing, manufacturing, sales and finance—effective inventory
management is essential to organizational competitiveness.
The heart of inventory decisions lies in the identification of inventory costs and
optimizing the costs relative to the operations of the organization: When items should
252 be ordered, how large the order should be, and “when” and “how many to deliver.”
Operations Management
The following costs are generally associated with inventories: Holding (or carrying)
costs, Cost of ordering, Setup (or production change) costs, and Shortage or Stock-out
Costs.
Many selective inventory management techniques are used. The most common is the
ABC Classification. The ABC classification is based on focusing efforts where the
payoff is highest; i.e. high-value, high-usage items are tracked carefully and
continuously, while the level of control for other items tapers off. Other similar types
of classifications are the XYZ Classification, VED Classification, and the HML
classification of inventory. All these techniques are used to focus management
attention in deciding on the degree of control necessary for different items in the
inventory.

9.15 LESSON END ACTIVITY

‘Shortages are undesirable, but some organizations create shortages intentionally’.
How is this justified from an economic point of view? Derive an expression for total
cost in the inventory model for intentional shortages.

9.16 KEYWORDS
ABC Classification, or the alphabetical approach, is based on the annual consumption
value based on the 80:20 principle, efforts are focused where the payoff is highest.
Anticipation Stock: Stock kept at hand to meet seasonal fluctuations in demand or to
meet the shortfall caused by erratic production. Also called build stock or seasonal
stock.
Cost of Ordering: The cost to replenish inventory.
Decoupling Stock: A buffer stock used between productions processes to make one
process independent of the other.
Economic Order Quantity (EOQ): Models determine order size by minimizing the
cost of ordering and the cost of holding inventory.
Fixed-order Quantity Models: At an identified level of the stock the fixed-order
quantity model initiates an order; they are “event triggered”.
Fixed-time Period Models are “time triggered” i.e. the model initiates an order after a
fixed-time.
Holding (or Carrying) Costs: The cost to hold inventory. This category includes the
costs for storage facilities, handling, insurance, pilferage, breakage, obsolescence,
depreciation, taxes, and the opportunity cost of capital.

9.17 QUESTIONS FOR DISCUSSION

1. What is economic order quantity (EOQ)? Explain the EOQ model of inventory
with its simplifying assumptions. How is the model of inventory used by a
manufacturer different from a retailer?
2. Inventory control system may need to be modified as demand, costs, and
competitive pressures changes. What are the parameters that should be reviewed
for the fixed reorder quantity and periodic reorder systems?
3. What is the cost of uncertainty in demand during lead time?
4. Nuvyug Industries Ltd. has an annual requirement of 5,000 pieces of brake 253
Inventory Control
cylinders for its popular brand of golf carts. Each brake cylinder has a carrying
cost of `25 per unit per year. The Ordering Cost per order is ` 800. Calculate the
total inventory cost for the following values of number of orders: 5, 10, 20, and
25. Plot the various costs with respect to these orders on a graph and use it to find
the EOQ.

Check Your Progress: Model Answers

CYP 1
1. True
2. True

CYP 2
1. True
2. True
3. True
4. True

CYP 3
1. False
2. False

9.18 SUGGESTED READINGS

Chopra and Meindl, Supply Chain Management – Strategy, Planning, and Operation,
Prentice, Hall of India, 2006.
Gattorna, J., Gower, Handbook of Supply Chain Management, 2003.
Mentzer (ed.), Supply Chain Management, Response Books, 2001.
Wisner, Leong and Tan, Principles of Supply Chain Management – A Balanced
Approach, Thomson South-Western, 2005.
Lee, Heu L., and Corey Billington, “Managing Supply Chain Inventory,” Sloan
Management Review (Spring 1992), pp. 65-73.
Solver, Edword A., David Pyke, and Rein Peterson, Inventory Management and
Production Planning and Scheduling, Wiley, New York, 1998.
30
Micro-Finance:
Perspectives and Operations