INVENTORY MANAGEMENT

AND CONTROL
• Materials are the raw materials, components, subassemblies, and supplies
used to produce products and services. The following facts reveal the
importance of materials management and hence the need of inventory
management and control.
• Cost involved in materials can account for 50-75% of product cost.
• A survey conducted by ‘Directorate of Industrial Statistics’ (of 29 major industries in
India) shows that on average, material cost is 64% of the sales value. The remaining 36%
is taken up by wages, salaries, overheads, profits, and other miscellaneous costs. A
significant portion of miscellaneous costs comprises of inventory carrying and storage
costs. These include interest charges on the inventory and also physical deterioration and
obsolescence of stored material, handling etc. The inventory carrying costs are roughly
about 20% of the material cost i.e. 20% of (64% of sales revenue) = 13% of sales revenue.
Thus 77% of the sales revenue is only material cost and other associated costs. This
hugely significant figure is enough to establish the importance of materials management
and thus inventory management and control.
• Manufacturing organizations, in the past, have tried to increase their profits by
making savings in wages/salaries. The point to be understood is that wages and
salaries constitute only, on average, 15-20% of the sales revenue. Moreover
trying to reduce them creates labour problems. The better option is savings in
materials cost which constitute major share of sales revenue. The potential of
savings is more with this option and further it does not cause any labour
problems. It involves issues like correct purchasing procedures, warehousing,
distribution, inventory control and management etc.
• Let us explain these two options with the help of an example:
Consider an organization with annual turnover : Rs. 10 crores
Material Cost : Rs. 6 crores
Profits : Rs. 1 crores
Salaries, Wages, Overheads : Rs. 3 crores
• Management wishes to increase profits to say, ₹ 1.3 crores.
Option–1: The manufacturing organization can increase the sales turnover
by 30% so that profits get increased by ₹ 0.3 crores (i.e. becomes ₹ 1.3 Cr)
Option–2: The organization can decrease the materials cost by just 5%. This
5% decrease in materials cost would be
= 5% of (Material Cost)
= 5% of 6 crore
= 0.3 crore
• It can be seen that the result of efforts in reducing material cost by just 5%
is equivalent to result of efforts of increasing sales by 30%. Further,
increase in sales call for a lot of additional activities like time and expenses
on additional production, more pressure on the workers to produce at an
accelerated pace, marketing and advertising expenditures etc. Thus the
materials management option is better.
• Materials Management is a function of operations
management which aims for integrated approach
towards the management of materials in an industrial
undertaking. Its main object is cost reduction and
efficient handling of materials at all stages and in all
sections of the undertaking. Materials Management
function includes several important aspects associated
with materials such as purchasing, storage, inventory
control, materials handling etc.
Objectives of Materials Management
The main objective of materials management is to reduce the cost of production so
as to increase the profits. These main issues are as follows:
• To reduce the material costs using scientific methods. Materials department can
reduce the overall materials cost through an efficient system of buying. Low
prices and low possession costs are the main objectives.
• To ensure uniform flow of materials required for production.
• To ensure right quality, right quality of materials at the right place and time.
• To establish and maintain good relations with supplies.
• To efficiently manage and control the inventories so that working capital is
released for productive purposes.
• Economy in using the imported items and to find better substitutes.
Functions of Materials Management
1. Materials Planning: The success of materials management in
an organization depends most importantly on materials
requirement planning and its timely provisioning. This includes
setting up of consumption standards i.e. planning for materials
requirements as per master production schedules. Also
information is collected on all relevant factors like make-buy
decisions, laying down the standards and specifications of raw
materials to be procured, identifying the sources of supply,
checking availability of stock, import substitution etc. To
determine the economic order quantity or the economic run
length is also a part of this function.
Functions of Materials Management
2. Purchasing: The purchasing process involves the acquisition
of items in exchange for funds. There are different methods of
purchasing an item depending upon its type, volume to be
purchased, cost of item etc. On this basis, items are classified
into three main categories:
(i) High Volume Items
(ii) Normal Items
(iii) Low Value Items

These have been discussed as follows:

Functions of Materials Management - Purchasing
(i) High Volume Items:
These items are used continuously and in large volumes
in the organization. For these items, the organization can
have a fixed supplier, who has agreed for a firm price for
a large number of items and has promised to deliver
them as per schedule sought by the buyer. The buyer
company issues what is called a Blanket Purchase Order
to the supplier e.g. a blanket purchase order would
enable a producer of bicycles to ensure an annual supply
of 12,000 sprockets at a quantity discount price. The
buyer would release order as needed to meet the
production schedule during the year.
Functions of Materials Management - Purchasing
(ii) Normal Items: These are items for which a number of suppliers are
available and it is not easy to select the supplier. A number of factors
have to be considered before the supplier can be selected. The factors
include price of the item, features offered in the item, ease of use, level of
technology, range and capacity of the item, ease of maintenance, delivery
reliability of the supplier, octroi terms and other conditions of payment
etc.
To select the supplier, the buyer advertises (issues) a request for
quotation (RFQ) containing details of specifications, volume required,
terms of payment etc. Different vendors (suppliers) respond to the RFQ
through their bids which provides the detail of specifications of item,
details of price, delivery schedule, payment terms etc. On receiving the
bids from different suppliers, the buyer organization evaluates vendor
offers through a comparative statement. The buyer releases a Purchase
Order (P.O) to the selected vendor.
Functions of Materials Management - Purchasing
• Low Value Items: These are items whose cost is very low. The order for such items
is not processed at the central level because the low cost of these items does not
justify that. So individual departments can obtain supplies of these items from
local suppliers without involving the purchase department. These items are
purchased through an Open Purchase Order (OPO). Examples include stationary
items etc.
The functions of the purchasing are discussed as follows:
• Market research for purchasing i.e. locating and developing sources of supply.
• Requesting for quotations, preparing comparative statements etc.
• Selection of suppliers
• Negotiating for prices and quantity.
• Entering into a rate contract.
• Issuing purchase order along with specifications.
• Providing delivery schedules, other terms and conditions.
• Follow-up of orders.
• Inspection of the purchased material.
• Payment of bills.
• Supplier’s performance evaluation.
• Preparing Materials Budget (Purchase Budget).
Functions of Materials Management
• Store Keeping: Store keeping involves the receipt, custody, and issue of
materials.
Materials are received at stores against purchase orders placed by the purchase
section. After being received, they are inspected for quality as per the
specifications and also for physical deterioration. These are now kept in stores in
a manner that they require minimum material handling and remain well
protected against any damage or loss. Materials are issued to different
departments against authorized indents/store issue vouchers. Proper record is
maintained for receipt and issue of materials. Store keeping also involves the
function of physical verification, salvage, and disposal for surplus
material/rework/scrap. This is also an important function of materials
management. Holding surplus items, scrap, or obsolete items is a costly affair
because it includes inventory carrying costs, cost of periodic stock taking, cost of
maintaining records, cost of security etc.
Functions of Materials Management
• Inventory Control: Inventory control involves the systematic location,
storage and recording of items and goods in such a manner that
desired degree of service can be made to the operating shops at
minimum ultimate cost. Inventory control has following functions to
perform:
• To ensure timely availability of materials and to avoid build up stock.
• To protect the inventories against physical deterioration, loss, leakage etc.
• To develop policies, plans and standards essential to achieve inventory control
objectives.
• To determine the economic order quantities (EOQ) and economic run lengths
(ERL).
• Material Economics: The function of materials management also
includes Value Analysis, Standardization (variety reduction).
NEED OF INVENTORY
• Inventory may be defined as any resource (raw material, fuels and lubricants,
components, spare parts, tools, maintenance consumables, semi-finished
products, finished products) that has a certain value and can be used at a later
time, when the demand for it arises.
• Inventory can also be defined as physical stock of items that a business or
production enterprise keeps on hand for efficient running of affairs or its
production.
• In simple words inventories refer to the stocks held by the firm. Inventory is
defined as the sum of the value of resources stocked at any point of time for the
smooth running of the plant.
• As inventory, the resources are idle. So inventory can be defined as an idle
resource of any kind that has an economic value and awaits future use or sale.
Inventories are created when the receipt of an item is more than its
disbursement. Inventory of an item is depleted when disbursement exceeds
receipt.
 NEED OF INVENTORY
The importance or the purpose of inventories has been describes as follows:

1. Economic Lot Inventories: All industrial units purchase some resources from an outside source.
Every time an order is placed for stock replenishment, there are certain costs involved called ‘Ordering
Cost’.
Ordering cost includes paper work cost, cost involved in dispatching, follow up costs to ensure timely
supply, costs involved in receiving the order is checking, inspection etc., installation costs charged by the
supplier etc.
If a manufacturing unit places order for only small quantities which satisfy just its current requirements,
time and again it will have to place orders and bear ordering costs each time, thereby making the affair
highly uneconomical.
Here the role of inventory comes into picture. The purchaser orders quantities beyond the immediate
needs and keeps excess of them as inventories. Fixed cost of ordering gets divided amongst a large
number of units. Also the supplier gains when he supplies in larger quantities and a portion of this gain
can be passed to the purchaser in the form of discounts.

When inventories are carried for the above mentioned purpose, they are called Economic Lot
Inventories.
Need of Inventory
2. Production Inventories: A major reason to maintain inventories is to keep
the production operations going without interruption due to shortages of
components, raw materials etc. When inventories are kept with this purpose
in mind, they are termed as Production Inventories. There are some other
items like supplies (oils, fuels, lubricants etc.), spare parts etc. that are
consumed in the production process but not form a part of the product.
These are also kept in excess to run operations smoothly. These production
inventories are specifically termed as MRO Inventories (Maintenance,
Repair, Operations).

3. Fluctuation/ Stabilizing Inventories: It is not always possible to match

the timing of production and sales. Inventories are collected because of this
time lag. Generally, demands are not accurately forecasted, so some reserve
stocks are necessary to avoid stock-outs or lost sales. Such inventories are
called Fluctuation or stabilizing Inventories.
Need of Inventory
4. Anticipation Inventories: These inventories are required for the following
purposes:
• To meet seasonal demands. The items are produced and stocked throughout the year to
meet high demands during the season.
• To meet high demands during periods of promotion programmes launched by the firm.
• To meet the demand of periods during temporary shut down. Manufacturing
organizations generally shut down production for some period during the year for
maintenance/repair/installing new facilities etc. The demand of this period is fulfilled
through stocked inventories.
• When inventories are kept with the above purposes in mind, they are termed as
Anticipation Inventories.
INVENTORY COSTS AND ORDER QUANTITIES
• The major costs associated with procuring and holding inventories are as follows:
(i) Ordering/Set-up Costs: If an item is to be purchased from an outside supplier, an order has
to be placed. Each order has a fixed cost associated with it called, the Ordering Cost. It
includes paper work cost, cost involved in dispatching, follow-up cost to ensure timely
supply, cost involved in receiving the order which includes checking, inspection etc. If the
item is produced in-house, the term ordering cost is replaced by Set-up Cost. This involves
the cost of changing the machine set-up, fixtures etc.

(i) Holding Costs/Carrying Costs: Holding Cost or Carrying Cost is the cost incurred by a
manufacturing organization because of the items and products kept on-hand in inventory.
Holding cost is a variable cost and it depends on the number of units contained in the
inventory and it changes with it. Holding cost comprises of the following expenses:
a) Interest or opportunity cost
b) Storage and handling cost
c) Insurance and shrinkage cost
a)Interest or Opportunity Costs: Inventories are idle resource but have
an economic value. To keep items in inventory, requires capital.
Manufacturing organizations either obtain loan on interest to carry
inventories or pays cash to carry inventories. In either case, the capital gets
blocked in this idle resource (inventories) which otherwise could have been
used for more productive purposes.

b)Storage and Handling Costs: Inventories take up storage space and

have to be handled in and out of the storage area. If the organization, rents
the storage space, it pays for it and so costs are involved. Even if the
organization has its own storage area, there is an opportunity cost as the
space could have been utilized for a more productive purpose.
a)Insurance and Shrinkage Costs: More inventories mean more
Insurance and Shrinkage Costs. Shrinkage involves pilferage or theft,
obsolescence, deterioration etc. Pilferage or theft of inventories by
employees/customers can be significant in some businesses. Deterioration
through physical spoilage/damage results in lost value. Obsolescence
occurs when inventory can’t be sold at full value because of model
changes, unexpectedly low demand, engineering modifications.
Obsolescence is a big expense in retail clothing, where at the end of the
season, heavy discounts are given.

• The annual cost of maintaining one item in inventory

typically ranges from 20-40% of the item’s value.
ECONOMIC ORDER QUANTITY
• Managers have conflicting pressures to keep inventories:
(i) Keep low amount of inventory to avoid excess inventory
carrying costs.
ii) Keep high amount of inventory to avoid excess ordering/set-
up costs.
• A good starting point to balance these conflicting pressures
and determine the best inventory level for an item is to
determine its Economic Order Quantity (EOQ). Economic
Order Quantity represents the lot size for an item which
minimizes the total cost (ordering and holding) involved in its
inventory.
ECONOMIC ORDER QUANTITY
The expression for EOQ is determined based on the following assumptions:
• Demand rate for the item is constant and is known with certainty. Also the lead time
is known and is constant.
• There are no constraints on the size of each lot e.g. there are no restrictions like
truckload capacity, material handling limitations etc.
• There are two main costs comprising total inventory costs: Holding Costs and Ordering
Costs.
• Decision regarding order quantity for one item is made independently of decisions of
other items (no advantage is gained by combining several different orders going to the
same supplier).
• Amount received is exactly what was ordered and it arrives all as a whole rather than
piece meal.
• Purchase costs do not vary with quantity ordered i.e. no discount in price of item if
large quantities of item are purchased.
• Replenishment is instantaneous at the expiration of lead time.
Determining the EOQ
• If the EOQ assumptions are followed, inventory behaves as shown below:
Determination of EOQ
The following points can be noted from the above figure:
• The cycle begins with Q units of item held in inventory, which happens when a
new lot is received.
• During the cycle, inventory is consumed at a constant rate.
• Because demand is known precisely and lead time is constant, a new lot can be
ordered so that inventory falls to 0 exactly when the new lot is received.
• Because inventory varies uniformly from Q to 0, average inventory equals (Q +
0)/2 = Q/2 throughout.
• Total Cost (annual) involved in inventory (TC) is calculated as follows:
• Total Cost = Annual Holding Cost + Annual Ordering Cost ------- (i)

• Annual Holding Cost = (Holding Cost per unit)*(Average number of units

held in inventory)
= H * Q/2 ------- (ii)
• Annual Ordering Cost = (Ordering Cost/lot) * (number of orders placed
annually)
= S * D/Q ------- (iii)

Q D
T .C.  H .  S .
2 Q
 Let us now determine the number of units in a lot (order quantity, ‘Q’) corresponding to which total cost (T.C) in inventory is minimum.

Q D
T.C.  H.  S.
2 Q
Value of Q corresponding to which total cost (T.C) is minimum can be obtained as follows:

d(TC ) 1  1 
 0  H.    2 SD  0
dQ 2  Q 

H 1
  2 .SD
2 Q

2SD
Q
H

2SD
EOQ 
H
• The above term is referred to as Economic Order Quantity
(EOQ) or Economic Lot Size (ELS). It is the lot size which
satisfies the total demand at the lowest total cost. It can be
noted that purchase price of the item is an important
component of total cost, but it does not affect the EOQ. As
long as the purchase price does not vary with the quantity
ordered, it should not directly effect the decision as to
what is the most economical lot size.
• Number of Orders per year: D/EOQ
ECONOMIC RUN LENGTH
• When an item is purchased from outside, an ordering cost per order
is associated with the inventory of the item. For such items, an
economic lot size is calculated called EOQ. EOQ tends to minimize the
total cost involved in inventory. EOQ is based on the assumption that
supply of the item is instantaneous. The supply begins and ends at
one instant and there is no consumption during the supply period.
After the supply is received, the item is consumed at some constant
demand rate. As the inventory of the item becomes zero, at that
instant itself, fresh supply is received and a new cycle begins. This
situation (Instantaneous Supply) is depicted in Figure.
Instantaneous Supply in EOQ Model
• When a manufacturing organization produces an item in-house rather than
purchasing it, ordering cost is replaced by set-up cost and the term,
Economic Order Quantity (EOQ) is replaced by the term Economic Run
Length (ERL). Economic Run Length (ERL) of an item refers to the lot size of
that particular item that should be manufactured with one set-up before
switching over to the lot of some other item.
• When the manufacturing firm is producing the item in-house, it is following
some specific production rate. As a result, the item is not being received at
one instant (as is the case with a purchased item ordered to an outside
supplier) but over a period of time governed by the production rate (p).
This is a case of non-instantaneous supply and is depicted in Figure.
Non-Instantaneous Supply in ERL Model
• The expression for ERL is determined based on the following
assumptions:
• The production rate (p) of an item is always greater than its demand rate (d).
• The main characteristic of non-instantaneous supply is that as the item is being
produced, a portion of it is being concurrently used or sold. This means, all the items
being produced do not go into the inventory and thus reduce the inventory carrying
costs.
• While calculating the economic run length (ERL), the expression for ordering cost
remains the same (as was in the expression for EOQ) but here this cost is replaced
by set-up cost. The expression for holding cost changes, because a proportion of
the production is consumed and does not go into inventory.
• Suppose, d = demand rate of the item (units/day)
• p = production rate of the item (units/day)
• d/p = proportion of production allocated to daily demand
• 1-d/p = proportion of production that goes into inventory
• So the inventory carrying cost is not equal to ‘H’ (as in EOQ) but will be lesser and
equal to ‘H (1- d/p)’. If this decreased carrying cost of this reduced level of
inventory is taken into account, the expression for Economic Run Length (ERL) in
number of units to be produced per production set-up is given as follows: