Inventory Management What Is Inventory

INVENTORY MANAGEMENT
WHAT IS INVENTORY
Inventories are materials and supplies that an organisation carry for

sales or to provide inputs to the production process.
Inventories are the idle materials and goods that are held by the
organisation for use sometimes in future.
these materials are assets of the organisation. In balance sheet
inventory is reflected in the asset side of the statement.
Items carried in the inventory include the raw materials, purchased
parts, spares, components, assemblies, sub-assemblies; work in process
materials and finished goods and services.
1
WHAT IS INVENTORY
Managing inventory is costly and difficult. There are many costs

associated with holding of inventory. Thus the relevant question is how
much inventory is to be stocked or held.
Inventory is classified mainly into into three classes:
(a) Raw material inventory
(b) In process inventory
(c) Finished goods inventory.
2
COSTS ASSOCIATED WITH INVENTORY

There are two types of costs associated with inventory. There are some
costs that decreases with increase in level of inventory. Again there are
some costs that increases with increase in level of inventory.
The costs that decreases with increase in inventory are:
(a) Ordering Cost
(b) Stock - out Cost
(c) Acquisition Cost
(d) Start up quality cost
3

The costs that increases with increase in inventory are:
(a) Inventory Carrying Cost
(b) Cost of customer responsiveness
(c) Cost of co-ordinating production
(d) Cost of diluting Return on Investment (ROI)
(e) Reduced capacity Cost
(f) Large lot quality cost
(g) Cost of production problem.
4

Thus, we can see there are two trends of costs associated with the
inventory. There are some costs that increases with increase in inventory
level, these costs are generally termed as inventory carrying cost. Again,
there are some costs that tends to decrease with increase in inventory,
these costs are generally termed as ordering cost.
Thus, how much inventory is to be ordered is a trade-off between these
two trends of costs.
5
PURPOSE OF INVENTORY
All firms, including those involved in JIT operations, keep a supply of
inventory. Inventory is required by a firm for the following reasons:
1. To meet the variation in product demand.
2. To maintain independence of operation.
3. To allow flexibility in production scheduling.
4. To provide a safeguard for variation in raw material delivery time.
5. To take advantage of economic purchase order size.
6
NATURE OF INVENTORY
There are two basic questions/ issues underlying inventory planning/

management
(a) How much to order for each material?
How much to order per order is called Order quantity or Lot size.
(b) When to place order?
When to place order is called order point.
The inventories are ordered – received – used – and ordered again.
This cycle is called Inventory Cycle. For some items the inventory cycle
may be short and for some items the inventory cycle may be ling.
7
NATURE OF INVENTORY
The inventory may contain materials that have:

1. Independent Demand.
2. Dependent Demand.
In independent demand inventory the demand of the item is independent ( or
not related ) of the demand of any other item held in the inventory. Finished goods
generally has independent demand. The demand of independent demand item is
established by the sales and marketing department. They use techniques like
consumer survey. Forecasting, actual customer order etc. to estimate the demand.
As the demand of independent demand item is uncertain, some extra units
must be carried in the inventory.
8
NATURE OF INVENTORY
Inventory planning/management mainly deals with independent demand

inventory.
Dependent demand inventories/items are those whose demand does not
depend upon any other item held in the inventory. For example the
requirement of wheels, tyre, tube of automobile. The packing case os number
of TV produced. Typically if we know the demand of finished goods
(independent demand item) we can calculate the demand for raw materials,
components etc. And from the production process we know when the material
is needed.
The order quantity and order point for dependent demand items are
distinctly different from those of independent demand items.
9
NATURE OF INVENTORY
For an independent demand item, how much to order and when to

place order is an important decision. The answer depends on cost of
ordering too much and the cost of ordering too little. The cost of ordering
too much include all costs of inventory carrying cost. Cost of ordering too
little too little include all costs of ordering cost. Thus the quantity of
material or inventory to be ordered is such that cost of ordering too much
is balanced by cost of ordering too little.
This is shown in the graph.
10
NATURE OF INVENTORY
11
NATURE OF INVENTORY
The annual stocking cost is determined by adding annual carrying cost

and the annual ordering cost.
The total cost curve demonstrate an important concept in inventory
planning. For every material held in the inventory there exist an optimal
order quantity where the total annual stocking cost is minimum. This
optimal order quantity traditionally called Economic Order Quantity
(EOQ).
12
INVENTORY PLANNING SYSTEM
There are mainly two types of inventory planning system

1. Fixed Order Quantity System
2. Fixed Order period System.
In fixed order quantity system each time order is placed for

fixed (same) quantity of material. However, order is placed when
the item in the inventory reaches to a predetermined minimum
level, called Order Point. So every time order is placed for a fixed
quantity of material at order point.
13
In Fixed order period system, the inventory is reviewed at

fixed time intervals, and order is placed for enough materials, to
bring the inventory level back to the same pre determined level.
In this system order is placed at equally spaced time interval,
however the quantity ordered in each cycle varies.
14
Fixed order quantity system.
In fixed order quantity system each time order is placed for fixed
quantity of material. However, when the order is to be placed varies.
Whenever the inventory level comes down to a pre-determined
critical inventory level, the order is placed. This pre-determined critical
inventory level is called Order Point (OP). The order point is
determined by estimating how much we expect to use the material
between the time interval of ordering the material and receiving the
lot of material. That is the demand of the material during the Lead
Time Period (LT). When the batch of the material is received the
inventory is replenished.
15
In fixed order quantity system the level of inventory is
monitored continuously, thus it is also called perpetual inventory
control system.
In fixed order quantity system often two bin system of
inventory control is applied. In two bin system, the inventory is
kept in two bins or baskets. That is the material is physically held in
two bins in a warehouse. One is a large bin and material is used
from that bin until this bin is empty. At the bottom of the large bin
there is a prepared requisition for another order of the material.
16
As the large bin is empty order is placed for the material, and the
material from the smaller bin being used. The small bin just carry
the enough material to last until the next inventory replenishment,
that is, requirement for the lead time period. When the inventory is
replenished, again a requisition is placed at the bottom of the large
bin and both bins are filled and the cycle is repeated.
Here the order quantity is the amount of inventory needed to fill
both the bins and the order point is the amount of inventory
needed to fill the smaller bin.
17
In fixed order quantity system the re is perpetual inventory
accounting. That is whenever the inventory is added or
subtracted inventory record is made and inventory level is
updated. With this method we can determine the amount of
material in the inventory at any point of time by looking at the
inventory record, often called the Bin Card. The bin card display
all the inventory transactions.
Today in most cases this type of display is a part of company’s
computer system and appear at the screen with a click.
18
In fixed order quantity system two decisions are important:
(a) Order Quantity
(b) Order point.
Determination of order quantity
Order quantity determines or decides how much quantity of a
material to order each time order is placed.
There is no single formula that satisfy all the situations. Each
situation is analysed separately based on its characteristics and we
develop the order quantity.
19
Generally there are three situations and there are three
models:
1. Model I : Basic Economic order Quantity (EOQ)
2. Model II : Economic Order Quantity for production lot.
3. Model III: Economic Order Quantity with Quantity discount.
20
Model I : Basic Economic Order Quantity (EOQ)
Assumptions:
1. Annual demand, carrying cost and ordering cost for a material can be
determined.
2. Average inventory level for a material is ordered quantity divided by 2. this
implies:
(a) No safety stock is utilised.
(b) Orders are received all at once.
(C) Materials are used at a uniform rate.
(d) Materials are entirely used up when the next order arrives.
21
Assumptions:
3. Stock out, customer responsiveness and other costs are inconsequence.
4. Quantity discount do not exist.
Variable definitions:
D = Annual demand for a material per year ( Units per year).
Q = Quantity of material ordered at each order point (unit per order).
C = Cost of carrying one unit in inventory for one year (Rs per unit per year).
S = Average cost of completing an order for a material (Rs per year).
TSC = Total annual stocking cost for a material (Rs per year).
22
Cost formula:
Annual Carrying cost = Annual inventory level X Carrying cost
= Q/2 X C
Annual Ordering Cost = Orders per year X Ordering Cost
= D/Q X S
Total Annual Stocking Cost (TSC) = Annual Carrying Cost +
Annual Ordering Cost
= (Q/2) X C + (D/Q) X S
23
Determination of Economic Order Quantity:
The Optimal Order Quantity is found by taking the first derivative
of the TSC with respect to Q and setting it equal to Zero.
TSC = Q/2 X C + D/Q X S
d/dQ ( TSC) = d/dQ [ Q/2 X C + D/Q X S]
= C/2 – (DS)/Q^2
=0
24
Determination of Economic Order Quantity:
Thus C/2 – (DS)/Q^2 = 0
This gives C/2 = (DS)/ Q^2
Q^2 = (2DS)/C
Q = Sq Root [(2DS)/C]
EOQ = Sq Root [(2DS)/C]
25
Now an important thing is to be noted. To determine EOQ we have not
considered the cost of the material and the acquisition cost of it. This is
because the price of the material does not change and remains constant
through out the year. Thus, if we purchase the material whether in January
or February or in December the cost remains the same and it is constant.
And its derivative is zero.
Even if we consider the cost of material and take the derivative it will
give the same result.
26
for example,
Total cost = cost of material + Inventory carrying cost + Ordering Cost
TC = p X D + Q/2 X C + D/Q X S when p = price of unit item.
Now d(TC)/dQ = 0 for minimum cost
or d (TC)/dQ = d/dQ [ p X D + Q/2 X C + D/Q X S] = 0
or C/2 – (D X S )/ Q^2 = 0
or Q = Sq Root [(2 D X S)/ C]
Thus, in Model –I to determine EOQ, only balancing is required is of Ordering
Cost and Inventory carrying cost. 27
If we buy more quantity per order, the ordering cost is less as the number
of orders per year is less, but the average inventory level increases and the
inventory carrying cost increases. If we buy less quantity per order, the
ordering cost per order is more as more number of orders are to be placed
per year but the average inventory level decreases and the inventory carrying
cost decreases. Thus, balancing the ordering cost and inventory carrying cost
determines the EOQ.
From the Total Annual Stocking Cost graph it can be seen that the total cost
is minimum when the ordering cost and the inventory carrying cost are equal.
28
Thus, we can also determine the EOQ by equating Inventory carrying
cost and ordering cost. That is,
Ordering cost = inventory carrying cost
(D/Q) X S = (Q/2) X C
or, Q^2 = (2 X D X S)/ C
or Q = Sq Root [( 2 X D X S )/C]
29
While using this model one has to see how well the assumptions fit the
inventory situation or are the deviations from the assumptions are minor.
The figure shows :
(a) An average inventory level is Q/2. That is there is no safety stock.
(b) Orders are placed at order point (OP) and all items received at
once.
(c) Materials are used at uniform rate.
(d) Materials are entirely used when the next order received. 30
31
Presence of all these characteristics is rare in practice. Yet this model is
very popular and Q/2 is still used as average inventory.
32
Problem 1
ABC hardware supply Co. stocks thousands of hardware items and sell it to plumbers,
contractors and the retailers. The manager is presently using rules of thumb to stock the
items. He wanders how much he will be able to save annually if EOQ were used.
He instructed Uma Sen an inventory analyst to conduct an analysis of one material only
( material # 3925 a brass valve) to see if significant saving is there from using EOQ.
Uma Sen developed the following estimates from accounting information:
D = 10,000 valves per year
Q = 400 Valves per order ( present order quantity)
C = 0.40 Rs per valve per year
S = Rs 5.50 per order
Determine annual savings from the item and conclude.
33
Problem 2.
In a house mean quantity of rice requirement per day is 2 Kg. But it can
vary from 1 kg through 2 Kg to 3 Kg per day. The lead time is 2 days.
Determine how much quantity of rice to be ordered to guard againdt
two days demand. Also determine average consumption and its
probability.
34
Problem 3 :
Demand for an item per year is 12,000units. The average
ordering cost is Rs 120.00 per order. The inventory carrying cost
is 20% of cost of the item. Cost of item per unit is Rs 10.00 .
Determine EOQ.
35
Problem 4 :
Consider the purchasing decision of a standard item #x by a Co.
The annual demand(D), which is deterministic and uniform. The
relevant costs are the inventory carrying cost and the ordering cost.
currently the item is ordered in a batch of 500 units per order.
The annual carrying cost is found to be almost four times that of
annual inventory carrying cost.
Decide on the optimal batch size that would minimise the total
cost. ( You can assume any symbol of your choice).
36
Problem 5 :
Consider two items P1 and P2 that are consumed by an organisation
regularly over the years. Demand for both the items are deterministic
and uniform. The annual demand and cost per unit of the items are D1
and D2 and (ac1) and (ac2) respectively. The S/C ratio (where S= ordering
cost per order and C = the inventory carrying cost per unit per year)are
same for both the items.
You may assume that EOQ is used to determine the order quantity.
It is known that D1  D2 and ac1  ac2
Determine which item P1 or P2 will be ordered more frequently?
37
Model II: EOQ for production lot
EOQ for production lot is more suitable for in house
manufacturing of product to decide on production lot.
Model II, EOQ for production lot is used to determine the size of
the order if:
(a) A material is produced at one stage of production and stored
as inventory.
(b) Then the product is sent along to the next stage of
production or shipped to the customers. 38
Model II: EOQ for production lot
In this model
(a) Production occurs and flow to inventory at a production
rate (p) units per unit time.
(b) The demand of the product in the next stage is (d) units
per unit time . At this rate the product flows out of the inventory.
(c) p  d
39
Model II: EOQ for production lot.
The main difference of this Model with Model-I is that
* In Model-I items are received all at once. But in this model
items are produced at constant rate (p) units per unit time
throughout the cycle.
* Products are used at constant rate (d) units per unit time
through out the cycle.
* Thus inventory is build up at a rate (p – d) and never
reaches the level Q as in Model – I. 40
Assumptions:
1. Annual demand, carrying cost, and ordering cost for a material can be
determined.
2. No safety stock is utilised.
3. Materials are supplied at an uniform rate (p) and used up at uniform rate
(d) and materials are entirely used up when the next order begins to arrive.
4. Stock out, customer responsiveness and order cost are inconsequential.
5. Quantity discount does not exist.
6. Supply rate (p) is greater than demand rate (d).
41
1. p = rate at which the units are supplied to the inventory.
2. d = rate at which units are used up or demanded.
3. (p) and (d) are in the same unit.
42
Formula:
Maximum inventory level = Inventory build up rate X
period of delivery
If it is producing a lot size (Q) with daily production rate (p) units, and if time
(t) is the number of days of production run, then Q=pXt
or t = Q/p
Therefore, maximum inventory level = (p – d) X t
= (p – d) X (Q/p)
43
Formula:
Minimum inventory level = 0 (zero)
Therefore,
Average inventory = (maximum inventory +minimum inventory ) / 2
= [{(p – d) x Q/p} + 0] / 2
= (Q/2) x {(p – d) / p}
44
Formula:
Annual carrying cost = average inventory level x carrying cost per unit
= {(Q/2) (p – d)/ p} x c
Annual ordering cost = Number of orders per year x ordering cost per
order
= (D/Q) x s
Total annual stocking cost(TSC)=Annual carrying cost+annual ordering cost
= [(Q/2) x (p – d)/p] x c – [(D/Q) x s] 45
Derivation of EOQ:
1. Differentiating TSC with respect to (Q) and equating to zero and
solving for (Q)
d/dQ [ { Q/2 x (p – d)/p x c} + { D/Q x s}] = 0
or, (p – d)/(2p) x c – (D/Q^2) x s = 0
or, (D/ Q^2) x s = (p – d)/(2p) x c
or, Q^2 = {(2Ds)/c} x { p/(p – d)}
or, Q = Sq Root [ (2Ds/c) x (p/(p – d)] = EOQ 46
47
Problem 1:
ABC Hardware Supply Co. has a production department that can produce the brass valve (material #3925).
The valves are produced in house and gradually flow into inventory at the main warehouse for further use.
The carrying cost, ordering cost and the annual demand would remain about the same. Because the valve
actually flow into inventory rather than being received all at once as a batch. The manager of the Co.
wonders how this would affect the order quantity and actual stocking cost.
Miss Uma Sen developed these estimators:
D = 10,000 valves per year.
C = Rs 0.40 per valve per year.
d = 40 valves per day ( 10,000 per year / 250 working days)
p = 120 valves per day
Determine:
(a) EOQ for production lot
(b) Total annual stocking cost
48
Model III: EOQ with Quantity Discount:
In Model-I and Model – II price of the product was considered constant. But price of
the product is not always constant. Suppliers often offer quantity discount to
encourage purchase of larger quantity.
Often suppliers offer lower unit price if larger quantity are ordered to encourage
higher purchase of the item. This is called Quantity discount. Quantity discount may be
beneficial because larger order quantities may be less expensive to produce or ship.
In this case critical concern is not the EOQ, but the order quantity in each order
should be enough to qualify for the best possible price, but not so much that carrying
cost consumes the savings in purchase cost.
49
Model III: EOQ with quantity discount.
Here, the ordering quantity is the quantity that minimises the
sum of :
(a) Annual Acquisition cost.
(b) Annual Carrying cost.
(c) Annual ordering cost.
these three costs combinely called Total material Cost ( TMC).
50
Model –III, that is EOQ with quantity discount can be
superimposed to both Model – I and Model – II. Model-I formula
is used if delivery of the order is all at once and model – II
formula is used if delivery occurs gradually.
51
Assumptions:
1. Annual demand, carrying cost and ordering cost of the material can
be estimated.
2. Average inventory level
(a) Q/2 if assumption of Model-I
(b) {(p-d)/p} Q/2.
3 Stock out, customer responsiveness and other costs are inconsequence.
4. Quantity discount exist.
52
1. All definitions of Model-I and Model-II
2. TMC = Total Annual material Cost ( Rs per year)
= Acquisition cost + inventory carrying cost + ordering cost
= {QC/2 + DS/Q} + D x ac
= [{ (Q/2) x (p – d)/p} x C } + DS/Q ] + D x ac
3. ac = acquisition cost of either purchasing or producing one unit of
material. (Rs per unit)
53
Formulas:
1. The EOQ and TSC formula for Model-I and Model-II fits to Model-III
depending on assumptions best fit the inventory situation.
2. Annual Acquisition Cost = Annual demand x Acquisition cost
per unit.
= D x ac
3. Total Material Cost (TMC) = Total annual stocking cost + Annual
Acquisition cost
= TSC + D x ac 54
1. Model-I : Order delivered all at once.
EOQ = Sq Root (2DS/C)
TMC = QC/2 + DS/Q + D x ac
2. Model-II : Gradual delivery
EOQ = Sq Roor { (2DS/C) x (p/(p – d)}
TSC = {(Q/2) x (p – d)/p x C } + (D/Q) x S + D x ac
55
Procedure:
1. Compute EOQ using each sales prices. Inventory carrying cost (C) is usually a
function of sales price or production cost. For example, (C) may be 20% of sales
price. Therefore (C) changes as ac changes.
2. Determine which EOQ from step-1 above is feasible. In other words,
determine the EOQ in the quantity range for its price.
3. The total annual material cost (TMC) is computed for the feasible EOQ and
quantity at any price break with lower sales price.
4. The order quantity with lowest total annual material cost (TMC)is the
economic order quantity for the material. 56
It is important to recognise that the key quantities to be
considered are :
* any feasible EOQ
* quantity at any price break with lower prices
To clarify this the figure shows four different quantity discount
and order quantity situations.
57
58
Identify key quantities to investigate when
quantity discount exist
Quantity price feasible EOQ key quantity to investigate
1 – 399 2.20
400 – 699 2.00 524.5 524.4
700+ 1.80 700
59
Quantity price feasible EOQ key quantity to investigate
1 – 699 43.50 500 500
700 – 1499 36.95 700
1500+ 35.50 1500
--------------------------------------------------------------------------------------
1 - 499 6.95
500 – 999 6.50
1000 - 1999 6.25 1700 1700
2000+ 6.10 2000 60
Problem :
A supplier of material #3925 brass valve has offered to ABC hardware Co. quantity
discount as follows:
Range of order quantity Cost per unit
1 – 399 2.20
400 – 699 2.00
700+ 1.80
Miss Uma Sen was asked to investigate the price discount under two assumptions:
(a) Orders are received all at once
(b) Delivery gradual. cont……
61
Problem : cont….
Uma Sen found the following information:
D = 10,000 valves per year
C = 20% of price [ 0.2 x ac per valve per year]
p = 120 valves per day
d = 40 valves per day. 62
Solution :
Situation 1: Order received all at once
1. Determine EOQ at various price level
EOQ (2.20) = Sq Root (2DS/C) = Sq Root {( 2 x 10,000 x 5.50)/(0.2 x 2.20)}
= 500
= 524.5
= 552.8 63
Solution :
2. Draw the (TMC) curve /graph for each acquisition.
The graph can be plotted by substituting different values of (Q) in the
TMC formula.
TMC = (Q/2) x C + (D/Q) x S + D x ac
[ eg. TMC (2.20) = (Q/2) x (2.20 x 0.2) + (10,000/ Q) x 5.50 + 10,000 x 2.20]
64
Solution :
2. Draw the (TMC) curve /graph for each acquisition.
From Step -1 it is clear that only EOQ ( 2.00) is feasible, because this
EOQ only falls in the price range.
Thus, we have to investigate EOQ = 524.5 units per order at unit price
Rs 2.00 and EOQ = 700 per order at unit price Rs 1.80.
65
66
Solution :
When Q = 524.5 units
TMC = (Q/2) x C + (D/Q) x S + D x ac
= (524.5/2) x ( 0.2 x 2.00) + (10,000/524.5) x 5.50 + 10,000 x 2.00
= 104.88 + 104.88 + 20,000
= 20, 209.76 Rs per year.
When Q = 700 units
TMC = (Q/2) x C + (D/Q) x S + D x ac
= (700/2) x ( 0.2 x 1.80) + (10,000/700) x 5.50 + 10,000 x 1.80
= 126.00 + 78.57 + 18,000
= 18,204.57 Rs per year.
It can be concluded that if all the items are delivered at once 700 valves should be ordered per order.
67
Solution :
Situation 2: Gradual delivery
Calculation of EOQ at different price levels
EOQ (2.20) = Sq Root {(2DS/C) x ( p/(p – d)} = Sq Root [{(2 x 10,000 x 5.5)/(0.2 x 2.2)} x 120/( 120 – 40)]
= 612.4
= 642.3
= 677.0
68
Solution :
Calculation of EOQ at different price levels
= 612.4
= 642.3
= 677.0
69
Solution :
Here only EOQ (2.00) is feasible as the EOQ falls in the price range.
Thus we have to investigate TMC at 642.3 unit and 700.0 units per order.
Q = 642.3 units per order:
TMC = Q/2 { p/(p – d)} x C + (D/Q) x S + D x ac
= (642.3/2) x {(120 – 40)/120} (0.2 x 2.0) + (10,000/ 642.3) x 5.50 + 10,000 x 2.00
= 85.63 + 85.63 + 20,000 = 20,171.26 Rs per year
Q = 700 units per order:
TMC = Q/2 { p/(p – d)} x C + (D/Q) x S + D x ac
= (700/2) x {(120 – 40)/120} (0.2 x 1.80) + (10,000/ 700) x 5.50 + 10,000 x 1.80
= 84.00 + 78.57 + 18,000 = 18,162.57 Rs per year
In the case of gradual delivery ABC hardware Co should order 700 units per order 70

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INVENTORY MANAGEMENT

Inventories are materials and supplies that an organisation carry for

Managing inventory is costly and difficult. There are many costs

COSTS ASSOCIATED WITH INVENTORY

COSTS ASSOCIATED WITH INVENTORY

COSTS ASSOCIATED WITH INVENTORY

There are two basic questions/ issues underlying inventory planning/

The inventory may contain materials that have:

Inventory planning/management mainly deals with independent demand

For an independent demand item, how much to order and when to

The annual stocking cost is determined by adding annual carrying cost

There are mainly two types of inventory planning system

In fixed order quantity system each time order is placed for

In Fixed order period system, the inventory is reviewed at

Model III: EOQ with Quantity Discount:

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