Inventory Fundamentals

Inventories
• Materials and supplies that a firm carries
for sale or inputs.

• Inventories are used their value is

converted to cash.

• Represent 20 to 60 % of total assets

 Classification of Inventories
• Raw materials - Items purchased that have not
entered the process. I.e. components ,
subassemblies etc
• WIP – RM that have entered the process and
not yet complete.
• Finished goods – Finished products that are
ready to be sold.
• Distribution Inventories – FG in distribution
system
• MRO – Items used in production that do not
become part of the product.
 Functions of Inventories
• One purpose of inventory in batch
manufacturing is to buffer :

– Supply and demand

– Customer demand and finished goods

– Finished goods and component availability

– Parts and materials needed to production

 Inventory Types
• Anticipation Inventory – for peak season, promotion
or threat of strike. (Milk and bread)

• Fluctuation Inventory – protects against random

fluctuations in demand , supply or lead-time.

• Lot-size inventory – these take advantage of lot

pricing. (Wal-Mart)

• Transportation Inventory – in transit inventory

• Hedge inventory – Protects against price fluctuations

 Objectives of IM
• Maximize customer service – correct
materials in stock, % of orders filled

• Low cost plant operation

• Minimum inventory investment

 Inventory Costs
• Item or landed cost

• Carrying cost

• Ordering cost

• Stockout cost

• Capacity-associated cost
 Example Problem
• A company carries an average annual inventory of
$2M. If they estimate the cost of capital is 10%,
storage cost of 7%, and risk costs are 6%, what does
it cost per year to carry inventory.

• Total cost of carrying inventory =

10% + 7% + 6% = 23 %

• Annual cost of carrying inventory =

0.23 X $2M = $460,000
 Inventory turns
• Inventory turns =
annual cost of goods sold
average inventory in dollars
COGS = $1M
AVG Inv - $.5M
$1M/.5 = 2 turns per year
 Example Problem
a. What will be the inventory turns ratio if the cost of goods sold is
24 million a year and the average inventory is 6 million.
24M / 6M = 4 turns per year

b. What would be the reduction in inventory if inventory turns were

increased by to 12 times per year.
24M / 12 = 2M
Reduction in inventory = 6M – 2M = 4M

c. If the cost of carrying inventroy is 25% of the average inventory,

what will the savings be?
Reduction in inventory = 4M
Savings = 4M X 0.25 = 1M
 Inventory Control
• Questions to ask :

– What is the importance of the inventory?

– How are they to be controlled?

– How much should be ordered at one time?

– When should an order be placed?

 Pareto’s Principle
• The 80/20 rule is usually attributed to Pareto.

• Vifredo Pareto (1848 - 1923) was an Italian economist who

formulated this well known principle:

• ‘In any series of elements to be controlled, a selected small

fraction in terms of number of elements almost always
accounts for a large fraction in terms of effect’.

• The 80/20 Rule is really an extension of this principle, in the

sense that it deals with the more general case. It can be applied
in real world situations whenever there is a question of
effectiveness versus diminishing returns on effort, expense or
time.
• When applied to Knowledge Management systems, for
instance, the 80/20 Rule can be paraphrased as ‘Perfection
costs too much’.
 ABC Analysis
• Is a classification of the inventory items that have the greatest value.
This is important because if the items are known that cost the most then time can be
spent on these items instead of the others. Generally , a small amount of items are
the most costly.

• 20 % of inventory accounts for 80% of dollars these are A items

• 30 % of inventory accounts for 15 % of dollars these are B items
• 50 % of inventory account for 5 % of dollars are C items

• The process of ABC analysis is classifying the items as A ,B or C. Then the

level of inventory control is determined. A items require greater control and should
be kept at the lowest quantity possible. Because of the small quantity, monitoring
costs are somewhat lower than the entire inventory. These items must be monitored
constantly.

• The B's and C's require less harsh monitoring and because of the lower cost higher
safety stocks are possible. Yet this is a call the inventory manager must make.

• Examples are any item that has significant cost or is out of stock. I'm sure your
company has some of these items.
                    
Part Unit Unit Annual $ Cum $ Cum % $ Cum %
Number usage Cost $ Usage Usage Usage of items Class

1 1500 10
1500*10=15000
2 1200 20
1200*20=24000
3 100 1500
4 1258 25
5 3658 1
After usage is calculated it is just a matter of
6 365 658 sorting from highest to lowest then add those
7 3 124 figures up to get the cumulative usage. Then
8 3692 125 each cumulative usage is divided by the sum of
all of the $ for the Cum %$ usage
9 156 154
15000/Σ
10 1245 365
Cumulative % of items is simply the % of items
total. If there are ten items each are 10% each.

ABC 1
 Part Unit Unit Annual $ Cum $ Cum % $ Cum % of Cla
Number usage Cost $ Usage Usage Usage items ss
3692*125=461500 0+461500=461500 461500/1404599=.32
8563526
461500+454425=915925
8 3692 125 461500 461500 0.328563526 10 A
10 1245 365 454425 915925 0.652090027 20 A
6 365 658 240170 1156095 0.823078331 30 B
3 100 1500 150000 1306095 0.929870376 40 B
4 1258 25 31450 1337545 0.952261108 50 B
9 156 154 24024 1361569 0.969364922 60 C
2 1200 20 24000 1385569 0.986451649 70 C
1 1500 10 15000 1400569 0.997130854 80 C
5 3658 1 3658 1404227 0.999735156 90 C
7 3 124 372 1404599 1 100 C

1404599 1

1404599
ABC 2
 Problems

• 9.3 , 9.5 , 9.14 & 9.17