INVENTORY MANAGEMENT

Meaning of Inventory

 Inventory generally refers to the materials in

stock.
 It is also called the idle resource of an
enterprise.
 Inventories represent those items which are
either stocked for sale or they are in the
process of manufacturing or they are in the
form of materials, which are yet to be utilized.

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Inventory
 Inventory is the stock of any item or
resource used in an organization and can
include: raw materials, finished products,
component parts, supplies, and work-in-
process
Purposes of Inventory
1. To maintain independence of operations
2. To meet variation in product demand
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/Quantity discounts
Inventory Costs
 Holding (or carrying) costs
 Costs for storage, handling, insurance,
obsolescence, depreciation, opportunity cost of
capital,etc
 Holding costs tend to favor low inventory levels
and frequent replenishment
 Setup (or production change) costs
 Costs for arranging specific equipment setups,
etc
 Ordering costs
 Costs of placing an order, etc
 Shortage costs
 Costs of canceling an order, etc
 Independent vs. Dependent
Demand
Independent Demand (Demand for the final end-product
or demand not related to other items)

Finished
product

Dependent
Demand
(Derived demand
items for
E(1)
component parts,
subassemblies,
raw materials, etc)
Component parts
The Role of Inventory In
Supply Chain Management
 Since demand is usually not known with certainty, it is
not possible to produce exactly the amount
demanded
 So an additional amount of inventory, called safety or
buffer is kept on hand to meet variations in product
demand
 The bullwhip effect: The distortion of demand
information as it moves away from end-user
customer
 This effect causes distributers, manufacturers and
suppliers to stock increasingly higher safety stocks
 Inventory and Quality
Management
 Level of customer service: The ability to meet effectively
internal or external customer demand in a timely and
efficient manner
 Customer for finished goods perceive quality service as
availability of goods they want at the time when they want
them
 To provide this level of quality customer service, the
tendency is to maintain large stocks of all types of items
 However, there is a cost associated with carrying items in
inventory, which creates a trade-off between the quality
level of customer service and the cost of that service
Conti..
 As the level of inventory increases to provide better
customer service, inventory costs increase, whereas
quality-related customer service costs, such as lost
sales and loss of customers decrease
 The conventional approach to inventory
management is to maintain a level of inventory that
reflects a compromise between inventory costs and
customer service
 But according to the contemporary “zero defects”
philosophy of quality management, the long term
benefits of quality in terms of large market share
outweigh lower shot-term production-related costs
such as inventory costs
Inventory Control System
 An inventory system is the set of policies
and controls that monitor levels of
inventory and determines what levels
should be maintained, when stock should
be replenished, and how large orders
should be
 There are two basic inventory systems:
 Continuous system
 Periodic system
Continuous Inventory Systems
 In a continuous inventory system, a
continual record of the inventory level for
every item is maintained
 It is also referred to as a “perpetual system”
or a “fixed-order-quantity system”
 Whenever the inventory at hand decreases
to a predetermined level, referred to as the
“reorder point”, a new order is placed to
replenish the stock of inventory
Continuous Inventory Systems

 The order that is placed is for a fixed

amount that minimizes the total inventory
costs
 This amount of order placed is called the
“economic order quantity”
 Continuous inventory systems often
incorporate information technology tools to
improve the speed and accuracy of data
entry. E.g. Barcodes
 Continuous Inventory Systems
 Since inventory level is continuously
monitored, so management always knows
the inventory status
 This is advantageous for critical items such
as replacement parts or raw material
supplies
 However, maintaining a continual record of
the amount of inventory on hand can also be
costly
Periodic Inventory Systems
 It is also referred to as “fixed-time-period
system” or “periodic review system”
 In a periodic inventory system, the inventory
on hand is counted at specific time intervals-
every week or at the end of each month
 After the inventory in stock is determined, an
order is placed for an amount that will bring
inventory back up to a desired level
 Since inventory level is not monitored at all
during the time interval between orders, little
or no record keeping is required
Periodic Inventory Systems
 Disadvantage is less direct control
 Results in larger inventory levels to guard
against unexpected stock outs early in the
fixed period
 Also requires that a new order quantity be
determined each time a periodic order is
made
 Used in college library, small retail stores,
drug stores, grocery stores, and offices
Techniques of Inventory Control
 ABC Analysis
 HML analysis
 VED analysis
 FSN analysis
 EOQ (Economic Order Quantity)

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The ABC Classification System
 The ABC system is a method for classifying
inventory according to several criteria including its
dollar value to the firm
 About 5 % - 15% of all inventory item account for
70% to 80% of the total dollar value of inventory.
These are classifies as class A items
 B items represent approximately 30% of total
inventory units but only about 15% of the total
inventory dollar value
 C items account for 50% - 60% of all inventory
units but represent only 5% - 10% of total dollar
value
The ABC Classification System
 In ABC analysis each class of inventory requires a
different levels of inventory monitoring and
control-the higher the value of the inventory, the
tighter the control
 Class A items require tight inventory control,
minimized safety stocks, accurate demand
forecasting and detailed record keeping
 B and C items require less stringent inventory
control
 Since carrying costs are usually lower for C items,
higher inventory levels can sometimes be
maintained with larger safety stocks
The ABC Classification System
 A items require a continuous control system,
while for B and C items periodic review
system with less monitoring
 Items kept in inventory are not of equal
importance in terms of:
 Dollars invested
 Profit potential
 Sales or usage volume
 Stock-out penalties
Illustration of ABC
The maintenance department for a small manufacturing firm has
responsibility for maintaining an inventory of spare parts for the
machinery it services. The parts inventory, unit cot and annual
usage are as follow:
Part Unit Cost $ Annual Usage
1 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
The department manager wants to classify the inventory parts according to
the ABC system to determine which stocks of parts should most closely be
monitored.
total value = sum of all parts’ value
• For % of total value: (Part’s value/total value) * 100

Part Total Value % of Total % of Total % Cumulative

Value Quantity
9 30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14, 000 16.4 4.0 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 83.0
7 1,700 2.0 17.0 100.0
Conti..
ABC Classification of the items:
Class Items % of Total % of Total
Value Quantity
A 9, 8, 2 71 15

B 1, 4, 3 16.5 25

C 6, 5, 10, 7 12.5 60
 HML analysis:
 In this analysis, the classification of existing inventory is
based on unit price of the items. They are classified as
high price, medium price and low cost items.

 VED analysis:
 In this analysis, the classification of existing inventory is
based on criticality of the items. They are classified as
vital, essential and desirable items. It is mainly used in
spare parts inventory.

 FSN analysis:
 In this analysis, the classification of existing inventory is
based consumption of the items. They are classified as
fast moving, slow moving and non-moving items. 23
EOQ (Economic Order Quantity)
 In 1913 F. W. Harris developed the EOQ model to
determine the optimum order quantity

 Inventory models deal with idle resources like

men, machines, money and materials.

 These models are concerned with two decisions:

how much to order (purchase or produce) and
when to order so as to minimize the total cost.

24
 For the first decision—how much to order, there are two
basic costs are considered namely, inventory carrying
costs and the ordering or acquisition costs. As the
quantity ordered is increased, the inventory carrying cost
increases while the ordering cost decreases.

 The ‘order quantity’ means the quantity produced or

procured during one production cycle. Economic order
quantity is calculated by balancing the two costs.
Economic Order Quantity (EOQ) is that size of order
which minimizes total costs of carrying and cost of
ordering.

 i.e., Minimum Total Cost occurs when Inventory Carrying

Cost = Ordering Cost
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The Basic EOQ Model
 In a continuous system, when inventory
reaches a specific level, referred to as the
reorder point, a fixed amount is ordered
 The most widely used and traditional means
of determining how much to order in a
continuous system is the “Economic Order
Quantity (EOQ) Model”
 The function of EOQ Model is to determine
the optimal order size that minimizes total
inventory costs
 Basic Fixed-Order Quantity Model
and Reorder Point Behavior
1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point you place your next Q
Q = Economic order quantity sized order.
L = Lead time
The Basic EOQ Model -
Assumptions
1. Demand is known with certainty and is
constant over time
2. No shortages are allowed
3. Lead time for the receipt of orders is
constant
4. The order quantity is received all at once
Assumptions of EOQ Model
 The price of inventory item (p) is independent of the
order quantity. It means that the benefits of economies
of scale are not taken into consideration while buying

 The Cost of Ordering (Co) is fixed and is independent of

the quantity ordered (Q).

 The total carrying or holding cost of the inventory is

proportional to the number of inventory items stored.

 Demand for product and its usage rate is constant over

a time
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 Lead time for material delivery is known with
certainty and it remains constant.

 The quantity of inventory ordered is delivered in

a single lot and there is no scope for splitting of
deliveries
 Reorder Point = d X LT,
 Where, d = Average Daily Demand
LT = Lead Time

30
Ordering cost/unit time = Co [D/Q]
Where, D = Demand per unit time
Q = Quantity Ordered

Holding Cost per unit = Ch [Q/2]

Where,

Cost per Unit = Cp

Quantity purchased per unit Time = D

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Therefore,

Total Cost (TC) =

Co [D/Q] + Ch [Q/2] + Cp . D
Note: Total cost is minimum when the cost of ordering is equal
to inventory holding or carrying cost.

C o . D Ch . Q
Q 2
Solving the equation we get,

32
Co . D Ch
Q2 2

Q2
2 Co . D
Ch
Q √ 2 Co . D
Ch

33
Cost Minimization Goal
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Sum 1
 The ePaint stocks paint in its warehouse and sells
it online on its Internet Website. The store stocks
several brands of paints; however, its biggest
seller is Sharman-Wilson Ironcoat paint. The
company wants to determine the optimal order
size and total inventory cost for Ironcoat paint
given an estimated annual demand of 10,000
gallons of paint, an annual carrying cost of $0.75
per gallon, and an ordering cost of $150 per order.
They would also like to know the number of
orders that will be made annually and time
between orders (i.e. order cycle)
Sum 2
 Electronic Village stocks and sells a particular
brand of personal computer. It costs the store
$450 each time it places and order with the
manufacturer for the personal computers.
The annual cost of carrying the PCs in
inventory is $170. the store manager
estimates that annual demand for the PCs will
be 1200 units. Determine the optimal order
quantity, total minimum cost and order cycle
time.
The Production Quantity Model
 In this EOQ model the assumption that
orders are received all at once is relaxed
 The order quantity is received gradually is
over time and the inventory level is depleted
at the same time it is being replenished
 This situation is commonly found when the
inventory user is also the producer as in a
manufacturing operation where a part is
produced to use in larger assembly
Sum 3
 Assume that the epaint Store has its own
manufacturing facility in which it produces
Ironcoat paint. The ordering cost is the cost
of setting up the production process to make
paint. The manufacturing facility remains
open for the same number of days as the
store is open and produces 150 gallons of
paint per day. Determine the optimal order
size, total inventory cost, the length of time
to receive an order, the number of orders per
year and the maximum inventory level.
Sum 4
 I-75 Discount Carpets manufactures Cascade
carpet, which it sells in its adjoining showroom
store near the interstate. Estimated annual
demand is 20,000 yards of carpet with an
annual carrying cost of $2.75 per yard. The
manufacturing facility operates 360 days and
produces 400 yards of carpet per day. The cost
of setting up the manufacturing process for a
production run is $720. determine the optimal
order size, total inventory cost, length of time
to receive an order and maximum inventory
level.
Quantity Discounts
 A “quantity discount” is a price discount on an
item if predetermined numbers of units are
ordered
 Determining if an order size with a discount is
more cost effective than optimal Q is the main
task
 When a discount price is available, it is
associated with a specific order size, which may
be different from the optimal order size and the
customer must evaluate the trade off between
possibly higher carrying costs with the discount
quantity versus EOQ cost
Sum 5
 Avtek, a distributor of audio and video equipment,
wants to reduce a large stock of televisions. It has
offered a local chain of stores a quantity discount
pricing schedule, as follows:
Quantity Price
1-49 $1,400
50-89 1,100
90+ 900

The annual carrying cost for the stores for a TV is $190,

the ordering cost is &2,500, and annual demand for this
particular model TV is estimated to be 200 units. The
chain wants to determine if it should take advantage of
this discount or order the basic EOQ order size.
Sum 6
 The bookstore at Tech purchases jackets emblazoned with
the school name and logo from a vendor. The vendor sells
the jackets to the store for $38 a piece. The cost to the
bookstore for placing an order is $120 and the annual
carrying cost is 25% of the cost of jacket. The bookstore
manager estimates that 1700 jackets will be sold during
the year. The vendor has offered bookstore the following
volume discount schedule. What is the bookstore’s
optimal order quantity?
Order Size Discount
1-299 0%
300-499 2%
500-799 4%
800+ 5%
Reorder Point
 The “Reorder Point” is the determinant of
when to order in a continuous inventory
system, i.e. the inventory level at which a new
order is placed
 Reorder point for basic EOQ model with
constant demand and a constant lead time is:
R = dL
Where
d = demand rate per period (daily demand)
L = Lead Time
Example of Reorder Point with
Constant Demand and Lead Time
 The ePaint Store is open 311 days per year. If
annual demand is 10,000 gallons of Ironcoat
paint and the lead time to receive an order is
10 days. Determine the reorder point for
paint.
Stockout, Safety Stock and
Service Level
 Stockout: An inventory shortage
 Safety Stock: A buffer added to the inventory on
hand during lead time
 Service Level: the service level is the probability
that the amount of inventory on hand during the lead
time is sufficient to meet the expected demand-i.e.
that the customer will e served
 For E.g. A service level of 90% means that there is a
0.90 probability that the demand will be met during
the lead time, and the probability that a stockout will
occur is 10%
Sum 7 (Reorder Point with
Variable Demand)
 Kelly’s Tavern serves Shamrock draft beer to its
customers. The daily demand for beer is normally
distributed, with an average of 20 gallons and a
standard deviation of 4 gallons. The lead time
required to receive an order of beer from the local
distributor is 12 days. Determine the safety stock
and reorder point if the restaurant wants to
maintain a 90% service level. What would be the
increase in the safety stock if a 95% service level
were desired?
Sum 8
 The amount of denim used daily by the Southwest
Apparel Company in its manufacturing process to
make jeans is normally distributed with an average
of 4000 yards of denim and a standard deviation of
600 yards. The lead time required to receive an
order of denim from the textile mill is constant 7
days. Determine the safety stock and reorder point
if the company wants to limit the probability of a
stock out and work stoppage to 5%? What level of
service would a safety stock of 2000 yards provide?
Order Quantity For Periodic
Inventory System
 A periodic inventory system is one in which the time
between the orders is constant and the order size
varies
 Small retailers often use this system of inventory
management; E.g. Drugstore
 In this case the vendors who provide stock of materials
make periodic visits-every few weeks or every month-
and count the stock of inventory on hand
 If the inventory is exhausted or at some predetermined
reorder point, a new order will be placed for an amount
of inventory that will bring the inventory level back up
to the desired level
Order Quantity For Periodic
Inventory System
 In periodic inventory system, usually the manager
does not monitor the inventory level between
vendor visits but instead will rely on the vendor to
take inventory
 Since the items are generally of low value, larger
safety stocks will not pose a significant cost
 However, if the inventory becomes exhausted early
in the time period between visits, resulting in a
stockout that will not be remedied until the next
scheduled order
Order Quantity For Periodic
Inventory System
 If the demand rate and lead time are constant, then
the fixed-period model will have a fixed-order
quantity that will be made at specified time
intervals, which is same as the fixed-order (basic
EOQ) model
 But the fixed-period model reacts differently than
the fixed-order model when the demand is variable
Sum 9
 KVS Pharmacy fills prescriptions for a popular
children’s antibiotic, Amoxycilin. The daily demand
for Amoxycilin is normally distributed with a mean
of 200 ounces and a standard deviation of 80
ounces. The vendor for the pharmaceutical firm that
supplies the drug calls the drugstore’s pharmacist
every 30 days and checks the inventory of
Amoxycilin. During a call the druggist indicated the
store had 60 ounces of the antibiotic in stock. The
lead time to receive an order is four days.
Determine the order size that will enable the drug
store to maintain a 99% service level.
Sum 10
 Food Place Market stocks frozen pizzas in a
refrigerated display case. The average daily demand
for the pizzas is normally distributed, with a mean of 8
pizzas and a standard deviation of 2.5 pizzas. A vendor
for a packaged food distributor checks the market’s
inventory of frozen foods every 10 days. During a
particular visit there were no pizzas in stock. The lead
time to receive an order is 3 days. Determine the order
size for this order period that will result in a 98%
service level. During the vendor’s following visit there
were 5 frozen pizzas in stock. What is the order size for
the next order period?