INVENTORY MANAGEMENT

What are the costs of inventory?

Production system converts raw materials into value added products of
consumption. Among the input costs, material cost is predominant. Simply
stated, materials required for production are procured and stored and
consumed. This is to prevent any production interruption for want of raw
materials. There are many other reasons why materials are required to be
stocked like availability, seasonality, price, delays, to reduce dependency on
Raw materials
Suppliers & plants.
Work in process
Machines & product line.
Finished goods
Plant, customers & market.
Protect against stock out situation and production interruption. It is thus
obvious that certain amounts of inventories of raw materials, WIP & FP are
inevitable in production. When these inventories are in stock they represent
locked up capital and carry interest or cost of capital. This apart they occupy
valuable store space and cost is incurred in safety and security of such
inventory.
Moreover when there is a shortage of stock, an indirect cost is incurred as lost
opportunity.
Thus the costs involved in inventory are
Ordering costs.

Carrying costs.

Shortage costs.

Ordering costs are costs associated with

planning procurement.

Forecasting demand

selection of vendor

bid invitation & evaluation

issuing purchase order.

Follow up

transportation.

Receipt

Inspection

Handling

accounting & auditing

Dr. M KOTEESWARAN

MBA II SEM

POM 2012

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INVENTORY MANAGEMENT

stocking

Men are employed to attend to all these and each purchase order issued
consumes direct and indirect labour hours. This cost per order is called
Ordering Cost. Carrying costs are costs incurred in holding the inventory in
storage. This depends on the nature, value, size, volume, time of storage,
lighting, ventilation, security required for safe keeping of the inventory. This
is called inventory carrying cost/holding cost shortage costs.
The purpose spending money in carrying inventory and safe keeping is to
ensure smooth production floor and output. If for same reason this is not
achieved, and a stock out situation docs arise, loss is incurred.
Such stock out at raw material stage / WIP may cause temporary disruption
in production incur man/machine idle time. Production loss capacity underutilisation
customer dissatisfaction Shortage of finished goods will be lost business, loss
of profit, good will of customer and customer dissatisfaction.
The ordering cost is directly proportional to the no. of orders placed. As the
no. of orders is reduced, the volume of ordered quantity is proportionately
high.If the quantity is 1,000 the order quantity per order will be 1000, 500, 250,
100 etc for 1,2,4 or 10 orders. As the no. of orders increases, ordering costs
increases.
As the no. of orders reduced, the inventory increases, thus the carrying cost
will increase & shortage cost will decrease as the chances of stock out will be
less. The objective is to minimise the costs of ordering, carrying & stock out.
Basic Inventory Model
In Basic inventory model it is assumed that
the demand for an item is at a constant rate or uniform over a period and

the entire ordered quantity of material is received at a time.

This model is known as Q system

fixed order quantity system or

continuous or perpetual review system.

Order is placed as a predetermined point of time when the inventory

reached the reorder level.

Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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INVENTORY MANAGEMENT

Basic Inventory Model

In this model
1. Demand is known
2. Demand is constant over time.
3. No shortage is allowed.
4. Lead time is also known
5. Lead time is constant.
6. The ordered quantity arrives at a time & immediately.
Basic Inventory Model
Thus, to start with, the required quantity Q is available. Since the demand or
consumption is at a constant rate, over a period of time, Q reduces in a right
sloping line Q1, Q2, Q3 at time 1,2 & 3 etc. When Q reaches the
predetermined reorder level, order is placed. With the lead time, as the
inventory reaches zero, stock is fully replenished for the next cycle. Thus, we
have a saw tooth model.
In this basic EOQ Model:
Only one product is involved.

Annual requirement is known

Demand rate is uniform & constant.

There is no constraint internal / external.

Only ordering cost & carrying cost are considered.

No uncertainty.

Lead time is fixed & constant.

Order is delivered in a single lot.

Qty ordered is received in full.

No Qty discount is considered.

Let annual demand = D

Unit cost = P
Ordering cost = Co
Carrying cost per unit per year = Cc
Economic ordering Quantity = Q
a. No. of orders required = D/Q
b. Total Ordering cost = (D/Q)*Co
c. Total carrying cost = (Q/2)*Cc
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

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INVENTORY MANAGEMENT

d. Total cost of units per year = D*P

e. Total cost of inventory
= b +c +d
= {(D/Q)*Co}+{(Q/2)*Cc} +D*P
TC={(D/Q)*Co}+{(Q/2)*Cc} +D*P
Differentiating w r t Q =
dTC/dQ= [{(-D/Q2)*Co}+{(Cc/2)} +0]
0 = {(-D/Q2)*Co}+{(Cc/2)}
{(D/Q2)*Co} = (Cc/2)
2*D* Co /Cc = Q2
Q= Sq. root of (2*D* Co /Cc )
No. of orders = D/Q
Time between orders = Q/D year
D = 5400
Co = 250
Cc = 30 per unit pa
Find :
a. EOQ
b. No. of orders / year
c. Time between successive orders
Find :
a. EOQ
b. No. of orders / year
c. Time between successive orders
Annual Demand D

24000

15000

Ordering Cost Co

150

125

Carrying Cost Cc

20%

20%

Unit Cost in Rs

50

75

Let annual demand = D

Unit cost = P
Ordering cost = Co
Carrying cost per unit per year = Cc
Shortage cost = Cs
Economic ordering Quantity = Q
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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INVENTORY MANAGEMENT

Basic Inventory Model with shortage

Q = Sr of (2*D*Co/Cc)*{(Cs+Cc)/Cs}
Q1 = Sr of (2*D*Co/Cc)*{Cs/(Cs+Cc)}
Q2 = Q-Q1
Cycle time T = Q/D
Inventory period T1=Q1/D
Shortage period T2=Q2/D
D=7,200
Cc=500/unit/year
Co=1,500 per order
Cs=2,000 / unit/year
Find:
1. Ordering Quantity
2. Max. inventory
3. Max. shortage quantity
4. Cycle time
5. Inventory period
6. Shortage period
D=7,200
Cc=500/unit/year
Co=1,500 per order
Cs=2,000 / unit/year
1. Ordering Quantity =Q
Q = Sqr of (2*D*Co/Cc)*{(Cs+Cc)/Cs}
Q = SQR {2*7,200*1,500*/500}*{(2,000+500)/2,000}
=Sqr 43200*1.25
=233
D=7,200
Cc=500/unit/year
Co=1,500 per order
Cs=2,000 / unit/year
2. Max. inventory = Q1
Q1 = Sr of (2*D*Co/Cc)*{Cs/(Cs+Cc)}
Q1 = SQR {(2*7,200*1,500/500)}*{2,000/(2,000+500)}
= Sqr 43200*0.8
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

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INVENTORY MANAGEMENT

=186
D=7,200
Cc=500/unit/year
Co=1,500 per order
Cs=2,000 / unit/year
3. Max. shortage quantity = Q2
Q2 = Q Q1
= 233-186=47
D=7,200
Cc=500/unit/year
Co=1,500 per order
Cs=2,000 / unit/year
4. Cycle Time = t
t = Q/D = (233/7200)*365 =11.81 days
D=7,200
Cc=500/unit/year
Co=1,500 per order
Cs=2,000 / unit/year
5. Inventory period = t1
t1 = Q1/D = (186/7200)*365 =9.43 days
D=7,200
Cc=500/unit/year
Co=1,500 per order
Cs=2,000 / unit/year
6. Shortage period = t2
t2 = t- t1
= 11.81-9.43=2.38days
Basic Production Model
Let annual demand = D
Production rate = Pr
Set up cost = Co
Carrying cost per unit per year = Cc
Cost of production per unit = C
Economic Batch Quantity = EBQ = Q
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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INVENTORY MANAGEMENT

Let annual demand = D

Production rate = Pr
Set up cost = Co
Carrying cost per unit per year = Cc
Cost of production per unit = C
Economic Batch Quantity = EBQ = Q
EBQ= Sqr (2*D*Co)/{Cc*(1-D/Pr)}
T1 = Q/Pr
T2 = Q* (1-D/Pr)/D
Cycle time = T1+T2
Let annual demand = D = 36000
Production rate = Pr = 72000
Set up cost = Co = 250
Carrying cost per unit per year = Cc = 25/unit
Economic Batch Quantity = EBQ = Q
EBQ= Sqr (2*D*Co)/{Cc*(1-D/Pr)}
= Sqr (2*36000*250)/{25(1-36000/72000)}
= 1200
T1= Q/Pr=(1200/72000)*365=6.08days
T2 = {Q*(1-D/Pr)}/D=(600/36000)*365=6.08 days
Cycle time T = 12days
EOQ helps to decide how much to order in the most economical way.
It is equally important to know when the place the order.
In the basic EOQ model an important assumption is made that the
consumption/demand is at a uniform rate during the period and that
replenishment is instantaneous.
This does not reflect the real life situation.
Fluctuations in consumption due to other factors and delays in supplies in
shipping, transporting, wrong order size, shipped quantity etc.,
Hence, in order to encounter this fluctuation, a few precautions are taken: Lead Time required for an order to materialise.

To meet some delays in supplies, a reserve stock.

A safety stock to meet unforeseen circumstances

Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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INVENTORY MANAGEMENT

Hence over and above the EOQ, three layers of stocks Buffer, Reserve &
Safety stocks are built.

Any stock held costs money to carry.

The time the stock recedes to buffer level, the outer limit by which P.O is to
be released is called the ROL the system is said to have reached the
reorder point.

It is known as continuous Review system or Q system.

In this model also a basic assumption is made that the lead time remains
constant.

This obviously increases the carrying cost and other risks of obsolescence
and perishability.

Since the demand rate and lead time are known, the ROL is the inventory
which meets this demand during the lead time. This is also known as Buffer
Stock.
ROL = (Normal or Ave. demand rate) x (Ave. Lead time)
However when either the demand rate or lead time is not certain, the demand
may vary under normal distribution or poisson distribution or the lead time is
extended, the probability of max. extension of lead time is Px, then extra stock
called the safety stock is required.
Safety Stock = [(Ave.demand rate) x (Max. extn.of lead time)] x [Probability of
that
tension]
= A x Px
Thus, ROL = Safety stock + Reserve Stock + Buffer stock.
Classification & Codification of stock.
Inventory represents a significant portion of current assets

Inventories or stock are different in

kind,

nature,

size,

Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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INVENTORY MANAGEMENT

form,

value,

weight,

volume,

usage,

requirement etc.

It is necessary to study each item of stock

Take appropriate action to store.

Since large number of items is to be stored at a time, it is important to

classify them

Stock in such a manner that they are easily accessible and identifiable.

Classification of stock
Systematic grouping of similar items of varying sizes ex:

nuts & bolts,

fasteners,

rivets,

gears.

Nature of usage
Raw materials,

components,

consumable,

spare,

tools,

WIP,

Hardware

Nature of item
Gaseous,

liquid,

solid,

paste,

inflammable,

requiring temp. Control.

Value of items
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

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INVENTORY MANAGEMENT

highly valuable,

scarce resource, common item.

Criticality of items availability,

lead time,

imported etc.,

Movement of items
Fast,

medium &

slow.

By source
Bought out /

manufactured in house.

Tax and costing structure will very

Codification of items:
In a manufacturing unit hundreds/thousand of items will be stocked and
consumed.

In order to stock the items in a scientific manner to avoid many problems

of handling, items are codified by numbers.

They are not simple serialized no. but group of numerals and alphabets
each conveying some information useful in handling and locating. Such
codes also become locational addresses.

Different kinds of codes are used to denote

(a) Source of supply.
(b) Location of supplier.
(c )Major aggregate / group to which the part belongs.
(d) Major subassembly in which the item is used.
(e) Specific part no which is unique for the item read with the group & sub
assembly id.
(f) The ABC / VED classification
(g) Any special condition to use the item.
The code may be
L B C M 05 09 172
This will mean
Leyland
-L
Class item from
-B
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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INVENTORY MANAGEMENT

Type source of
Medium moving
Transmission group
Gear box assembly
Item issued in unique no
Technique
1. A B C
2. X Y Z
3. V E D
4. F S N
5. H M L
6. S D E
7. S OS
8. G O L F

-C
-M
- 05
- 09
- 172

Purpose
1. Classification by consumption value.
2. Inventory Value of items.
3. Classification by criticality of items.
4. Consumption rate.
5. Unit rate of items.
6. Availability in market.
7. Seasonal items.
8. Item by source.

Uses of Classification of items:

1. Control/Review
2. Authority to sanction.
3. Ordering frequency.
4. ROL, safety & buffer stock levels.
5. Order quantity.
6. Control on issue for consumption.
7. Accuracy in material planning.
8. Lead time required/ to be allowed.
9. No. of sources.
10. Degree of follow up.
11. Inspection & waste control.
12. Value Analysis for cost reduction.
13. Forecasting
14. Obsolescence / surplus control.
Materials Requirement Planning called MRP determines the schedule and
quantities for each item required for a product. MRP takes the output from
the MSPMaster Schedule of the Production Plan. Then it combines the MSP
with inventory record information to know the stock on hand and in pipeline
and the product structure records to arrive at the requirement of each item &
when.
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

Page

INVENTORY MANAGEMENT

The objective of MRP is to get the right materials to the right place at the right
time.
However, MRP does not take into account capacity in calculating the
production lot size. The capacity may exceed resulting in longer production
time. Hence, closed loop MRP was developed which ensures feed back from
capacity planning module. This is the first component of MRP II
Manufacturing Resource Planning.
Production Plan
Rough cut Capacity Plan
Master Production Schedule
MRP
Capacity Requirement Planning
Requirement Schedule
MRP class
D

C
B
A

Coverage
Computing only. Probably inv. Records one poor.
Very few outputs used
used for inv. Ordering but not for
scheduling.
capacity planning & shop floor
controls mainly a PPC tool.
Closed loop is working full MRP II.

Inputs to MRP are Master production schedule.

Bill of materials.
Inventory status file.
Output of MRP
Timing & Quantity of sub assemblies, parts & raw materials required.
MRP UsesPlan Purchase.
Plan Production Action.
Lot sizing:Lot for Lot
EOQ
Minimum cost per period.
Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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INVENTORY MANAGEMENT

Period order Qty. Approach.

Least unit cost approach.
Least Total cost.
Part Period Balancing.

Dr. M KOTEESWARAN

MBA II SEM

POM 2012

Hand Out - 7

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