Abstract

The word Inventory refers to any kind of resource that has economic value and
is maintained to fulfil the present and future needs of an organization.
Inventory of resources held to provide desirable service to customers (users)
and to achieve sales turnover target. Investment in large inventories adversely
affects an organizations cash flow. Working capital as investment in inventory
represents substantial portion of the total capital investment in any business. It
is, therefore, essential to balance the advantage of having inventory of resources
and the cost of maintaining it so as to determine an optimal level of inventory of
each resource. This would ensure that the total inventory cost is minimum.

Introduction
The word inventory refers to any kind of resource that has economic value and
is maintained to fulfil the present and future needs of an organization. Fred
Hansman defined inventory as: an idle resource of any kind provided such a
resource has economic value. Such resources may be classified into three
categories:
(i)
(ii)
(iii)

Physical resources such as raw materials, semi finished goods,

finished goods, spare parts, lubricants, etc.
Human resources such as unused labour (manpower)
Financial resources such as working capital, etc.

The following are a few examples of the type of inventory held by various
organizations. Since the final product of a service organization such as bank,
hospital, etc. cannot be stored for use in the future, the concept of inventory
control for them is associated with the various forms of productive capacity.

Type of organization
1.Manufacturer
goods, spare parts, etc
2.Hospital
personnel, etc.
3.Bank
4.Airline Company
maintenance, crew, etc.

Type of Inventories Held

Raw materials, semi-finished goods, finished
No. of beds, stock of drugs, specialized
Cash reserves, tellers, etc.
seating capacity, spare parts, specialized

Meaning of Inventory Control

Inventory control systems appear complicated; however, there are only a few
basic questions that need to be answered for an efficient control of inventory.
The most important of these are:
1. What items should be stocked :
Since physical storage of inventory items is expensive, control is needed
to ensure that inventory level remains as low as possible. This implies
that:
Inventory level of existing items is kept at reasonable level.
Unnecessary items are not added to the inventory.
Items which have not been used for long time are removed from
the inventory.

The decision regarding physical storage of items needs an efficient inventory

policy to develop trade-off between holding cost and demand of items. That is,
comparison should be made between costs and benefits of holding an item n
stock. Regular audit is required on the usage of items already in stock, and to
discontinue stocking of certain item if it is cheaper.

2. When should an order be placed replenish inventory :

There are three different approaches to check the status of inventory.
Periodic review system in which orders are placed at regular
interval of time. The quantity ordered varies, depending on the
inventory in hand and in order at the time of review. This system is
often used in situations where the level of inventory is reviewed at
the end of fixed intervals of time and units consumed are
replenished.
Fixed order quantity system is one in which the level of inventory
is monitored regularly and when it drops to a specified level; a
replenishment order for a fixed quantity is placed. Variation in
demand is allowed by changing the time between orders.
Optimal replenishment system combines a periodic review system
with a minimum order quantity restriction. If the calculated order
3

quantity is less than the minimum forecasted value, no order is

placed. This avoids the placement of small orders.
3. How much should be ordered in each replenishment :
Every time an order is placed, there are certain costs incurred on account
of administration, transportation, inspection, etc. If large and frequent
orders are placed, it increases the level of inventory. Consequently the
average inventory value then becomes high. If small and frequent orders
are placed, it increases the cost of ordering and delivery but the average
stock level becomes low. Thus the objective becomes to determine
optimal inventory policy so as to minimize the total inventory cost. The
order quantity usually depends on:
Demand pattern
Price of an item, discount options, total budget and warehouse
space, etc
Lead time.

Functional Role of Inventory

Since investment in inventory represents a substantial portion of the total capital
investment in any business, therefore, questions like, why invest funds in
inventory? And what benefit can be derived by investing in inventories? are
frequently raised. However, certain distinct forms of inventories are discussed
below. The summary of inventory functions and their forms are shown in table
1.
Inventory
Functions

Inventory forms
Raw material
Finished Goods

Logistics decisions
Transmit
(pipeline)

Work-in-progress

Design of supply Design of layout Design of plant

system, supplier and
materials location
and
location,
handling system.
product
transportation
distribution
mode.
system.
Product/process Design decisions
Cycle (EOQ,lots) Order size, order cost Lot size, set-up Distribution
cost
costs, lot sizes
Management risk Level Decision and Uncertainty
Buffer
Probability
Probability
Probability
(uncertainty)
distribution
of distribution
of distribution
of
price,
supply, machine
and demand
and
stock out and product
associated
carrying costs.
capabilities.
carrying
and
shortage costs.
Price Availability Decision and Uncertainty, seasonality Capacity
Anticipation
Know future supply Capacity,
Demand
(price/shortage)
and demand price production costs patterns
levels.
of hire,
fire, (seasonal).
transfer,
overtime,
idle
time, etc
Production Control Decisions
Decoupling (inter- Dependence/interdepe Dependence/inte Dependence/in
5

dependence)

ndence from supplier rdependence of terdependence

behaviour
successive
from market
production
behaviour.
Lot size (or cycle) inventory: It is the inventory necessary to meet the average
demand during the successive replenishments. The amount of such inventory
depends upon the production lot size, economical shipment quantities,
warehouse space available, replenishment lead time, inventory carrying cost,
etc.
Pipeline (or transit) inventory: Since the movement of item cannot be
instantaneous, optimal inventory level is required for shipment of inventory
items to distribution centres and customers from production centres. Such an
inventory is called a process inventory. This is because as it consists of materials
actually being worked on or moving between work centres.
Safety (or buffer) inventory: It is the specific level of extra stock of inventory
that is maintained for protection against uncertainties of demand and the lead
time necessary for delivery of goods. Despite the principle of just-in-time as
well as expected customer service needs, the demand and lead time both, in
general, are random variables with known probability distribution.
Seasonal inventory: Inventory is also needed for items whose sales depend
upon seasonal pattern of demand and whose production or supply is not uniform
i.e. it varies with time. These include fashion items, agriculture products,
calendars, etc. In these cases the manufacturer faces peak demand where the
production facility is unable to meet demand on a period-by-period basis.
Decoupling inventory: If various manufacturing processes operate
successively, then in the case of the breakdown of one, or due to any
disturbance at some stage, the entire system could be affected. The decoupling
inventories may be classified into four groups:
(a) Raw materials and Component Parts: The bulk part of physical storage in
terms of volume and value is of raw materials because it is processed to
finished products. Thus, the raw materials inventory is used to decouple
the producer from the supplier.

(b) Work-in-Process Inventory: Since it takes time to convert raw material

into finished goods, work-in-process inventory is incurred. This may be
6

due to unbalanced loading of machines, holdups, shortages of tools, etc.

This inventory takes the form of orders waiting to be transported between
machines or of orders waiting to be processed on a particular machine.
(c) Finished Goods Inventory: This is the inventory of final products that
could be released for sale to the customers. The size of this inventory
depends upon the demand, and the ability of the firm to sell its products.

(d) Spare Parts Inventory: These are the parts that are used the production
process but do not become part of the product. The size of the inventory
depends on the average life of the components.

Reasons for Carrying Inventory

Inventory has been viewed as a necessary evil (non-earning asset) that cannot be
eliminated. It is termed as evil because maintaining inventory ties up money
that could otherwise have been used for alternative purposes. It also increases
carrying cost. However, it is considered a necessary investment to achieve
workable system of production, distribution and marketing of physical goods.
Reasons for carrying inventory are as follows:
1. Improve customer service: An inventory policy cannot be designated to
respond to customers request for products or services in an instantaneous
manner. It provides a desirable level of product or service to the
customers. An optimal level of inventory maintains the sales as well as
increases it to certain extent.
2. Reduce Costs: Inventory holding or carrying costs are the expenses that
are incurred during the storage of items. However, carrying items in the
warehouse can indirectly reduce operating costs in other activities and
may actually bring in more revenue than carrying costs.
3. Maintenance of operational capability: One of the advantages of
stocking inventory of raw materials and work-in-process items is to link
various production stages so that downtime in one stage does not affect
the entire production process. It helps to continue the production by
acting as buffer between successive stages of production.
4. Irregular Supply and Demand: Any change in production and delivery
schedule of a product or a service has its impact on the operating costs as
well as the customer service level.
5. Quantity Discounts: Large size replenishment orders help to take
advantage of price-quantity discount because many suppliers offer
discounts for large orders. However, such an advantage must keep a
balance between the storage costs and costs due to spoilage, damaged
stock, theft, insurance, etc.
6. Avoiding stock outs (shortages): Labour strikes, natural disasters,
variations in demand, and delays in suppliers are the type of
contingencies against which inventories can afford some protection. A
company also requires large inventories in order to avoid the reputation
of constantly being out of stock.
8

Factors involved in Inventory Problem Analysis

A number of factors must be considered while analysing inventory problems.
Among the most important are:
(a) Relevant inventory cost
(b) Demand for inventory items
(c) Replenishment lead time
(d) Length of planning period
(e) Constraint on the inventory system

Regardless of the type of inventory items maintained, an inventory system that

comprises the various sub-systems is shown as follows:
Systems Performance
(Total Inventory Cost)

Inventory System

Replenishment
pattern

Demand Pattern

(i)Instantaneous

Deterministic

(ii)Gradual

Operating
constraints

Probabilistic
Operating
Decision Rules

(a)Warehouse

How much to
order (Order
Quantity)

When to order
(reorder point)

(b)Finance

(c)No. of units of each item

Buffer stock
Safety stock
Reserve stock

Customer service
level

#1 Inventory Cost Components

The costs that are affected i.e. increase or decrease by the firms decision to
maintain a particular level of inventory is called relevant costs. These costs play
an important role in the study of an inventory system. These are classified as:
Purchase Cost: This cost consists of the actual price paid for the procurement
of items. Its unit of measurement is Rs per unit. The unit price C of an item is
independent of the size of the quantity ordered or purchased. The purchase price
is given by
Purchase cost = (Price per unit) X (Demand per unit time) = C.D
When price-break or quantity discounts are available for bulk purchase above a
specified quantity, the unit price becomes smaller as the size of order, Q,
exceeds a specified quantity level. In such cases the purchase cost become
variable and depends on the size of the order. In this case, purchase cost is given
by
Purchase cost = (Price per unit when order size is Q) X (Demand per unit time)
= C (Q).D

Carrying Cost: these are the expenses incurred for holding inventory items in
the warehouse. They include:
(i)
(ii)
(iii)
(iv)
(v)
(vi)

Storage cost for providing warehouse space to store the products

Inventory handling cost for payment of salaries to employees
Insurance cost against possible loss from fire or other damage
Opportunity cost of the money invested in inventory
Obsolescence and deterioration costs when a portion of inventory
becomes either obsolete or is lost
Depreciation

Carrying cost = (Cost of carrying one unit of an item in the inventory for a
given length of time, usually one year) X (Average no of
units of an item carried in the inventory for a given length)

10

Ordering cost: includes all costs that do not vary with the size of the order but
are incurred each time an order is placed for procuring items from the outside
suppliers. The cost per order generally includes:
(i)
(ii)
(iii)
(iv)

Requisition cost of handling of invoices, stationery, payments, etc.

Cost of services which include cost of mailing, telephone calls,
transportation, and other follow up actions.
Materials handling cost incurred in receiving, sorting, inspecting and
storing the items.
Accounting and auditing.

Ordering cost = (Cost per order) X (No. of orders)

Shortage and customer-service cost: The shortage of items occurs when items
cannot be supplied on demand. The shortage can be viewed in two different
ways:
(i)
(ii)

The supply of items is awaited by the customers; i.e. the items are
back-ordered.
Customers are not ready to wait.

Shortage cost = (Cost of being short one unit of an item) X (average no of units
short)

Total inventory cost: If a unit of an item depends on the quantity purchase, i.e.
price discounts are available than we should formulate an inventory policy what
takes into consideration the purchase cost of items also held in stock. The total
inventory cost is then given by
Total Inventory Cost = Purchase cost + Ordering Cost + Carrying Cost +
Shortage Cost

11

#2 Demand for Inventory Items

The understanding of the nature of demand i.e. the size and pattern for the
given inventory item is essential to determine an optimal inventory policy
for that item. The size of the demand refers to the no. of units of the item
required in each period. The size may be deterministic or probabilistic.
The pattern of demand is the manner in which inventory items are required by
the customers. The demand for a given period of time may be satisfied
instantaneously at the beginning of the period, or uniformly during the period.

#3 Replenishment Lead Time

Order cycle is the time period between two successive replenishments. It may
be determined in two ways:
Continuous Review: this is also called perpetual inventory record as the
no of units of an item on hand are always known. In this case an order of
fixed size is placed every time the inventory level reaches at a prespecified level.
Periodic Review: in this case the orders are placed at equal intervals of
time, but the size of the order may vary depending on the inventory on
hand as well as on order at the time of review.

Lead time When an order is placed, it may require some time before the
delivery of the items ordered is reached. The time delay between placing an
order and receipt of delivery is called lead time.

Stock replenishment Although an inventory may operate with lead time, the
actual replenishment of stock may occur instantaneously or gradually.

12

#4 Length of Planning Period

The length of planning period defines the period over which a particular
inventory level will be maintained. This period may be finite or infinite
depending on the nature of demand.

List of Symbols used

C : Purchase cost of an item (Rs/unit)
Co: Ordering cost per unit( Rs/unit)
r : cost of carrying one rupees worth of inventory expressed in terms of
% of rupee value on inventory (% per unit time)
Ch : C.r = Cost of carrying one unit of an item in the inventory for a
given length of time (Rs per item per unit time)
Cs : shortage cost per unit per time(Rs per unit time)
D : annual demand of an item (units per unit time)
Q : order quantity
ROL : reorder level or point
LT : replenishment lead time
n : no. of orders per time period
t : reorder cycle time
tp : production period
rp : production rate
TC : total cost
TVC : total variable cost

Single item Inventory Control Models without Shortages

13

Model I(a) : EOQ Model with Constant Rate of Demand

In this model, demand is assumed to occur at constant rate for an infinite time
into future. The objective is to select an inventory policy i.e. to choose an
economic order quantity Q* (EOQ) the ordering frequency (time when an order
must be placed) in such a way that the total yearly inventory cost is minimized.
For this model, the following characteristics are assumed :

The inventory system involves one type of item or product.

The demand is known and constant and is resupplied instantaneously.
The inventory is replenished in single delivery for ezch order.
Lead time (LT) is constant and known, i.e. replenishment is
instantaneous, so that inventory increases by q units as as an order is
placed.
Shortages are not allowed.
Purchase price and reorder costs do not vary with the quantity ordered.
That is, the quantity discount is not available.
Carrying cost per year as a fraction of product cost) and ordering cost per
order are known and constant.
Each item is independent and money cannot be saved by substituting by
other items or grouping cost several items into a single order.

Though in practice these assumptions seem unrealistic, however, we should

remember the following two points:
1. The main purpose of this simplified model is to derive useful results
rather than representing real-life problems. The results so obtained may
not provide an optimal answer to real-life problems but they are goo
approximations and provide useful guidelines.
2. It is a basic model and can be extended in many ways. The few
assumptions made in this model will be removed in the subsequent
models to bring them close to realistic problems of inventory control.

14