INVENTORY MANAGEMENT
during off-season periods to meet
Learning Objectives – After completing
this topic, you should be able to:
1. Define inventory.
2. Identify types of inventory.
3. List some reasons why
organizations have inventory.
4. Discuss the concerns and objective
of inventory management.
5. List the two basic inventory
decisions.
6. List the requirements for effective
inventory management.
7. Discuss the relevant inventory costs.
8. Discuss the two general types of
inventory systems and do the
computations related to each type.
INVENTORY – a stock or store of goods.
TYPES OF INVENTORIES
1. Raw materials and purchased parts
2. Work-in-process or partially completed
goods
3. Finished goods (manufacturing firms)
or merchandise (retail stores)
4. Replacement parts, tools, and supplies
5. Goods-in-transit to warehouses or
customers
WHY ORGANIZATIONS HAVE
INVENTORY
1. To meet anticipated demand
 Anticipation stocks are held to
satisfy expected average demand.
2. To protect against stockout
 Safety stocks, which are stocks in
excess of average demand to
compensate for variability in demand
and lead time, can reduce the risk of
shortages.
3. To smooth production requirements
 Seasonal inventories are stored
overly high requirements during
certain seasonal periods.
4. To decouple components of the
production-distribution system
 Buffer inventories are stocked
between successive operations to
maintain continuity of succeeding
operations in case of disruptions in
preceding operations.
 Raw materials and supplies
inventories serve as buffer between
the suppliers and the firm.
 Work-in-process inventories serve as
buffer between successive
workstations.
 Finished goods inventories serve as
buffer between the firm and its
customers.
5. To permit operations
 Pipeline inventories exist throughout
the production-distribution system due
to the fact that production operations
take time; i.e., they are not
instantaneous.
6. As a result of taking advantage of order
cycles
 To minimize purchasing and
transportation costs, a firm may buy in
quantities that exceed immediate
requirements. This necessitates
storing the excess for later use.
 Similarly, it is usually economical to
produce in larger rather than small
quantities. Again, the excess output
must be stored for later use.
7. As a result of hedging against price
increases or taking advantage of quantity
discounts
 Occasionally, a firm may suspect that
a substantial price increase is about to
occur and, thus, purchase larger-than-
normal amounts to avoid the increase.
THE 2 CONCERNS OF INVENTORY
MANAGEMENT
1. Availability of the stock when needed –
to maximize level of customer service
2. Cost of ordering and carrying the
inventory – to minimize inventory costs
THE OBJECTIVE OF INVENTORY
MANAGEMENT
 To achieve satisfactory levels of
customer service while keeping
inventory costs within reasonable
bounds; i.e., try to achieve a balance
between the two concerns.
THE 2 BASIC INVENTORY DECISIONS
1. Order quantity (size) – How much to
order
2. Reorder point (timing) – When to
order
REQUIREMENTS FOR EFFECTIVE
INVENTORY MANAGEMENT
1. A system to keep track of the inventory
on hand and on order
2. A reliable forecasting system that
includes an indication of possible
forecast error.
3. Knowledge of lead time and lead time
variability.
4. Reasonable estimates of inventory
procurement costs, storage costs, and
shortage costs.
5. A classification system for prioritizing
inventory items.
THE 4 RELEVANT INVENTORY COSTS
1. Cost of the item or purchasing
costs
 The sum paid to the supplier for the
item received.
 The direct manufacturing cost.
 Irrelevant if the item unit cost is
constant for all quantities ordered.
 Relevant if item unit cost varies
with quantity ordered, e.g., quantity
discounts.
2. Ordering or setup or procurement
costs
 The costs incurred by placing an
order for and receiving the item or
incurred as setup costs when item
is manufactured.
 Include cost of postage, phone
calls to vendors, labor costs in
purchasing and accounting,
receiving costs, record keeping and
purchase order supplies.
3. Carrying or holding or storage
costs
 The costs associated with having
the inventory on hand.
 Include insurance, warehouse
rental, heating and lighting, taxes,
losses due to pilferage, spoilage, or
breakage.
 Opportunity cost – for having
capital tied up in inventory.
4. Stockout or shortage costs
 The costs associated with demand
when stocks have been depleted.
 Lost sales
– actual unmade sales
– lost customer goodwill
 Backorder costs
– money spent to reorder goods
– money spent to notify customers
when goods arrive
– loss of goodwill
ASSUMPTIONS OF THE BASIC EOQ MODEL

1. There is only one item involved.

2. Annual demand (usage) is known.
3. Demand (usage) rate is uniform.
4. The item unit cost does not vary with the
order size (no quantity discounts).
5. Each order is received in a single delivery.
6. Lead time is known and does not vary.
7. Ordering or setup cost is the same
regardless of the amount ordered.
8. Inventory holding cost is based on average
inventory level.
9. All demands for the item will be satisfied (no
stockout; no backorder).

SYMBOLS USED IN THE BASIC EOQ MODEL

TC = Total annual inventory cost

D = Annual demand, units
C = Cost per unit of the item, P/unit
Q = Quantity to be ordered (the optimum
amount is the economic order quantity,
EOQ)
S = Setup or ordering cost, P/order
H = Annual holding or carrying cost per unit of
average inventory, P /unit;
(Often, holding cost is expressed as
percentage of the item unit cost, such that
H = i C, where i is the percent carrying
cost).
L = Lead time, days
R = Reorder point, units

INVENTORY COSTS vs. ORDER QUANTITY

D Q
T .C.  S  H
Q 2
Q
HoldingCos t  H
2
Annual cost

D
OrderingCost  S
Q

EOQ Order quantity