INVENTROY MANAGEMENT

4.1. Meaning of inventory

The meaning of inventory can be defined in the following two ways (Ahuja; 1992):
 Inventory is an idle resource (physical stock of goods) possessing economic value which
is waiting (kept) for future use. Here the responsibility of materials management is to
maintain sufficient inventories to meet demand for goods and at the same time incurring
the lowest inventory handling costs.
 Inventory is a stock of materials that are used to facilitate production or to satisfy
customers’ demand.
4.2. Functions/importance and types of inventory
4.2.1. Functions/Importance of Inventory
Inventories serve a number of functions. Among the most important are; (Stevenson; 2005)
1. To meet anticipated customer demand - A customer can be a person who walks in off the
street to buy a new stereo system, a mechanic who requests a tool.
2. To smooth production requirements - Firms that experience seasonal patterns in demand
often build up inventories during pre-season periods to meet overly high requirements.
3. To decouple operations - To provide a buffer between successive operations.
4. To protect against stock outs - Delayed deliveries and unexpected increases in demand
increase the risk of shortages.
5. To take advantage of order cycles - To minimize purchasing and inventory costs, a firm
often buys in quantities that exceed immediate requirements.
6. To hedge against price increases - Occasionally a firm will suspect that a substantial price
increase is about to occur and purchase larger-than-normal amounts to beat the increase.
7. To take advantage of quantity discounts - Suppliers may give discounts on large orders.
4.2.2 Types of Inventories

Although inventories are classified in many ways, the following classification is convenient for
use in further discussion of the topic:

i. Production inventories - Raw materials, parts, and components which enter firm’s
product in the production process.

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 ii. Work in process or In-process inventories - Semi finished products found at
various stages of the production
iii. Finished goods inventories - completed products ready for shipment, or waiting for
sale.
iv. MRO inventories - Maintenance, Repair, and Operating supplies which are
consumed in the production process but which do not become part of the product (e.g.,
lubricant, soap).
4.3. Objectives of Inventory Management
Inventory management has two main concerns. One is to have the right goods, in sufficient
quantities, in the right place, at the right time. The other is the cost of ordering and carrying
inventories. The overall objective of inventory management is to achieve satisfactory levels of
customer service while keeping inventory costs within reasonable bounds. Specifically,
inventory control has the following objective;
 Minimize the investment in inventory.
 Minimize warehouse costs.
 Minimize losses from damage, obsolescence and perishable.
 Make forecasts of inventory requirements.
 Establish an inventory system (policies and regulation that monitors inventories).
 Maximize customer service.
 Maximize the efficiency of purchasing and production.
 Maximize profit.
 Ensures availability of materials
 Reduce chances of going out of stock.
 Offers advantage of price discounts from bulk purchasing.
Inventory Management/control thus, determines the levels of inventories or parts, materials and
products that will most effectively protect the production, sales and financial requirements of the
business. In inventory control, we are primarily concerned with the inventory cost control. The
aim is focused to bring down the total inventory cost per annum as much as possible. Two
important questions are (1) how much to stock or how much to buy and (2) how often to buy or
when to buy. An answer to the above questions is usually given by certain mathematical models,
popularly known as “economic order quantity models” or “economic lot/batch size models.”
4.4. Inventory COST
There are four major elements of inventory costs that should be taken for analysis;
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(1) Item (Purchased) costs
This is cost of the item whether it is manufactured or purchased. If it is manufactured, it includes
such items direct material and labor, indirect materials and labor and over head expenses. When
the item is purchased, the item cost is the purchase price of one unit.
(2) Ordering (setup) costs
These are fixed costs usually associated with the production of a lot internally or the placing of
an order externally with a vendor.
(3) Holding (or carrying) costs
If the item is held in stock, the cost involved is the item carrying or holding cost. Carrying
material in inventory is expensive.
(i) Opportunity cost of invested funds. When a firm purchases $50,000 worth of a
production material and keeps it in inventory, it simply has this much less cash to
spend for other purposes. This is the “opportunity cost” associated with inventory
investment.
(ii) Insurance costs. Most firms insure their assets against possible loss from fire and
other forms of damage.
(iii) Property taxes. Property taxes are levied on the assessed value of a firm’s assets.
(iv) Storage costs. The warehouse in which a firm stores its inventory is depreciated a
certain number of dollars per year over the length of its life.
(v) Obsolescence and deterioration. In most inventory operations, a certain %age of the
stock spoils, damaged, pilfered, or eventually becomes obsolete.
(vi) Cost of maintaining inventory records
(vii) The salaries and wages of storing, receiving and issue of material personnel.
NB: - It is convenient to express the holding cost in terms of birr per unit per year.
(4) Shortage (penalty or Stock-out) costs.
The cost of lost production or downtime due to stock out is considered a shortage/penalty cost.
4.5. Nature of Demand in Inventories
The demand for inventory may be dependent or independent.
 Dependent Demand Items: are those items where their demand is related to the
demand for another item. This demand is also known as Derived Demand.
 Independent Demand Items: are those items that are not influenced by
production/operation but by the market forces.

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For example, if an automobile company plans on producing 500 automobiles per day, then
obviously it will need 2,000 wheels and tires (plus spares). The number of wheels and tires
needed is dependent on the production level for automobiles and not derived separately. The
demand for automobiles, on the other hand, is independent-it comes from many sources external
to the automobile firm and is not a part of other products and so is unrelated to the demand for
other products.
4.6. Inventory Model
4.6.1 Inventory Model for Independent Demand
There are a number of mathematical models that can be applied to determine the optimum
(economical) level for independent demand materials. Some of these models are discussed in this
section.
I. Economic Order Quantity (EOQ) Model
The EOQ (Economic Order Quantity) model is one method of determining the adequate
(optimum) inventory level for independent demand materials. It is used to identify a fixed order
size that will minimize the sum of the annual costs of holding inventory and ordering inventory.
Assumptions of this model are;
- Only one product is involved. - Lead time does not vary.
- Annual demand requirement are known. - Demand is constant.
- Each order is received in a single delivery. - There are no quantity discounts
Figure 4.1 below shows clearly that as the order quantity increases, carrying costs rise-and at the
same time ordering costs decrease. Carrying cost is thus a linear function of Q: carrying costs
increase or decrease in direct proportion to changes in the order quantity Q. On the other hand,
annual ordering cost will decrease as order size increases. Therefore, at the point of EOQ, the
total inventory cost will be kept at minimum level.
In constructing any inventory model, the first step is to develop a functional relationship between
the variables of interest and the measure of effectiveness. Thus, total cost obtained by;
Tot Annu Annua Annu
al = al + l + al
Ann Order Holdi Purch
ual ing ng ase
cost cost cost cost

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To develop an equation for total inventory cost and for the purpose of analyzing inventory
models, the following symbols will be used throughout the chapter.
TC = Total annual cost CO = Set up or Ordering cost
D = Annual demand in units Q = Quantity to be ordered
Cc = Carrying cost per unit P = Purchase price per unit or cost per unit.
NB: D and Cc must be in the same units, e.g., months, years.
i. Annual Ordering Cost
Annual (Number of (Ordering cost
Orderin = orders Placed x per order)
g cost per year)

NB - The number of orders per year will be D/Q, and hence:

D
Annual Ordering cost = Q Co
Annual
Holding = (average inventory value) x (inventory carrying cost as a % of inventory
cost value)

ii. Annual Holding Cost

In order to calculate the annual carrying cost (ACc) let us look at the concept of average
inventory. The concept of average inventory is based on the following assumption; Purchase is
made at the beginning, Usage rate is constant and the last item is used on the last date. Then the
average inventory will be Q/2 where Q is the order quantity in units.
Q
Annual holding cost = 2 Cc
iii. Annual Purchase Cost
Annual purchase cost = DP

iv. Total Cost Equation.

TC =

D Q
Co+ Cc +DP
Q 2
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The next step is to find that order quantity, Q, for which total cost is a minimum. This can be
done by Equating ordering and carrying costs. i.e.
NB - Minimum D Q Inventory
( Co )= ( Cc)
Cost = ACc + Q 2 ACo
2
Q
2.D .Co . Cc
Q= √ Cc
by Q)
D.Co = 2 (Multiplying both sides

2D.Co = Q2. Cc (Multiplying both sides

by 2)
2 D .Co
2
Q = Cc

Example
A local distributor for Addis tire company expects to approximately 9,600 steel belted tires of
certain size next year. The annual carrying cost is 16.00 Birr per tier per year and the ordering
cost are 75.00 Birr per order. The distributor operates 288 days a year.

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Required:
1. Determine EOQ.
2. What is the Ordering Cost per year and annual carrying cost at EOQ?
3. What is the total incremental or total inventory cost at EOQ
4. If purchase price per tire is 80.00 Birr. What is the total cost at EOQ?
5. How many times per year the store does reorders.
6. Determine the length of an order cycle.
7. Compute Ordering, Carrying, Total Inventory costs & overall total costs. If order
quantities are 100, 150, 200, 250, 300, 350 and 400 units. What do you infer from this
exercise?
Solution:
Given: D = 9,600
Cc = 16.00 Birr
Co = 75.00 Birr
Working days per year 288

2×D×OC
1. Q 0 = √ CC Where Q0 is optimum Quantity.

2×9600×75
= √ 16
= 300 tires per order.
2. ACc = Q/2 x Cc ACo = D/Q x Co
= 300/2 x 16 = 9,600/300 x75
= 2,400 Birr = 2,400 Birr
3. Minimum Inventory Cost = 2,400 +2,400
= 4,800 Birr
4. Total Cost = ACo + ACc+ DP Pc = is purchase cost
= 2,400 +2,400 +80(9600)
= 772,800 Birr
5. Number of Order per year = Annual Demand
Order Size
= 9,600
300
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 = 32 Order
6. Length of Order Cycle = Annual Working Days x Q0
D
Or
= Annual Working Days
No. of orders per year
= 288 = 9 Working Days
32
7. It means the optimum quantity will be used within working days

Order ACC AOC Annual Overall

Quantity = = Total Total
(Q/2 x (D/Q Inventory Cost
CC) x OC) Cost
100 800 7200 8000 Birr
776,000
150 1200 4800 6000 774,0
00
200 1600 3600 5200 773,200
250 2000 2880 4880 772,880
300 2400 2400 4800 772,800
350 2800 2057 4857 772,857
400 3200 1800 5000 773,000
450 3600 1600 5200 773,200

From this we can infer that that at EOQ, total inventory or overall total cost will be minimum.
When the order size is large, the ACC will be high & for small order sizes the AOC will be high.
Reorder Point (ROP)
The reorder point occurs when the quantity on hand drops to a predetermined amount. That
amount generally includes expected demand during lead time and perhaps an extra cushion of
stock.
Lead-time:- is defined as the time interval between the placing of the orders and the actual
receipt.
i. ROP when demand and lead time are both constant. If demand and lead time are both constant,
the reorder point is simply

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 ROP = d x LT

Where: d = Demand rate (units per day or week)

LT = Lead time in days or weeks.
Note: Demand and lead time must be expressed in the same time units.
Example1:
Mr. X takes two vitamins tablets a Day, which are delivered to his home by a route man seven
days after an order is called in. At what point should Mr. X reorder?
Solution:
Usage = 2 vitamins a day
Lead time = 7 days
ROP = Usage x Lead time
= 2 vitamins per day x 7 days
= 14 vitamins
Thus, Mr. X should reorder when 14 vitamin tablets are left.
ECONOMIC PRODUCTION QUANTITY
 EPQ is also called Economic Run Size
Economic Production Quantity (EPQ) Assumptions
 Production done in batches or lots
 Capacity to produce a part exceeds the part’s usage or demand rate. (p>d)
 Assumptions of EPQ are similar to EOQ except orders are received incrementally during
production.
Economic Production Quantity Assumptions
1. Only one item is involved
2. Annual demand is known
3. Usage rate is constant
4. Usage occurs continuously
5. Production rate is constant
6. Lead time does not vary
7. No quantity discounts
EPQ or ECONOMIC RUN SIZE Formula

2. D . S
EPQ = √ Cc (1−d / p)

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 Where:
S = Set up cost in birr/set up
D = annual demand in units
Cc = Carrying costs in birr//unit/year
d = demand rate
P = production rate
The Run time (the production phase of the cycle) is a function of the run size and production rate
Run time = EPQ/p
Cycle time = EPQ/d
Example for EPQ
A toy manufacturer uses 48,000 rubber wheels per year for its popular dump- truck series. The
firm makes its own wheel, which it can produce at a rate of 800 per day. The toy trucks are
assembled uniformly over the entire year. Carrying cost is Br 1.00 per wheel a year. Set up
cost for a production and change over from the previous production is Br. 45.00. The firm
operates 240 days per year. Determine each of the following.
A) The optimum Size (EPQ)
B) The minimum total inventory cost.
C) The cycle time for the optimal size.
D) The run time.
E) The number of production runs in a year.
F) Maximum level of inventory.
Solution:
Given: D = 48,000
P = 800/day
CC = Br. 1/unit /year
Sc = Br. 45/production
Run
Working Days = 240 days

Daily demand = 48000 = 200/day

240

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 A) The optimum Size

2×D×Sc
= EpQ = √ (1−d / p)×cc

2×48 ,000×45
= √ (1−200/800 )×1 = 2400 Wheels

Here one run will last for 3 days = 2400/800 and form these quantity level 600 wheels will be
consumed (3 x 200) and the remaining 1,800 units will be kept in the sore.
B) The minimum Total inventory cost is = ASc + ACc
D Q d
 The Total Annual =
( ) Q0
×Sc 1− ×CC
2 p ( )
48 , 000 2 , 400 200
=
( 2400 )
×45+
2
1−(800
×1 )
= 900 + 900
= Birr 1,800
C) The cycle time for the optimal run size:
Optimum Quantity = 2,400 =12 Working days
Daily Demand 200
The optimal run size covers 12 working days. i.e. 3 days for production & usage time & 9 days
will be idle time.
D) The Run time:
t = Q0 = 2,400 = 3 days
p 800
E) The number of production runs in a year:
= Annual demand = 48000 = 20 runs.
Optimal Quantity 2,400
The 20 runs cover 60 production days. I.e. 20 x 3 = 60 days and in this period there is
production and consumption simultaneously. The remaining 180 days are idle time between runs
& during these periods there is only consumption.
F) Maximum inventory level:
= Q0 x (1 – d/p)

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 = 2,400 (1- 200/800) = 1800

4.6.2 Inventory Model for Dependent Demand

To address the inventory issues that are associated dependent products for example, the demand
for automobile tires is dependent on the demand for cars. Similarly, the demand for keyboards is
dependent on the demand for personal computers, a concept known as Materials Requirements
Planning (MRP) is used.
Before directly going to materials requirement planning (MRP), there are two plans that should
be developed prior to MRP:
Aggregate planning:- is the process of planning the quantity and timing of output over the
intermediate time horizon (often 3 months to 1 year). The main purpose of the aggregate plan is
to specify that combination of production rate, workforce level, and the resulting inventory on
hand.
Master production schedule (MPS):- is developed directly from the aggregate plan-and is the
instrument that drives the firm’s entire production system. The aggregate plan establishes an
overall level of operations that balances the plant’s capability with external sales demand. The
master schedule translates the aggregate plan into specific numbers of specific products to be
produced in identified time periods.
Material Requirements Planning (MRP)
MRP is a computer-based information system that translates the finished product requirements of
the master schedule into time-phased requirements for subassemblies, component parts, and raw
materials, working backward from the due date using lead times and other information to
determine when and how much to order.
MRP is designed to answer three questions: what is needed? How much is needed? and when it
is needed?
MRP Inputs
An MRP system has three major sources of information/inputs: a master schedule, a bill-of-
materials file, and an inventory records file.
i. The Mater Schedule
The master schedule also referred to as the master production schedule, states which end items
are to be produced, when they are needed, and in what quantities. The quantities in a master

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schedule come from a number of different sources, including customer orders, forecasts, and
orders from warehouses to build up seasonal inventories.

ii. The Bill of Materials

A bill of materials (BOM) contains a listing of all of the assemblies, subassemblies, parts, and
raw materials that are needed to produce one unit of a finished product. Thus, each finished
product has it own bill of materials. The listing in the bill of materials is hierarchical and it is
clear when you consider a product structure tree.

B (2) C

E E(2) F(2)
X
D(3)
E(4)

Use the information presented above

a. Determine the quantities of B, C, D, E, and F needed to assemble one X.
b. Determine the quantities of these components that will be required to assemble 10 Xs,
taking into account the quantities on hand (i.e., in inventory of various components):
Componen On
t hand
B 4
C 10
D 8
E 60
Solution:
1x
X

B: 2x1=2 B C=1x1=1 C
(2)

E: 2x1=2 E F: 2x1=2 E (2)

D: 3x2=6 D (3)E: 1x2=2 E (2)

E: 4x6=24 E
(4)
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Thus, one X will require - B: 2 D: 6
C: 1 F: 2
E: 28 (Note that E occurs in three places, with requirements of
24+2+2= 28)
iii. The Inventory Records
Inventory records refer to stored information on the status of each item by time period, called
time buckets. This includes gross requirements, scheduled receipts, and expected amount on
hand. It also includes other details for each item, such as supplier, lead time, and lot size policy
changes due to stock receipts and withdrawals, canceled orders, and similar events also are
recorded in this file.
MRP Processing
The essence of MRP is determining the quantity and timing necessary for each component in
order to achieve the quantity and timing of end items in the master schedule.
Conceptually, this is the same as identifying and end items product tree. Next, the actual amounts
(net requirements) of each component are determined, level-by-level, beginning at the top of the
tree and working down.

Net = Gross - Projectd + Safety stock

requirements requirement inventory in (if any)
in period t s in period t period t

Definition of Terms
Gross requirement: The total expected demand for an item or raw materials during each time
period without regard to the amount on hand.
Scheduled receipts: Open orders (orders that have been placed and are) scheduled to arrive from
vendors or elsewhere in the pipeline by the beginning of a period.
Projected on hand: The expected amount of inventory that will be on hand at the beginning of
each time period: scheduled receipts plus available inventory form last period.
Net requirements: The actual amount needed in each time period.
Planned-order receipts: The quantity expected to be received by the beginning of the period.
Under lot-for-lot ordering, this quantity will equal net requirements.

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Planned-order releases: Indicates a planned amount to order in each time period; equals
planned-order receipts offset by lead time. This amount generates gross requirements at the
next level in the assembly or production chain. When an order is executed, it is removed
from “planned-order releases” and entered under “scheduled receipts.”
Lot-for-Lot Ordering: Perhaps the simplest of all the methods is lot-for-lot ordering. The order
or run size for each period is set equal to demand for that period. Not only is the order size
obvious, it also virtually eliminates holding costs for parts carried over to other periods.
Hence, lot-for-lot ordering minimizes investment in inventory.
Format for MRP
Week 0 1 2 3 4 5 6 7 8
Number
Item:
Gross
requirements
Scheduled
receipts
Projected on
hand
Net
requirements
Planned-
order
receipts
Planned-
order
releases

Illustration on MRP
Suppose that we want to produce product T, which consists of two parts U, three parts V, and
one part Y. Part U, in turn, is made of one part W and two parts X. Part V is made of two parts
W and two parts Y. Figure 4.5 shows the product structure tree for product T.

U (2) V (3)

Y (1)

W (1) X (2) W (2) Y (2)

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 Figure 4.5 Product Structure Tree for Product T

Assume that the lead times to make the parts and their respective on-hand inventories and
scheduled receipts are as follows:

Part Lead On-Hand

*Subassemblies or Scheduled
pats that have been previously
Time(weeks) Inventory Receipts*
ordered but are not scheduled
T for delivery
1 until a future
25 date (week- three for subassembly U in
U 2 5 5
this example). V 2 15 -
W 3 30 -
If 100T is required,X we can create 2
a time schedule
20
chart specifying
-
when all the material
necessary to build T Ymust be ordered1 and received to10meet this requirement.
-

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4.7. Inventory analysis system (classification)

Items that are in the inventory are not of equal importance in terms of the amount invested, profit
potential, sock-out penalties…etc. Therefore, all items do not deserve the same degree of
attention.

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Inventory can be controlled by selective control methods based on Pareto 80-20 principle,
which states that there are a critical few and trivial many.
According to this all the items of an industry are classified into some broad groups on certain
basis and the attention is paid to their control accordingly. It is not practical to monitor
inexpensive items with the same intensity of care as very expensive items.
Some of the popular classifications selective control techniques are as follows:
• ABC classification
• FSN classification
• VED classification
1. ABC classification
ABC stands for ‘always better control’. The items on hand are classified into A, B, and C types
on the basis of the value in terms of capital or annual dollar usage (i.e., dollar value per unit
multiplied by annual usage rate), and then allocates control efforts accordingly.
Thus, the items with high value and low volume are kept in A-type, items with low value and
high volume are kept in C-type, and the items with moderate value and moderate volumes belong
to the B-type.
A-type items are given the maximum attention while ordering for purchase, and C-type the least.
B-type gets the moderate attention. Typically, three classes of items are called: A (very
important), B (moderately important), and C (least important).
The actual number of categories varies from organization to organization, depending on the
extent to which a firm wants to differentiate the control efforts. With three classes of items, A
items generally account for about 15 to 20 percent of the number of items in inventory but about
60 to 70 percent of the dollar usage. At the other end of the scale, C items might account for
about 60 percent of the number of items but only about 10 percent of the dollar usage of an
inventory.
The distributions of these three types are shown in Figure below.

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A type items should receive close attention through frequent reviews of amounts on hand and
control over withdrawals to make sure that customer service levels are attained. The C type
items should receive lesser control (e.g. two-bin systems, bulk orders), and the B type items
should have controls that lie between the two extremes.
Note that C type items are not necessarily unimportant; incurring a stock-out of C items such as
the nuts and bolts used to assemble manufactured goods can result in a costly shutdown of an
assembly line. However, due to the low annual dollar volume of C items, there may not be much
additional cost incurred by ordering larger quantities of some items, or ordering them a bit
earlier.
2. FSN Classification
In this method, the items are classified according to the rate of consumption. Thus, the
materials can be fast (F), slow (S) and non-moving types (N).
F-type materials get the maximum attention and the N type the minimum for their control and
procurement.
Let us apply this concept in our kitchen as they say charity begins at home. Let the different
items in our home be: rice, salt, sugar, tea, vegetables, fruits, medicine, cosmetics, shaving
blades, wound plasters, and dry-fruits.
According to FSN, they can be classified as
F = Rice, salt, sugar, tea are consumed almost daily at relatively faster rate and they need
more attention to avoid stock-out situation in the house especially if some unexpected
guests happen to drop in from somewhere.
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 S = Fruit, dry fruits are consumed at a moderate speed and need moderate attention.
N = Medicine, shaving blades, wound plasters; cosmetics are consumed at a very
negligible rate and need less attention. They can be bought once and can be consumed
leisurely when need arises.
The same concept can be extended to industrial or war situation. For example, the bullets are fast
moving items but a nuclear bomb is almost a non-moving item. In fact it may never be used but
it consumes lot of revenue. Such items are sometimes called insurance items as they ensure a
kind of deterrent and may prevent a war between two nations just by their presence.
3. VED Classification
The materials are classified according to its criticality in the production system. Thus,
materials can be vital (V), essential (E) and desirable (D) types. Maximum attention is paid to the
procurement and control of vital items and less to the desirable ones. It is so because the lack of
vital items can bring the production of the plant down and the plant will run into losses.
 V-item – are items when go out of stock or when not readily available, completely bring
the production to a halt. So, they should be stored adequately to insure continuous
production.
 E-item – are items without which temporary losses of production or dislocation of
production work occurs.
 D-item – are all other items which are necessary but do not cause any immediate effect on
production.

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