INTRODUCTION

Inventory can be one of the most expensive assets of an organization. It may account for more
than ten percent of total revenue or total assets for some organizations. Although companies in
the manufacturing sector usually carry more inventory than service firms, effective inventory
management is nonetheless important to both manufacturers and service organizations. Table 7.1
shows the amount of inventory, and the ratio of inventory to total revenue and total assets, of a few
large globally recognized manufacturing and service firms. While the inventory to total assets ratio
for service organizations such as casino hotels (such as the first two companies shown in Table
7.1) is relatively low compared to most manufacturers, inventory management for service firms
poses a different challenge. Casino hotels for example carry a wide range of perishable food
items to stock the diverse restaurants operating within their properties. Managing perishable
inventory presents a unique challenge to operations managers. Inventory management policy
affects how efficiently a firm deploys its assets in producing goods and services. Developing
effective inventory control systems to reduce waste and stockouts in manufacturing or service
organizations is a complex problem. The right amount of inventory supports manufacturing,
logistics and other functions, but excessive inventory is a sign of poor inventory management
that creates unnecessary waste of scarce resources. In addition, excessive inventory adversely
affects financial performance. The need for better inventory management systems continues to
challenge operations managers. This chapter first explains the difference between dependent
demand and independent demand items. Then it focuses on the independent demand items to
describe the basic concepts and tools of inventory management, including the ABC inventory
control system, inventory costs and radio frequency identification. The chapter also discusses
the three fundamental deterministic inventory models and the two major types of stochastic
inventory models.

Dependent demand: Is the internal demand for parts based on the demand of the final
product in which the parts are used. Subassemblies, components and raw materials are
examples of dependent demand items. Dependent demand may have a pattern of abrupt and
dramatic changes because of its dependency on the demand of the final product, particularly if
the final product is produced in large lot sizes. Dependent demand can be calculated once the
demand of the final product is known. Hence, material requirements planning (MRP) software
is often used to compute exact material requirements. The dependent demand inventory
system was discussed in Chapter 6. For example, the ATV Corporation’s master production
schedule discussed in Table 6.4 in Chapter 6 shows that 120 all-terrain vehicles will be produced
in January. The firm thus knows that 120 handlebars and 480 wheel rims will be needed. The
demand for handlebars, wheel rims and other dependent demand items can be calculated
based on the bill of materials and the demand of the final product as stated on the master
production schedule.
Independent demand: Is the demand for a firm’s end products and has a demand
pattern affected by trends, seasonal patterns and general market conditions. For example, the
demand for an all-terrain vehicle is independent demand. Batteries, headlights, seals and
gaskets originally used in assembling the all-terrain vehicles are dependent demands; however,
the replacement batteries, headlights, seals and gaskets sold as service parts to the repair shops
or end users are independent demand items. Similarly, the original battery used in assembling
your new car is a dependent demand item for the automobile manufacturer, but the new
battery that you bought to replace the original battery is an independent demand item.
Independent demand items cannot be derived using the material requirements planning logic
from the demand for other items and, thus, must be forecasted based on market conditions.

Inventory Costs
The bottom line of effective inventory management is to control inventory costs and minimize
stockouts. Inventory costs can be categorized in many ways: as direct and indirect costs; fixed
and variable costs; and order (or setup) and holding (or carrying) costs. Chapter 7 Inventory
Management 211 Direct costs are those that are directly traceable to the unit produced, such
as the amount of materials and labor used to produce a unit of the finished good. Indirect costs
are those that cannot be traced directly to the unit produced and they are synonymous with
manufacturing overhead. Maintenance, repair and operating supplies; heating; lighting;
buildings; equipment; and plant security are examples of indirect costs. Fixed costs are
independent of the output quantity, but variable costs change as a function of the output level.
Buildings, equipment, plant security, heating and lighting are examples of fixed costs, whereas
direct materials and labor costs are variable costs. A key focus of inventory management is to
control variable costs since fixed costs are generally considered sunk costs. Sunk costs are costs
that have already been incurred and cannot be recovered or reversed. Order costs are the
direct variable costs associated with placing an order with the supplier, whereas holding or
carrying costs are the costs incurred for holding inventory in storage. Order costs include
managerial and clerical costs for preparing the purchase, as well as other incidental expenses
that can be traced directly to the purchase. Examples of holding costs include handling charges,
warehousing expenses, insurance, pilferage, shrinkage, taxes and the cost of capital. In a
manufacturing context, setup costs are used in place of order costs to describe the costs
associated with setting up machines and equipment to produce a batch of product. However, in
inventory management discussions, order costs and setup costs are often used interchangeably