INVENTORY MANAGEMENT

CHAPTER 9
 • Inventory is defined as goods on
hand or any stock of economic
resources at a given point of
time, in anticipation of
satisfying a future demand for
them.
• The objective of inventory
management is to strike a
balance between inventory
investment and customer
service.
• Inventory investment involves a
trade off between risk and
return.
• Nevertheless having excess
inventories will burden firms
financially as it involves high
inventory carrying costs in the
form of:
– Cost of capital

INTRODUCTION – Storage and insurance fees

– Risks
obsolesces
of potential
OBJECTIVES OF INVENTORY
MANAGEMENT
 FUNCTIONS OF INVENTORY
1. TO MEET ANTICIPATED DEMAND
The demand for finished goods may fluctuate due to
seasonal or other factors.
2. TO SMOOTHEN PRODUCTION REQUIREMENT
Production may be interrupted due to insufficient stocks;
therefore inventory helps in preventing interruptions in
production schedules due to late delivery or insufficient
materials in stocks.
3. TO PROTECT AGAINST STOCK OUT
To meet unforeseen circumstances that arise as a result of
inconsistent demand and delivery time.
 FUNCTIONS OF INVENTORY
4. TO HEDGE AGAINST FUTURE PRICE INCREASE
By buying more and stocking up more when price is
low enables firm to temporarily reduce the
purchasing cost.
5. TO TAKE ADVANTAGE OF QUANTITY
DISCOUNTS
Suppliers usually offer discounts to encourage bulk
buying.
 TYPES OF INVENTORY
1. INVENTORY OF RAW MATERIALS –
Items purchased by firms such as parts, components and spare
parts for machines, tools and other supplies are needed to
produce finish products.
2. INVENTORY OF WORK IN PROGRESS (WIP) –
Partially completed items that are currently in production or
semi-finished products that require additional work before
they become finished goods.
3. INVENTORY OF FINISHED GOODS –
Completed products.
 TYPES OF INVENTORY
4. MAINTENANCE/REPAIR/OPERATING
INVENTORY –
consist of items that are necessary to keep machine
and process productive.
 INVENTORY MANAGEMENT
SYSTEM
Policies and control on inventory:-
1. What levels should be maintained?
2. When should be replenished?
3. How large an order should be?
 INVENTORY MANAGEMENT
TECHNIQUES
1. ABC ANALYSIS
2. RECORD ACCURACY
3. CYCLE COUNTING
4. CONTROL OF SERVICE INVENTORIES
 ABC ANALYSIS
• There are 3 classes on the basis of annual dollar
volume.
1. CLASS A
2. CLASS B
3. CLASS C
• The principle of ABC analysis is that the approach
used to monitor inexpensive inventory and
expensive inventory should not be the same.
• Annual dollar volume = annual demand x unit cost
 ABC ANALYSIS
1. CLASS A
– Consist of items which has the highest dollar value. Such
items represents only 15% of the total inventory items,
they represent 70%-80% of the total dollar usage.
2. CLASS B
– Those inventory items of medium annual dollar volume.
It represent 30% of the materials in inventory that is 15%-
25% of the inventory value.
3. CLASS C
– Consists of items with low annual dollar volume.
Represent 55% of the materials in inventory that is 5% of
the inventory value.
 ABC ANALYSIS
• Often classifies inventory according to dollar value
(RM/unit x annual usage rate).
• The classification are:
100
90
80
A items
% of RM Value

70
60
50
40
30
B items
20
C items
10
0
10 20 30 40 50 60 70 80 90 100

% of Inventory Items
 RECORD ACCURACY

• It is critical ingredient in production and

inventory systems.
• It allows the organization to focus on those
items that are needed rather than settling for
being sure that everything is in the inventory.
• Accurate records are necessary to assist the
operations manager in making precise
decisions about ordering, scheduling and
shipping.
 CYCLE COUNTING

• Continuing audit known as cycle counting should be done in

order to ensure that items are counted and records are
updated on a periodic basis.
• Cycle counting is often used with ABC analysis to determine
the cycle.
• Five advantages of cycle counting are:
1. It eliminates shutdowns and interruption of productions
as a result of the annual physical inventories checking.
2. It eliminates annual inventory adjustment.
3. It uses trained personnel to audit inventory accuracy.
4. It allows causes of error to be identified and corrected.
5. It maintains accurate inventory records.
 CONTROL OF SERVICE INVENTORIES

• Management of service inventories deserves

special consideration
• Extensive inventory holding in the wholesale
and retail business make inventory control a
crucial aspect.
• Applicable techniques that can be used to
control service inventories include:
1. Good personnel selection, training and discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving the facility
 WHY IS THERE A NEED FOR
INVENTORY CONTROL?
Since it accounts for 40% of current assets or
18% of total assets.
When a firm keeps inventory, it has to forego the
earnings opportunity that it might earn if the
money is invested in other forms of income
generating revenues.
Is used to smoothen the production and sales
process for instance to operate the production
systems with or without minimum interruption.
 ADVANTAGES & DISADVANTAGES
OF HOLDING INVENTORY
ADVANTAGES
Firms can minimize cost by taking
advantages of the discounts offered by
suppliers
Raw materials are always available and
this can minimize disruption to the
operations process.
Customers’ demands can always be met
Inventory can be used to hedge against
future price increase
DISADVANTAGES
The risk that inventory items can be
damaged.
Losses due to obsolesces and
depreciation of inventory items
Inventory hides process problems
High cost incurred when large amounts of
inventory are kept
Inaccurate inventory records can cause
low productivity
Too much inventory can hide quality
problems
 INDEPENDENT & DEPENDENT DEMAND

Dependent demand
Items used to produce final product, typically
components or raw materials.

Independent demand
finished products and the numbers are influenced by
the market conditions.
 COST ASSOCIATED WITH
INVENTORY MODEL
1. HOLDING COST OR CARRYING COST
The cost to keep or carry inventory in stock. It is varying
according the level of inventory. The larger the inventory the
higher would be the carrying cost. The components of
carrying cost:
i. Cost of capital – this cost is vary. Depending on the firm’s
financial situation.
 COST ASSOCIATED WITH
INVENTORY MODEL
ii. Handling and storage cost
• Handling cost
• Storage cost
iii. Obsolescence, spoilage and pilferage cost
• Stock may be stolen due to poor security; material
may damage due to the faulty handling or accidents
and may become obsolete due to stocking the wrong
items or changes in trend.
iv. Insurance premium on inventories
• Companies may insured their inventory against theft
or fire.
 COST ASSOCIATED WITH
INVENTORY MODEL
v. System cost
• Associated with the task of inventory control.
2. ORDERING COST
– The cost of placing the order and receiving goods.
 COST ASSOCIATED WITH
INVENTORY MODEL
3. SETUP COSTS
– The costs of preparing a machines and facilities, so that
they can be used to produce a particular product or
component.
4. STOCK OUT COST
– Relates to the cost of unavailability of inventory to meet
sales & production schedules.
 INDEPENDENT DEMAND MODELS
1. BASIC ECONOMIC ORDER QUANTITY (EOQ MODELS)

2. EOQ MODEL WITH QUANTITY DISCOUNT

a) Constant Carrying Costs
b) Carrying Costs as a percentage of unit price/ is not
constant
INDEPENDENT DEMAND MODELS
1. BASIC ECONOMIC ORDER QUANTITY (EOQ
MODELS)
– To determine the optimal order size that
minimizes the sum of the annual carrying costs
and ordering costs.
 BASIC ECONOMIC ORDER
QUANTITY (EOQ MODELS)
Basic EOQ model
• Assumptions:
1. Demand is known, constant and independent.
2. Lead time is known and constant.
3. Receipt of inventory is instantaneous and complete. Orders
are delivered as whole units at a single point in time.
4. Quantity discounts are not possible.
5. The only variable costs are setup costs and holding costs.
6. Shortages can be completely avoided if orders are placed
at the right time.
INVENTORY MODELS FOR INDEPENDENT
DEMAND
INVENTORY MODELS FOR INDEPENDENT
DEMAND
 INVENTORY ORDER CYCLE
MAX INVENTORY
LEVEL = ORDER QUANTITY, Q

DEMAND
RATE
INVENTORY LEVEL

REORDER
POINT ,ROP

TIME
MIN PLACED LEAD ORDER
INVENTORY ORDER TIME, RECEIVE
LEVEL = 0 L
 FORMULA
The EOQ can be determined using the following variables and
equations:
 INVENTORY MODELS FOR INDEPENDENT
DEMAND (cont.)
A summary of the formulas that are normally used in the EOQ model:

Safety stock = (d x ss days)

 INVENTORY MODELS FOR INDEPENDENT
DEMAND (cont.)

Or Total Inventory Cost (without safety stock)

TIC or

Or Total Inventory Cost (with safety stock)

TIC or

Total Annual Relevant Cost ( without safety stock ) TARC = S D + IC Q + (C x D)

Q 2

Total Annual Relevant Cost ( with safety stock ) TARC = S D + IC Q ss + (C x D)

Q 2
 INVENTORY MODELS FOR INDEPENDENT
DEMAND (cont.)
• Reorder point (ROP)
It determines when to order inventory. It refers to the level that
signals the need to reorder inventory.

• Lead time (L)

Is the length of time between the moment orders are placed and
the time the inventory or stock arrives or are received.

• Safety stock (ss)

Refers to buffer stocks or additional stocks that the firm carries in
excess of the economic order size.
INVENTORY MODELS FOR INDEPENDENT
DEMAND (cont.)

(d x L) + (d x ss)
INVENTORY MODELS FOR INDEPENDENT
DEMAND (cont.)
 EXAMPLE 1
Company X operates 365 days per year and uses 10,000 units
of components. The ordering cost is RM50. The cost of storing
components is RM0.25 per component. The lead time takes 5
days and X keeps a safety stock of 2 days usage. Find:
i. EOQ
ii. Reorder point
iii. Total ordering cost
iv. Total carrying cost
v. Total Annual Inventory Cost
vi. Numbers of times an order is placed
vii. Reorder cycle
viii. Maximum inventory level
 SOLUTION EXAMPLE 1
D= 10,000 units/year S = RM50 IC = RM0.25/component L= 5 days
Working days = 365 days d = 10,000/365 = 27.40 @27units
ss = (27 units x 2 days) = 54 units

i. EOQ = 2DS/IC = (2 x 10,000 x 50)/0.25 = 2,000 units

ii. Reorder point (ROP) = (d x L) + (d x ss)

= (27units x 5 days) + (27units x 2 days)
= 135 units + 54 units = 189 units

iii. Total ordering cost = S (D/Q) = RM50 (10,000 units/2,000 units)

= RM250
iv. Total carrying cost = IC(Q/2+ss) = RM0.25(2,000 units/2 + 54 units)
= RM263.50
 SOLUTION EXAMPLE 1
v. Total Annual Inventory Cost (TAIC) = S(D/Q) + IC(Q /2 + ss)
= [50 (10,000/2,000)]+ [0.25(2,000/2+54)]
= RM250 + RM263.50 = RM513.50

vi. Numbers of times an order is placed (N) = D/Q = 10,000/2,000 = 5 times

vii. Reorder cycle (ROC) = no of working days/ no of order = 365 days /5 times
= 73 days

viii. Maximum inventory level = EOQ + ss = 2,000 units + 54 units = 2054 units
 EXAMPLE 2
Pulp technology uses a material at a rate of 300 units per day.
The cost of ordering material is RM 54 per order and the cost
of carrying inventory is RM0.05 per unit per day. The material
cost is RM9 per unit. In order to protect uncertainty in
demand, the firm holds a safety stock at 3 days usage. The
materials requires 5 days to arrive at the factory. Pulp
technology operates 300 days in a year. Calculate:
i. EOQ
ii. No of order
iii. Reorder level
iv. Total Annual Relevant Cost
 SOLUTION EXAMPLE 2
d = 300 units/day D = (300 units x 300 days/year) = 90,000 units S = RM54
IC = (RM0.05 x 365 days/year) = RM18.25/year L = 5 days C = RM9/units
Working days = 300 days ss = (300 units x 3 days) = 900 units

i. EOQ = 2DS/IC = (2 x 90,000 x 54)/18.25 = 729.80 @ 730units

ii. Numbers of times an order is placed (N) = D/Q

=90,000/730
=123.2@123 times
iii. Reorder level = (d x L) + (d x ss)
= (300 units x 5 days) + (300units x 3 days)
= 1,500 units + 900 units = 2400 units
 SOLUTION EXAMPLE 2
iv. Total Annual Relevant Cost (TARC) = [S(D/Q)] + [IC(Q /2 + ss)] + (C x D)
= [54 (90,000/730)]+ [18.25(730/2+900)]
+ (9 x 90,000)
= 6,657.53 + 23,086.25 + 810,000
= RM839,743.78
 INDEPENDENT DEMAND MODELS
2. EOQ MODEL WITH QUANTITY DISCOUNT

• The quantity discount model assumes that suppliers or

distributors often offer quantity discounts to their customers
to attract the customers to purchase in large quantities.
• The main objective of the quantity discount model is to
determine the best order size or order quantity that would
minimize total inventory costs, which is now includes
materials cost.
• Two approaches that can be used in analyzing the quantity
discount model. The approaches depend on whether the
carrying cost is constant or not constant.
 EOQ MODEL WITH QUANTITY DISCOUNT
✓APPROACH 1 (CARYYING COST IS CONSTANT)
– Example: IC is RM1.50 per unit per year or just
simply RM1.50 per unit.
✓Remember this step:
1. Compute the EOQ
2. Find the unit price that matches EOQ
3. Compute the TARC using the price determined in
step 2 to calculate the purchased cost.
4. Repeat procedures in step 3 for all lower price
breaks until you have found the quantity that
results in the lowest TARC.
5. Selecting the order size that has the lowest TARC
 EXAMPLE 3
• Sri Kampong Restaurant uses 1,000 bottles of Black Soya
ketchup annually. The cost of ordering and receiving the
ketchup is RM18 per order. The holding cost is RM1.50 per
unit. The suppliers has provided the following price
quotations for its ketchup. Determine the order size that
should be purchased.
Quantity Price per bottle (RM)
1-100 RM3.00
101-199 RM2.80
200-299 RM2.60
300 or more RM2.40
 SOLUTION EXAMPLE 3
1. Compute the EOQ
EOQ = 2DS/IC = (2 x 1,000 x 18)/1.50 = 154.92 @ 155 units
2. Find the unit price that matches EOQ
= RM2.80
3. Compute the TARC using the price determined in step 2 to calculate
the purchased cost.
Total Annual Relevant Cost (TARC)155 units
= [S(D/Q)] + [IC(Q /2)] + (C x D)
= [18 (1,000/155)]+ [1.50(155/2)] + (2.80 x 1,000)
= 116.13+ 116.25 + 2,800
= RM3,032.38
 SOLUTION EXAMPLE 3
4. Repeat procedures in step 3 for all lower price breaks until you have
found the quantity that results in the lowest TARC.

Total Annual Relevant Cost (TARC) 200 units

= [S(D/Q)] + [IC(Q /2)] + (C x D)
= [18 (1,000/200)]+ [1.50(200/2)] + (2.60 x 1,000)
= 90+ 150 + 2,600
= RM2,840

Total Annual Relevant Cost (TARC) 300 units

= [S(D/Q)] + [IC(Q /2)] + (C x D)
= [18 (1,000/300)]+ [1.50(300/2)] + (2.40 x 1,000)
= 60 + 225 + 2,400
= RM2,685
 SOLUTION EXAMPLE 3
5. Selecting the order size that has the lowest TARC

The order size that should be purchased is 300 units because it has the lowest
TARC which is RM2,685
 EOQ MODEL WITH QUANTITY DISCOUNT

✓APPROACH 2 (CARRYING COST IS A

PERCENTAGE OF UNIT PRICE/ IS NOT
CONSTANT)
– IC is specified in terms of percentage of unit
prices.
– Example: IC is 20% of the unit cost of item. If the
unit price is RM10, the IC is equal to RM2.00 (20%
of RM10.00)
APPROACH 2 (CARRYING COST IS A PERCENTAGE
OF UNIT PRICE/ IS NOT CONSTANT)

✓Remember this step:

1. Compute the EOQ for each price break, starting with the
lowest price break until a feasible EOQ is found.(an EOQ
that falls in the quantity range for its price).
2. Compute TARC for the feasible EOQ.
3. Then calculate the TARC for the next lower price break.
Use the minimum quantity to qualify for the discount as
the order quantity. Repeat this step until the lowest price
available in the price structure.
4. Selecting the quantity that has the lowest TARC.
 EXAMPLE 4
• Manufacturing of Jebat Motorbike orders 40,000
units of component ‘x’ per year. The ordering cost is
RM60 per order. The carrying cost is 15% of the unit
price. Determine the best order size that minimizes
the total inventory cost.
Quantity Price/Unit (RM)
1-999 22
1000-2999 21
3000 or more 20
 SOLUTION EXAMPLE 4

Quantity Price/Unit (RM) IC (RM)

1-999 22 0.15 x 22 = 3.30
1000-2999 21 0.15 x 21 = 3.15
3000 or more 20 0.15 x 20 = 3.00
 SOLUTION EXAMPLE 4
1. Compute the EOQ for each price break, starting with the
lowest price break until a feasible EOQ is found.(an EOQ
that falls in the quantity range for its price)

EOQ = 2DS/IC = (2 x 40,000 x 60)/3.00

= 1,264.91 @ 1,265 units (NOT FEASIBLE)
EOQ = (2 x 40,000 x 60)/3.15
= 1,234.43 @ 1,234 units (FEASIBLE)
 SOLUTION EXAMPLE 4
2. Compute TARC for the feasible EOQ

Total Annual Relevant Cost (TARC)1234 units

= [S(D/Q)] + [IC(Q /2)] + (C x D)
= [60 (40,000/1234)]+ [3.15(1234/2)] + (21 x 40,000)
= 1,944.89 + 1,943.55 + 840,000
= RM843,888.44
 SOLUTION EXAMPLE 4
3. Then calculate the TARC for the next lower price break. Use
the minimum quantity to qualify for the discount as the
order quantity. Repeat this step until the lowest price
available in the price structure.

Total Annual Relevant Cost (TARC)3000units

= [S(D/Q)] + [IC(Q /2 + ss)] + (C x D)
= [60 (40,000/3000)]+ [3.00 (3000/2)] + (20 x 40,000)
= 800 + 4,500 + 800,000
= RM805,300
 SOLUTION EXAMPLE 4
4. Selecting the quantity that has the lowest TARC

The best order size that minimize the total inventory cost is
3,000 units because it has the lowest TARC which is
RM805,300
 CONCEPTS OF • Is computer-based system that determines how
much of each material, any inventory, with
MATERIAL unique part number, should be purchased or
REQUIREMENT produced in each future time period to support
PLANNING the Master Production Schedules (MPS)
• MRP is designed to answer questions on:
(MRP)
1. What is needed?
2. How much is needed?
3. When is needed?
 • Master Production Schedules (MPS)
MASTER – Is a schedules of the number and timing of
all end items to be produced in a
PRODUCTION manufacturing plant over a specific
planning horizon.
SCHEDULES – End items – a product, a service part or any
(MPS) other output that has a demand from
customers, distributors or other
departments.
 1. To minimize unnecessary inventory investment.
2. To determine what to order, how much to
order, when to order to ensure that material is
OBJECTIVES 3.
available no earlier or later.
To improve customer service
OF MRP 4. To determine when to schedule delivery. By
providing timely delivery of goods, customer
satisfaction can be enhanced.
5. To maximize production efficiency.
 ADVANTAGES OF MRP
1. It is dynamic in nature since it reacts well to changing
market conditions.
2. Company can reduce inventories and its associated
costs since it carries only materials needed.
 DISADVANTAGES OF MRP

1. Dependent on MPS. It will not be successful if

there is no MPS or inaccurate MPS.
2. Requires effective computer system to cater for
large volume of materials and suppliers and the
speed to react to changing market situation.