CHAPTER 4 INVENTORY MANAGEMENT INTRODUCTION Good inventory management is essential to the successful operation of most organizations for a number of reasons. One is the significant amount of money that inventory represents; another is the impact that inventory has on ‘the dally operations, particularly on meeting demand and restocking functions. Some organizations have excellent inventory management and others have satisfactory inventory management. However, many organizations have unsatisfactory inventory management. This is a sign that the management does not appreciate and understand the importance of maintaining a well stocked inventory. n this chapter, we will discuss the importance of inventory, keeping it well maintained and techniques for computing ordering and reordering functions. DEFINITION ‘An Inventory is a set or collection of items that are consumable through sales (as in goods for sale) or through the regular operations of an organization (as In office supplies such as pencils and papers). The usual Inventory is composed of the following items: 1. Raw materials and purchased parts ~ these includes bought items that will be part of the finished product that the organization has not created itself 2. Partially completed goods, called work in progress —these includes items that are already processed but not yet ints final finished form. 3. Finished goods inventories (for manufacturing organizations) and/or merchandise inventory (for commerce or retail stores) ~ these will be the items that will be considered as the output of the organization for consumption ofits consumers. 4. Replacement parts (for items replaced periodically such as cutting blades, chains for motor parts, etc), tools (note that tools such as cutters, staplers, and hammers are considered as part of the inventory since they do not represent a significant amount of investment to be classified in accounting papers under “machines” or “equipment” like trucks, heavy machinery, etc) and supplies (consumable in the dally operations of the organization such as folders, ink, tape, etc) 5. Goods in transit (note that this particular category varies depending on the terms of the company and the customer, as in F.0.B. ete) Functions of inventory Inventories serve a number of functions, depending on the nature of the organization. You can imagine what comprises the inventory of a restaurant and compare that to the inventory kept by a hospital, an appliance store, an RTW factory and others. However, the important functions are the following: To meet anticipated demand To smooth production requirements ‘To simplify the distribution system (as in Coca-Cola warehouses all over the country) To protect against items going out of stack (not only for your loyal customers but also as an advantage over your competitors with under-stocked inventories) 5. To take advantage of order cycles (an order cycle will be discussed later, for now, this means that the organization can minimize expenses incurred during orders and setting up multiple batches of production runs) To hedge against sudden price increases (asin oil companies’ inventories priced over a constantly changing SRP) 7. To permit operations and earn profit (this means minimum required units by the government of minimum units required in order to generate profit) To summarize the stated reasons, a well maintained inventory is needed so that whenever the need arises, the organization will have available resources. Inadequate control of inventory can result to either understocking or overstocking of items that can result to unmet demand, losses and damaged reputation not only towards consumers but also towards suppliers and even among personnel.Requirements for Effective Inventory Management. ‘An organization needs to have a basis for evaluating their respective inventory systems. In order to check the effectiveness of your Inventory Management Systems, the following areas for evaluation are given: 1 A system to keep track of the inventory on hand, for order (next order's projected size) and in transit. ~ ideally, the organization should have a recorded system, preferably computerized, that can quickly monitor the amount of inventory at any given time, for better and accurate information to be used by the managers in decision making. Here, the organization may create an Inventory Counting System such as: a. Periodic Inventory System ~ the organization checks inventory periodically (weekly, monthly, semi-annually, etc) and creates the next order based on the information derived. Examples of these include restocking your sari-sari store or semi-monthly restocking your groceries. ». Perpetual Inventory System — the organization uses computers to check and record every transaction Instentaneously, allowing quick and accurate information about the available inventory on hand. This system ses universal product codes, more popularly known as bar codes. Multiple Bin System ~ the organization keeps atleast two containers or batches of Inventory items. Once the first container is emptied, the organization places orders and uses the second container as inventory while the organization waits for the next batch to arrive, A reliable forecast of demand that includes that indication of level of accuracy and possibilty of forecasting errors. ~ As discussed earlier, forecasting is necessary for us to have an idea on how much will be needed for us ‘to meet demand and also indicate important factors such as Mean Average Deviation to avoid very high forecasting errors. Knowledge of lead times and lead time variability. ~ Lead time refers to the length of time that an order or process usually requires to be accomplished. Most orders are not instantly sent upon order placement, Most will require an allowance of time to finish the order. In some cases different suppliers would have different lead times and each would have variations or averages on their respective lead times. Reasonable estimates of inventory holding costs, ordering costs and setup costs. ~ Some goods, when kept for 2 period of time, incur expenses to maintain. These includes electricity, manpower related expenses, watering, feeding, etc. These are Holding Costs. Some orders require a fixed charge per order, of Ordering Cost, while Set Up Costs refer to expenses incurred in connection with preparing resources before creating 2 batch of items (as in production) A classification system for inventory items. ~ A vast collection of items that a company keeps should be well organized and classified so that the operations will go smoothly. Examples of classification methods are the following: a. A-B-C Approach here, the organization assigns groups into categories based on the importance of the item oF cost of the item, For example, A items (very important), B items (moderately important), C items (average), D items (less than average important) and E items (expendable). This system is just the same as classifying by First Class, Second class, Third Class; Economy, Cabin, Executive; XQ, Premium, Fancy; etc. 'b. Alphabetical Approach - simply put the items are named and arranged alphabetically. Numerical Approach — Different from the ABC Approach, this system can simply put numbers o represent groups in no particular order of importance. For example, a shoe store may categorize at 1 = ladies’ shoes, 2 men’s shoes, 3 = socks etc, under which 2.1 can represent men's formal shoes, 2.2 = men’s flat shoes, etc d. Mnemonic Approach ~ Same as Numerical Approach, but instead uses symbols such as shapes, Greek characters, etc. ‘e. Combination Approach ~ Combines any of the aforementioned techniques,How Much To Order: Inventory Replenishment Replenishment refers to the activities of the organization connected to restocking their inventory. Under this, there are two types of replenishment: 41. Instantaneous Replenishment — From the word “instant, this type of replenishment refers to the restocking of inventory through ordering a batch of items from an external source. For exemple, an organization may need tires for the motorcycle that they manufacture. Here, they order tires from a separate supplier. 2. Incremental Replenishment - Increment here means gradual or step by step. Here, the organization restocks its inventory by creating the demanded items itself. For example, the motorcycle organization also has a separate division that creates tire, This division isa part of the organization ise. Economic Order Quantity Model (E0Q) We have mentioned that keeping an inventory also has its costs. An organization alms to maximize profit by maximizing revenue yet minimizing costs and this area is no exemption. We can identify the ideal amount to be ordered ‘hat will a), meet demand and b). minimize all connected costs. We call this ideal amount as Economic Order Quantity For each type of replenishment, we have 2 model for solving this amount. Before using this mode|, several assumptions have to be met: Only one product is involved. ‘Annual demand requirements are known. Demand is spread evenly throughout the year so that the demand rate is reasonably constant. Lead time does not vary. Each order is received in a single delivery. ‘There are no quantity discounts. Ordering cost is constant, regardless of the ordered amount of units. 1 2 3. 4, 5. 6 7. Instantaneous Replenishment Where: ‘A= The Y axis represents the Quantity of items under consideration B= Usage rate, the speed of how many items are being consumed periodically C= The Quantity of goods on hand. Notice that as Time passes, this amount decreases, (D= The point in time when the order is received E = The point in time when orders will be placed. F = The point in time when the next order is received G= The £09, the ideal amount to be ordered per period H= The Lead Time, the allowance needed by the supplier to send their items | = The X axis represents the TimeFormulas: Annual Carrying Cost = (Q/2)H TC = Annual Carrying Cost + Annual Ordering Cost (ay2}H+ (0/0) = /TOSVH Length of Order Cycle: OC =(Q./ D)(number of work days per year) Number of Orders per ear: TO=D/Q Where: Q = Ordering Quantity in units 0c = Order cycle H =Holding or Carrying Cost per unit.» TO_—= Total Orders S__=Ordering Cost per batch/delivery «= Economic Order Quantity Te =Total Cost D annual Demand Important points to remember: 1, The units of D and H must be the same (e.g. months, years, days, etc). Depending on the problem's given units, conversion might be necessary so that both notations would have the same units. 2. Ordering Cost is represented by “S” and not “O” because, under incremental replenishment, the equivalent of ordering cost is “Setup Costs”, hence "S”. Total cost here covers only the total ordering cost and carrying cost. ‘At Qs, the total cost is at its lowest. ‘At Q,, annual carrying cost should be equal to the annual ordering cost. ‘The number of operating days varies from organization to organization. Sample Problem ‘A local distributor for a national tire company expects to sell approximately 9,600 stee! belted tires of a certain size and design next year. Annual carrying cost is P160.00 per tire and ordering cost is P750.00 per batch. The distributor operates 288 days a year. ‘a. To minimize total costs and still meet demand, how many tires should the distributor order per batch? b. Ifthe answer on letter “a” will be followed, how many times will the company order next year? c. How long will t take between orders? d._Atthis rate, how much would be the total costs of the distributor (regarding ordering and carrying costs)? Solutions and Explanations: First, we should ist the given values that we can use. 9,600 = this is the estimated number of tires that the distributor expects to sell for next year, regarding a certain model of tire. This will be our demand (0). P160.00 = this is the cost that the distributor spends per tire per year to keep it in good condition while in storage. This will be our holding cost (H) 750.00 = this is the cost that the distributor spends per batch that the distributor orders from their manufacturer. This will be our ordering cost (S) 288 = this is the number of days that the distributor operates per year. Hence, we have the following: Given: 9,600 tires for the whole year H=P160.00 per tire per year ‘5 = P750.00 per batch ordereda. To minimize total costs and still meet demand, how many tires should the distributor order per batch? This question refers to the Economic Order Quantity (Qo), where the ideal number of units per order is identified by the organization in order to meet demand, yet minimize costs and prevent overstocking and understocking. Qo= [20S "= PEEROLTE = 300 irs H 16 This answer means that the organization should order 300 tires per batch to minimize costs. b. Ifthe answer on letter “a” will be followed, how many times will the company order next year? This question refers to the total number of orders that the organization would have to make for next year if it will follow the Economic Order Quantity. TO=0/Qo=9,600/ 300 32 orders will be made for the whole year How long will it ake between orders? This question refers to the length of an order cycle. OC = (Q./ D)(number of work days per year) (300 / 9,600) (288) S days The organization will take 9 days between orders. This also means that the organization consumes the entire batch of 300 tires over 9 days. d. At this rate, how much would be the total costs of the distributor (regarding ordering and carrying costs)? TC=(Q/2)H+(0/a)s = (300/2)160 + (9,600/300)750 + (32)750 + 24,000 The distributer will incur P48,000.00 as its total costs (regarding holding and ordering costs) over the next year. Note that the annual carrying cost is equal to the annual holding cost. Some organizations may think that in order to save money spent on annual ordering costs they can lessen the total orders by buying larger batches of items, This however means that there are more items to spend carrying costs on, thus increasing annual carrying costs. For example, if the distributor orders 1,600 tires per batch (reducing the number of orders to 6, instead of 32), we have: TC=(Q/2)H-+(0/Q)s = (1,600/2)160 + (9,600/1,600)750 + (6)750 + 4,500 Even if the distributor incurs only P4,500.00 on orders, it incurs a whopping P128,000.00 on holding costs. On the same manner, organizations may think that the organization can save money spent on carrying costs by lessening the amount of inventory on hand through ordering smaller batches, this would mean that small amounts would mean more orders. For example, if the distributor stores only 100 tires per order, we have: T= (Q/2)H + (0/Q)s 100/2)160 + (9,600/100)750 =(50)160 + (96)750 3,000 + 72,000 80,000.00 Even if the organization incurs only P8,000.00 on carrying cost for the whole year, it would still incur P72,000.00 on ‘more orders. You know that you have the correct Economic Quantitv when the annual costs are ecial.Incremental Replenishment A= quantity of units B= actual amount produced (C= point in time where the Run ends D= maximum inventory, Ix Estime F =the quantity on hand ie run time, how long they would create items ssage rate, how fast they consume the it Wun Size(Qo) length of time to consume the maximum inventory. During this period, no new items are created, = Cycle time. This is the total time in between starting runs Formulas to be used: 2050 cycle Time: CT =(Q4/u) Hip-u) — NumberofRunsperYear: — TR=D/Q. ‘Annual Carrying Cost = (Isc / 2) H TC = Annual Carrying Cost + Annual Ordering Cost ‘Annual Set Up Cost = (0/Q)S = (huwe/ 2) H + (D/Q)S Run Time: AT = Qo/p Juxx = Qo (D=u P Where: Q = Quantity in units CT = Cycle Time H_—=Holding or Carrying Cost per unit ©» TR_-—= Total Runs S —=setup cost per batch Q& = optimal run size TC =Total Cost D = annual Demand P= production rate (how fast the organization makes these items per day) U__= Usage rate (how fast they consume the items per day) RT = runtime (length of time that the firm creates items per run) ‘Sample Problem: ‘A toy manufacturer uses 48,000 rubber wheels per year for its popular dump truck series. The firm makes its own wheels, which it can produce at a rate of 800 pieces per day. The toy trucks are assembled uniformly over the entire year. Carrying cost is P10.00 per wheel per year and creating a batch requires P450.00 to prepare. The firm operates 240 days per year. Determine the following: In order to meet demand, minimize costs, how many units should the firm create per run? Based on the ideal run size, how much would be the total cost (regarding carrying and set up costs) for the entire year? How long would the firm create rubber wheels per run? How long would it take to use up the maximum inventory? How long would be the cycle time? How many runs would the company make in the entire year?Solution and Explanations: First, lets list down all the values that can be used for our solutions: 48,000 = this is the estimated number of rubber wheels that the toy manufacturer expects to use for next year, regarding a certain model of dump truck toy. This will be our demand (0), 1800 this is the number of rubber wheels that the toy manufacturer can create per day. This will be our production rate (p. P1000 = this is the cost that the toy manufacturer spends per rubber wheel per year to keep it in good condition while in storage. This will be our holding cost (H). 450.00 = this is the cost that the toy manufacturer spends to prepare equipment per batch of rubber wheels that the firm creates. This will be our set up cost (S). 240 = this is the number of days that the distributor operates per year. Hence, we have: 48,000 rubber wheels 800 rubber wheels per day 10.00 per rubber wheel per year S = PAS0.00 per batch ‘year = 240 days Before we can start solving for the required values, we have to notice that there is no given usage rate (u) in the problem. We have to derive this amount through the following process: //Lyear = 48,000 rubber wheels / 240 days = 200 rubber wheels per day If the firm uses 48,000 rubber wheels over 240 days, that means it uses 200 rubber wheels each working day. Going back tothe problems 2. Inorder to meet demand, minimize costs, how many units should the frm create per run? This requies the optimal un sie a. Be = (ARE. = (eT H{p-u) 110(800 - 200) 10(600) 400 ruber wheels per run ‘This meats that the toy manufacturer has to continue creating rubber wheels until they reach 2,400 pieces, as in ““B" in the diagram, if they are to minimize costs while still meet demand for the items. \sre0 p00 . Based on the ideal run size, how much would be the total cost (regarding carrying and set up costs) for the entire year? Before we can compute for the total cost, we have to find the maximum inventory, Iuax Imax = Qo (p= 2,400 (800-200) = _2,400(600)_ = _1440000 800 rubber wheels Pp 800 '200 800 By the time that the firm stops producing the items, they would stil have 1,800 in its inventory. Since we already have the data for maximum inventory, we can proceed to solving for the total cost: TC= (hax 2) H+ (0/Q)S (2,800/2)P10 + (48,000/2,400)P450 = 900(P10) + 20(P450) 9,000 + P9,000 18,000.00, Note that if we get the correct optimal run size, we would have an equal amount for both annual holding and set Up costs. Also, be reminded that, in comparison to the Total Cost in Instantaneous Replenishment, we will be sing lax instead of Qo, & How long would the firm create rubber wheels per run? In our diagram on incremental replenishment, this item refers to the “6” aspect. RT=Qo/p. 2,400 rubber wheels per run / 800 rubber wheels nerdav = 3 davs ver runFor each run, the firm targets 2,400 rubber wheels. With a production rate of 800 rubber wheels per day, it ‘would take the firm 3 days to finish each run. 1d. How long would it take to use up the maximum inventory? In our diagram, the “D’ refers to the maximum Inventory. At this point in time, when the firm stops creating rubber wheels, they would still have 1,800 rubber wheels in their inventory. The question here asks how long would it take for the firm to use up the remaining inventory before starting another run. This can be done by dividing the remaining inventory by the usage rate of the firm, thus: 1,800 wheels / 200 wheels per day = 9 days eHow long would be the cycle time? In our diagram, this tem asks for “K”, the total time for the whole cycle to end, before creating another run. CT =(Q./u) =2,400 rubber wheels per cycle / 200 rubber wheels per day = 12 days per cycle On the other hand, itis also acceptable to simply just add the run time and the pure usage time (G and J), where 3 days of creating and using, plus 9 days pure usage equals 12 days for the entire cycle. f. How many runs would the company make in the entire year? This isa tricky question since we cannot simply divide the number of days per year (240 days) by the run time (3 days per run}, equaling to 80 runs. This is because the answer will be based on the number of cycles. Note that ‘one cycle will have one run, and that there is a rest period for pure usage only (9 days). Therefore, our answer will be: TR=D/Q = 48,000 wheels per year / 2,400 wheels per run 20 runs per year This can also be answered simply by dividing the total year by the cycle time. 240 days in a year / 12 days per run 20 days per run ‘Sample Problems: 1. Atoy company estimates that it would sell a total of 32,000 poker chips annually, to be used by local casinos. The chips ere sold at a steady rate during the 240 days a year that the store operates. Each unsold chip will cost 6.00 per year to keep in good condition. Ordering poker chips from their supplier would charge P240.00 per batch being sent, Find the following: How many Poker Chips should the company order per batch? If the answer on letter “a” willbe followed, how many times How long will it take between orders? At this rate, how much would be the total costs of the company? the company order next year? 2. A producer of summer themed souvenirs can make up to 750 paperweights per day. They sell 15,000 pieces of these, over the 60 - day summer vacation period. Creating a batch would cost P750.00 to prepare and holding cost is at P15.00 per piece per year. 2, In order to meet demand, minimize costs, how many paperweights should the firm create per run? Based on the ideal run size, how much would be the total cost (regarding carrying and set up costs) for the entire year? How long would the firm create paperweights per run? How long would it take to use up the maximum inventory? How long would be the cycle time? How many runs would the company make in the entire year?