INVENTORY MANAGEMENT

11
INTENDED LEARNING OUTCOMES
By the end of the learning experience, students must be able to:
1. Understand the concept of inventory;
2. Discuss the substance of purchasing plan;
3. Describe and illustrate the functions of inventory to organizational operations;
4. Identify the types of inventory utilized by the organization and its specific purpose;
5. Recognize and demonstrate the concepts of inventory planning;
6. Discuss and apply inventory cost and its advantage; and
7. Identify the inventory control utilized by the organizations and assess or evaluate its
significant effect to day-to-day operations.

INTRODUCTION
The term ‘inventory’ means any stock of direct or indirect material (raw materials or
finished items or both) stocked in order to meet the expected and unexpected demand in the
future. A basic purpose of supply chain management is to control inventory by managing the flows
of materials. It sets policies and controls to monitor levels of inventory and determine what levels
should be maintained, when stock should be replenished, and how large orders should be.
Inventory is a stock of materials used to satisfy customer demand or support the
production of goods or services. By convention, inventory generally refers to items that contribute
to or become part of an enterprise’s output. In simple terms, inventory is an idle resource of an
enterprise comprising physical stock of goods that is kept by an enterprise for future purposes.
Inventory is one of the new, noticeable and concrete aspects for many small business
owners. Raw materials, goods in process and finished goods all represent various forms of
inventory. Each type represents money tied up until the inventory leaves the company as
purchased products. Similarly, merchandise stocks in a retail store contribute to profits only when
their sale puts money into the cash register. Inventory is an idle stock of physical goods that
contain economic value, and are held in various forms by an organization in its custody awaiting
packing, processing, transformation, use or sale in future.

A. INVENTORY
Literally, inventory refers to stocks of anything necessary to do business. These stocks
represent a large portion of the business investment and must be well managed in order to
maximize profits. In fact, many small businesses cannot absorb the types of losses arising from
poor inventory management. Unless inventories are controlled, they are unreliable, inefficient
and costly.
Inventory is a list of goods and materials or those goods and materials themselves, held
available in stock by a business. Inventory are held in order to manage and hide from the customer
the fact that, manufacture delay is longer than delivery delay, and also to ease the effect of
imperfections in the manufacturing process that lower production efficiencies if production
capacity stands idle for lack of materials.
Any organization which is into production, trading, sale and service of a product will
necessarily hold stock of various physical resources to aid in future consumption and sale. While
inventory is a necessary evil of any such business, it may be noted that the organizations hold
inventories for various reasons, which include speculative purposes, functional purposes, physical
necessities etc.

Learning Module in Production and Operations Management 1|P a g e

 Purchasing plan
One of the most significant aspects of inventory control is to have the items in stock at
the moment they are required. This includes going into the market to buy the goods early enough
to ensure delivery at the proper time. Thus, buying requires advance planning to determine
inventory needs for each time period and then making the commitments without procrastination.
For instance, a retail firm must formulate a plan to ensure the sale of the greatest number of units.
Similarly, a manufacturing business must formulate a plan to ensure enough inventories
are on hand for production of a finished product. In summary, the purchasing plan details will be
as follows:

When commitment should be placed

When the first delivery should be

received
Purchase Plan
When the inventory should be
Details peaked
When reorders should not be
placed
When the item should no longer be in
stock

Figure 11.1. Summary of purchasing plan

Functions of inventory
1. Though inventory is an idle resource, it is almost essential to keep some inventory in order
to promote smooth and efficient running of business. To maintain independence of
operations, a supply of materials at a work center allows that center flexibility in
operations. Consider the case—an enterprise that does not have any inventory. Clearly,
as soon as the enterprise receives a sales order, it will have to order for raw materials to
complete the order. This will keep the customers waiting. It is quite possible that sales
may be lost. The enterprise may also have to pay a high price for various other reasons.
2. Another aspect relates to the costs for making each new production set up. Independence
of workstations is desirable in intermittent processes and on assembly lines as well. As the
time that it takes to do identical operations varies from one unit to the next, inventory
allows management to reduce the number of setups. This results in better performance.
Consider the case of seasonal items. Any fluctuation in demand can be met if possible, by
either changing the rate of production or with inventories. However, if the fluctuation in
demand is met by changing the rate of production, one has to take into account the
different costs.
3. The cost of increasing production and employment level involves employment and
training, additional staff and service activities, added shifts, and overtime costs. On the
other hand, the cost of decreasing production and employment level involves
unemployment compensation costs, of the employee costs, staff, clerical and services
activities, and idle time costs. By maintaining inventories, the average output can be fairly
stable. The use of seasonal inventories can often give a better balance of these costs.
4. Inventory can be used, among other things, to promote sales by reducing customer’s
waiting time, improve work performance by reducing the number of setups, or protect

Learning Module in Production and Operations Management 2|P a g e

 employment levels by minimizing the cost of changing the rate of production. If the
demand for the product is known precisely, it may be possible (though not necessarily
economical) to produce the product to exactly meet the demand. However, in the real
world this does not happen and inventories become essential. Inventories also permit
production planning for smoother flow and lower cost operation through larger lot-size
production. They allow a buffer when delays occur. These delays can be for a variety of
reasons—a normal variation in shipping time, a shortage of material at the vendor’s plant,
an unexpected strike in any part of the supply chain, a lost order, a natural catastrophe
like a hurricane or floods, or perhaps a shipment of incorrect or defective materials.
5. Broadly speaking, some other functions of inventories are:
a. To protect against unpredictable variations (fluctuations) in demand and supply.
b. To take advantage of price discounts by bulk purchases.
c. To take advantage of batches and longer production run.
d. To provide flexibility to allow changes in production plans in view of changes
in demands, etc. and
e. To facilitate intermittent production.

Types of inventory
Inventories can be further classified according to the purpose they serve. These types include
transit inventory, buffer inventory, anticipation inventory, decoupling inventory, cycle
inventory, and MRO goods inventory. Some of these are known by other names, such as
speculative inventory, safety inventory, and seasonal inventory.

Transit
Inventory

MRO
Goods Inventory Buffer
Inventory
Types of
Inventory

Cycle Inventory Anticipation

Inventory

Figure 11.2. Types of inventory

• Transit Inventory: Transit inventories are the ones that need to transport items or
material from one location to another, and from the fact that there is some transportation
time involved in getting from one location to another. Sometimes this is referred to as
pipeline inventory. Merchandise shipped by truck or rail can sometimes take days or even
weeks to go from a regional warehouse to be tail facility. Big companies such as
automobile manufacturers, employ freight consolidators to pool their transit inventories
coming from various locations into one shipping source in order to take advantage of

Learning Module in Production and Operations Management 3|P a g e

 economies of scale. Of course, this can greatly increase the transit time for these
inventories, hence an increase in the size of the inventory in transit. Take the case of HPCL,
the transports are done from refinery to the customer through different modes of
transport i.e., Pipeline, Roadways (Tankers), Shipping, etc. the time taken for goods to
reach from refinery to the customer is called transit inventory.
• Buffer Inventory: Some inventory used to protect against the uncertainties of supply and
demand, as well sun predictable events such as poor delivery reliability or poor quality of
a supplier’s products. These inventory cushions are often referred to as safety stock.
Safety stock or buffer inventory is any amount held on hand that is over and above that
currently needed to meet demand. Generally, the higher the level of buffer inventory, the
better the firm’s customer service. This occurs because the firm suffers fewer “stock-outs”
(when a customer’s order cannot be immediately filled from existing inventory) and has
less need to backorder the item, make the customer wait until the next order cycle, or
even worse, causes the customer to leave empty-handed to find another supplier.
Obviously, the better the customer service the greater the likelihood of customer
satisfaction.
• Anticipation Inventory: Some firms will purchase and hold inventory that is in excess of
their current need in expectation of a possible future event. Such events may include a
price increase, a seasonal increase in demand, or even an impending labor strike. This
tactic is commonly used by retailers, who routinely build up inventory months before the
demand for their products will be unusually high (i.e., at Halloween, Christmas, or the
back-to-school season). For manufacturers, anticipation inventory allows them to build
up inventory when demand is low (also keeping workers busy during slack times) so that
when demand picks up the increased inventory will be slowly depleted and the firm does
not have to react by increasing production time (along with the subsequent increase in
hiring, training, and other associated labor costs).
• Cycle Inventory: Those who are familiar with the concept of economic order quantity
(EOQ) know that the EOQ is an attempt to balance inventory holding or carrying costs
with the costs incurred from ordering or setting up machinery. When large quantities are
ordered or produced, inventory holding costs are increased, but ordering/setup costs
decrease. Conversely, when lot sizes decrease, inventory holding/carrying costs decrease,
but the cost of ordering/setup increases since more orders/setups are required to meet
demand. When the two costs are equal (holding/carrying costs and ordering/set up costs)
the total cost (the sum of the two costs) is minimized. Cycle inventories, sometimes called
lot-size inventories, result from this process. Usually, excess material is ordered and,
consequently, held in inventory in an effort to reach this minimization point. Hence, cycle
inventory results from ordering in batches or lot sizes rather than ordering material strictly
as needed. Inventory management is the most integral part of any business, small or large.
The principles of inventory management can be listed as under:

• Demand Forecasting: Depending on the industry, inventory ranks in the top five business
costs. Accurate demand forecasting has the highest potential savings for any of the
principles of inventory management. Both over supply and under supply of inventory can
have critical business costs. Whether it is end-item stocking or raw component sourcing,
the more accurate the forecast can be. Establishing appropriate max-min management at
the unique inventory line level, based on lead times and safety stock level help ensure that
you have what when you need it. This also avoids costly overstocks. Idle inventory
increases incremental costs due to handling and lost storage space for fast-movers.

Learning Module in Production and Operations Management 4|P a g e

 Demand
Forecasting

Process Auditing Warehouse Flow

Principles of
Inventory
Management

Inventory
Cycle Counting Turns/Stock
Rotation

Figure 11.3. Five principles of inventory management

• Warehouse Flow: The old concept of warehouses being dirty and unorganized is out
dated and costly. Lean manufacturing concepts, including 5S have found a place in
warehousing. Sorting, setting order, systemic cleaning, standardizing, and sustaining the
discipline ensure that no dollars are lost to poor processes.

Setting Systemic Cleaning

Figure 11.4. The 5S

Learning Module in Production and Operations Management 5|P a g e

 The principles of inventory management are not any different from other industrial
processes. Disorganization costs money. Each process, from housekeeping to inventory
transactions needs a formal, standardized process to ensure consistently outstanding
results.
• Inventory Turns/Stock Rotation: In certain industries, such as pharmaceuticals, food
stuffs and even in chemical warehousing, managing inventory can be critical to
minimizing business costs. Inventory turns is one of the key metrics used in evaluating
how effective your execution is of the principles of inventory management. Defining the
success level for stock rotation is critical to analyzing your demand forecasting and
warehouse flow.
• Cycle Counting: One of the key methods of maintaining accurate inventory is cycle
counting. It helps measure the success of your existing processes and maintains
accountability of potential error sources. There are financial implications to cycle
counting. Some industries require periodic 100% counts. These are done through
perpetual inventory count maintenance or through full-building counts.
• Proactive: One of the cornerstone principles of inventory management is to audit early
and often. Error source identification starts with process audits. Process audits should
occur at each transactional step, from receiving to shipping and all inventory transactions
in between.

Inventory Planning Concepts

Every organization which is engaged in production, sales or trading of products, hold
inventory in one or the other form. While production and manufacturing organizations hold raw
material inventories, finished goods and spare parts inventories, trading companies might hold
only finished goods inventories depending upon the business model. Raw material inventory
management essentially deals with two major functions, which are:

Functions of Raw
Material Inventory
Management

Inventory Inventory
Planning Tracking

Figure 11.4. Functions of raw material inventory management

Inventory Costs
As inventory is a necessary but idle resource, inventory costs in manufacturing need to be
minimized. The heart of inventory decisions lies in the identification of inventory costs and
optimizing the costs relative to the operations of the organization. Therefore, an analysis of
inventory is useful to determine the level of stocks. The resultant stock keeping decision specifies:
1. When items should be ordered

Learning Module in Production and Operations Management 6|P a g e

 2. How large the order should be
3. “When” and “how many to deliver”.
Inventory can have a significant impact on both a company’s productivity and its delivery
time. Large holdings of inventory also cause long cycle times which may not be desirable as well.
What are the costs identified with inventory? The following costs are generally associated with
inventories:
• Holding (or Carrying) Costs: It costs money to hold inventory. Such costs are called
inventory holding costs or carrying costs. This broad category includes the costs for
storage facilities, handling, insurance, pilferage, breakage, obsolescence, depreciation,
taxes, and the opportunity cost of capital. Obviously, high holding costs tend to favor low
inventory levels and frequent replenishment.
• Cost of Ordering: Although it costs money to hold inventory, it also, necessary to
replenish inventory, these costs are called inventory ordering costs. Ordering costs have
two components:
1. One component that is relatively fixed
2. Another component that will vary
It is good to be able to clearly differentiate between those ordering costs that do not
change much and those that are incurred each time an order is placed.
• Shortage or Stock-Out Costs: When the stock of an item is depleted, an order for that
item must either wait until the stock is replenished or be canceled. There is a trade-off
between carrying stocks to satisfy demand and the costs resulting from stock out. The
costs that are incurred as result of running out of stock are known as stock-out or
shortage costs. As a result of shortages, production as well as capacity can be lost, sales
of goods maybe lost, and finally customers can be lost.

Inventory Control
Recent industry reports show that inventory costs as a per cent of total logistics costs are
increasing. Despite this rise, many organizations have not taken full advantage of ways to lower
inventory costs. There are a number of proven strategies that will provide payoff in the inventory
area, both in customer service and in financial terms. Some of these strategies involve having
fewer inventories while others involve owning less of the inventory.
ERP and information technology solutions have been able to provide solutions, not only
for inventory management but also for aggregate planning, material requirement planning and
operations scheduling. Regardless of which technique or solution one employs, proactive
inventory management practices make a measurable difference in operations. In this
supplement, we will cover some of the important inventory models and their characteristics,
which are used in many of these ERP solutions.
• Inventory metrics: Managing inventory at manufacturing and service companies is
critically important. Too much or too little, or the wrong inventory, all have detrimental
impacts on operational and financial results. Inventory represents a tremendous capital
investment and also is an idle resource. Companies that can operate with lesser inventory
are considered to operate more efficiently. Inventory measures reflect, in part, the success
in structuring supplier relationships to optimize inventory at the buying company. Several
aggregate performance measures can be used to judge how well a company is utilizing its
inventory resources.
• Average Inventory Investment: The rupee value of a company’s average level of
inventory is one of the most common measures of inventory. The information is easily
available and it is easy to interpret. It represents the average investment of the company.
However, it does not take into account the differences between companies.
• Inventory Turnover Ratio: In order to overcome this problem, inventory turnover ratio is
used. This measure allows for better comparison among companies. This is calculated as

Learning Module in Production and Operations Management 7|P a g e

 a ratio of the company’s sales to its average inventory investment:

Inventory turnover = annual cost of goods sold/average inventory investment

This is a measure of how many times during a year the inventory turns over. Because it is
a relative measure, companies of different sizes can be more easily compared. A higher
turnover ratio reflects there are less idle resources in the company, and therefore the
company is using its inventory efficiently. This ratio can only be used in this manner to
compare companies that are similar.

References

Anil Kumar, S and N. Suresh. (2009). Operations Management. New Age International (P) Ltd.,
Publishers. New Delhi. Retrieved from
http://182.160.97.198:8080/xmlui/bitstream/handle/123456789/436/Operations_Management%2
0-%20Kumar%20A%20A%20and%20Suresh%20N.pdf?sequence=1

Production and Operations Management. (2013). 1st Edition. Jaipur National University, Jaipur.
Retrieved from http://jnujprdistance.com/assets/lms/LMS%20JNU/MBA/MBA%20%20BPO%20
Management/Sem%20II/Production%20and%20Operation%20Management/Production%20an
d%20Operation%20Management.pdf

Slack, N., Brandon-Jones, A. and Johnston, R. (2013). Operations Management. 7th Edition.
Pearson Education Limited. Retrieved at
https://colbournecollege.weebly.com/uploads/2/3/7/9/23793496/operations_management_by_sl
ack_nigel_7th.pdf

Stevenson, W. J. (2012). Operations Management. 11th Edition. McGraw-Hill/Irwin. New York.

Retrieved from https://baixardoc.com/documents/operation-management-by-william-j-
stevenson-11th-edition-shuvo--5cf6d512051d3

Learning Module in Production and Operations Management 8|P a g e