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Chapter 23

Meaning and Definition

The term inventory includes raw material,
work-in-process, finished goods and stores and
There are different kinds of inventories i.e
production inventories, MRO inventories, inprocess & finished goods inventory.
MRO inventories required for maintenance,
repair and operating machinery.

Uses of Inventory
To satisfy the
customer demand
To protect
against price
increases and
to take
advantage of

To avoid
stock outs
(Safety Stock
or Buffer


To minimize
the total cost
by ordering the
Order Quantity

To provide buffer
between successive
(Decoupling Inventory
or Work-in-process

To satisfy periods of
seasonal high demand
(Seasonal Inventory)

To act as a buffer between

various elements of the
Supply-Chain (SuppliersProducers-DistributorsWholesalers-RetailersCustomers) (Pipeline or
Transit Stock)

Inventory Costs
Inventory costs includes ordering cost plus carrying
1. Ordering Costs
2. Carrying Costs
Opportunity Costs

Opportunity cost is the loss of interest on money

invested in inventory building and inventory
control equipment.
Storage Space Costs

Inventory Service Costs

Handling-equipment Costs
Inventory Risk Costs

3. Out-of-stock Costs
4. Capacity Costs

Inventory Management
and Control
Inventory management involves administration,
policies and procedures to reduce in inventory cost.
Factors Influencing Inventory Management and
Type of Product
Type of Manufacture
Volume of Production
Other factors

Benefits of Inventory
Management and Control
1. Adequate supply of materials and stores
2. Low investment in inventories
3. Benefits of purchasing economies
4. No duplication in ordering
5. Better utilization of available stocks
6. Low loss of materials through carelessness or pilferage
7. Better cost accounting
8. Cost comparison

Disposal of obsolete items

10. Data for financial statements

Process of Inventory
Management and Control
Step 1. Determination of optimum inventory levels and
procedures of their review and adjustment.
Step 2. Determination of the degree of control that is
required for the best results.
Step 3. Planning and design of the inventory control
Step 4. Planning of the inventory control organisation.

Fixed order quantity system or

Q system
A fixed quantity of material is ordered
whenever the stock on hand reaches the
reorder point.
The fixed quantity of material ordered each
time is nothing but the economic order
quantity (EOQ).

Operation of Fixed Order Quantity System

Total Annual Inventory

Cost with EOQ Model

Total annual cost= annual ordering cost + annual

holding costs

TCQ S H; and Q

Continuous (Q) Review System Example: A computer

company has annual demand of 10,000. They want to
determine EOQ for circuit boards which have an annual
holding cost (H) of $6 per unit, and an ordering cost (S) of
$75. They want to calculate TC and the reorder point (R) if
the purchasing lead time is 5 days.



2 * 10,000 * $75
500 units

Reorder Point (R)

R Daily Demand x Lead Time

* 5 days 200 units
250 days

Total Inventory Cost (TC)


$6 $1500 $1500 $3000



Advantages of Q system
Each material can be procured in the most
economical quantity.
Purchasing and inventory control personnel
automatically devote attention to the items
that are needed only when required.
Positive control can easily be exerted to
maintain total inventory investment at the
desired level simply by manipulating the
planned maximum and minimum value.

Disadvantages of Q system
The orders are raised at regular interval which might not
be convenient for the supplier.
In case the lead time is very high, say three months, and
the ordering quantity happens to be material supplies for
one month, there would be two or three pending orders
with the supplier each time.
The items can not be grouped and ordered at a time
since the reorder points occur irregularly.
EOQ may give you an order quantity which is much
below the supplier minimum (for a good discount)
Further, the system assumes stable usage and definite
lead time.

Fixed-order Period System or

P system
The stock position of each item of material
is regularly reviewed.
When the stock level of a given item is not
sufficient to sustain the production
operation until the next scheduled review,
an order is placed replenishing the supply.
The frequency of reviews varies from firm
to firm.

Periodic Review System

Advantages of P System
The ordering and inventory costs are low.
The ordering cost is considerably reduced
though follow up work for each delivery may
be necessary.
The suppliers will also offer attractive
discounts as sales are guaranteed.
The system works well for materials which
exhibit an irregular or seasonal usage and
whose purchases must be planned in
advance on the basis of sales estimates.

It compels a periodic review of all items, this
in itself makes the system somewhat
Usage patterns might change in between,

Replenishment quantities (Q) vary

Order quantities may not quality for quantity
On the average, inventory levels will be
higher than Q systems-more stockroom
space needed

Some more mathematics

(Max safety stock without taking any risk of
stock out) = (normal consumption rate) X
(maximum extension of lead time).
Safety stock with some risk of stock out =
normal consumption rate X max extension
of lead time X cumulative probability of
that extension of lead time.
Buffer stock = normal consumption rate X
normal lead time

Distinction between Q System and P System

Inventory Control Techniques

1. Always better control (ABC) classification.
2. High, medium and low (HML) classification.
3. Vital,
4. Scarce, difficult and easy to obtain (SDE).
5. Fast moving, slow moving and non-moving
6. Economic order quantity (EOQ).
7. XYZ Analysis

ABC Classification
ABC classification is a method for determining
level of control and frequency of review of inventory
A Pareto analysis can be done to segment items into
value categories depending on annual dollar volume
A Items typically 20% of the items accounting for
80% of the inventory value-use Q system
B Items typically an additional 30% of the items
accounting for 15% of the inventory value-use Q or
C Items Typically the remaining 50% of the items
accounting for only 5% of the inventory value-use P.

The AAU Corp. is considering doing an ABC analysis

on its entire inventory but has decided to test the
technique on a small sample of 15 of its SKUs. The
annual usage and unit cost of each item is shown

(A) First calculate the annual dollar volume

for each item

B) List the items in descending order based on annual dollar

volume. (C) Calculate the cumulative annual dollar volume as a
percentage of total dollars. (D) Classify the items into groups

Graphical solution: the ABC classification of


The A items (106 and 110) account for 60.5% of the value and 13.3% of the items

The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the items

The C items make up the last 14.5% of the value and 60% of the items

How might you control each item classification? Different ordering rules for each?