INVENTORY MANAGEMENT

Dr. Arshdeep
Introduction
Inventory management is about
determining and maintaining an
optimal level of inventory i.e. a level
that is neither inadequate nor
excessive.


The management of inventory

assumes significance in the light of
the magnitude of funds blocked in
them.

 Meaning of Inventories
Inventories are stock of the product a
company is manufacturing for sale and
components that make up the product.
For a typical manufacturing firm inventory
comprises of:
–raw material,

–work-in-process and

–finished goods.

For a trading business it refers to the

finished goods stock held for sale.

 Components of Inventory
Raw materials: are those basic inputs
that are converted into finished product
through the manufacturing process.
Work-in-process inventories: are
semi-manufactured products. They
represent products that need more work
before they become finished products
for sale.
Finished goods inventories: are those
completely manufactured products
which are ready for sale. Stocks of raw
materials and work-in-process facilitate
production, while stock of finished goods
Motives for holding Inventory
Transaction motive
Precautionary motive
Speculative motive
 Transaction Motive
It is the need to hold inventories to facilitate
smooth production and sales.
1.Stock of raw material is to be held to facilitate
continuous supply of material to production
department for uninterrupted production.
2.Stock of W.I.P. is to be held because of
production cycle, which is the time span
between introduction of raw material into
production and emergence of finished
product.
3.Stock of finished goods is to be held to facilitate
continuous supply of product to customers.
Precautionary Motive
It is the need to hold inventory to meet
contingencies in future.

S p e cu la tive Motive
It is th e n e e d to h o ld in ve n to ry in o rd e r to
ta ke a d va n ta g e o f p ro fita b le o p p o rtu n itie s
a s a n d w h e n th e y a rise .
 What is Inventory Management?
Inventory management means planning,
organizing, directing and controlling of
inventory.
It provides an answer to the following two basic
questions:
1.How much to order?
 It means what should be the size of an
order. How much to order will depend upon
the annual consumption, carrying cost per unit
per annum, ordering cost per order. It involves
the determination of E.O.Q.
2.When to place an order?
 It means when the fresh order should be
placed with supplier to procure additional
inventory. It involves the determination of re-
 Inventory Management
Inventory management involves
reconciling the interests of the different
departments involved in the production
distribution function.
Basic issues in inventory management
are:
1.Optimal level of inventory
2.Reorder point
3.Should the inventory level be changed
4.Monitoring and control of inventory
Inventory management is guided by the
principles of efficient business operation
and cost minimisation.
 Importance of Inventory
Management
Inventories form a link between
production and sale.
Inventory allows the firm to service
customer needs adequately.
Due to the sheer size of funds blocked
in inventory its management
assumes significance.

 Objectives of Inventory
Management
To ensure a continuous supply of raw
materials to facilitate uninterrupted
production.
To maintain sufficient stocks of raw
materials in periods of short supply and
anticipate price changes.
To maintain sufficient finished goods
inventory for smooth sales operation
and efficient customer service.
To minimize the carrying cost and time.
To control investment in inventories and
 Need for Balanced Investment in
Inventory
 Consequences of Excessive Investment in Inventory
Block of funds
Loss of liquidity
Mis-handling of inventory
Increases carrying cost
Physical deterioration


 Consequences of inadequate investment in Innovation

Disturbs production
Unable to deliver goods on delivery date
Loss of customers

Deciding Optimal Level of
Inventory
Optimal level of inventory involves a
trade-off between
–carrying costs and

–ordering costs.

At this trade-off point the total cost is

minimum.
This point is referred to as Economic
Ordering Quantity (EOQ).

 Carrying Costs
Carrying Costs are the cost of
maintaining inventory in a company's
warehouse.
It is alternatively referred to as holding
cost.
They include both, costs associated with
physically carrying inventories, such as
–warehouse rent,

–insurance of inventory and

–financial cost of funds tied up in the

inventory i.e. the opportunity cost of
alternative investments.
Such costs have a positive correlation
with the level of inventory, and hence
 Ordering Costs
Ordering cost refer to the costs that are
incurred at the time an order is placed.
These costs are periodic and are
regardless of the size of the order.
The examples include
–cost of placing or processing orders,

–cost of transportation,

–cost of follow up with the vendors,

–cost of receiving new shipment,

–cost of inspecting goods.

Ordering Costs
These costs do not vary with the size
of the order but with the number of
orders.
Total order costs decrease as the
number of units ordered each time
increases.
With more units being ordered each
time, the number of orders placed
decreases.
Total ordering cost =
 Annual requirement * Per order
cost
Average inventory = Order size/2 or Q/2
Total carrying cost = Average inventory *
Per unit carrying cost
TCC = Qc/2
Total cost = Total carrying cost + Total
ordering cost
TC = Qc/2 + AO/2
Economic order quantity =
 2 * quantity required * ordering
cost
 carrying cost
EOQ = 2AO/C
 Economic Order Quantity
(EOQ)
The two questions that the inventory
theory tries to address are:
1.How much should be ordered?
2.When should it be ordered?
The EOQ model of inventory
management provides answer to the
first question.
Economic Order Quantity (EOQ) refers to
the lot size of inventory that is most
economical to procure and hold.
 Contd…


Economic Order Quantity
(EOQ)
The EOQ is the point at which both
ordering costs and carrying costs are
equal.
This is the point of trade-off between
carrying and ordering costs.
At this point the total cost of inventory
shall be lowest.
This is the most economical quantity
that can be ordered by the firm.

Economic Order Quantity
(EOQ): Model
E O Q M O D E L –A n E xa m p le
E x a m p le :
A u n it m a n u fa ctu rin g p la stic co n ta in e rs
co n su m e s 1 3 5 0 u n its o f m o u ld e d p la stic
u n ifo rm ly th ro u g h th e m o n th . T h e
cu rre n t co st o f a cq u isitio n is R s. 2 0 p e r
u n it a n d th e ca rryin g co st fo r th e firm ,
3 0 % o n a ve ra g e b a se d o n re ce n t d a ta
a va ila b le , is n o t like ly to ch a n g e in th e
co m in g m o n th s. T h e firm h a s to b e a r a
co st o f R s. 2 4 0 0 e ve ry tim e it p la ce s a n
o rd e r. C o m p u te th e o p tim a l in ve n to ry
le ve l fo r th e ye a r a h e a d u sin g th e E O Q
m o d e l.
Assumptions of EOQ:

Demand for the product is constant and uniform

throughout the period.
Lead time (time from ordering to receipt) is
constant.
Price per unit of product is constant.
Inventory holding cost is based on average
inventory.
Ordering costs are constant.
 Deciding When to Order
The level of inventory at which the firm
should place an order for replenishment
is its reorder point.
It depends on the lead time, average
usage, and the EOQ.
Lead time is the time normally taken in
replenishing inventory after the order
has been placed.
Reorder point = Lead time * Average
usage

 Deciding when to order
(under conditions of
uncertainty)
The reorder point has been determined
under the assumption of certainty.
The model assumes that usage and lead
time are certain, and can be predicted
accurately.
When delivery is delayed or usage
increases unexpectedly, a stock-out is
likely to occur.
To reduce the likelihood of stock-outs,
firms hold safety stocks, additional
inventory over and above that
 Safety stock
Safety stock is an additional level of
inventory intended to enable the firm to
continue to meet demand in case sales
levels turn out to be higher than
predicted and in case there are
unexpected delays in either receiving
raw materials or in producing goods.
Safety stock provides cushion against
demand and supply side
uncertainties.
Then the formula to determine the
reorder point when safety stock is
To o ls o f In v e n to ry C o n tro l
ABC analysis
Ratio Analysis
EOQ
VED classification
FSN classification
JIT technique
 A B C A n a ly sis - M e a n in g
ABC analysis is a system of inventory
control.
It exercises discriminating control over
different items of stores classified on the
basis of the investment involved.
It is based on the principle of management
by exception i.e. concentrate more on
critical areas than others.
According to this technique, only those
items of inventory are paid more attention
which are significant for business.

According to this technique, all items
are classified into 3 categories A, B and C.
In ‘A’ category those items are taken which
are very precious and their quantity or
number is small.
In ‘B’ category those items are reserved
which are less costly than the items of
category ‘A’ but their number is greater.
In category ‘C’ all those items are included
which are low priced but their number is
highest.
 Working of ABC Analysis
Cat. Composition Degree of Control

A It consists of those items which require High degree of control is

large investments (say about 70% of exercised by use of various
total value of stores) but constitute a techniques such as fixing stock
small %age (say about 10%) of total levels like max. level, min. level,
items of stores. re-order level, determine EOQ.

B It consists of those items which require Moderate degree of control is

relatively moderate investments (say exercised. Orders are placed on a
about 20% of total value of stores) and periodic review basis.
constitute relatively moderate %age
(say about 20%) of total items of
stores.

C It consists of those items which require Lower degree of control is

small investments (say about 10% of exercised.
total value of stores) but constitute a
large %age (say about 70%) of total
items of stores.
 A B C A n a ly sis : A G ra p h ica l
R e p re se n ta tio n

100

80
Value of items (%)

60
Item A Item B Item C
40

20

10 20 30 40 50 60 70 80 90 100

No of Items (%)
V ED
ABC classification is also referred to as
the VED (Vital, Essential, and
Desirable) classification.

R a tio A n a ly sis
Inventory can be monitored by looking at
the following inventory-related financial
ratios:


Inventory Turnover Ratio (ITR) =

 COGS / Average
Inventory


Inventory Holding Period =

 365 Days / Inventory
Turnover Ratio


 Contd…
ITR suggests the number of days
'worth of sales on hand.
It is alternately referred to as analysis
of ageing of inventory.
Combined with the demand
projections, this ratio helps in
scheduling production and
procurements.

 Ju st- in -T im e ( JIT )
It is a Japanese concept of an inventory
management.
The underlying philosophy of JIT is to reduce
the level of inventory to zero so that the
firm is able to cut down its carrying cost.
The focus of JIT is on shedding the excess
inventory: the safety stock that does not
contribute to the production process.
JIT inventory system is all about having ‘the
right material, at the right time, at the
right place, and in the exact amount’.
