Operations Management

Topic – Inventory Management

Course Instructor:
Mansoor Qureshi
 What is Inventory?
Inventory is basically a stock or store of goods which
can be accounted physically or information based. A
physical resource that a firm holds in stock with the intent
of selling it or transforming it into a more valuable state.

– Raw Materials

– Works-in-Process

– Finished Goods

– Maintenance, Repair
and Operating (MRO)
 Why Hold Inventories (1)
• For economies of scale
– It may be economical to produce a relatively large number
of items in each production run and store them for future
use.
• Coping with uncertainties
– Uncertainty in demand
– Uncertainty in lead time
– Uncertainty in supply
• For speculation
– Purchase large quantities at current low prices and store
them for future use.
– Cope with labor strike
 Why Hold Inventories (2)
• Transportation
– Pipeline inventories is the inventory moving from point
to point, e.g., materials moving from suppliers to a plant,
from one operation to the next in a plant.
• Smoothing
– Producing and storing inventory in anticipation of peak
demand helps to alleviate the disruptions caused by
changing production rates and workforce level.
• Logistics
– To cope with constraints in purchasing, production, or
distribution of items, this may cause a system maintain
inventory.
 Why Hold Inventories (3)
• Finished Goods
– Essential in produce-to-stock positioning strategies
– Necessary in level aggregate capacity plans
– Products can be displayed to customers

• Work-in-Process
– Necessary in process-focused production
– May reduce material-handling & production costs

• Raw Material
– Suppliers may produce/ship materials in batches
– Quantity discounts and freight/handling $$ savings

Contribute to the efficient and effective operation of the

production system. Inventory balances supply and demand.
Inventory acts as a buffer between critical supply chain
interfaces
 Inventory
Inventory Management is truly interdisciplinary and spans from financial and managerial
accounting, to operations research, material handling to logistics. Inventory and the
management therefore belong to everyone in the company but nobody wants to own it.
 
The smoother your supply chain operates and the better you are able to forecast the less
inventory you have to hold, unless you gain some economies of scale in purchasing,
transportation and or manufacturing.

Inventory System- A set of policies and controls that

monitors levels of inventory and determines what levels
should be maintained, when stock should be replenished, and
how large orders should be handled
 Characteristics of Inventory Systems
• Demand (patterns and characteristics)
– Constant versus variable
– Known versus random
• Lead Time
– Ordered from the outside
– Produced internally
• Review
– Continuous: e.g., supermarket
– Periodic: e.g., warehouse
• Excess demand
– demand that cannot be filled immediately from stock
– backordered or lost.
• Changing inventory
– Become obsolete: obsolescence
 Design of Inventory Mgmt.
Systems: Macro Issues
• Need for Finished Goods Inventories
– Need to satisfy internal or external customers?
– Can someone else in the value chain carry the
inventory?

• Specific Contents of Inventories

• Locations of Inventories
• Tracking
 Design of Inventory Mgmt.
Systems: Micro Issues

• How much to order of each material when

orders are placed with either outside
suppliers or production departments within
organizations i.e. Order quantity

• When to place the orders i.e. Order timing

 Concerns of Inventory Control

• Level of customer service (on time delivery)

• Costs of ordering and carrying inventories –
Allow cost efficient operations
• Minimize inventory investment

Overall Objective of Inventory Management is

to achieve satisfactory levels of customer
service while keeping inventory costs within
reasonable bounds
 Objectives of Inventory Control
• 1) Maximize the level of customer service
by avoiding understocking.

• 2) Promote efficiency in production and

purchasing by minimizing the cost of
providing an adequate level of customer
service.
 Basic Inventory Trade off
Logistics and Finance
Inventory increases costs and decreases ROA
(return on assets)

Vs

Marketing and Manufacturing

Inventory increases responsiveness to
demand and ability to achieve economies of
scale
 Types of Inventory Stocks
The following types of inventory/ stocks have its own characteristics
with respect to environment changes or uncertainty or business
perspective.

• Cycle stock: If demand and lead time is constant, only cycle

stock is necessary.
• In-transit stock: In transit inventory is usually accounted for on
the place of shipment as it is not available at the destination. It
can be reduced through faster modes of transportation.
• Safety or buffer stock: It is a result of uncertainty of demand and
lead time.
• Speculative stock/ Seasonal stock: It is inventory held for
reasons other than satisfying current demand, often acquired to
reach economies of scale or to generate seasonal stock. This
type of inventory is used to use in labor strike.
• Dead stock: It includes items for which no demand has been
registered and may become obsolete.
 Key Inventory terms
• Unit cost – Basic manufacturing cost of the item including mterial, labour
and overheads.

• Ordering costs - costs of ordering and receiving inventory. This refers to

the amount that is spent in placing one-time orders. It includes clerical costs
incurred for writing and placing replenishment orders. Costs for setting up
production equipment and transportation of goods from plants to
warehouses are also included.

• Holding (carrying) costs – cost to carry an item in inventory for a length of

time, usually a year. It includes costs directly calculated from the size of
inventory, time period of holding inventory and value of goods carried in
inventory. It also includes some indirect costs in the form of benefits, which
the company is denied had it not invested in inventory. Some of these costs
are interest rates that could be earned from the amount invested in
inventory, cost of taxes and insurance on inventories.

• Shortage and customer service costs – These are the costs realized
when demand of a product crosses the inventory for that item. As such
these costs are considered equal to the amount paid by the customer to buy
the product from other firms. Sometimes the problem assumed serious
measures due to loss of goodwill for the company which might prove costly
in the long run.
 Inventory Costs
Procurement costs
• Order processing
• Shipping
• Handling

Carrying costs
• Capital (opportunity) costs
• Inventory risk costs
• Space costs
• Inventory service costs

Out-of-stock costs
• Lost sales cost
• Back-order cost
 Information requirement
A system to keep track of items in inventory –
• What is on order
• What is on hand
• What is where
• How much is where
• What condition is it in

How much and when to order –

• Demand Forecast
• Knowledge of lead time and lead time variability
• Reasonable estimates of holding costs, ordering
costs and shortage costs
• Classification system of inventory items
 Inventory Counting systems
• Periodic System: Physical count of items made at periodic
intervals.

• Perpetual Inventory System: System that keeps track of

removals from inventory continuously, thus monitoring
current levels of each item.

• Two-Bin System: Two containers of inventory; reorder when

the first is empty, use the contents of the second until order
received.

• Universal Bar Code: Bar code printed on a label that has

information about the item to which it is attached.
 Types of Inventory Management
Systems
• Reorder point systems

• EOQ

• ABC Analysis
 Reorder Point
• Quantity to which inventory is allowed to drop
before replenishment order is made

ROP = D X LT
D = Demand rate per period
LT = lead time in periods
A Reorder Point System
 Economic Order Quantity EOQ
A quantitative decision model based on the trade-off between annual
inventory holding costs and annual order costs.

The EOQ model seeks to determine an optimal order quantity, where

the sum of the annual order cost and the annual inventory holding cost
is minimized.

– Order Cost is the direct variable cost

associated with placing an order.
– Holding Cost or carrying cost is the cost
incurred for holding inventory in storage.
 Assumptions
• Constant rate of demand
• Shortages not allowed
• Stock replenishment can be scheduled to arrive
exactly when inventory drops to zero
• Purchase price, ordering cost, and per unit
holding cost are independent of quantity
ordered
• Items are ordered independently of each other
 Notation
• Q = order quantity

• U = annual usage or annual demand

• CO = ordering cost per order

• CH = annual holding cost per unit

Graph of Annual Inventory
Costs
Finding an Optimal Policy
 Q  U

  H   CO
C
 2  Q

 Q2 
  C H  UC O
 2 

2 UC O
Q 
2

CH
2UC O
EOQ =
CH
 EOQ Example
• Given:
– 25,000 annual demand
– $3 per unit per year holding cost
– $100 ordering costs

2(25,000)(100)
EOQ =  1291
3
 EOQ Model
When To Order
Inventory Level
Optimal Average
Order Inventory
Quantity (Q*/2)
(Q*)

Reorder
Point
(ROP)

Time
Lead Time
 EOQ Example
Given:
– 7,200 = Annual replenishment
– $3 = Per unit per year holding cost
– $100 = Ordering cost per order
– 20% = Annual Holding rate
– $20 per unit = Unit Purchase cost
– 6 days = Lead Time
– 360 = Days per year

EOQ = √2x7200x100 / 0.2x20 = 600 units

ROP = (7200/360) x 6 = 120 units

Number of Orders placed per year = 7200 / 600 = 12 orders

Time Between orders = 360 / 12 = 30 days

Graphical illustration
 ABC Analysis

• Divides inventory into 3 classes.

– A class, B class, C class.
• Basis on money ($) value.
• Closer and stricter control on those items
which represent a major portion of total
stock value.
• Saving in stock carrying.
 ABC Classification
• Typical observations
– A small percentage of the items (Class A) make
up a large percentage of the inventory value
– A large percentage of the items (Class C) make
up a small percentage of the inventory value

• These classifications determine how much

attention should be given to controlling the
inventory of different items
 Classifying Inventory Items
• ABC Classification (Pareto Principle)
• A Items: very tight control, complete and
accurate records, frequent review
• B Items: less tightly controlled, good records,
regular review
• C Items: simplest controls possible, minimal
records, large inventories, periodic review and
reorder
 Classifying Items as ABC
% Annual $ Usage Class % $ Vol % Items
100 A 80 15
B 15 30
80
C 5 55
60
40
A
20 B C
0
0 50 100 150
% of Inventory Items