Inventory Management

What Is Inventory?
• Stock of items kept to meet future demand
• Stock is required to protect against uncertainty in demand
(Customer) as well as supply side (Manufacturer/Supplier)
• Inventory management policy
• how many units to order
• when to order
Why Inventory Management?

To safeguard against unpredictable:

• Sales levels
• production times
• demand
• usage needs

Inventory serves as buffer against uncertain and fluctuating usage

Types of Inventory

• Raw materials
• Purchased parts and supplies
• Work-in-process (partially completed) products (WIP)
• Items being transported
• Tools and equipment
Inventory and Supply Chain Management

• Bullwhip effect
• demand information is distorted as it moves away from the end-use customer
• higher safety stock inventories are stored to compensate
• Seasonal or cyclical demand
• Inventory provides independence from vendors
• Take advantage of price discounts
• Inventory provides independence between stages and avoids work
stoppages
Two Forms of Demand

 Dependent
 Demand for items used to produce
final products
 Tyres stored at a Goodyear plant are
an example of a dependent demand
item
 Independent
 Demand for items used by external
customers
 Cars, appliances, computers, and
houses are examples of independent
demand inventory
Demand

Dependent Demand
demand of wheels and tyres for an automobile company
car music system
Pictures Tubes for TVs
SIM for Mobile sets

Independent Demand
Car,
PCs, Laptops, and DVD players
TVs
Mobile Sets
What are inventory related costs?
There are mainly four types of cost related to
inventory
• Cost of an item
• Ordering or procurement costs
• Carrying or holding costs
• Stockout or shortage costs
 • This is the cost, or value of the item or the money paid to the
Cost of an item supplier for the item received, OR
• The direct manufacturing cost if produced. It is normally
equal to purchase price.
• In case of the company itself producing an item, then this
cost depends upon the variable and fixed costs.
• In case of items being purchased from suppliers, purchase
price remains fixed unless and until the price or quantity
discount is offered.
 Carrying or • Inventory carrying costs are those costs
associated with the amount of inventory stored.
holding costs
• Inventory carrying costs are made up of a number
of different costs.
Calculating inventory carrying costs

Inventory carrying costs should include only those

costs vary with the quantity of inventory and that
can be categorized into the following groups;
• capital costs,
• inventory service costs,
• storage space costs,
• inventory risk costs.
5 3
Inventory Carrying Cost Methodology

Capital
costs Inventory Investment

Inventory Insurance
service
costs Taxes
Inventory Plant warehouses
Carrying
Costs Storage Public warehouses
space costs
Rented warehouses
Company-owned warehouses

Obsolescence

Inventory Damage
risk costs
Pilferage
Relocation costs
 Holding inventory ties up money
that could be used for other
types of investments
(Opportunity Cost of the
Capital)
1. Capital Costs on
Inventory Investment Some companies differentiate
among projects by categorizing
them according to their risk and
looking for rates of returns that
reflect the perceived level of
risk.
 Calculating Capital Costs on Inventory Investment

Cost of money

In the situation of financing the inventory: cost of money is

actual cost of borrowing
Shortage of capital: If cost of money for inventory decisions
is high-decrease in inventory
Abundance of cash: If cost of money for inventory is low-
increase in inventory
 2. Inventory • Ad valorem-personal property costs [Latin phrase ad
valorem means "according to value”]
Service Costs • Taxes,
• Fire and theft insurance paid as a result of holding
the inventory
 3. Storage Storage space costs relate to four general types of
facilities:
Space Costs
• Plant warehouse costs
• Public warehouse costs
• Rented or leased(contract) warehouses
• Company owned(private) warehouses
 Inventory risk costs vary form company to company, but
typically include charges for;
4. Inventory • Obsolescence cost is the cost of each unit that must be
disposed of at a loss because it can no longer be sold at
Risk Costs a regular price.
• Damage costs incurred during shipping, should be
considered a throughput cost, since they will continue
regardless of inventory levels.
• Shrinkage costs: inventory theft, poor record
keeping,shipping wrong quantities etc. These costs have
become an increasingly important for businesses
• Relocation costs are incurred when inventory is
transshipped from one warehouse location to another
for avoiding obsolescence.
 Excessive inventory levels can lower corporate profitability in
two ways;
Inventory 1.Net profit is reduced by out of pocket costs associated
with holding inventory, such as insurance, tax,storage,
and obsolescence, damage, and interest expense, if the firm
borrows money specifically to finance inventories,
Corporate
Profitability 2.Total assets are increased by the amount of the
inventory investment, which decreases asset turnover, or
the opportunity to invest in other more productive assets
foregone.
 • Also known as procurement costs
• Ordering costs refer to those costs associated with ordering
inventory, such as order costs and setup costs.
Inventory
• These costs are those incurred on a purchase (known as
Ordering ordering costs) or incurred as set up costs related with the
Costs initial preparation of a production system if manufactured.
• These costs vary directly with each purchase order placed or
with the set up made and are usually assumed independent
of the quantity ordered or produced.
• Procurement costs include costs of administration (such as
salaries of the persons concerned, telephone calls, computer
costs, postage etc.), transportation of items ordered,
expediting and follow up, receiving and inspection of goods,
processing payments etc.
• This cost is expressed as the cost per order or per set up.
 Ordering Examples of order costs include:
• Costs of receiving an order (wages)
costs…….. • Conducting a credit check
• Verifying inventory availability
• Entering orders into the system
• Preparing invoices
• Receiving payment
Inventory Stock-out Costs

Also known as shortage costs

Stockout cost is an estimated cost or penalty that is realized when

a company is out of stock when a customer wants to buy an item.

Stockout costs involve an understanding of a customer’s reaction to

a company being out of stock.
Stock-out costs……
One form of these costs is known as back-order on the selling side (or backlog costs on the
manufacturing side) when the unfilled demand can be satisfied at a later date, i.e. customer
waits till he gets the supply.

Another form of these costs is known as lost sales costs on the selling side (or no backlogging
cost on the manufacturing side) when the unfilled demand is lost.

It happens when the customer does not wait for the supply and goes else where.

These include the costs of production stoppage, overtime/idle time payments, expediting,
special orders at higher price, idle machine, loss of goodwill, loss of opportunity to sell, loss
of profitability, etc.
Types (or Models) There are mainly three types of
inventory systems
of Inventory • The fixed order quantity system
System • The fixed order periodic system
• The gradual replenishment system
 The fixed quantity order method is a method that facilitates
for a predetermined amount of a given material to be
Fixed ordered at a particular period of time.
• This is also known as the Q/R inventory system.
Quantity
• In this system, whenever the stock on hand reaches the
Order System reorder point (R), a fixed quantity of materials (Q) is
ordered.
• The fixed quantity of material ordered each time is actually
the economic order quantity (EOQ).
 • Whenever a new consignment arrives, the total stock is
Fixed Order maintained within the maximum and the minimum limits.
Quantity • This method helps to limit reorder mistakes, conserve space
for the storage of the finished goods, and block those
System unnecessary expenditures that would tie up funds that
(Contd…) could be better utilized elsewhere.
• The fixed order quantity may be bridged to an automatic
reorder point where a particular quantity of a good is
ordered when stock at hand reaches a level which is already
determined.
Fixed Order Quantity System

Inventory decreases at
In a constant rate
v
e Level of Maximum Inventory
n
t
o
r
y
Q
L 1st Inventory 2nd Inventory 3rd Inventory 4th Inventory
e Cycle Cycle Cycle Cycle
v
e
l
0
t t t
Time
1 order is placed &
st
2 order is placed &
nd
3 order is placed &
rd

immediately the goods are immediately the goods are immediately the goods are
 Advantages of
fixed order • Each material can be procured in the most economical
quantity system: quantity.
• Purchasing and inventory control people automatically gives
their attention to those items which are required only when
are needed.
• Positive control can easily be handled to maintain the
inventory investment at the desired level only by calculating
the predetermined maximum and minimum values.
 • Sometimes, the orders are placed at the irregular time periods
which may not be convenient to the producers or the
suppliers of the materials.
Disadvantages of • The items cannot be grouped and ordered at a time since the
fixed order quantity reorder points occur irregularly.
system • If there is a case when the order placement time is very high,
there would be two to three orders pending with the supplier
each time and there is likelihood that he may supply all
orders at a time.
• EOQ may give an order quantity which is much lower than
the supplier minimum and there is always a probability that
the order placement level for a material has been reached but
not noticed in which case a stock out may occur.
• The system assumes stable usage and definite lead time.
When these change significantly, a new order quantity and a
new order point should be fixed, which is quite 
 • This is also known as periodic inventory system or P system
• In this system, order quantity will be whatever is needed to
Fixed Period Order bring the amount of inventory back up to some pre-established
base stock level
System • The stock position of each material of a product is checked at
regular intervals of time period.
• Order for stock is placed at regular interval which is remained
fixed
• However, ordered quantity may vary in each interval
• The frequency of reviews varies from organization to
organization.
• It also varies among products within the same organization,
depending upon the importance of the product,
predetermined production schedules, market conditions and
so forth.
• The order quantities vary for different materials.
Fixed Period Order System
Base
Stock
Level Q2

Q3
Units in Inventory

Q1

0 1T 2T 3T
Time

Periodic inventory system: T is the time between orders and Q1, Q2 and Q3,
the order quantities in the time 1T, 2T and 3T
 • The ordering and inventory costs are low. The ordering
cost is considerably reduced though follow up work
Advantages of for each delivery may be necessary.
fixed period order • The suppliers will also offer attractive discounts as
system sales are guaranteed.
• The system works well for those products which
exhibit an irregular or seasonal usage and whose
purchases must be planned in advance on the basis of
sales estimates.
Disadvantages • The periodic testing system tends to peak the
of fixed period purchasing work around the review dates.
order system: • The system demands the establishment of rather
inflexible order quantities in the interest of
administrative efficiency.
• It compels a periodic review of all items; this itself
makes the system somewhat inefficient.
Point of difference Q/R system (Fixed Quantity Order) P system (Fixed Period Order)

Based on fixed review period and not

Initiation of order Stock on hand reaches to reorder point
stock level

Any time when stock level reaches to

Period of order Only after the predetermined period
reorder point

Continuously each time a withdrawal or

Record keeping Only at the review period
addition is made

Constant the same quantity ordered Quantity of order varies each time order
Order quantity
each time is placed

Size of inventory less than the P system Larger than the Q system

Less than due to only at the review

Time to maintain Higher due to perpetual record keeping
period
Gradual Replacement Model
• In this system economic production quantity (EPQ) is determined
• EPQ is associated with a manufacturing environment, while EOQ is
more common in retail situations.
• Sometimes, part of order is delivered instantaneously, but the rest of
order is supplied in small quantities over time.
• When the order is placed, the supplier begins producing the required
quantities, which are supplied continuously to purchaser.
• While these units are added to inventory (causing it to grow), other
units are being taken out of inventory (causing it to diminish).
Gradual Replacement Model
Qmax

Units in Inventory

Tp TD Tp TD

Time

Gradual Replacement (Finite Production Rate) System; Tp and TD are the inventory
replenishment time and inventory depletion time respectively
Gradual Replacement Model
• EPQ realistically shows that inventory is gradually built over a period
of time because production and the consumption go side by side where
production rate is higher than the consumption rate.
• Order size is taken as production size, the annual production rate is
taken as P such that P > D.
• Here P is also known as replenishment rate and D, the withdrawal (or
consumption) rate
• During time Tp, the slop of inventory accumulation is not vertical, as
entire order is not received at one time.
• Tp represents the status of receiving the stocks from the suppliers as
well as consumption by the purchaser (manufacturer).
Gradual Replacement Model

• Once the maximum quantity is delivered (Qmax), thereafter, during

time Td, units are taken out of inventory, but other units are not added
to it
• The slope of inventory depletion corresponds to the withdrawal rate
• At the end of time Td another order for Q is placed, partial delivery is
instantaneous, and the cycle repeats
•Cycle
  time t is the sum of the production time t1 plus the depletion time,
t2 of maximum inventory level BD. Production starts at point A, and
stops at point E as soon as the level of inventory becomes BE.
• 
Example
•A  unit is used at the rate of 100 per day and can be manufactured at a
rate of 600 per day. It costs Rs. 2000 to set up the manufacturing
process and Rs. 0.1 per unit per day held in inventory based on the
actual inventory any time. Shortage is not allowed. Find the minimum
cost and the optimum number of units per manufacturing run.
Solution:
 Inventory related decisions
Manager must take two basic inventory policy decisions
• How much stock to reorder (Reorder quantity)
• When to recorder (Reorder point)
• When to review
• Continuous review systems ( Fixed order quantity)
• Periodic review systems
The main objective behind inventory policy decisions is to
minimize total inventory related costs
 • 
As we know that inventory related costs are
• Cost of item or purchase cost
• Ordering cost
• Carrying cost
• Stock-out or shortage cost
What is
Economic
Order Quantity + Stock-out cost (SO)
(EOQ)?
 Further,
Carrying cost is inversely related to ordering cost
Economic Order It means that any reduction in carrying cost will lead to
Quantity (Contd…) increase in the ordering cost and vice versa
Question: How much quantity should be ordered?

EOQ: This is the quantity Q (size of order) at which overall

costs related to inventory is minimum.
Assume that the annual demand (D) is fixed and known with
certainty
EOQ Cost Model (cont.)
Annual
cost (Rs)
Total Cost
Slope = 0

CQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost =
Q

Optimal order Order Quantity, Q

Qopt
 Definition
Before calculating EOQ, it is necessary to become familiar with terms
associated with it. These terms are known as Quantity Standards.
a) Maximum Quantity Concepts of Inventory
This term is applied to designate the upper limit of the inventory and
represents the largest quantity which should generally be kept in stores.
b) Minimum Quantity
The lower limit of the inventory and represents a reserve or margin of
safety to be used in case of emergency or uncertainty
The purpose should be to hold enough and not excessive stock of
materials so as to :
i. avoid running out of stock; and
ii. create a buffer stock which may be utilized if the material falls
below the minimum level.
Definition (Contd…)

c) The Ordering Point or Re-order Point

Quantity required to ensure that there is adequate material for the interval between the
placement of an order and delivery.
d) Lead Time
In other words, lead time is the time taken from the time the requisition for an item is
raised till the supplies are received, inspected and taken into stock. Lead time involves
the time taken by following activities :
‒ Inquiries, quotations, scrutiny, negotiations and approval
‒ Import formalities, in case of imported items
‒ Placing an order, time taken by supplier for making the goods ready
‒ Transportation , receipts of goods
‒ Inspection , taking the material into stock
 e) Reserve (Safety or Buffer) Stock
Definition In order to safeguard production processes against uncertainties
in consumption rate and lead time, an extra stock is maintained
(Contd…) all along which is called safety stock, reserve stock or buffer
stock.
The factors considered for this purpose are :

i. Variation in consumption expected during the lead time; and

ii. Variation in lead time expected considering the prevailing
market conditions for that item.  
Safety stock, should then be sufficient to last for the periodic
difference between maximum and normal lead time.
 Assumption of  Demand is known with certainty and is
constant over time
Basic EOQ Model
 Consumption of items is uniform
 No shortages are allowed
 Lead time for the receipt of orders is constant
 The item is replenished in lots or batches,
either by purchasing or by manufacturing
 Order quantity is received all at once
Determination of EOQ

Co - Cost of placing order D - Annual demand

Cc - Annual per-unit carrying cost Q - order quantity

Co D
Annual ordering cost =
Q
Cc Q
Annual carrying cost =
2
Co D Cc Q
Total cost = ++
Q 2
Determination of EOQ

Deriving EOQ or Qopt Proving equality of

costs at optimal point
Co D CcQ
TC = +
Q 2 C oD CcQ
=
TC CoD C Q 2
= + c
Q Q2 2 2CoD
Q = 2
C0 D Cc Cc
0= +
Q2 2
2CoD
2CoD Qopt =
Qopt = Cc
Cc
 EOQ Example 1
Yantra Ltd is a supplier of speedometers to Speed auto Ltd. It
supplies 20,000 speedometers to Speed auto annually.
Ordering cost per order is Rs5 and carrying cost is 2.5 percent
of unit price. The price per unit of piece is Rs200. The
company has a policy of placing 10 orders every year. Advise
the management of Speed Auto Ltd to whether it should
continue with present policy or switch over to EOQ model
EOQ Example 2

Cc = Rs 0.75 per item Co = Rs.150 D = 10,000 items

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = TCmin = +
(0.75) 2,000 2

Qopt = 2,000 Items TCmin = Rs. 750 + Rs. 750 = Rs1,500

Order cycle time = 311 days/(D/Qopt)

Orders per year = D/Qopt = 311/5
= 10,000/2,000 = 62.2 store days
= 5 orders/year
•Solution
 
Here D = Rs. 20,000, C0 = Rs. 50, Cc = 12.5 % of average inventory
value/unit.
Let Q* be the optimal order size
•TC =

We get, Q* =

=Rs 4000/-
The cycle period t is given by

No. of orders per year

 Re-order point
Level of inventory at which a new order is
placed is known as Re-order point or Re-order
level

R =dxL
Where
R is the re-order point
d is the demand rate per period ( or demand
during lead time)
L is the lead time
Quantity Discounts

Price per unit decreases as order quantity increases

CoD CcQ
TC = + + PD
Q 2
where

P = per unit price of the item

D = annual demand

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