CHAPTER 5:

INVENTORY
MANAGEMENT
 LEARNING OUTCOMES

After completing this chapter, you should be able to

• explain why firms need inventory
• describe the common types of inventory
• calculate inventory-related costs
• discuss the different types of demand
• analyse demand
• undertake qualitative and quantitative forecasting in inventory management
• perform an ABC (Pareto) analysis
• discuss different types of ordering systems.
 INTRODUCTION
Figure 5.1 Intra-firm links within a supply chain

we see a stock point for raw materials (RM). Raw materials are ordered and stored at this stock point. These
raw materials are used to produce end products, which are stored at another stock point. The raw materials
that are procured are probably end products (EPs) of the previous link in the chain, and the end products
produced at this point could well be the raw materials for the next link in the chain. Of course, in many
production environments we will find internal stock points for sub-assemblies and components. However, we
will not go into these stock points here, because the way to control them is similar to the ones we will describe
at a later stage. Firstly, we will explain why we need inventory, and the different purposes of inventory. We will
discuss how to select a proper inventory strategy for which the ABC analysis (also called a Pareto analysis) is a
powerful instrument. There will be an in-depth discussion on the two important questions regarding inventory
control: when to order and how much to order. Thereafter we will describe the important inventory strategies.
 DEFINING INVENTORY

Typically includes:
• Raw materials
• Work-in-progress items
• Parts/equipment
• Finished items
 INVENTORY MGT
FURTHER DEFINED … (Copy slide)

• Refers to stocks of goods and materials that are maintained for many purposes, the
most common being to satisfy normal demand patterns

• Inventory decisions drive other business activities like:

– Warehousing
– Transportation
– Materials handling
• Objectives can differ for different functional areas of an organization

• Must consider inventory costs

– Carrying costs
– Ordering costs
– Stockout costs
 COMMON TYPES OF INVENTORY
• Cycle stock
This describes the portion of inventory that is carried by an organisation specifically for the purpose of satisfying regular orders. For a manufacturing organisation, such stock
comprises all of the items that are consumed in the course of normal operations of the company. For a selling organisation, cycle stock would include all items that the
organisation carries in order to satisfy sales orders. Typically, because this kind of stock is either consumed or sold routinely, these items are not expected to spend a lot of time
in storage, and so their replenishment pattern is cyclical.
• Safety stock
This refers to the portion of inventory items held as a buffer to enable the organisation to cushion the effects of uncertainties in demand and/or supply of said items. Therefore, this
kind of stock describes the extra or additional quantities of an inventory item carried by an organisation, over and above its cycle requirements, particularly to mitigate the risk of
stock-outs.
• Anticipation stock
This is the kind of stock that an organisation carries because of a future event, with a high likelihood of occurrence, which justifies the stocking of quantities of the item above
regular cycle quantities. It is important not to confuse anticipation stock with safety stock. The holding of anticipation stock is tied to a specific future event, such as imminent
scarcity of the item, predicted price increases for the item or expected increase in demand for the item, among others.
• Seasonal stock
Items that are carried in store simply because of the levels of demand that are peculiar to particular periods of the year can be categorised as seasonal stock. While there may be
similarities, this type of stock may be distinguished from anticipation inventory on the basis of the rationale that informs its stocking. The reason for carrying seasonal stock is
temporal; it is tied to a period rather than an event. For example, just before the winter season arrives, many clothing outlets tend to stock items like coats and sweaters.
• Promotional stock
This kind of stock is carried by organisations to enable them to satisfy high levels of demand that are due to a promotion campaign. In order to encourage sales of a particular item,
organisations may create some kind of incentive that encourages more purchases. Thus, it becomes necessary for the stock of that specific item to be carried in larger quantities,
so as to meet with greater demand.
• Dead stock
This is the type of stock that an organisation may have but cannot utilise as was intended. This may be a consequence of keeping the stock item for too long in storage, beyond its
shelf life. If the stock item is perishable, it could be that the item has expired. In other cases, where the item is not perishable, it may be that the item has become so outdated that
it can no longer be used in the normal operations of the organisation.
• Non-conformance stock
This category of inventory items is similar to the dead stock category. The similarity lies in the fact that the stock items are no longer usable by the organisation that has kept them
in storage. However, the difference is that they could still be utilised by other parties. The reason the organisation may not be able to use such items anymore may be related to a
change in operational requirements or the use of different machines or equipment.
 PURPOSE OF HOLDING INVENTORY
• Creating a cushion for uncertainties

– Three major kinds

» Uncertainty in demand
» Uncertainty in supply
» Uncertainty in yield
Uncertainty in demand: we do not know exactly when a customer will order and how he will order.
2. Uncertainty in supply: we do not know exactly when a supplier will deliver or whether he will deliver the quantity
demanded.
3. Uncertainty in yield: we do not know exactly how much we will produce. There will usually be some losses or scrap
owing to irregularities in the process.
 PURPOSE OF HOLDING INVENTORY continued

• Holding batch stock

The second purpose of carrying stock is to hold batch stock. This stock occurs because firms usually cannot buy or produce products in the quantity needed. The incurred stock is
called batch stock or cycle stock, and this has to do with either physical or financial restrictions. This situation also occurs when we do our weekly shopping. We buy in
larger quantities than immediately necessary, in order to avoid the need to go shopping every time we want some sugar, or an egg. In production environments we see the
same principle in practice.
• Providing for seasonal stock or anticipation stock
Another purpose for carrying stock is to provide for seasonal stock or anticipation stock. This is stock that is built up in slow periods, because in peak season there is not enough
capacity to do so. In Holland, producers of ice skates start making them in summer so as to have enough stock for the winter period; but this technique can also be used to
cover holiday periods.
• Providing for strategic stock
A type of stock that resembles safety stock is strategic stock. This is stock used by the tobacco industry or the coffee industry, for example, to compensate for crop failures. Not
having enough raw materials (tobacco, coffee) would immediately lead to huge problems. For these firms, this strategic stock is the main component of total stock
• Enabling smooth production processes
In production environments, we find stocks on the shop floor, which is needed for the smooth operation of the process. This stock is called work in process/progress (WIP).
• Compliance with legal/contract requirements
A very special kind of stock is the guarantee stock, which consists of parts and components that suppliers have to keep in stock for a number of years. If a mining firm orders an
expensive excavator, for example, they demand that components and spare parts be available for a number of years. Thus, it can happen that firms have to carry these stocks
even though demand for them may be very low and some of the stock probably will have to be scrapped.
• Overcoming supply disappointments
Sometimes expected deliveries from suppliers do not take place when scheduled. This may be for a medley of reasons on the part of the supplier, such as labour strikes,
transportation challenges, stock-outs and incorrect shipment, among others. Without inventories, such disappointments would have severe knock-on effects on the
organisation that requires the deliveries from the supplier in order to operate.
• Compensating for a shutdown in production
Some organisations, especially in the manufacturing industry, have scheduled shutdowns. At other times, a shutdown could also be unplanned. During such periods, no production
takes place, as the entire plant stops running and extensive maintenance work is undertaken. A shutdown in production is never complemented by a shutdown in demand.
 Inventory Costs
(Slide to Copy)

• Assets cost money, which means that inventory

costs money
• Inventory costs between 2010 and 2014 represent
approximately one-third of total logistics costs
• Inventory cost should factor into an organization’s
inventory management policy
• Logistics manager must understand nature of
each cost as well as trade-offs
 INVENTORY CARRYING COSTS
(Slide to Copy)
–Costs associated with holding inventory
–In general, expressed in percentage terms
and this percentage is multiplied by the
inventory’s value
–Resulting number represents dollar value
associated with holding the particular
inventory
 INVENTORY HOLDING COSTS
• Capital cost
If we look at the different components of the holding cost rate, one of the most important is capital costs. We had to pay money to purchase inventory and this money
could have been invested elsewhere. So what are the alternative revenues for this money? Accountants are not very clear about this matter. Many firms use
different values, depending on their financial structure and the required yield. Some firms use market interest plus a certain percentage; others use a kind of
ROI (return on investment); but opportunity costs are mentioned in the literature as well. Personal research has shown these values to be between 8% and 20%.

• Cost of obsolescence

The second important cost factor is the risk of obsolescence. This component is very much product related. Products with a short life cycle (e.g. fashion items,
computer parts or digital cameras) have a high risk of obsolescence, while for common ferrous and non-ferrous metals the risk is almost non-existent. As for
the cost of capital, it is difficult to give an exact value, but it seems that an overall value of 10% is not unrealistic. Again we have to bear in mind that this is
both product related and branch related.

• Handling and storage costs

The third component relates to handling and storage. This means mortgage on, or rent of, warehouses; people and equipment for handling and storage; computer
hardware and computer software; insurance, theft, and so on. In order to illustrate this, the inventory holding costs of three wholesalers are shown in Table 5.1.
 INVENTORY HOLDING COSTS continued

Table 5.1 Inventory holding costs for three different wholesalers

INVENTORY MANAGEMENT
 DEMAND AND INVENTORY

Independent demand and dependent demand

Figure 5.2 Independent and dependent demand items
 DEMAND AND INVENTORY continued

Independent demand and dependent demand continued

Figure 5.3 Independent demand stock levels

Reorder level = Safety stock + Demand during lead time

 DEMAND AND INVENTORY continued

Independent demand and dependent demand continued

Figure 5.4 Dependent demand stock levels

 DEMAND AND INVENTORY continued

Random demand and predictive demand

Figure 5.5 Common demand patterns
Source: Wilcox (2008)
 DEMAND AND INVENTORY continued

Fast demand and Slow demand

(Go through text)

 ANALYSIS OF DEMAND

Average demand
Average demand =

where:
Smin = Minimum stock level of the item
Smax = Maximum stock level of the item
 ANALYSIS OF DEMAND continued

Total demand
Total demand = Total quantities of an item in received orders +
Total quantities of an item in lost orders
 ANALYSIS OF DEMAND continued

Measurement of demand variability

Figure 5.6 Normal distribution of demands for item Y
Source: Wilcox (2008)
 ANALYSIS OF DEMAND continued

Measurement of demand variability continued

Table 5.2 Demand frequency table for item Y

 ANALYSIS OF DEMAND continued

Standard deviation and safety stock

Table 5.3 Deviations for the period January to December
 ANALYSIS OF DEMAND continued

Standard deviation and safety stock continued

 FORECASTING

Qualitative forecasting
• Panel consensus method
• Delphi method
 FORECASTING continued

Quantitative forecasting
Table 5.4 Hypothetical forecasted and actual demand figures
 FORECASTING continued

Quantitative forecasting continued

Simple average

Year-to-date average
 FORECASTING continued

Quantitative forecasting continued

Moving average

Weighted average
 FORECASTING continued

Quantitative forecasting continued

Exponential smoothing
 FORECASTING continued

Quantitative forecasting continued

Seasonal analysis
Table 5.5 Determination of seasonal indices for Horistics
 FORECASTING continued

Quantitative forecasting continued

Seasonal analysis continued

Table 5.6 Forecasted demand for Horistics based on seasonal indices

 FORECASTING continued

Quantitative forecasting continued

Evaluation of forecast quality

 FORECASTING continued

Quantitative forecasting continued

Evaluation of forecast quality continued

Table 5.7 Absolute deviations for the period January to December

VALUE OF INVENTORY ITEMS

Table 5.8 Generic ABC categorisation

 VALUE OF INVENTORY ITEMS continued

Table 5.9 Annual expenditure on items

 VALUE OF INVENTORY ITEMS continued

Table 5.10 ABC categorisation of items

 ORDERING SYSTEMS
Ordering dependent demand
items
Figure 5.7 Logic of the MRP
 ORDERING SYSTEMS continued

Ordering independent demand items

Table 5.11 Planned order release
 ORDERING SYSTEMS continued

Economic order quantity

Ordering costs (OC) = Costs for placing an order (C) × Number of orders (N)

Number of orders = Annual usage (U)/ Quantity ordered each time (Q) = U/Q

OC = C x (U/Q)

Holding costs (HC) = Value of items to be held (V) × Holding percentage (H)

Value of items held = Average inventory × Price of item (P)

Since average inventory is Q/2 (where Q is the order quantity), then

HC = (Q/2) x P x H
 ORDERING SYSTEMS continued

Economic order quantity continued

Figure 5.8 Holding costs and ordering costs

Source: Wilcox (2008)
 ORDERING SYSTEMS continued

Re-order point system

RP = (D × L) + SS

Where:
D is the forecasted demand per period
L is the replenishment lead time in periods
SS is the desired safety stock level
 ORDERING SYSTEMS continued

Variable order quantities

Lot-for-lot system

Target inventory level system

TIL = D (L + R) + S
 ORDERING SYSTEMS continued

Period order quantity system

Table 5.12 The POQ system logic
 ORDERING SYSTEMS continued

Periodic ordering
Table 5.13 The PO system logic
 ORDERING SYSTEMS continued

Time-phased order point system

Table 5.14 The time-phased order point system
 ORDERING SYSTEMS continued

Kanban system
Figure 5.9 Kanban squares
 ORDERING SYSTEMS continued

Order modifiers
 Contemporary Issues with Managing Inventory [1]
(Slide to Copy)

• Lean manufacturing

–Focuses on the elimination of waste and the

increase of speed and flow
–Identifies seven major sources of waste including
inventory
–Just-in-time (JIT) is one of the best-known lean
inventory practices
 Contemporary Issues with Managing Inventory [2]
(Slide to Copy)

• Lean manufacturing

–Just-in-time (JIT)
• Seeks to minimize inventory by reducing (or
eliminating) safety stock while having the
required amount of materials arrive at the
production location at the exact time they are
needed
 Contemporary Issues with Managing Inventory [3]
(Slide To Copy)
• Service parts logistics

–Involves designing a network of facilities to

stock service parts
• Deciding upon inventory ordering policies
• Stocking the required parts
• Transporting parts from stocking facilities
to customers
Contemporary Issues with Managing Inventory [4]
(Slide to Copy)

• Vendor-managed inventory (VMI)

–Size and timing of replenishment orders are the

responsibility of the manufacturer
–Allows manufacturers to have access to a distributor’s
or retailer’s sales and inventory data
–Benefits include reduced inventories, fewer stockouts,
and improved customer retention