Inventory Management

Models
 Types of inventory

Transit inventory / Transportation inventory

The transit or pipeline inventories, arise due to transportation of

inventory items to distribution centres and customers from various
production centres. It refers to

• the finished goods that have been shipped by a vendor and haven’t yet
been received by the buyer.

• the purchased inventory that is currently on its way to a physical store,

an eCommerce warehouse, or a distribution center.
Buffer inventory

These are maintained to meet uncertainties of demand and supply. Buffer inventory
(also known as safety stock, supply chain safety net, or contingency stock) refers to
a surplus of inventory that is stored in a warehouse in case of an emergency, supply
chain failure, transportation delays, or an unexpected surge in demand.

Lead time is the time gap between placing an order and its actual arrival in the
inventory(or having the goods in stock ready for use). Usually stocks are
maintained to just meet the average demand during the lead time.

A company may apply the concept of buffer inventory at all levels of the supply
chain. The main objective is to ensure that production or sales don’t stop.
Anticipation inventory

Anticipation inventory is the stock that is kept according to the

expected consumer demand. It is quite similar to safety stock but it
differs in the sense that this stock is usually kept seasonally when the
demand for products can vary greatly.

For example, a retailer stocks more Ice-cream just while the summer
season is about to begin because he is expecting the demand for it
rising during the hot season. While the same retailer reduces his Ice-
cream stock as the winter season approaches.
Cycle inventories

Cycle inventory is the products, materials or raw ingredients that a company

keeps to fulfill its minimum production quotas. Cycle stock is the inventory that
varies due to regular and cyclical changes in demand. In other words, it is the
inventory that a company needs to hold to meet demand during a typical sales
cycle or production cycle for fulfilling customer orders.

Cycle inventory is crucial to the company's operations because regular business

operations use or "cycle" the inventory frequently. Managing cycle inventory
effectively helps ensure the business can meet customer demands and continue
to produce high-quality products.
 Inventory Costs
Inventory costs are the costs associated with the procurement, storage and

management of inventory. It includes costs like ordering costs, carrying

costs and shortage / stock out costs. Inventory is one of the most important

assets for a company or a manufacturer. They need to handle it well and it

requires cost for maintaining, storing, replacing and moving inventory.

All these costs are collectively known as inventory costs.

 Setup cost

This is the cost associated with the setting up of machinery before

starting production. Set up cost is generally assumed to be independent
of the quantity ordered for or produced
 Ordering cost

These costs are the expenses incurred when replenishing inventory, and
transportation fees are typically included in an overhead cost pool and
allocated to the number of units produced in each period.
• Cost of finding suppliers
• Preparation of purchase orders
• Transportation costs
• Receiving costs
• Cost of electronic data interchange
• Benefits and the wages of the procurement department, labor costs
In order to minimise the ordering cost of inventory we make use of the concept
of EOQ or Economic Order Quantity.
 Purchase cost (Nominal cost)

The cost of purchasing or producing a unit of item is known as purchase

(or production cost). The purchase price will become important when
quantity discounts are allowed for purchases above a certain quantity
or when economies of scale suggest that per unit production cost can
be reduced by a larger production run.
 Inventory Holding cost/ Inventory Carrying cost

Inventory holding cost/ Inventory Carrying cost is simply the amount of rent a
business pays for the storage area where they hold the inventory. This can be either
the direct rent the company pays for all the warehouses put together or a
percentage of the total rent of the office area utilized for storing inventory.

When inventory remains in stock for an extended period of time and then it refers to
the amount of interest a business looses out on the unsold stock value lying in the
warehouses.

They include costs associated with rent for space, security, depreciation costs, and
insurance.
 Shortage/Stock out cost

Shortage or stockout costs arise when inventory levels are insufficient

to meet customer demand. They encompass

• Emergency orders/shipments costs

• Disrupted production costs

• Missed sales opportunities

• Customer dissatisfaction

• Customer loyalty and brand reputation

Inventory Decisions/Objectives

• When should the order be placed?

• What is the quantity for which the order be placed?

• What level of safety stock be kept?

 Inventory Management Systems

• Fixed Order Quantity System (Q - system)

Order quantity is fixed and order placed when the stock level reaches a
pre- determined re-order point

• Periodic Review System (P - system)

Orders are placed periodically at fixed intervals while ordering quantities

can vary

• Ss System

Combines the features of P and Q systems

Model 1: Classical EOQ Model
• The demand is known with certainty, and constant over time.

• Lead time is known and fixed.

• Holding cost ₹ C1 per unit and ordering cost is ₹ Cs per order and are
constant.

• Purchase price of items is constant, and no discount is available on

purchases of large items.

• No shortages are allowed.

• The inventory is replenished immediately as the stock reaches to zero.

t – time period per run/lot

T – Optimum length of time between orders

Q – denotes the lot size ie. quantity produced/purchased after each time t

D – The total number of units produced/purchased throughout the entire

time period, say one year

n – denotes the total number of times quantity Q is purchased/produced

during the year

Then D = n*Q

And T = n*t
- Holding cost per unit in inventory
=I*C
Where C = cost of one unit in inventory
I = Inventory carrying charge expressed as percentage of the
value of average inventory

Average amount of inventory at hand on any day in the time period t is

Thus the Annual inventory holding cost is
- Ordering cost/set up cost per production run
Annual ordering cost = n* =
Total annual Cost
TC = +

Optimum no. of units to be placed

Q=

Minimum Total Annual Cost

TC =
Optimum no of orders placed per year
D=nQ n= n=

Optimum length of time between orders

T = n * t t = t= t = as T = 1
Ex 1: A manufacturing company has determined from an analysis of its
accounting and production data for a certain part, that
• Demand is 9000 units per annum and is uniformly distributed over the year
• Cost price is ₹. 2 per unit
• Ordering cost is ₹. 40 per order
• Inventory carrying charge is 9% of the inventory value
Further it is known that the lead time is uniform and equals 8 working days,
and that the total working days in a year are 300.
Determine:
1. The economic order quantity (EOQ)
2. The optimum number of orders per annum
3. The re-order level
4. The number of days’ stock at re-order level
5. The length of the inventory cycle
Ex 2: Mr. Ram keeps his inventory in special containers. Each container
occupies 10 sq ft of store space. Only 5000 sq ft space is available. The
annual demand for the inventory item is 9000 containers, priced at ₹. 8
per container. The ordering cost is estimated at ₹.40 per order, and the
annual carrying costs amount of 25% of the inventory value. Would you
recommend to Mr. Ram to increase the storage space? If so, how much
should be the increase?
Ex 3: The purchasing manager of a distillery company is considering
three sources of supply for oak barrels. The first supplier offers any
quantity of barrels at ₹. 150 each. The second supplier offers barrels in
lots of 150 or more at ₹. 125 per barrel. The third supplier offers in lots
of 250 or more at ₹. 100 each. The distillery uses 1500 barrels a year at
constant rate. Carrying costs are 40 percent of its inventory value, and
it costs the purchasing agent ₹. 400 to place order. Calculate the total
annual costs for the orders placed to the probable suppliers and find
out the supplier to whom orders should be placed.
 ABC Analysis
Every firm has a large variety of inventories in its stock room. Each
inventory will have a particular use. The flow of inventory should be in a
well-defined manner so that there is no wastage or overflow of
inventories in the firm.

To ensure that the appropriate amount of inventory is available in the

organization inventory control is practiced in most organizations. There
are different types of techniques used in inventory management. They
include batch tracking, economic order quantity, demand forecasting, etc.
ABC analysis colloquially known as Always Better Control is a inventory management technique used
to identify items that constitute a significant part of the overall inventory value and categorize them
into critical, important, and moderately important. This allows managers and decision-makers to
prioritize their inventories and other materials according to the immediate needs of their business.
The inventory is mainly classified into 3 categories :

A - Items of utmost importance and high market value for the items constitutes 10-20% of total
inventory value but the annual consumption may be up to 80%.

B - Important but not as important as A and has relatively lesser market demand. Constitutes 30% of
the total inventory value and the annual consumption can move up to 20% depending on the
consumption of category A.

C - Marginally important products which need the least attention as they are not sold much.
Constitutes 50% of the total inventory value and has the least annual consumption i.e. 5%
The division of items into various categories is accomplished by plotting the usage
value of the items to obtain the ABC distribution curve.

PROCEDURE

Step 1: Determine the number of units sold or used in the past 12-month period

Step 2: Determine the unit cost for each item

Step 3: Determine the items’ inventory value by multiplying their price and
consumption volume during the given period.

Inventory Value = Item Cost * Consumption Volume

Step 4: Arrange these items according to inventory value from highest to lowest
Step 5: Obtain the percentage value for each of the items. For n items, each item would
represent 100/n percent. For example, if there are 20 items involved in classification,
then each item would contribute 100/20=5% of the materials.

Then compute the cumulative percent value of the items.

Step 6: Calculate the cumulative inventory value of items and hence calculate the
cumulative percentage inventory value of items

Cummulative % Inventory Value of items

= Cumulative Inventory Value of items / Total Inventory Value of all items

Step 7: Using the data on cumulated % values of items and the cumulated percentage
inventory value of items, plot the curve taking these values on x and y axis respectively.
Step 8: Determine appropriate divisions for the A, B, and C categories. The
curve would rise steeply up to a point. This point is marked and the items up
to that point constitute the A-type items.

Similarly, the curve would only be moderately sloped towards upright.

These items are the B-type items for which the curve depicts a gradual
upward rise.

The point beyond which the slope is negligible is marked and the items
covered beyond that point are classified as C-type because they cause only a
negligible increase in the cost.
Ex 1: Perform ABC analysis using the following data.
Item Units Unit price
1 700 5.00
2 2400 3.00
3 150 10.00
4 60 22.00
5 3800 1.50
6 4000 0.50
7 6000 0.20
8 300 3.50
9 30 8.00
10 2900 0.40
11 1150 7.10
12 410 6.20
Item Units Unit price Inventory value = Ranking
unit price * no. of units
1 700 5.00 3500 4
2 2400 3.00 7200 2
3 150 10.00 1500 7
4 60 22.00 1320 8
5 3800 1.50 5700 3
6 4000 0.50 2000 6
7 6000 0.20 1200 9
8 300 3.50 1050 11
9 30 8.00 240 12
10 2900 0.40 1160 10
11 1150 7.10 8165 1
12 410 6.20 2542 5
Item Ranking % value of the item Cummulative Cummulative % of
inventory value total inventory value
11 1 8.3 8165 23
2 2 16.7 15365 43
5 3 25.0 21065 59
1 4 33.3 24565 69
12 5 41.7 27107 76
6 6 50.0 29107 82
3 7 58.3 30607 86
4 8 66.6 31927 90
7 9 75.0 33127 93
10 10 83.3 34287 96
8 11 91.6 35337 99
9 12 100.0 35577 100
 % usage
105

100

95

90

85

80

75

70

65

60

55

50

45

40

35

30

25

20

15

10
A- Type B- Type C- Type
5

0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Ex 2: The following information is known about a group of items. Perform
ABC analysis
Model Annual consumption Unit price(in Rs.)
number in pieces
501 30,000 10
502 2,80,000 15
503 3,000 10
504 1,10,000 5
505 4,000 5
506 2,20,000 10
507 15,000 5
508 80,000 5
509 60,000 15
510 8000 10