Unit 6: Inventory Management 7 LHs
• Overview of inventory management;
• Types of inventory;
• Need to hold inventories;
• Significance of inventory management;
• Determining the inventory investment;
• Inventory cost: carrying cost, ordering costs, total inventory costs; The
optimum order quantity: economic order quantity; reorder point,
reorder point, safety stock and goods in transit;
• Inventory control system: ABC system; JIT system; Computerized
system, Outsourcing.
What is Inventory?
Concept of Inventory
Inventory refers to the goods and materials held by the organization for the purpose of
resale or production. Basic three types of inventory are:
Raw materials,
work in process and
finished goods.
These inventories are recorded as a current asset on the balance sheet.
Inventory Management
Inventory Management is the process of ordering, storing, using, and tracking a company’s
inventory. Major objective of inventory management is to Minimize costs while ensuring
availability and balancing act between overstocking and understocking. It is An aspect of
current assets management associated to a firm, which is concerned with maintaining
optimum investment in inventory and effective control of inventory. Excess of inventory
generate opportunity cost and deficit of inventory cannot fulfill the organizational
requirement.
Objectives of Inventory
Management
• Ensure continuous supply of materials
• Optimize inventory investment
• Minimize wastage and obsolescence
• Improve customer service
• Enable production efficiency
Functions of Inventory
• Buffer function: Acts as a cushion between demand and supply
• Speculative function: Stocking up in anticipation of price changes
• Transit function: Goods in movement
• Decoupling function: Smoothens production stages
Inventory in the Value Chain
• Procurement → Storage → Production → Distribution
• Inventory supports each stage
• Delays or shortages can affect the entire chain
Importance in Financial Management
• Inventory ties up working capital
• Affects liquidity, profitability, and cash flows
• Direct impact on Cost of Goods Sold (COGS)
Consequences of Poor Inventory Management
• Overstocking: Increased carrying costs, obsolescence
• Stockouts: Lost sales, customer dissatisfaction
• Inefficiencies in operations
• Strain on cash flow
Inventory Management and Business Strategy
• Aligns with cost leadership or differentiation strategies
• Supports just-in-time or lean operations
• Enables data-driven decision making.
In this way, inventory is one of the most Strategic asset of the
business and Inventory management is crucial for operational
and financial performance
Determining Inventory Levels: Demand Forecasting
• Accurate demand forecasting is essential for inventory planning
• Methods include:
• Quantitative (e.g., moving average, exponential smoothing)
• Qualitative (expert judgment, market research)
• Influences: market trends, seasonality, historical data
• Impacts EOQ, reorder point, and safety stock
Factors Affecting Inventory Investment Decisions
• Lead time: Longer lead time → higher inventory
• Sales volatility: Greater fluctuations → more buffer stock
• Storage capacity
• Capital availability
• Cost of obsolescence and perishability
• Order frequency and supplier reliability
• Inventory Turnover Ratio
• Inventory Turnover = COGS /Average Inventory
• Indicates how often inventory is sold and replaced
• High ratio: Efficient use of inventory
• Low ratio: Overstocking or slow-moving goods
• Must be benchmarked by industry
Inventory Turnover – Implications
• High turnover → less capital tied up, but risk of stockouts
• Low turnover → higher carrying cost, potential obsolescence
• Affects:
• Working capital
• Liquidity
• Operating efficiency
Carrying Costs
• Cost of holding inventory
• Includes:
Components of •
•
Storage and warehousing
Insurance
Inventory Costs: • Depreciation and obsolescence
• Opportunity cost of capital
• Carrying Costs • Usually 15%–35% of inventory value annually
• Ordering Costs Ordering Costs
• Costs incurred during the procurement process
• Stockout Costs • Examples:
• Total Inventory •
•
Preparing purchase orders
Transportation and handling
Cost = All above • Inspection and receiving
• Administrative processing
• Decreases with larger, less frequent orders
Stockout Costs and Hidden Costs Total Inventory Cost – Trade-Offs
• Total cost = Carrying cost + Ordering
• Costs of running out of
cost + Stockout cost
inventory
• Trade-off:
• Direct: Lost sales, urgent • Large orders → low ordering cost, high
purchases, backorders carrying cost
• Small orders → low carrying cost, high
• Indirect: ordering cost
• Customer dissatisfaction • Objective: Find optimal order size
• Brand damage (EOQ)
• Production halts • Inventory investment is a balancing
act. Forecasting and turnover ratio
Often difficult to quantify, but are key to inventory efficiency
critical to consider Understanding cost components
helps optimize stock levels
• Aim: Minimize total cost without
sacrificing service levels
Economic Order Quantity (EOQ)
• EOQ refers to the size of inventory to be ordered at which total inventory costs is minimum.
Total inventory cost is the minimum at the order size where total ordering cost is equal to
total carrying cost. It is Optimal order quantity to minimize total inventory costs. Basic
assumptions of EOQ Model are: Constant demand, Constant lead time, no stockouts and
Instantaneous replenishment. The Model ignores quantity discounts and it is not suitable for
seasonal or variable demand EOQ refers to the size of inventory to be ordered at which total
inventory costs is minimum. Total inventory cost is the minimum at the order size where
total ordering cost is equal to total carrying cost. The algebraic view of EOQ is given by:
Formula:
EOQ =
• Where:
• A = Annual demand
• O = Ordering cost
• C = Carrying cost
Economic Order Quantity (Graphical Presentation)
Costs (in Rs)
Total costs
Carrying costs
Ordering costs
Order Size
(in units)
EOQ
Reorder Point and Safety Stock
The basic problem associated to the inventory management is to
determine when the order should be placed. EOQ solves the problem
of how much to order. Once order is placed it will take sometimes to
receive the delivery. The time consumed between the placing an order
and receiving the order is known as lead-time or delivery period.
Reorder point (ROP) refers to the level of inventory at which a reorder
should be placed to receive the inventory at the time when previous
stock is exactly finished. It is the Inventory level that triggers reorder
level. Ensures stock arrives before current inventory depletes.
Long/variable lead times increase stockout risk
ROP = Average Lead time × Average usage
• To avoid the possibilities of being out of stock due to increased average
consumption and excess lead-time, firm should maintain safety stock and it must
be adjusted to ROP calculations as below
ROP = (Average lead time × Average usage) + Safety Stock
• If a new order is placed prior to the receipt of previous order, the normal
delivery time is longer than the time between the orders.
• A "goods in transit" inventory builds up in this situation.
• It refers to the inventory for which orders have been placed but still not
received.
• It has to be deducted in calculating ROP:
Re-order Point (ROP)
ROP = Formula:
• ROP = Lead Time × Average Daily Demand
Safety Stock and Goods in Transit
• Extra inventory held to cover uncertainties
• Calculation:
• Safety Stock = Z × σLT × √LT
• Z = service level factor, σLT = demand variability during lead time
• - Used with ROP for reliability
Goods in Transit
• Inventory that has been ordered but not yet received
• - Affects stock availability and planning
• - Must be tracked for accurate stock records
Inventory Control Systems
Why Inventory Control Systems?
• Prevent stockouts and overstocking
• Improve customer service
• Reduce carrying and ordering costs
• Support data-driven decision making
ABC Analysis: Concept and Example
Classify inventory based on value:
• A: High-value, low-quantity (10%)
• B: Moderate value (20%)
• C: Low-value, high-quantity (70%)
Focus control efforts on 'A' items
Example: Item A = 70% value, 10% items
Just-In-Time (JIT): Philosophy
and
• Inventory arrives 'just in time' for use
Practice
• Goal: Zero inventory
• Requires strong supplier coordination
• Reduces waste and holding costs
Traditional vs JIT Inventory System
Traditional:
• Large inventories
• Safety stock held
• Less supplier coordination
JIT:
• Minimal inventory
• Frequent deliveries
• High quality and timing emphasis
Computerized Inventory Systems:
Features
• Real-time tracking
• Automated reordering
• Barcode/RFID integration
• Reports and analytics
• Reduces manual errors
Outsourcing in Inventory Management
Third-party manages storage, ordering, delivery
• Benefits:
• Cost savings
• Scalability
• Expertise
• Risks:
• Loss of control
• Dependency
Best Practices in Inventory Control
• Regular audits and cycle counts
• Use ABC for prioritization
• Automate where possible
• Align with demand forecasts
• Evaluate supplier performance
Inventory control systems optimize operations. ABC & JIT improve
efficiency and Tech and outsourcing enable better management
Thank You
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