Inventory Management

Operations Management II
What is OM 2 all about?

• Some of the biggest challenges faced by managers:

• Materials and supplies- module 1

• Managing quality – module 2

• Waiting lines – module 3, sessions 10-12

• Modern technology and Operations Strategy – module 3, sessions 13-15

Course logistics:

Quizzes CP End Term

• Two announced Credit: Problems from all modules and
quizzes conducted • Good contribution in the class sections
by the office (20 • Attendance - Numerical
marks each) Debit: - Conceptual
• 2-3 surprise • Bad conduct
quizzes conducted • Late entry
in the class (10 • Casual walkouts from the class
marks each) • Caught sleeping
• Working on laptop/smartphone during class
• etc..
Material (inventory) management
• “The more inventory a company has, the less likely they will have
what they need.” — Taiichi Ohno
• “Inventory is money sitting around in another form.” — (Anonymous /
industry adage)
• “What gets measured, gets managed.” — Peter Drucker
Inventory statistics:
• The country’s “changes in inventories” (stocks of goods held by firms) averaged ~ ₹493.53 billion from 2011
to 2025, reaching an all-time high of ~ ₹897.01 billion in Q1 2025.
https://tradingeconomics.com/india/changes-in-inventories?utm_source=chatgpt.com
• The market for inventory management software in India (which supports better materials/inventory control)
generated USD 167.1 million in 2024 and is expected to reach USD 457.9 million by 2033 (CAGR ~12.3%).
https://www.grandviewresearch.com/horizon/outlook/inventory-management-software-market/india?utm_sou
rce=chatgpt.com

• According to the report by Arthur D. Little on India’s supply chain, inventory-carrying and related costs are
estimated at 15-25% of inventory costs (which themselves are 4-6% of total logistics costs) amounting
roughly to USD 120-180 billion.
https://www.adlittle.com/en/insights/report/reimagining-india%E2%80%99s-supply-chain?utm_source=chat
gpt.com

• The logistics & warehousing sector review for India emphasises that inefficient inventory, warehousing &
transport links contribute to a relatively high logistics cost base (which affects inventory carrying/turnover).
https://assets.kpmg.com/content/dam/kpmgsites/in/pdf/2022/10/The-logistics-and-warehousing-market-in
-India.pdf.coredownload.inline.pdf?utm_source=chatgpt.com
What is inventory management?
• Inventory?
• Stock of items kept to meet future demand
• Purpose of keeping inventory?
• The rate of consumption is rarely same as that of production/procurement
• To meet anticipated customer demand
• Protect against stock-outs
• To take advantages of economies of scale through economic order quantities
• Maintain independence of operations
• To allow for smooth and flexible production operations
• To guard against price increase
 How to measure inventory in supply chain - I

Inventory Turnover Ratio (IT)

Where:
• COGS is the total cost of goods sold during a period (typically a year).
• Average Inventory = (Opening Inventory + Closing Inventory) ÷ 2
• Interpretation: This ratio measures how many times inventory is sold and replaced during a period.
• A higher turnover indicates efficient inventory management — goods are moving quickly.
• A lower turnover may signal over-stocking, slow-moving goods, or weak demand.
• Example: If a company’s annual COGS = ₹1,20,00,000 and its average inventory = ₹20,00,000, then

That means the company cycles through its inventory six times per year.
How to measure inventory in supply chain - II
Inventory Days (Days of Inventory on Hand / Days Sales of Inventory)

Interpretation:
• Indicates how long (in days) on average the company holds inventory before it is sold.
• Lower values suggest leaner operations; higher values imply slower turnover.
Other measures
Firm level:
• Inventory : Sales
• Inventory : Total assets
Economy level:
• Inventory : GDP
 Inventory
types

Process stage Demand Type Purpose Others

Raw Materials
WIP Independent Cycle Spares
Finished Goods Dependent Safety Consumable
Inventory Seasonal
Pipeline
context
What is inventory management?
Contd.
• Problems with less inventory?
• Customer service
• Ordering/setup cost
• Resource utilization
• Payments to suppliers
• Problems with more inventory?
• Holding/carrying cost
• Cost of capital
• Storage and handling cost
• Taxes, insurance, shrinkage
• Wastage, confusion, hindrance
What is inventory management?
• Inventory management?
To have the correct inventory at the right place at the right time to
minimize system costs while satisfying customer service requirements

• Inventory policy?
The strategy, approach, or set of techniques used to determine how to
manage inventory.
• How to classify the items
• How to collect data related to inventory
• How much to order and when to order
Supply Chain Inventory models

Single-period
Fixed order quantity
Fixed time period

Materials
Requirements
Planning (MRP)
 Inventory models

Single-period model

• Used when we are making a one-time purchase of

an item

Fixed-order quantity model

• Used when we want to maintain an item “in-stock,”

and when we restock, a certain number of units
must be ordered

Fixed–time period model

• Item is ordered at certain intervals of time

Comparing multi-period models:
 ABC analysis

• Stock-keeping units (SKU)

• Identify the classes so management can control inventory levels
• A Pareto chart
 ABC Classification
• Class A
• 5 – 15 % of units
• 70 – 80 % of value
• Class B
• 30 % of units
• 15 % of value
• Class C
• 50 – 60 % of units
• 5 – 10 % of value
 ABC Classification
PART UNIT COST ANNUAL USAGE TOTAL VALUE

1 $ 60 90 (60 * 90) 5400

2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
 ABC Classification
TOTAL % OF TOTAL % OF TOTAL
PART VALUE VALUE QUANTITY % CUMMULATIVE
9 $30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0 15.0
A
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 30.0 B
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 83.0 C
7 1,700 2.0 17.0 100.0
$85,400
ABC classification

% OF TOTAL % OF TOTAL
CLASS ITEMS VALUE QUANTITY
A 9, 8, 2 71.0 15.0
B 1, 4, 3 16.5 25.0
C 6, 5, 10, 7 12.5 60.0
Inventory related costs

• Holding cost
• Ordering cost
• Buyer time
 Time of buyer for placing extra order, ZERO otherwise
 Internet and communication has reduced this cost significantly

• Receiving costs
 Administrative work such as purchase order matching with updating inventory records
 Quantity dependent should not be included here

• Transportation costs
 Fixed cost should be included here
Inventory related costs

Any other cost related to inventory?

Shortage cost: Two possibilities:
• Permanent
– Lost profits due to unsatisfied demand
– Lost profits of future sales

• Temporary (CB)
– Backordered, so not necessarily lost
– Special clerical & paperwork costs
– Extraordinary transportation cost to customer
Inventory • Everything inside is perishable, occupies space, consumes electricity (carrying cost).
• Too much stock → waste and electricity bills.
costs • Too little → frequent buying trips (ordering cost).
illustration • Items that never get used = dead stock.
A simple EOQ policy for Continuous Review Policy
Assumptions:
• Demand is fixed and known
• Lead time to receive an order is fixed and known
• Inventory is updated instantaneously upon receipt

Inventory
25

20

15

10

0
0 1 2 3 4 5 6

Time (Days)
Notations:
D – total demand in the planning horizon (1 year)
d – daily (or weekly) demand
Q – fixed order quantity
S – ordering cost (one time)
H – inventory holding cost per unit (Rs.)
C – product cost per unit
H– inventory holding cost as percentage of product cost (H = h*C)
h (i) – inventory holding cost as percentage of product cost
L – lead time of delivery by the supplier
 A simple EOQ policy contd.

Inventory
25

Q 20

15

10

0
0 1 2 3 4 5 6

Time (Days)

Average inventory level (across a long time horizon) = Q/2

A simple EOQ policy contd.

Average inventory level (across a long time horizon) = Q/2

Time horizon for estimating costs = 1 year

Different cost components measured annually:

1. Inventory holding cost
2. Total ordering cost
3. Product purchase cost (?)
A simple EOQ policy contd.

Annual inventory holding cost:

= Average inventory * inventory holding cost per unit

Inventory cost
= 120

100

Or 80

60

= 40

20

0
0 2 4 6 8 10 12
A simple EOQ policy contd.

Annual ordering cost:

= Number of orders in the year * one-time ordering cost

Ordering cost
= 12000000

10000000

8000000

6000000

4000000

2000000

0
0 2 4 6 8 10 12 14 16
Estimating EOQ 1200

Total cost (relevant to Q) 1000

= 800

Total inventory holding cost

+ Total ordering cost 600

400

= +
200

0
0 2 4 6 8 10 12

Order quantity for minimum cost (Q*)

Estimating EOQ
TC = +
At the lowest total cost:
Inventory holding cost = Ordering cost

EOQ, =
=
Calculus approach:
TC = +
Differentiating both sides with Q (for maxima or minima):

EOQ, =
So, we have answered how much to order.
Now what?
When to order?
Reorder point: Inventory level at which we raise the order
If Lead Time, L = 1 day & daily demand, d = 10 units

Inventory
25

20

R = d*L
15
R
10

0
0 2 4 6 8 10 12
L = 1 day
Inventory Order Cycle under Certainty

Order quantity, Q
Demand Average
rate inventory
Inventory Level

Q
2

Reorder point, R

0 Lead Time
Lead
time time
Order Order Order Order
placed receipt placed receipt
Let’s include uncertainty
Notations:
d = daily (or weekly) demand
σd = standard deviation of daily demand
L = lead time of delivery in days (or weeks)
σL = standard deviation of lead time
 Variable demand with Reorder Point

Inventory level

Reorder
point, R

0
LT LT
Time
Demand During
the Lead Time
(DDLT)
Safety Stock:
Buffer added to the on-hand inventory during lead time

Stock-out:
An inventory shortage

Service level:
• Probability that the inventory available during the lead time will meet
demand
• P(Demand during the lead time <= Reorder point)
 Establishing Safety Stock
Levels
Safety stock – refers to the amount of inventory
carried in addition to expected demand.

• Safety stock can be determined based on many different criteria.

A common approach is to simply keep a certain

number of weeks of supply.

A better approach is to use probability.

• Assume demand is normally distributed.

• Assume we know mean and standard deviation.
• To determine probability, we plot a normal distribution for expected demand
and note where the amount we have lies on the curve.
 Reorder point with safety stock

Inventory level
Q
Reorder
point, R

Safety Stock
0
LT LT
Time
Inventory breakup for Hewlett Packard

Ref: Tom Davis.(1993). “Effective supply chain management”. Sloan Management Review
Reorder point for a service level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock

zDLT
𝑅−𝑑 𝐿
𝑧=
𝜎 𝐷𝐿𝑇
dL R
Demand (during the lead time)
Fixed-Order Quantity Model with Safety Stock
Demand is variable,
but follows a known
distribution/

After the reorder is placed,

demand during the lead time
may be higher than expected,
consuming some (or all) of the
𝑅=𝑑 𝐿+ 𝑧 𝜎 𝐷𝐿𝑇
safety stock/
Estimating DLT (Standard deviation of demand during the lead time)

• Demand during the lead time =

• If only d is probabilistic with N.D () and L is certain:
•

• If only L is probabilistic with N.D () and d is certain:

• If both d and L are probabilistic:

Math behind- Wald’s equation

Example
A paint store wants a reorder point with a 95% service level and a 5%
stockout probability. Average demand is 30 L/day, lead time is 10 days
and standard deviation of demand is 5 L/day.
d = 30 Litres per day
L = 10 days
d = 5 Litres per day
For a 95% service level, z = 1.65

R = dL + z d √L Safety stock = z d √L
= 30(10) + (1.65)(5)(√10) = (1.65)(5)(√ 10)
= 326.1 Litres = 26.1 Litres
Periodic Review System / Fixed-Time period system

A B

Time periods
are equal, Reorder quantity varies,
but ending depending upon ending
inventory inventory level. Beginning
varies. inventory is always the
same.
Order quantity for a periodic review system

Q = d(T + L) + zd T+L -I

where
d = average demand rate
T = the fixed time between orders
L = lead time
sd = standard deviation of demand

zd T + L = safety stock

I = inventory level

Do we know what is the best value of T?

Derivation of optimal fixed time interval (T) or frequency (N)

To determine optimum N:

We know that minimum cost occurs at,

Fixed period model with variable
demand
d = 6 packages per day
sd = 1.2 packages
T = 60 days
L = 5 days
I = 8 packages
z = 1.65 (for a 95% service level)

Q = d(T + L) + zd T+L -I

= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 packages
 Fill Rate:
• CSL only says about the probability of stock-out in a single cycle.
• Another important parameter is the expected actual sales fulfilled out of stock in
a cycle:

Where, E(z) = normal loss function with standard normal distribution

Thus, Fill rate:

Expected number of units short per year, E(N) = ?

Fill Rate: concept of ESC

𝑅−𝑑 𝐿
𝑧= Safety stock
𝜎 𝐷𝐿𝑇
zDLT 𝑬𝑺𝑪=𝝈 𝑫𝑳𝑻 ∗ 𝑬 ( 𝒛 )
dL R
Probability of
Demand (during the lead time) a stockout
Key Electronics Mexico