INVENTORY

MANAGEMENT
 Inventories are materials and supplies that a
business or institution carries either for sale or
provide inputs to the production process.

 Inventories are stock of materials of any kind stored

for future use, mainly in the production process.

 Inventory are the physical stocks of items that a

manufacturing or service organization keeps in hand
for efficient running of its office or manufacturing
activity.
 Financially inventories are very important to
manufacturing companies.

 On the balance sheet, they usually represent from

20% to 60 % of total assets.

 As inventories are used, their value is converted into

cash, which improve cash flow and return on
investment.
 There is a cost for carrying inventories, which
increases operating costs and decreases profits.

 Hence good inventory management is essential.

 Type of Inventory needed

Inventories are classified as,

 Raw Materials :- Purchased items which are not entered
the production process

 Work-in-process :- Raw materials that have entered the

manufacturing process and are being worked on or
waiting to be worked on.

 Finished goods :- They are ready to be sold as

completed items. They may be held at factory or central
warehouses or at various points in the distribution
system.
 Distribution Inventories :- Finished goods located
in the distribution system.

 Maintenance, repair and operational supplies

(MROs) :- Items used in production that do not
become part of the product. It include hand tools,
spare parts, lubricants, cleaning supplies.
Inventory Management
 Inventory Management is responsible for planning
and controlling inventory from the raw material stage
to customer.

 Inventory must be considered at each of the

planning level and is thus a part of production
planning, master production scheduling, Material
requirement planning.
 The basic objective of Inventory Management is to
be able to determine,
1. What to order
2. When to order
3. How much to order
4. And How much to carry in stock so as to gain
economy in purchasing, storing, manufacturing
and selling.
Why does a firm carry Inventories?

1. To economize on buying / manufacturing cost.

2. To keep pace with changing market condition.

3. To satisfy demand during period of replenishment.

4. To take care of contingency (ie prevent stockout)

5. To stabilize production

6. To prevent loss of sale

7. To satisfy other business constraints ie,

 Supplier’s condition of minimum quantity.
 Government regulation
 Seasonal availability
Symptoms of poor Inventory
Management
 Uneven Production with frequent layoffs and
overtime working.
 Increase in inventory investment as
compared to increase in sales.
 Partial utilization of machines due to frequent
shortage of materials.
 Periodic backlog of orders or frequent failures
in delivery commitments.
 Inventory Management Techniques

ABC Analysis Usage value (Consumption per period * price per unit )
HML Analysis (High –Medium –Low) Unit Price
VED Analysis (Vital-Essential-Desirable) Criticality of the item
SDE Analysis (Scare-Difficulty-Easy) Procurement difficulties
GOLF Analysis (Govt.- Ordinary-Local-Foreign) Source of Procurement
SOS Analysis (Seasonal-OF-Seasonal) Seasonality
M-N-G Analysis (Moving and Non-moving item)
XYZ Analysis Investment
ABC Analysis
 It tends to segregate all items or materials into three
categories: A,B & C on the basis of their annual
usage

 Items called ‘A’ hold a key to business

 Other items are numerous in number but there

contribution is less significant.( Items ‘B’ and ‘C’)
 A-Items : It is usually found that hardly 5-10% of
the items account for 70-75% of the total money
spent on the materials.

These items require detailed and rigid control and

need to be stocked in smaller quantities.

These items should be procured frequently, the

quantity per occasion being small
 B-Items : These items are generally 10-15% of the
total items and represent 10-15% of the total
expenditure on the materials.

 C-Items : These are numerous, as many as 70-

80% of the total items and inexpensive, 5-10% of
the total annual expenditure on materials.
Conducting ABC analysis

1. Prepare the list of items and estimate their annual

consumption
2. Determine unit price of each items
3. Multiply each annual consumption by its unit price
to obtain its annual consumption in rupees
4. Arrange items in descending order of their annual
usage starting with the highest annual usage down
to the smallest usage
5. Calculate cumulative annual usage and express
the same as cumulative usage percentage and
cumulative item percentage

6. Graph cumulative usage percentage against

cumulative items percentage and segregate the
items into A, B, and C

7. Decide the policies of control for the three

categories.
Graphical analysis of ABC Classification
Y

100
90
80

70
C
60
o
s 50
t 40
30

20
10

0 10 20 30 40 50 60 70 80 90 100 X
A B C
Items
Control of ABC Material
 The Fix-Order-Interval system useful for high value
items i.e. A category of items requiring strict control
on stock level.

 The Fix-Order-Quantity system is suitable for B-class

of items and low value items ordered infrequently in
large quantity

 Two bin system is best suited for C-class of items.

Inventory Cost

1. Item cost
2. Carrying Cost
3. Ordering cost
4. Stockout cost
5. Capacity associated cost
 Item cost
 It is the price paid for purchased item, which consist of
cost of item and any other direct costs associated in
getting the item into the plant.

 This could include such as transportation, custom

duties, insurance.

 The inclusive cost is often called as landed price.

 For an item manufactured in house the cost includes

direct material, labour and factory overhead which can
usually be obtained from either purchasing or
accounting.
Carrying Cost
 It include all expenses incurred by the firm
because of volume of inventory carried.
 As inventory increases this cost increase.
 They are broken down into three
categories,
1. Capital cost
2. Storage cost
3. Risk cost
Ordering cost

 Cost associated with placing an order either with the

factory or a supplier.

 The cost of placing an order does not depend upon

the quantity order.

 Annual cost of ordering depends upon the number

of orders placed in a year.
Stockout cost
 If demand during the lead time exceeds forecast we
can expect a Stockout.

 A Stockout can potentially be expensive because of

back order cost, lost sales, and possibly lost
customer.

 It can be reduced by carrying extra inventory to

protect against those times when the demand during
lead time is greater than forecast.
Capacity associated cost

 When output levels required to change, there may

be cost of overtime, hiring, training, extra shift.

 These cost can be avoided by leveling production by

producing items in slack periods for sale in peak
periods.

 However, this builds inventory in the slack period.

ECONOMIC ORDER QUANTITY
(EOQ)
 One of the important decisions in stock system is
that of determining the ordering / manufacturing
quantities of different items.

 Investment in inventories largely depends upon the

quantities in which they are ordered/manufactured.
 Ordering/manufacturing large lots infrequently
reduces administrative work but makes investment
in stocks large.

 Ordering/manufacturing small lots frequently keep

investment low but increase administrative work.

 The economic lot size for an order or the economic

order quantity depends upon two types of costs :
 a). Inventory procurement costs, which
consist of expenditure connected with :
 Receiving quotations
 Processing purchase requisition
 Following up and expediting purchase order
 Receiving material and then inspecting it
 Processing vendor’s invoice.
 b). Carrying costs, which vary with
quantity ordered, base on average
inventory and consist of :
 Interest on capital investment
 Cost of storage facility, up-keep of material
(preservation), record keeping, etc
 Cost involving deterioration and obsolescence
 Cost of insurance, property tax, etc.
Economic Order Quantity Model

Assumptions :
 The demand of the item occurs uniformly over the
period at the known rate

 The replenishment of stock is instantaneous.

 The price per unit is fixed & is independent of order

size.

 The cost to place the order & process the delivery is

fixed & does not vary with the lot size.
 The inventory carrying charges vary directly &
linearly with the size of the inventory & are
expressed as a percentage of average inventory
investment.

 The item can be procured free from restrictions of

any kind.

 The item has fairly long shelf life, there being no fear
of deterioration or spoilage
 Derivation of EOQ Formula :

 Annual consumption of the item (units): S

 Unit Price : Cu
 Order Quantity ( Units) : q
 Procurement cost per order ( Rs.) : Cp
 Inventory carrying cost expresses as a

Percentage of Average inventory investment : i

 1. Annual procurement cost = [ No. of orders
per year ] * [ Procurement cost per order
APC = S/q * Cp ------ (1)
 2.Annual inventory carrying cost = [Average
inventory investment ] * [Inventory carrying cost ]
= ½ [ Order Qty. x Price per unit ] * i

ACC = q/2 * Cu * i ------ (2)

 3. Annual Total Cost ( ATC )
= S/q * Cp + q/2 * Cu* i ------(3)

To get , EOQ, differentiate ATC with respect to q

 d( ATC) = -S.Cp + Cu.i = 0

dq q02 2
 q02 = 2. S.Cp
Cu.i

q0 = 2. S.Cp
Cu.i
Economic 2 X [ Annual consumption (units)]
X [Procurement Cost / Order]
Order =
Quantity Price per unit X Inventory Carrying Cost
 Investment in inventories to a large extent depends
on the quantities in which the items are ordered for
replenishment.

 Ordering bigger lots reduces procurement cost but

increases investment in stocks.

 Ordering small lots keeps investment in inventories

low but increases procurement cost
 The two costs Procurement cost and Inventory
carrying cost are diametrically opposite to each
other.

 When these costs have been properly balanced, the

total cost is minimum and the resultant quantity is
called Economic Order Quantity.
 500 Total Cost

C 400
o
s
300
t
Carrying Cost
200

100 Ordering Cost

EOQ

50 100 150 200 250 300 350 400

LOT SIZE
EOQ ?
 Suppliers minimum order quantity condition
 Lead time
 Government regulation
 Seasonal availability
 Packing size
 Space restriction
 Risk of obsolesce and deterioration
 Price discounts
 Unstable market conditions
Service levels and safety stocks

 The replenishment action is taken at the right

time
 There is no increase in demand during the
lead time
 There is no delay in getting the supplies
Replenishment Systems

1. Fixed order quantity system

2. Fixed order interval system