UNIT – 6

Inventory Management
 French – Latin Origin: Inventaire & Inventorium :

“A list of things found”

The term inventory includes materials like – raw, in process,

finished packaging, spares and others; stocked in order to meet
an unexpected demand or distribution in the future

Includes:
Production, MRO (Maintenance, Repair & Operating) supplies,
In-Process inventory, Finished Goods
 Why Hold Inventory?

Satisfy expected demand

Protect against stock outs

Take advantage of economic order cycles

Maintain independence of operations

Allow for smooth and flexible production

Protect against price increase

Why Hold Inventory?
 Types of Inventories

Direct Indirect

Used for Manufacturing the Does not play any role in finished
Product product, but required for
manufacturing
• Raw Material
• Fluctuation Inventory
• WIP
• Anticipation Inventory
• Finished Goods
• Transportation Inventory
• Spare Parts
•Decoupling Inventory
 Objectives of Inventory Control
Maximize the level of customer service by avoiding under stocking

- Under stocking causes missed deliveries, backlogged

orders, lost sales, production bottlenecks, and unhappy
customers.

Promote efficiency in production or purchasing by minimizing the

cost of providing adequate level of customer service

- Too much emphasis on customer service can lead to over

stocking
- Too much capital tied up

Conflicting Objectives
 Objectives of Inventory Control

It all comes down to:

When to Order ?

How much to Order ?

Perform the balancing act

Maintain efficiency in production

 Costs Involved

Purchase Cost • Preparing Purchase Order

Inventory holding cost • Processing payments

• Receiving & Inspection

Shortage cost
• Machine setup

Setup cost/Ordering Cost • Scrap

Total inventory cost

 Costs Involved

Purchase Cost • Deterioration

Inventory holding cost • Pilferage

• Insurance
Shortage cost
• Storage space rent

Setup cost/Ordering Cost • Interest/Credit

Total inventory cost

 Important Variables

Demand

Independent Demand Dependent Demand

Demand for items are unrelated to Need for 1 item directly related to
each other the need for another item

Usually determined by market Straightforward and easy to

research and sales department calculate

Customer survey, forecasting,

trends etc.
 Important Variables
• Lead Time

• Cycle Time

• Planning Horizon / Time

• Type of Product

• Type of Manufacture (Intermittent/Continuous)

• Volume of Production

• No. of components
Benefits of Inventory Management & Control
• Ensure adequate supply of materials

• Control investment in inventories

• Eliminate duplication in order

• Better utilization of available stock

• Check against loss of material

• Cost accounting

• Cost – Consumption comparisons

• Disposal of obsolete/inactive items

• Preparing financial statements

 Process of Inventory Management & Control

Step 1 - Determination of optimum inventory levels and procedures

of their review and adjustment

Low inventory – Risk of stock out, release working capital for other
purposes, reduced carrying costs, increased ordering costs

High Inventory – Uninterrupted supply of materials, working capital

locked up, increased carrying costs

Trend of sales must be watched closely

Study of the manufacturing cycle

Determine level of inventory to be held

Optimum level may change on a day to day basis

 Process of Inventory Management & Control

Step 2 - Determining Degree of Control

How Much Control is Needed??

Do all items require the same type of control?

ABC Analysis

A – High Value, Low Quantity

Tight or Loose Control
B – Intermediate

C – Low Value, High Quantity

 Process of Inventory Management & Control

Step 3 - Planning & Design of the Inventory Control System

Organizational structure & Operating Policies

Maintaining & Controlling Goods

Keeping Track (What, How Much, From Whom, When ?)

Has vendor received the order? Lead Time? Has it been shipped?
Are the items correct?

Reordering and returning undesirable items

Fixed Order Quantity System – “Q” System Economic Order

Quantity (EOQ)
Fixed-Order Period System – “P” System
 Process of Inventory Management & Control

Step 4 - Organizational Arrangement Structure

Organizational Structure - Not everyone should be in control

Inventory usually integrated with:

Stores/Materials Management Dept

All material functions integrated into one department

Production Planning Dept

In a better position to plan – both for materials & production schedule
Can issue timely requests
Actual user of inventories
 Process of Inventory Management & Control

Step 3 - Planning & Design of the Inventory Control System

Fixed Order Quantity System – “Q” System

Fixed-Order Period System – “P” System

Fixed Order Quantity System – “Q” System
 Fixed Order Quantity System – “Q” System

EOQ = Fixed Quantity of Material ordered each time

 Fixed Order Quantity System – “Q” System

Advantages:

-Each Material procured in the most economical quantity

- Attention is given only to items that are needed and

when they are needed

- By planning maximum and minimum values, the

inventory levels can always be maintained at a positive
level
 Fixed Order Quantity System – “Q” System
Disadvantages:

-Orders raised at irregular intervals may be convenient for

suppliers

- Situation: Lead time 3 mths, ordering quantity 1 mth

- Items cannot be grouped and ordered at once

- EOQ may not be enough for discounts

- Minimal stock or re-order point may be missed

- Assumes fixed lead time

 Fixed Order Period System – “P” System
S1 S2 S3

Y3
Order
Y1 Y2 Placed
Order Order
Placed Placed

R1 R2 R3
R – Review period, S – Supply period Fixed Review Intervals
Y – Inventory level during review period
 Fixed Order Period System – “P” System

Advantages:

-Ordering and inventory costs are low

- Works well for materials showing seasonal demand

- Discounts may be possible on huge orders

 Fixed Order Period System – “P” System

Disadvantages:

-Requires periodic review

- EOQ depends on many variables

- Lot of work during the review dates

 Q System P System
Initiation of Order Stock on hand reaches reorder Fixed review period and not
point stock level
Period of Order Any time a stock reaches Only are predetermined time
reorder point intervals
Record Keeping Each time a transaction is made Only during the review period

Order quantity Same quantity each time Varies each time

 Fixed Order Quantity System – “Q” System
Economic Order Quantity
Annual Demand  D

Ordering cost per order  C0

Inventory carrying cost per item per year(%)  Ci

Unit price of the item  p

Inventory holding cost  Cip

 Fixed Order Quantity System – “Q” System
Economic Order Quantity

Inventory varies from 0 to Q, Hence average inventory = Q/2

Inventory Holding cost = (Q/2)* Ch

Number of orders placed = ? D/Q

Ordering Cost (OC) = (D/Q)*C0

OC is inversely proportional to Q

Cost of individual item is assumed to be constant regardless of the

order size
Fixed Order Quantity System – “Q” System
Economic Order Quantity

Total Inventory Cost TC = Ordering cost + holding cost

TC = ( D/Q) Co + ( Q/2) Ch
Fixed Order Quantity System – “Q” System
Economic Order Quantity

Total cost is minimum when Holding Cost = Ordering Cost

Order quantity at this point is the Economic Order Quantity
 Fixed Order Quantity System – “Q” System
Economic Order Quantity

Equate the first derivative of TC to Zero to get EOQ (Q*)

D Q
TC  ( )C0  ( )Ch
Q 2
dTC D C h
 ( 2 )C0  0
dQ Q 2
2 DC0 2 DC0
Q*  
Ch pCi
 EOQ with Constant Demand & Shortage allowed

Some times a company may permit shortages/backorders in the inventory

Customer places and order – No stock available – Waits for availability

Hoping the customer will be patient

What may be the reasons??

Increase the cycle time

Spreading the setup or ordering cost over a longer time period

High value of inventory or high inventory holding cost

 EOQ with Constant Demand & Shortage allowed

Assumptions:

Known and Constant Demand rate

Instantaneous delivery of goods to the inventory

(Or minimal time lag)

S = Amount of Shortage accumulated after the inventory

is finished

Q = Size of the new shipment

EOQ with Constant Demand & Shortage allowed
 EOQ with Constant Demand & Shortage allowed

When the new shipment of size Q arrives, the company immediately

ships the back orders of size S to the customers. The remaining units
Q-S immediately go into inventory.

The inventory level will vary from a minimum of -S units to a maximum

of Q-S units.

The inventory cycle of T units is divided into two distinct parts: t1 when
inventory is available for filling orders and t2 when inventory is not
available, stock outs occur, and back orders are made

Cs : cost of back order, per unit per unit time

S : the number of units short or back ordered.
 EOQ with Constant Demand & Shortage allowed

Ordering Cost  No. of Orders x Cost per order

 ( D / Q)C0

D = Annual Demand, Q = Order Quantity

t1 & t2 in terms of Q, S & D ??

t1  (Q  S ) t2  S
D D
Avg Inv = (Avg. Inv @ time period t1 + Avg. Inv @ time period t2)/t
 EOQ with Constant Demand & Shortage allowed

Inv. Holding Cost = Avg. Inv. X Cost of holding 1 unit

IHC in time period t1 ranges from (Q-S) to 0. Hence Avg. Inv. Level (t1) = (Q-S)/2

IHC in time period t2 is 0, as there is no stock. Hence Avg. Inv. Level (t2) = 0

QS
t1  0t2
IHC  ( 2 )Ch
t
Substitute the value of t1 & t2 in the above equation:

(Q  S ) 2
IHC  Ch
2Q
 EOQ with Constant Demand & Shortage allowed

Shortage Cost (SC) = Avg. No. of units short x Cost of 1 unit being short

Shortage ranges from 0 – S units. Average Shortage = (S/2) Units

S
t2 2
2 S
SC  Cs  Cs
t 2Q

Total Cost = Ordering Cost + Holding Cost + Shortage Cost

D (Q  S ) 2 S2
TC  ( )C0  Ch  Cs
Q 2Q 2Q
 EOQ with Constant Demand & Shortage allowed

D (Q  S ) S 2 2
TC  ( )C0  Ch  Cs
Q 2Q 2Q

Total Cost is now a function of 2 variables, Q & S

Determine Optimal order Quantity (Q*) and Optimal Shortage Quantity (S*)

Differential TC w.r.t Q & S, Equate the two resulting equations to 0 and solve
simultaneously

2 DC0 Cs  Ch S Q (
* * Ch
Q *
( ) )
Ch Cs C s  Ch
 EOQ with Constant Demand & Shortage allowed

The number of orders for the planning horizon = D/Q*

The maximum inventory level = Q* - S*

The average positive inventory level is = (Q* - S*) / Q*

The length of time during which there are no shortages = t1* = (Q* - S*) / D

The length of time during which there are shortages = t2* = S* / D

The length of the inventory cycle = t* = Q* / D

*2
D (Q  S ) S* * 2
TC  ( * )C0  *
Ch  * C s
Q 2Q 2Q
 EOQ with Constant Demand & Shortage allowed
*2
D (Q  S )
* * 2
S
TC  ( * )C0  *
Ch  * C s
Q 2Q 2Q

Substituting the values of Q* and S* in TC*

2 DC0 Cs  Ch S Q (
* * Ch
Q 
*
( ) )
Ch Cs C s  Ch

Cs
TC *  2 DC0Ch ( )
C s  Ch
 Model with Finite Production Rate, Constant Demand & No
Shortage – EPQ Model (Economic Production Quantity)

Units are supplied at a uniform rate over time rather than in economic quantities over
time

Ordered Qty is not delivered in 1 shot.

Received gradually over a length of time @ finite rate per unit time

Inventory is used as and when it is received

Rate of receiving the inventory >= Rate of using the inventory

EPQ Model
 EPQ Model

Inventory Batch Size (Q), received over time period tp

Received at the rate (p) = Q/ tp

Simultaneous usage of the inventory at a rate of (u) units / time period

Inventory being built up or stocked at the rate of = (p-u) units/time period

Production or receiving inventory stops when (Q) units are received

From this point onwards, accumulated inventory is used at the rate of (u)
units/time period

Inventory is again ordered at the re-order point with a known lead time so that
new orders are received when inventory level becomes 0.
 EPQ Model

Min. Inventory during time period (tp) = 0

Q u
Max. Inventory during time period (tp) = ( p  u )t p  ( p  u )  (1  )Q
p p

Inventory Holding Cost (IHC) = Avg. Inventory x Cost of holding 1 unit

u Q
IHC  (1  ) Ch
p 2

Total Cost (TC) = Ordering Cost + Inventory Holding Cost

D u Q
TC  C 0  (1  ) Ch
Q p 2
 EPQ Model

D u Q
TC  C 0  (1  ) Ch
Q p 2

Differentiating TC w.r.t Q and equating to 0 to determine the optimal lot size Q*

2 DC0  p 
Q *
 
Ch  p  u 

Q *
 u
tp  Q / p td  1  
* * *

u  p
 EPQ Model

Q Q*
 *
u  Q *
t  t p  td 
* *
 1   
p u  p u
*
D u Q
TC *  * C 0  (1  ) Ch
Q p 2

Substituting the value of Q* in the above equation

 u
TC  2 DC0Ch 1  
*

 p
 Inventory Classifications

ABC – High, Medium & Low Value, High, Medium and Low Volume

HML – High, Medium & Low unit price of items

VED – Vital, Essential & Desirable

SDE – Scarce, Difficult and Easily available

GOLF – Government, Ordinary, Local & Foreign trades

SoS – Seasonal & Off Seasonal

XYZ – Depending on Inventory values of Items Used

 Mechanics of ABC Analysis – How it Works

Calculate the Annual Consumption Value of each item to be used while manufacturing a
product. ( No. of units x price per unit)

Arrange the items in decreasing order of annual consumption value

Calculate the cumulative annual consumption value for each item

Compare the cumulative percentage of annual consumption value for each item