BATANGAS STATE UNIVERSITY

College of Accountancy, Business Economics and International Hospitality Management

GRADUATE SCHOOL

BA 506 OPERATIONS MANAGEMENT

Written Report on the Topic

INVENTORY MANAGEMENT
Apple R. Magpantay

INTRODUCTION

Inventory management is a core operations management activity. Effective

inventory management is important for the successful operation of most businesses and
their supply chains. Inventory management impacts operations, marketing, and finance.
Poor inventory management hampers operations, diminishes customer satisfaction, and
increases operating costs.
Some organizations have excellent inventory management, and many have
satisfactory inventory management. Too many, however, have unsatisfactory inventory
management. They either have too little or too much inventory, inaccurate inventory
tracking, or incorrect priorities. What is lacking is an understanding of what needs to be
done and how to do it. This chapter presents the concepts and knowledge base for
effective inventory management.
Inventories are a vital part of business. Not only are they necessary for operations,
but also they contribute to customer satisfaction. To get the sense of the significance of
inventories, consider the following: Although the amounts and dollar values of
inventories carried by different types of firms varies widely, a typical firm probably has
about 30 percent of its current assets and perhaps as much as 90 percent of its working
capital invested in inventory.
Inventory management is the supervision of non-capitalized assets, or inventory,
and stock items. As a component of supply chain management, inventory management
supervises the flow of goods from manufacturers to warehouses and from these facilities
to point of sale. A key function of inventory management is to keep a detailed record of
each new or returned product as it enters or leaves a warehouse or point of sale.
Organizations from small to large businesses can make use of inventory
management to manage their flow of goods. There are numerous inventory management
techniques, and using the correct one can lead to providing the correct goods, at the
correct amount, place and time. Inventory control is a separate area of inventory
management that is concerned with minimizing the total cost of inventory while
maximizing the ability to provide customers with products in a timely manner.

OBJECTIVES

1. Define the term inventory.

2. List the different type of inventory.
3. Describe the main functions of inventory.
4. Describe the main requirements for effective management.
5. Explain periodic and perpetual review systems.
6. Describe the cost that are relevant for inventory management.

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 BATANGAS STATE UNIVERSITY
College of Accountancy, Business Economics and International Hospitality Management
GRADUATE SCHOOL

7. Describe the A-B-C approach and explain how it is useful.

8. Describe the basic EOQ model and its assumptions and solve typical problems.
9. Describe the economic production quantity model and solve typical problems.
10. Describe the quantity discounts model and solve typical problems.
11. Describe reorder point models and solve typical problems.
12. Describe situation in which fixed-order-interval model is appropriate, and solve
typical problems.
13. Describe situations in which the single-period model is appropriate and solve
typical problems.

DISCUSSION

Inventory

An inventory is a stock or store of goods. Firms typically stock hundreds or even

thousands of items in inventory, ranging from small things such as pencils, paper clips,
screws, nuts, and bolts to large items such as machines, trucks, construction equipment,
and airplanes. Naturally, many of the items a firm carries in inventory relate to the kind
of business it engages in. Thus, manufacturing firms carry supplies of raw materials,
purchased parts, partially finished items, and finished goods, as well as spare parts for
machines, tools, and other supplies.
The different kind of inventories include the following:
 Raw materials and purchased parts.
 Partially completed goods, called work-in-process (WIP).
 Finished-goods inventories (manufacturing firms) or merchandise (retail
stores).
 Tools and supplies.
 Maintenance and repairs (MRO) inventory.
 Goods-in-transit to warehouses, distributors, or customers (pipeline
inventory).

Functions of Inventory

1. To meet anticipated customer demand. A customer can be a person who walks in off
the street to buy a new stereo system, a mechanic who requests a tool at a tool crib, or a
manufacturing operation. These inventories are referred to as anticipation stocksbecause
they are held to satisfy expected (i.e., average) demand.
2. To smooth production requirements. Firms that experience seasonal patterns in
demand often build up inventories during preseason periods to meet overly high
requirements during seasonal periods. These inventories are aptly named seasonal
inventories. Companies that process fresh fruits and vegetables deal with seasonal
inventories. So do stores that sell greeting cards, skis, snowmobiles, or Christmas trees.
3. To decouple operations. Historically, manufacturing firms have used inventories as
buffers between successive operations to maintain continuity of production that would

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 BATANGAS STATE UNIVERSITY
College of Accountancy, Business Economics and International Hospitality Management
GRADUATE SCHOOL

otherwise be disrupted by events such as breakdowns of equipment and accidents that

cause a portion of the operation to shut down temporarily. The buffers permit other
operations to continue temporarily while the problem is resolved.
4. To reduce the risk of stockouts. Delayed deliveries and unexpected increases in
demand increase the risk of shortages. Delays can occur because of weather conditions,
supplier stockouts, deliveries of wrong materials, quality problems, and so on. The risk of
shortages can be reduced by holding safety stocks, which are stocks in excess of expected
demand to compensate for variabilities in demand and lead time.
5. To take advantage of order cycles. To minimize purchasing and inventory costs, a
firm often buys in quantities that exceed immediate requirements.
6. To hedge against price increases. Occasionally a firm will suspect that a substantial
price increase is about to occur and purchase larger-than-normal amounts to beat the
increases.
7. To permit operations. The fact that production operations take a certain amount of
time (i.e., they are not instantaneous) means that there will generally be some work-in-
process inventory. In addition, intermediate stocking of goods—including raw materials,
semifinished items, and finished goods at production sites, as well as goods stored in
warehouses—leads to pipeline inventories throughout a production-distribution system.
8. To take advantage of quantity discounts. Suppliers may give discounts on large
orders.

Objective of Inventory Management

Inadequate control of inventories can result in both under- and overstocking of

items. Understocking results in missed deliveries, lost sales, dissatisfied customers, and
production bottlenecks; overstocking unnecessarily takes up space and ties up funds that
might be more productive elsewhere.
The overall objective of inventory management is to achieve satisfactory levels of
customer service while keeping inventory costs within reasonable bounds. The two basic
issues (decisions) for inventory management are when to order and how much to order.
Managers have a number of performance measures they can use to judge the
effectiveness of inventory management. The most obvious, of course, are costs and
customer satisfaction, which they might measure by the number and quantity of
backorders and/or customer complaints. A widely used measure is inventory turnover,
which is the ratio of annual cost of goods sold to average inventory investment. The
turnover ratio indicates how many times a year the inventory is sold.

Requirements for Effective Inventory Management

To be effective, management must have the following:

1. A system to keep track of the inventory on hand and on order.
2. A reliable forecast of demand that includes an indication of possible forecast error.
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
5. A classification system for inventory items.

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 BATANGAS STATE UNIVERSITY
College of Accountancy, Business Economics and International Hospitality Management
GRADUATE SCHOOL

Inventory Counting Systems

Periodic system Physical count of items in inventory made at periodic intervals (weekly,
monthly).
A perpetual inventory system (also known as a continuous review system) keeps track
of removals from inventory on a continuous basis, so the system can provide information
on the current level of inventory for each item.
A two–bin system, a very elementary system, uses two containers for inventory. Items
are withdrawn from the first bin until its contents are exhausted. It is then time to reorder.
Universal product code (UPC) Bar code printed on a label that has information about
the item to which it is attached.
Point-of-sale (POS) systems electronically record actual sales. Record items at time of
sale.

Demand Forecasts and Lead–Time Information

Lead time Time interval between ordering and receiving the order might vary; the
greater the potential variability, the greater the need for additional stock to reduce the risk
of a shortage between deliveries. Thus, there is a crucial link between forecasting and
inventory management.

Inventory Costs

Purchase cost is the amount paid to a vendor or supplier to buy the inventory. It is
typically the largest of all inventory costs.
Holding, or carrying, costs relate to physically having items in storage. Costs include
interest, insurance, taxes (in some states), depreciation, obsolescence, deterioration,
spoilage, pilferage, breakage, tracking, picking, and warehousing costs (heat, light, rent,
workers, equipment, security).
Ordering costs Costs of Ordering costs Costs of inventory.
Setup costs The costs involved in preparing equipment for a job.
Shortage costs Costs resulting when demand exceeds the supply of inventory; often
unrealized profit per unit.

Classification System

The A-B-C approach classifies inventory items according to some measure of

importance, usually annual dollar value (i.e., dollar value per unit multiplied by annual
usage rate), and then allocates control efforts accordingly.
To conduct an A-B-C analysis, follow these steps:
1. For each item, multiply annual volume by unit price to get the annual dollar value.
2. Arrange annual dollar values in descending order.
3. The few (10 to 15 percent) with the highest annual dollar value are A items. The most
(about 50 percent) with the lowest annual dollar value are C items. Those in between
(about 35 percent) are B items.

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 BATANGAS STATE UNIVERSITY
College of Accountancy, Business Economics and International Hospitality Management
GRADUATE SCHOOL

Cycle counting A physical count of items in inventory.

The key questions concerning cycle counting for management are
1. How much accuracy is needed?
2. When should cycle counting be performed?
3. Who should do it?

APICS recommends the following guidelines for inventory record accuracy: ± .2

percent for A items, ± 1 percent for B items, and ± 5 percent for C items. A items are
counted frequently, B items are counted less frequently, and C items are counted the least
frequently.

INVENTORY ORDERING POLICIES

Inventory ordering policies address the two basic issues of inventory

management, which are how much to order and when to order. In the following sections,
a number of models are described that are used for these issues.
Cycle stock The amount of inventory needed to meet expected demand.
Safety stock Extra inventory carried to reduce the probability of a stockout due to
demand and/or lead time variability

HOW MUCH TO ORDER: ECONOMIC ORDER QUANTITY MODELS

EOQ models identify the optimal order quantity by minimizing the sum of
certain annual costs that vary with order size and order frequency. Three order size
models are described here:
1. The basic economic order quantity model
2. The economic production quantity model
3. The quantity discount model

Basic Economic Order Quantity (EOQ) Model

The basic EOQ model is the simplest of the three models. It is used to identify a
fixed order size that will minimize the sum of the annual costs of holding inventory and
ordering inventory. The unit purchase price of items in inventory is not generally
included in the total cost because the unit cost is unaffected by the order size unless
quantity discounts are a factor.
The basic model involves a number of assumptions. They are listed
1. Only one product is involved.
2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year so that the demand rate is reasonably
constant.
4. Lead time is known and constant.
5. Each order is received in a single delivery.
6. There are no quantity discounts.
Inventory ordering and usage occur in cycles. A cycle begins with receipt of an
order of Q units, which are withdrawn at a constant rate over time. When the quantity on

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 BATANGAS STATE UNIVERSITY
College of Accountancy, Business Economics and International Hospitality Management
GRADUATE SCHOOL

hand is just sufficient to satisfy demand during lead time, an order for Q units is
submitted to the supplier. Because it is assumed that both the usage rate and the lead time
do not vary, the order will be received at the precise instant that the inventory on hand
falls to zero. Thus, orders are timed to avoid both excess stock and stockouts.
The optimal order quantity reflects a balance between carrying costs and ordering
costs: As order size varies, one type of cost will increase while the other decreases.
Annual carrying cost is computed by multiplying the average amount of inventory
on hand by the cost to carry one unit for one year, even though any given unit would not
necessarily be held for a year. The average inventory is simply half of the order quantity:
The amount on hand decreases steadily from Q units to 0, for an average of (Q + 0 )/2, or
Q/2. Using the symbol H to represent the average annual carrying cost per unit, the total
annual carrying cost is

Annual carrying cost =Q/2 H where

Q = Order quantity in units

H = Holding (carrying) cost per unit per year

On the other hand, annual ordering cost will decrease as order size increases
because, for a given annual demand, the larger the order size, the fewer the number of
orders needed. Annual ordering cost is a function of the number of orders per year and
the ordering cost per order:

Annual ordering cost = S D/Q where

D = Demand, usually in units per year

S = Ordering cost per order

The total annual cost (TC) associated with carrying and ordering inventory when
Q units are ordered each time is

TC = Annual Carrying Cost + Annual ordering cost= Q/2 H + D/Q S

(Note that D and H must be in the same units, e.g., months, years.) An expression for
theoptimal order quantity, Q0, can be obtained using calculus. The result is the formula

Q0 = 2DS/H
Thus, given annual demand, the ordering cost per order, and the annual carrying
cost per unit, one can compute the optimal (economic) order quantity. The minimum total
cost is then found by substituting Q0 for Q in Formula.

The length of an order cycle (i.e., the time between orders) is

Length of order cycle = Q/D

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 BATANGAS STATE UNIVERSITY
College of Accountancy, Business Economics and International Hospitality Management
GRADUATE SCHOOL

Economic Production Quantity (EPQ)

The batch mode is widely used in production. Even in assembly operations,

portions of the work are done in batches. The reason for this is that in certain instances,
the capacity to produce a part exceeds the part’s usage or demand rate. The assumptions
of the EPQ model are similar to those of the EOQ model, except that instead of orders
received in a single delivery, units are received incrementally during production. The
assumptions are:
1. Only one product is involved
2. Annual demand is known
3. The usage rate is constant
4. Usage occurs continually, but production occurs periodically
5. The production rate is constant when production is occurring
6. Lead time is known and constant
7. There are no quantity discounts

The number of runs or batches per year is D/Q, and the annual setup cost is equal
to the number of runs per year times the setup cost, S, per run: (D/Q)S.
The total cost is

TCmin = Carrying cost + Setup cost = (Imax/2) H + (D/Q) S where

Imax = Maximum inventory

Unlike the EOQ case, where the entire quantity, Q, goes into inventory, in this
case usage continually draws off some of the output, and what’s left goes into inventory.
So the inventory level will never be at the run size, Q0.
The economic run quantity is

Qp = √2DS/H p/p-u where

p = Production or delivery rate u = Usage rate

Note: p and u must be in the same units (e.g., both in units per day, or units per week).
The cycle time (the time between setups of consecutive runs) for the economic run size
model is a function of the run size and usage (demand) rate:

Cycle time = Qp/u

Similarly, the run time (the production phase of the cycle) is a function of the run (lot)
size and the production rate:

Run time = Qp/p The maximum and average inventory levels are

Imax = Qp/p (p-u) or Qp-(Qp/p)u and 1average=1max/2

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 BATANGAS STATE UNIVERSITY
College of Accountancy, Business Economics and International Hospitality Management
GRADUATE SCHOOL

Quantity Discounts

Quantity discounts are price reductions for larger orders offered to customers to
induce them to buy in large quantities. When quantity discounts are available, there are a
number of questions that must be addressed to decide whether to take advantage of a
discount. These include:
1. Will storage space be available for the additional items?
2. Will obsolescence or deterioration be an issue?
3. Can we afford to tie up extra funds in inventory?
If the decision is made to take advantage of a quantity discount, the goal is to
select the order quantity that will minimize total cost, where total cost is the sum of
carrying cost, ordering cost, and purchasing (i.e., product) cost:

TC = Carrying cost + Ordering cost + Purchasing cost

= (Q/2) H + (D/Q) S+ PD

Where
Q = Order quantity
H = Holding cost per unit (usually annual)
D = Demand (usually annual)
S = Ordering cost
P = Unit price or cost

REFERENCES

Stevenson, W; (2018); Operations Management (13th ed., pp. 550-585). New York, NY:
McGraw-Hill Education

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