MIT WPU

OPERATIONS MANAGEMENT – I

Unit 4: Inventory Management:

3.1 Concept, types, need of Inventory, Independent vs Dependent Demand

3.2 Inventory Costs: ordering cost, carrying cost, shortage cost.

3.3 Concept of EOQ

3.4 Selective Inventory control techniques: ABC, FSN, VED.

Concept
An inventory is the stock of idle resources in a firm for future use. In organizations,
inventories can be of various types. Manufacturing organizations, typically have inventories
of raw materials, components, sub-assemblies (e.g. headlight assembly for cars at Maruti
Udyog Ltd. is supplied by Lucas TVS Ltd.), tools and equipment, semi-finished goods,
finished goods, etc.

In service organizations, such as banks, financial institutions, hospitals, etc. the inventory
consists of various items to be used in the various service operations. For example, hospitals
have inventories of medical equipment such as syringes, glucose bottles, tablets, syrups etc.
and other accessories such as bandages, cotton, spirit etc. in addition to various types of
medicines. In banks, there are inventories of various types of forms (for banking operations),
brochures and pamphlets (for details of various banking instruments) etc. Banks also have
inventories of currency notes and coins.

Meaning
Inventory refers to all the items, goods, merchandise, and materials held by a business for
selling in the market to earn profit. Example: If a newspaper vendor uses a vehicle to deliver
newspapers to the customers, only the newspaper will be considered inventory. The vehicle
will be treated as an asset.

What Is Inventory?
The term inventory refers to the raw materials used in production as well as the goods
produced that are available for sale. A company's inventory represents one of the most
important assets it has because the turnover of inventory represents one of the primary
sources of revenue generation and subsequent earnings for the company's shareholders.
There are three types of inventory, including raw materials, work-in-progress, and finished
goods. It is categorized as a current asset on a company's balance sheet.

Thus inventory is the stock of any item or resource used in an organization. An inventory
system is the set of policies and controls that monitor levels of inventory and determine what
levels should be maintained, when stock should be replenished and how large orders should
be.

Types of Inventories
The four primary types of inventory are raw materials, work-in-progress items, finished
goods, and supplies. By understanding these four types of inventory, companies can more
effectively manage their inventory levels and optimize their operations.

Raw materials
Raw materials are the basic materials that a company uses to produce its products. For
example, a furniture manufacturer would have a raw materials inventory of wood, screws,
and upholstery fabric.
There are two types of raw materials that businesses may use:

 Direct materials. These are the items used directly in creating finished products. For
example, this may be thread used to construct a shirt.
  Indirect materials. These are items that may be used in the production process but
don’t make their way into the final product. For example, this could be disposable
gloves or tape used in manufacturing a product.
Work-in-progress (WIP)
Work-in-progress inventory includes items that are in the process of being manufactured or
assembled. This inventory includes raw materials that are in production when the accounting
period ends. WIP inventory would include the materials used in manufacturing furniture if it
has entered the production process — so it’s no longer in its raw form.

Finished goods
Finished goods inventory includes completed products that are ready for sale or distribution.
For example, the finished pieces of furniture — like chairs, desks, and dressers — would be
considered finished goods inventory.

Maintenance, repair, and operating (MRO) supplies

Maintenance, repair, and operating inventory includes the materials and supplies needed to
keep a business running smoothly. For example, a furniture manufacturer would consider
tools, safety equipment, and cleaning supplies as MRO inventory.

Additional types of inventory

Above are the main types of inventory that most businesses recognize and keep track of. But
here are a few additional kinds of inventory that could be important to some other businesses:
 Packing material. This category includes materials used for packing and protecting
products for shipping or storage. While packing material may be included in MRO
inventory, it can sometimes be a separate category.
 Ready for sale. This is any inventory that is in stock and ready to be sold. For
example, this could be a shirt hanging on the rack in a retail store that’s ready for a
customer to purchase.
 Allocated. Allocated inventory is anything that’s currently in stock but is set aside for
an order. This could be an online order that the customer is coming to pick up in store
or that needs to be shipped to a customer.
 In-transit. In-transit inventory includes anything that is currently being delivered or
moved from one location to another. This could be inventory moving from a
 warehouse to a retail store or an order that is being shipped from the warehouse to a
customer.
 Seasonal. Seasonal inventory is held to meet expected demand. For example, a
retailer may order additional goods to meet customer needs on Black Friday.
 Safety. Safety inventory is a backup supply used to cover unexpected demand or
supply issues.

Need of Inventory
Most of the organizations have raw material inventory warehouses attached to the production
facilities where raw materials, consumables and packing materials are stored and issue for
production on JIT (Just In Time) basis. The reasons for holding inventories can vary from
case to case basis.
1. Meet variation in Production Demand
Production plan changes in response to the sales, estimates, orders and stocking
patterns. Accordingly, the demand for raw material supply for production varies with
the product plan as well as batch quantities.
Holding inventories at a nearby warehouse helps issue the required quantity and item
to production just in time.
2. Cater to Cyclical and Seasonal Demand
Market demand and supplies are seasonal depending upon various factors like
seasons; festivals etc. and past sales data help companies to anticipate a huge surge of
demand in the market well in advance. Accordingly, companies stock up raw
materials and hold inventories to be able to increase production and rush supplies to
the market to meet the increased demand.
3. Economies of Scale in Procurement
Buying raw materials in larger lot and holding inventory is found to be cheaper for the
company than buying frequent small lots. In such cases one buys in bulk and holds
inventories at the plant warehouse.
4. Take advantage of Price Increase and Quantity Discounts
If there is a price increase expected few months down the line due to changes in
demand and supply in the national or international market, impact of taxes and
budgets etc., companies tend to buy raw materials in advance and hold stocks as a
hedge against increased costs.
 Companies resort to buying in bulk and holding raw material inventories to take
advantage of the quantity discounts offered by the supplier. In such cases the savings
on account of the discount enjoyed would be substantially higher that of inventory
carrying cost.

Reduce Transit Cost and Transit Times

In case of raw materials being imported from a foreign country or from a faraway
vendor within the country, one can save a lot in terms of transportation cost buy
buying in bulk and transporting as a container load or a full truck load. Part shipments
can be costlier.
In terms of transit time too, transit time for full container shipment or a full truck load
is direct and faster unlike part shipment load where the freight forwarder waits for
other loads to fill the container which can take several weeks.
There could be a lot of factors resulting in shipping delays and transportation too,
which can hamper the supply chain forcing companies to hold safety stock of raw
material inventories.
5. Long Lead and High demand items need to be held in Inventory
Often raw material supplies from vendors have long lead running into several months.
Coupled with this if the particular item is in high demand and short supply one can
expect disruption of supplies. In such cases it is safer to hold inventories and have
control.

Independent vs Dependent Demand

Demand is independent if it is unrelated to demand for any other product or service. Demand
is dependent if it is derived from the demand for another product or service. Independent
demand needs to be forecast; however, requirements for dependent demand are calculated
from the independent items.

Inventory Management deals essentially with balancing the inventory levels. Inventory is
categorized into two types based on the demand pattern, which creates the need for inventory.
The two types of demand are Independent Demand and Dependant Demand for inventories.
 Independent Demand
 An inventory of an item is said to be falling into the category of independent demand
when the demand for such an item is not dependent upon the demand for another
item.
Finished goods Items, which are ordered by External Customers or manufactured for
stock and sale, are called independent demand items. Independent demands for
inventories are based on confirmed Customer orders, forecasts, estimates and past
historical data.

 Dependant Demand
If the demand for inventory of an item is dependent upon another item, such demands
are categorized as dependant demand.
Raw materials and component inventories are dependent upon the demand for
Finished Goods and hence can be called as Dependant demand inventories.

This differentiation is necessary because the inventory management systems and

process are different for both categories. While Finished Goods inventories which is
characterized by Independent demand, are managed with sales order process and
supply chain management processes and are based on sales forecasts, the dependant
demand for raw materials and components to manufacture the finished goods is
managed through MRP - Material Resources Planning or ERP - Enterprise Resource
Planning using models such as Just In Time, Kanban and other concepts.

Examples of independent demand items are raw materials, parts, and finished
goods. Dependent demand items are those inventory items that are produced or assembled
within an organization. The demand of these items is dependent on the demand of other items
and they are usually ordered in bulk to maintain stock levels.

Inventory Costs
Inventory costs encompass all the expenses associated with ordering, holding, and managing
the inventory or stock levels of a product-based business. Total inventory costs are frequently
broken down into three distinct categories: ordering costs, carrying costs, and stock-out costs.
Inventory costs are the costs associated with the procurement, storage and management of
inventory. It includes costs like ordering costs, carrying costs and shortage / stock out costs.
Inventory is one of the most important assets for a company or a manufacturer. They need to
handle it well and it requires cost for maintaining, storing, replacing and moving inventory.
All these costs are collectively known as inventory costs.

Types of Inventory Costs

Inventory costs can be categorized into three main sub headings:
Ordering cost
Ordering cost of inventory refers to the cost incurred for procuring inventory. It includes cost
of purchase and the cost of inbound logistics.
In order to minimise the ordering cost of inventory, use of the concept of EOQ or Economic
Order Quantity.

Carrying Cost
Carrying cost of inventory refers to the cost incurred towards inventory storage and
maintenance.
The inventory storage costs typically include the cost of building rental and other
infrastructure maintained to preserve inventory.
The inventory carrying cost is dependent upon and varies with the decision of the
management to manage inventory in house or through outsourced vendors and third party
service providers.

Shortage Costs
Shortage or stock out costs and cost of replenishment are the costs incurred in unusual
circumstances.
They usually form a very small part of the total inventory cost.
Apart from these 3 there are other types as well:
Holding Cost
Sometimes inventory can be held at a location which is different from the expected location
e.g. intermediate city or warehouse. It can also be held because of formalities and clearances.
The costs which is involved in holding this inventory are called Holding Costs.

Perishability Costs
In industries where there is limited shelf life, products may get spoilt or out of its best usage
dates. Such inventory cannot be sold hence has to be disposed. These costs can also include
the mechanism which is required to keep these products fresh. Especially in case of
vegetables and some food products, air conditioning might be required to keep them insulated
from outside weather effects.

Miscellaneous Costs
Apart from these costs there would be other costs like administrative costs, labour costs,
software costs etc. These days’ software is used to manage inventory and manage costs.
There would be some cost incurred to run and maintain it also.

Importance of knowing Inventory Costs

Calculations and tracking of these inventory costs are very important because it helps manage
the inventory better. If one of the costs defined above is going high, manage that aspect of
inventory in a better way. Let us say that a company deals with tomatoes and ends up paying
a lot of costs in carrying and perishable costs. This can help the company plan better so that
the right amount of tomatoes can be procured and transferred before the next lot moves in.

Inventory costs example

Let us take an example of a company which sells biscuits. They procure these biscuits from a
manufacturer and then sell it to retailers. Now a pack of 10 biscuits is assumed to be the SKU
(Stock Keeping Unit). Now these packages would need proper storage so that the biscuits do
not break or crumble before reaching the end customer.
There would be carrying costs involved in that. Then there would be a best before date for
these biscuits. The company needs to move the biscuits well before that date is reached. Also
the ordering cost in the beginning to buy or procure these biscuits is also involved.

Concept of EOQ
Economic order quantity (EOQ) is the ideal quantity of units a company should purchase to
meet demand while minimizing inventory costs such as holding costs, shortage costs, and
order costs. This production-scheduling model was developed in 1913 by Ford W. Harris and
has been refined over time.

What is Economic Order Quantity?

Economic order quantity (EOQ) is a production-scheduling method of inventory control that has
been used since the early 1900s. This method is built around finding a balance between the
amount of sell and the amount spend on inventory management process.
Economic Order Quantity Definition
Economic order quantity is the ideal amount of product a company should purchase to minimize
inventory costs. Essentially, it is the amount of product you should order to meet demand without
having to store any excess inventory.

Optimal Quantity
The optimal quantity is the exact amount of inventory should be ordered and kept in hand to meet
demand. Finding optimal order quantity for a product is the goal of calculating its EOQ.
However, this number is very difficult to achieve as any slight variance in demand, cost, or price
will throw numbers off.

Importance of Economic Order Quantity

It can help avoid issues like excess stock or dead stock and keep avoidable losses to a minimum.
It also helps to establish goals for inventory KPIs, informs inventory forecasting decisions, and
helps increase the company's sales and revenue.

Advantages of Economic Order Quantity

Utilizing EOQ for business can provide many benefits as follows -
 Minimize costs. All warehouse inventory managers know that storage costs can quickly
rise if inventory isn't controlled. By only ordering the amount needed to fulfil customer
demand, these costs can be kept very low.
 Adapts to business. Many inventory methods are only viable for certain types of
business. EOQ utilizes only specific numbers, so it can benefit any business that uses it.

How to Calculate EOQ

Uncovering the economic order quantity for a product can be done using a slightly complicated
formula.
Here's that formula:
EOQ = √ (2 x Demand x Order Cost / Holding Cost)
Economic Order Quantity Formula and Example
There is a wholesale supplier for the food industry. It is looking to optimize, cans of creamed
corn. The first thing to do is look at historical data regarding creamed corn.
 After poring through data, calculate the normal sell. It states an average of 2,500 cans each year.
Look through purchase orders and inventory costs to calculate that each shipment of 100 cans of
corn costs $75. And found that storage of each can costs $20 per year.
With these variables in hand, now calculate optimal EOQ for cans of creamed corn.
EOQ = √ (2 x Demand x Order Cost / Holding Cost)
EOQ = √ (2 x 2500 x 75 / 20)
EOQ = 136.9 or 137 cans
It is discovered that the optimal order size is 137 cans of creamed corn.

Inventory control techniques:

A thorough inventory analysis allows businesses to determine the right amount of stock to
keep while considering their respective customer demands. Thus, Inventory Analysis
Methods can help them examine their stock!
The inventory analysis process allows businesses to avoid spending too much on storage.
But, they must use a balance sheet to analyse the carrying costs of goods sold, on hand, and
for order. As such, it is essential to practice systematic and real-time analysis of the amount
of inventory to have.

Through comprehensive analysis methods, companies have better control over stock when
running the business. Some common analysis methods can be used for business and their
benefits.

Benefits of Inventory Analysis

When the inventory is analysed, allow for a better Return On Investment. ROI determines
whether a company meets its money rules and is still worth continuing its operations. Also,
through inventory analysis, it helps significantly reduce lost sales.

Here are other ways analysing inventory helps business:

 Establishing a proper warehouse layout;
 Reducing lead time in acquiring raw materials and sellable items;
 Implementing proper authorization;
 Accurate item classification for better cost management;
 Adequate management of dormant inventory items;
 Improving utilization of capital;
 Improving cash flow and profit margins, and
 Future identification of possible opportunities or losses.

ABC Analysis
First, the ABC analysis method categorizes items into A, B, or C groups based on sales
revenue, profit margins, and demand frequency. Here’s a breakdown of the groups:
 Category A — High-Priority, High-Value. High-priority, in-demand products fall under
this category. Thus, they account for 10% of the total inventory on hand but contribute 70%
of the total consumption value.
 Category B — Medium-Priority, Moderate-Value. These stocks account for 20% of total
inventory, which accounts for about 20% of the total consumption value.
 Category C — Low-Priority, Low-Value. Lastly, these low-demand items account for 70%
of total inventory, which accounts for only 10% of the total consumption value.

Source: QuickBooks.

It’s important to periodically review and update the analysis to reflect changes in the market
and business priorities.
How to Use the ABC Analysis:
The ABC Inventory Analysis Method categorizes items based on their annual consumption
value. As such, an ABC analysis method classifies the essential items in a particular group,
usually constituting a small portion of the total items. Then, the majority of the items – as a
whole – will seem to be of minor significance. As a result, this analysis method helps
organizations allocate resources efficiently by prioritizing critical items over less important
ones.
 How to Do an ABC Analysis of Inventory:
The ABC analysis can result in better inventory management, cost reduction, and improved
customer service. Here’s what need to do to conduct a proper ABC analysis of inventory:
1. First, gather data about each item, such as an item’s revenue, profit margin, etc.
2. Next, sort and rank the items based on their annual usage value.
3. Divide the sorted list of items into the A, B, and C categories.
4. Focus on strict inventory control for Category A items, moderate attention for Category B,
and less management effort for Category C.
5. Ensure that you regularly review your stock to account for changes in market conditions.
6. Additionally, utilize inventory management software to automate reports so you can update
your analysis.

FSN or Fast-, Slow-, and Non-Moving Inventory Analysis

 Fast Moving — items that are frequently issued/used. They have a high turnover rate.
 Slow Moving — items issued or used less for a certain period. These types of items have a
relatively lower demand than fast-moving stocks. Also, they tend to remain in inventory for
longer, requiring careful management to avoid overstocking or obsolescence.
 Non-Moving — items not issued/used for more than a particular duration. Of course, they
have very low or no demand and may need to be liquidated, discounted, or disposed of.

What is FSN Analysis?

FSN analysis in inventory management classifies inventory-based quantity, consumption rate,
and frequency of issues and uses. FSN analysis helps optimize inventory levels and improve
overall management strategies. Here are its other benefits:
 Optimizing inventory levels;
 Managing capital;
 Reducing holding costs;
 Minimizing obsolescence, and
 Improving customer service.

How to Do an FSN Analysis:

Follow these steps to conduct a successful FSN analysis:
1. Gather historical data on the past year’s sales, consumption, and inventory levels.
 2. Determine thresholds for each category to classify items.
3. Categorize items into Fast, Slow-, or Non-moving based on your thresholds.
4. Use spreadsheets or inventory management software to automate categorization. List each
item, its sales or consumption data, and a formula to determine the threshold category.
5. Regularly review and refine analysis as market conditions change and take action to
maintain optimal inventory mix.

VED or Vital, Essential, and Desirable Analysis

VED analysis method, where companies organize the items into the following three
categories:
 Vital — inventory that you need to keep in stock consistently. After all, vital stock is
indispensable to the organization’s operations. For instance, not having these items in a
healthcare setting will result in life-threatening situations.
 Essential — keeping a minimum supply of this inventory is enough, as they’re often
necessary for emergencies. Stock-outs for this item are unacceptable since they have more
importance than desirable items. Still, they’re not as critical as the ones in the vital category.
 Desirable — though these items are convenient, they’re optional or non-critical. Operations
can run with or without them. As a result, the unavailability of these items won’t pose an
immediate threat to life.

What is VED Analysis?

VED Analysis is used primarily for inventory control in healthcare and medical supply chain
management. It’s an Inventory Analysis Method whose classification depends on the user’s
experience and perception. It classifies inventory according to the relative importance of
certain items to other items, like spare parts.

VED Analysis helps organizations focus on vital items while minimizing effort and cost. This
categorization is especially crucial in healthcare, where patient care and outcomes depend on
available medications, medical equipment, and supplies.

VED Analysis helps organizations prioritize the procurement and management of materials.
It’s vital to ensure the uninterrupted functioning of their systems or services. But, it’s best to
create a comprehensive strategy when it complements other inventory management
techniques, like ABC analysis.
How to Do a VED Analysis:
Follow these steps to conduct a VED analysis:
1. List all items to be identified and analyzed.
2. Collect data on item usage, impact on operations, and consequences of unavailability.
3. Define criteria for categorizing items into VED categories.
4. Next, assign the items to their proper classification.
5. Prioritize management and procurement efforts based on your categorization.
6. Regularly review and update categorization based on changing requirements or situations.
7. Lastly, you must incorporate findings into materials management and inventory control
processes.