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Inventory Management

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Inventory Management and Control

P r o f. ( D r ) P i n k i R a i
• Meaning and Definition of Inventory
• Management of Inventories
• Objectives of Inventory Management
• Problems faced by Management
• Management of Inventories
• Types of Inventories
• Role in SCM
• Inventory Models
Meaning and Definition of Inventory
In dictionary meaning of inventory is a “detailed list of goods, furniture etc.” Many understand the word
inventory, as a stock of goods, but the generally accepted meaning of the word ‘goods’ in the accounting
language, is the stock of finished goods only. In a manufacturing organization, however, in addition to the
stock of finished goods, there will be stock of partly finished goods, raw materials and stores. The collective
name of these entire items is ‘inventory’.

The term ‘inventory’ refers to the stockpile of production a firm is offering for sale and the components that
make up the production.
The inventory means aggregate of those items of tangible personal property which
(i) are held for sale in ordinary course of business.
(ii) are in process of production for such sales.
(iii) they are to be currently consumed in the production of goods or services to be available for
sale. Inventories are expandable physical articles held for resale for use in manufacturing a
production or for consumption in carrying on business activity such as merchandise, goods
purchased by the business which are ready for sale.
Finished Goods: Goods being manufactured for sale by the business which are ready for sale.

Materials: Articles such as raw materials, semi-finished goods or finished parts, which the business plans to
incorporate physically into the finished production.

Supplies: “Article, which will be consumed by the business in its operation but will not physically as they are a
part of the production.
The short inventory may be defined as the material, which are either saleable in the market or usable
directly or indirectly in the manufacturing process. It also includes the items which are ready for making
finished goods in some other process or by comparing them either by the concern itself and/or by outside
parties. In other words, the term inventory means the material having any one of the following
characteristics. It may be
1. saleable in the market,
2. directly saleable in the manufacturing process of the business,
3. usable directly in the manufacturing process of the undertaking, and
4. ready to send to the outside parties for making usable and saleable productions out of it.

In the present study raw materials, stores and spare parts, finished goods and work-in-process have been
included inventories. Firm also manufactures inventory to supplies.
Management of Inventories
Inventories consist of raw materials, stores, spares, packing materials, coal, petroleum products, works-
in-progress and finished products in stock either at the factory or deposits.

The maintenance of inventory means blocking of funds and so it involves the interest and opportunity
cost to the firm. In many countries specially in Japan great emphasis is placed on inventory management.
Efforts are made to minimize the stock of inputs and outputs by proper planning and forecasting of
demand of various inputs and producing only that much quantity which can be sold in the market.

The inventory cost is not only interest on stocks but also cost of store building for storage, insurance and
obsolesce and movement of inputs from place of storage to the factory where the materials have to be
finally used to convert them into finished goods. In japan industries have adopted concept of JIT (Just in
Time) and components, materials are received when required for which detailed instructions are given to
suppliers. There are many engineering companies who receive
components directly at assembly point and that too only for 3-4 hours requirements at a time. Even in case of bulk
materials like iron ore, which is imported from abroad, the minimum possible inventory is kept
Types of Inventories :
Employing the generic definition of inventory, a large spectrum of situations can be
structured as inventory management problems. These include the following:
(a) Raw materials inventory as input to manufacturing system.
(b) Bought-out-parts (BOP) inventory which directly go to the assembly of product as it is
(c) Work-in-progress (WIP) or work-in-process inventory or pipeline inventory.
(d) Finished goods inventory for supporting the distribution to the customers.
(e) Maintenance, repair, and operating (MRO) supplies.
These include spare parts, indirect materials, and all other sundry items required for
production/service systems. It may be noted that the basic definition of inventory being a
“usable but idle resource” remains valid irrespective of the type of inventory being
managed.
Why Do We Need Inventories?

From the resource management point of view, we should not have inventories as these constitute the idle
resources. However, if we did not have inventories, there will be shortages, production delays, and project
delays. Some of the reasons for having inventories in the production/service system are as follows:

1. Time lag between placing orders and getting supplies at the point of consumption – Whenever we place
a replenishment order, there is a time lag between placing the order and getting the materials at the
point of use. This is called “replenishment lead time.” In most cases the lead time is nonzero, and at
times it is quite high. This necessitates holding of inventory to take care of demand during the lead times

2. Variability of lead times – In most cases, particularly in Indian supply environment, there is some degree
of variability in lead times because the supply environment is perhaps “just-in-case” (JIC) type. Inventory has
to be maintained as a shield to cope with the supply uncertainty. Inventory is the premium an organization
pays for operating in a just-in-case supply environment. If there was no such uncertainty and if demand and
supply are deterministic, then in just-in-time (JIT)-type environment, no or low inventory will be required.
The greater the amount of supply uncertainty, the greater the amount of additional inventory required.
3. Demand variability – If either we are unable to estimate the demand correctly or if there are uncertainties
in demand, additional inventory will be required to act as a shield to absorb the demand variability. The
greater the demand variability, the greater the amount of additional inventory required.

4. Seasonal inventory – If the demand is cyclic or seasonal, then sometimes building inventory in the lean
period to meet the peak period demand is employed as a strategy in aggregate production planning. This
strategy results in inventory in some part of the year.

5. Pipeline inventory – This is the inventory due to the distribution of a product or a commodity over long
distances, so that the “goods in transit” become substantially important. This constitutes the pipeline
inventory. In the context of production processes, this is called in-process inventory or work in progress (WIP)
which is also inventory in terms of idle resource blocked in the nonproductive form. This can be reduced by
making the supply chain move faster.
6. Other factors – Sometimes inventory is maintained to take care of other situational
parameters such as inflationary pressures, shortage of materials in the markets, and quantity
discounts to encourage bulk purchasing or simply the desire to spend the budget allocated for
materials before the end of the financial year resulting in large and at times unnecessary
purchases which eventually become dead stock.
Role in the Supply Chain
Inventory exists in the supply chain because of a mismatch between supply and demand. This
mismatch is intentional at a steel manufacturer, where it is economical to manufacture in large lots that
are then stored for future sales. The mismatch is also intentional at a retail store where inventory is
held in anticipation of future demand or when the retail store builds up inventory to prepare for a
surge in sales during the holiday season. In these instances, inventory is held to reduce cost or increase
the level of product availability.

Inventory affects the assets held, the costs incurred, and responsiveness provided in the supply chain.
High levels of inventory in an apparel supply chain improve responsiveness but also leave the supply
chain vulnerable to the need for markdowns, lowering profit margins.
A higher level of inventory also facilitates a reduction in production and transportation costs because of
improved economies of scale in both functions. This choice, however, increases inventory holding cost.
Low levels of inventory improve inventory turns but may result in lost sales if customers are unable to
find products they are ready to buy. In general, managers should aim to reduce inventory in ways that
do not increase cost or reduce responsiveness.

Inventory also has a significant impact on the material flow time in a supply chain. Material flow time is
the time that elapses between the point at which material enters the supply chain to the point at which
it exits. For a supply chain, throughput is the rate at which sales occur. If inventory is represented by I,
flow time by T, and throughput by D, the three can be related using Little’s law as follows: I = DT

For example, if an Amazon warehouse holds 100,000 units in inventory and sells 1,000 units daily,
Little’s law tells us that the average unit will spend 100,000>1,000 = 100 days in inventory. If Amazon
were able to reduce flow time to 50 days while holding throughput constant, it would reduce inventory
to 50,000 units. Note that in this relationship, inventory and throughput must have consistent units.
EXAMPLE

Amazon.com Amazon attempts to provide a wide variety of books (among other products) to its
customers. Best-selling books are stocked in many regional warehouses close to customers for high
responsiveness. Slower-moving books are stocked at fewer warehouses to lower the cost of
inventory at the expense of some responsiveness. Some of the slowest-moving books are not held in
inventory but are obtained from the publisher/distributor or printed on demand when requested by
a customer. Amazon changes the form, location, and quantity of inventory it holds by the level of
sales of a book to provide the right balance of responsiveness and efficiency.
What Is an Inventory Problem?
Naddor (1966) suggested that we have an inventory problem when we need to decide about
(a) when to initiate a purchase order (when to buy) and (b) how much to buy [determine the lot size].

In solving these twin problems of decision making, we need to develop a model of inventory. A rational
scientific approach to decision making calls for developing an inventory model which links up the
objective function with the decision variables (e.g., lot size and reorder point) and various inventory-
related cost parameters as well as situational variables such as demand, uncertainty of demand, lead
time, uncertainty of lead time, constraints (if any), and any other relevant data such as quantity
discounts or inflationary trend.

An inventory model is a model which attempts to link up primarily the following three types of
inventory-related costs in which at least one is subject to control. In decision-making models, at least
one variable must be controllable; otherwise, it is only a descriptive model of the system. The three
costs are as follows:
(a) Inventory carrying costs or holding cost – This is the estimated or imputed
cost of holding or carrying a unit of material in the form of inventory for a unit
period of time. This is a function of the price of the material held in stock per
unit and a fraction of carrying charge expressed as a fraction or percentage of
unit price/unit time. The carrying cost is expressed as `per unit/unit time. For
example, if the material cost is `1,000 per unit and if the fraction of carrying
charge is 0.25 per year, then the unit carrying cost is `250 per unit/year. The
fraction of carrying charge is contingent upon a number of situational
parameters which will be detailed out in the next section, but the cost of capital
blocked in the nonproductive form (which inventories are perceived to be) is the
most dominant component. This in turn requires a method of estimating these
costs
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b) Cost of shortage or stockout – This is the estimated or imputed opportunity cost incurred if we do
not have materials in stock when the demand arises. This depends upon the consequences of such a
situation to arise. If we lost a customer, then it will be the opportunity cost of lost sales. If the demand
remains backlogged (or back-ordered), then this will be the penalty cost (if any), loss of goodwill, cost of
production or project delays, etc. Estimating the shortage cost is relatively more difficult than the
carrying cost, but an approximate estimate is better than ignoring such costs altogether.

(c) Ordering costs – Ordering or replenishment costs are the costs of efforts put in and expenses
incurred when a purchase order is initiated for procurement or replenishment of inventories. The
ordering cost is quite dependent on the purchase procedures and the extent of bureaucracy and
paperwork involved in the processing of a purchase order. This includes administrative efforts expanded
in paper flow, progress chasing, inspection, and other costs which will be detailed out in the next
section. However, for the sake of simplification, in many inventory models, the ordering cost is assumed
to be independent of the order size and is expressed as `per order. Though it may not be strictly true,
yet many inventory models are developed assuming this as an approximation of reality.
Estimation of Inventory-Related Cost Parameters

Estimated or imputed costs are relevant inputs to models of decision making for rationalizing inventory
policies, and hence it is important that these are properly estimated. These costs are situation specific
and may be different for different items even for the same organization depending upon the nature of
the item, its perishability characteristics, any special storage conditions required, and the impact of
nonavailability when needed. The following discussion will perhaps enable the materials planners to
estimate these costs more appropriately:
(a) Cost of carrying inventory (C1): These costs need to be realistically estimated on the incremental costing
basis to include those costs elements which vary directly with the amount of inventories held. These
costs can be divided into the following four subcategories:
1. Capital costs – These include the opportunity loss due to the return on investment of this fund in an
alternate way; if it is own capital or the interest paid on the borrowed capital (cost of capital). This is the
most dominant component of carrying cost and may nearly be half of the total carrying cost.
2. Storage costs – Costs associated with the need to house inventories in a physical storage facility. The cost
components could be amortized cost of land, building, storage equipment, and creating special storage
environment like temperature and humidity control and costs due to leasing or renting storage space or
depreciation, insurance, taxes, utilities, etc.
3. Service costs – Cost of hiring persons to process inventory transactions, materials handling, receiving and
storage, retrieval and issue of physical inventory, and any other cost of service.

4. Risk costs – These are associated with the risk of obsolescence or shrinkage of inventory due to pilferage,
spoilage, damage, disappearance (such as evaporation during storage), stock-dependent consumption, and
perishability or devaluation of selling price
Depending upon the nature of item stocked, the carrying cost may vary from 15 to 50 %
of the value of stock per year. In highly perishable situation, it could be even more. In
many illustrative examples, a figure of 25 % is assumed. However, it is only an
illustrative figure. The actual cost may be estimated specific to the item. Love (1979)
has cited studies suggesting that the companies generally underestimate the carrying
costs and that the capital cost is roughly 50 % of the total cost of carrying inventory
while the remaining three categories are essentially comparable. A simple heuristic way
to estimate carrying cost would then be to double the cost of capital blocked in
inventory and add extra for additional risks involved due to pilferage, perishability,
obsolescence, stock-dependent consumption rate, etc., as the case may be.
(b) Cost of shortage (C2 ): Cost of shortage is the opportunity cost of not having materials when required. This
includes tangible and intangible cost components and is relatively difficult to estimate. In inventory models, it
is divided into two categories – when the backlogging is allowed and when a shortage leads to lost sales.
Under the backlogging (or back-ordering) situation, it is estimated as number of unit short and the duration of
the backlogging. Thus, it is expressed as C2 ¼ `/unit short/unit time. The shortage cost could be estimated on
the basis of four possible scenarios as follows:
1. When remedial action is possible for a purchased item to prevent shortage such as emergency
purchase with cost consequences of premium material price, loss of purchase quantity discount,
extra ordering cost, and rush shipment. Alternatively it could mean the use of a substitute item,
which may be of higher cost including any adaptation costs.

2. Remedial action for manufactured item in preventing a shortage is to give overtime at higher rate,
subcontracting, emergency hiring, inferior quality, or use of a substitute item.

3. When no remedial action is possible in the case of purchased item – it includes the extra costs due
to penalty cost of late deliveries, special delivery when item arrives, loss of goodwill, lawsuit, extra
paperwork, and long-term loss of customers.

4. When remedial action is possible to prevent a shortage in manufacturing context – it includes


opportunity cost of production downtime, idle labor, equipment, failure to meet delivery schedules,
and unsafe conditions resulting in losses and damages.
(c) Ordering cost (C3 ): The cost of ordering (C3 ) is also called as cost of replenishing an order. For
manufactured item within the company, it may have the same meaning as the cost of production setup.
For the purchased items, it is the administrative cost of processing the order for approval, order placement
(paper work, communication), shipment – (freight, postage, demurrage, pickup), cost at the time of
receiving the shipments (paperwork, document preparation, materials handling, inspection); billing cost,
which includes the labor and overhead costs. A detailed checklist of tasks required to process an order and
attributing costs to it can help.
Inventory Models
An inventory model attempts to represent an inventory problem to facilitate decision making. Typically, the
inventory model enables us to rationally decide (a) how much to buy (b) and when to buy. In order to
answer these questions, we need to develop inventory model which combines decision variables with
situational parameters. The situational parameters are demand; lead time; C1, C2, and C3; unit purchase
price; and any uncertainties associated with demand and lead times. It may also include any special feature
such as quantity discounts, inflationary factors, budget or space constraints etc.

Naddor (1966) defines inventory model as a mathematical relationship which involves three inventory-
related costs C1 , C2 , and C3 , and at least two of these should be under control. If all the three are subject
to control, it is termed as type (1, 2, 3) inventory model. If C1 and C3 are relevant (C2 ¼ 1), then it is type (1,
3) inventory model.
Inventory Policies
Inventory policy is an operating framework or a standard operating procedure (SOP) in implementing an
inventory model. Obviously, the inventory model will depend upon the choice of inventory policy adopted.
Typically, an inventory policy results in an inventory graph as a function of time. This visually depicts how the
inventory status changes over time and when does procurement intervention take place. In practice, three
inventory policies are normally employed. These are described as follows:
1. Economic Order Quantity (EOQ)-Reorder Point (ROP) Policy
Under this policy, the inventory status is continuously monitored. Whenever the inventory level falls to a
predetermined level called as reorder point (ROP), a replenishment order of fixed quantity called
economic order quantity (EOQ) is placed. Thus EOQ (Q) and ROP (R) are the two decision variable
involved in solving the problem of how much to buy and when to buy. Figure 2.2 shows the graphical
operation of the (Q, R) policy. Such inventory model must have (Q, R) as decision variables.

Since this policy requires that the inventory levels be continuously monitored, it calls for keeping a
constant watch at stock levels, while in a computerized inventory control, it is easy; in manual systems
its administrative costs of operation could be more. To ease this situation, a very ingenious method of
manual monitoring of this policy has been evolved and is in practice for long and is called the “two-bin”
policy. Under the two-bin policy, total stock is kept in two bins. The second bin keeps the stock required
during the lead time, and the first bin contains the Q minus the stock in the second bin. The
consumption is met from the first bin until it gets totally consumed. The moment it happens, the reorder
point is deemed to have been reached, and a replenishment order of size (Q) is placed. During the
replenishment period, the demand is met from the second bin.
EOQ-ROP policy
Of course with the computerization of inventory records, the stock status can be continuously
monitored easily without the two-bin policy, because in the two-bin policy one has to keep two storage
units for each item. EOQ policy is perhaps the most talked about policy in inventory control literature
and is the oldest scientific model of inventory control

2. Periodic Review Inventory Policy

The stock status is periodically reviewed under this policy after a fixed time interval (T). When the
review period is reached, the order is placed which is determined by the following relationship: Q ¼
order quantity ¼ ð Þ S X where S ¼ maximum stock level (or order up to level) X ¼ stock on hand at the
time of review .
Under this policy, S, the maximum stock level and the time interval between two reviews (T) are the two
decision variables for optimization. Therefore, it is also called as (S, T) policy. Operation of this policy is
relatively easy because status of inventory is taken only after a fixed time interval. However, this policy is quite
sensitive to the consumption during the review cycle. If stock on hand is high, the order quantity for the next
period is low and vice versa. However, under this policy, an order has to be mandatorily placed even if the
stock levels are quite high at the review period due to which the order size is a small quantity. In order to
simplify the model, one may specify one of the decision variables S or T. Naddor (1966) called it (Sp, T) policy
if S is prescribed and T is the only decision variable. If T is prescribed, then it is called (S, Tp ) policy with S as a
decision variable
Optional Replenishment Policy This is a variant of periodic review inventory policy wherein there are two
levels of inventory identified as S (the maximum level) and s (the minimum level). The stock levels are
periodically examined at fixed time interval T. However, if the stock levels are more than the minimum level (s)
at the time of review, the replenishment decision is deferred to the next review cycle, and no order is placed
because the current stock is deemed to be adequate for the time being until the next review cycle. If, at the
time of review, the stock level (X) is less than or equal to (s), then the order quantity Q is determined so that it
raises the stock level to S. Thus under this policy, Q ¼ S X if X s ¼ 0 if X > s

This policy is also called as minimum-maximum stock level policy or (s, S) policy. Here the decision variables
are s, S, and T. This is also called as optional replenishment policy because there is an option of skipping the
replenishment decision to the next review period if the current inventory on hand is more than the minimum
level prescribed. Thus, intuitively, this would appear to be better than (S, T) policy provided (s, S) and T are
optimized.
There may be other variants of these three basic policies, but the most common policies are only
these. The inventory model to be developed depends upon the choice of inventory policy. Hence, we
have to first decide the inventory policy to be employed before we develop an inventory model for
optimal choice of the decision variables.
Conceptual Questions
1. Why is inventory a “necessary evil” with uncertain demand and lead time situations?
2. What are the different kinds of inventories?
3. How does inventory decouple various subsystems in a supply chain?
4. What cost factors influence cost of carrying cost? If the item is perishable in nature, what
influence will it have on estimating the inventory carrying cost?
5. Why is it more difficult to estimate shortages cost in an inventory system? What aspects are
necessary to be captured in such a cost estimation?
6. What is an inventory model? Which decisions are facilitated by an inventory model?
7. Describe three types of inventory policies and compare their strengths and weaknesses
THANK YOU !

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