 Concept or Nature of Inventory

 Importance of Inventory

 Inventory Costs

 Dependent and Independent Demand

 Inventory System: Continuous and Periodical

 Basic EOQ Models (with and without discount)

 ABC Classification
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.
Inventories are a vital part of business. Not only are they
necessary for operations, but they also contribute to customer
satisfaction.
In other words, inventory generally refers to the materials
in stock. It is also called the idle resource of an
enterprise.
Inventories represent those items which are either stocked
for sale or they are in the process of manufacturing
or they are in the form of materials which are yet to be
utilized.
 Inventory decisions in service organizations can be critical in
comparison to manufacturing organizations. Hospitals, for
carry an range of drugs and blood supplies that might be needed
example,
short
on notice.
The different kinds of inventories include the
following:
 Raw materials and purchased parts. (WIP)

 Partially completed
Finished-goods goods, called
inventories work-in-
(manufacturing firms) .
process
merchandise
or (retail stores).
 Tools and other supplies.
 Maintenance and repairs
 inventory.
Goods-in-transit to warehouses, distributors, or
customers (pipeline inventory).
 Inventory control is a planned approach of determining what
to order, when to order and how much to order and
how much to stock so that costs associated with buying
and storing are optimal without interrupting production and
sales.
Need or importance of inventories can be explained with the help
following
of points:
1. To Take Advantage of Price
Discounts
Usually the manufactures offer discounts for bulk buying and to gain
this
required
price immediately.
advantage Thus inventory
the materials is maintained
are bought to gain
in bulk even economy
though it is not
purchasing.
in
2. To Stabilize
Production
The demand for an item fluctuates because of the number of factors.
E.g. seasonally production schedule etc. The inventories (raw
materials and
components) should be made available to the production as per the
demand
takes failing
place whichofresults
for want in stock
materials. out and
Hence, the production
the inventory stoppage
is kept to take
of this fluctuation so that the production is
care
smooth.
3. this
In To Prevent Loss
competitive of Orders
scenario, (Sales)
one has to meet the delivery schedules at
100% service level, means they cannot afford to miss the delivery
schedule
which may result in loss of sales. To avoid this organizations have to
maintain inventory.
4.To Meet the Demand During the
Procurement Period The lead time for
procurement of materials depends upon many
factors like location of the sources, demand supply
condition etc. So inventory is maintained to
meet the demand during the procurement period.
5.To Keep Pace with Changing Market
Conditions The organizations have to
anticipate the changing
market sentiments and they have to stock materials
in anticipation of non availability of materials or
sudden increase in prices.
6. Others
Sometimes the organizations have to stock
materials due to other reasons like suppliers
minimum quantity condition, seasonal
availability of materials or sudden increase
in prices.
 Factory Warehouses
Suppliers

Lead

Time

Ordering
Cost or
Setup Cost

Stores Carrying Cost Customers

or Holding
Cost
1. Purchase (or Production) Cost
The value of an item is its unit purchasing (production) cost.
This cost becomes significant when availing the price
discounts. This cost is expressed as Rs/ unit.
2. Ordering Cost
It is also known by the name procurement cost or replenishment
cost or acquisition cost. Cost of ordering is the amount of money
expended to get an item into inventory. This takes into account
all the costs incurred from calling the quotations to the point at
which the items are taken to stock. Ordering costs are generally
classified under the following heads:
i. Purchasing: The clerical and administrative cost
associated with the purchasing cost of requisitioning
material, placing the order, follow-up, receiving and
evaluating quotations.
ii. Inspection: The cost of checking material after
they are received by the supplier for quantity and
quality and maintaining records of the receipts.
iii.Accounting: The cost of checking supply against
each order
making payments and maintaining records of
purchases.
3. Inventory Carrying Costs (Holding
Costs)
These are the costs associated with holding a
given level of inventory on hand and this cost
vary in direct proportion to the amount of
holding and period of holding the stock in stores.
The holding costs include:
Storage costs (rent, heating, lighting etc.)
Handling costs: Costs associated with moving
the items such as cost of labour, equipment for
handling.
Depreciation, Taxes and insurance.
Costs on record keeping.
Product deteriorations and obsolescence.
Spoilage, breakage, pilferage and loss due
to perishable nature.
4. Shortage Costs
When there is a demand for the product and
the item needed is not in stock, then we incur
a shortage cost or cost associated with stock
out.
Then storage costs include:
 Backorder costs.
 Loss of future sales.
 Loss of customer good will.
 Extra cost associated with urgent,
small quantity ordering costs.
 Loss of profit contribution by lost
sales revenue.
Demand for items in inventory is either dependent
or independent. Dependent demand is related to
the demand of another product. In other words,
dependent demand items are typically component
parts or materials used in the process of
producing a final product. When a product is built
up from components, the demand for these
components is dependent on the demand of the
product. Therefore, it a company plans to make
1,000 cars, the supplier who suppliers tires would
make plans to supply 4,000 tires. If an automobile
company plans to produce 1000 new cars, then it
will need 5000 wheels and tires (including
spares).
In an independent demand situation, stock is
not directly dependent upon orders for finished
products. The decision to purchase more
quantities of stock is dependent on the stock
itself. Car, retail items, grocery products, and
office supplies are example of independent
demand item. Independent demand items are
final or finished products that are not a
function of, or dependent on, internal
production activity. Independent demand is
usually determined by external market
conditions and, thus, is beyond the direct
control of the organization. In this chapter we
focus on the management of inventory for
independent demand items (Russell and
Taylor, 2009).
1. Periodical Inventory System (P-model)
 In this, the stock position of each item of material is regularly
reviewed.
 Under this system, inventory is counted in fixed time interval (T)
to determine the quantity of inventory to place an order (Q).
 In this system, order quantity (Q) depends on the actual
quantity of
period.

Bas
Inventory levels

e
Q4 stoc
Q3
k
Q1 Q2 level
(Q)

0 T 2T 3 4
T T
Time
(T)
2. Continuous Inventory System/Perpetual
System
Inventory (Q-model)
In this model or system, a fixed quantity of material is
ordered whenever the stock on hand reaches the
reorder point.
The fixed quality of material ordered each time is
nothing
but the economic order quantity (EOQ).
In other words, this system first of all determines the
fixed order quantity Q, and reorder stock level ROL.
Fixed order may be in units or amount but the
reorder level should be in the units.
In other words, order quantity of stock Q, and the level
of stock ROL, at which level the order should be placed
is predetermined.
Therefore, it is also called fixed order quantity or
perpetual inventory system or economic order
quantity model (EOQ) or Q/R model.
MSL Maximu
m
Stock
Level
Inventory levels

Q1 Q2 Q4
Q3

ROL
(Q)

0
LT LT2 LT3 LT4
Tim
e
 Table : Distinction Between ‘Q’ System and ‘P’
System
Basis Q - P- System
System
Initiation Stock on hand reaches to Based on fixed review period
of reorder point and not stock level.
order.
Period of Any time when stock level Only after the predetermined
order reaches to reorder point. period.
Record Continuously (perpetual Only at the review period.
keeping. system) each time a
withdrawal or addition is
made
Order Constant the same quantity Quantity of order varies each
quantity. ordered each time. time order is placed
Size of Less than the ‘P’ system. Larger than the Q system.
inventory
Time to Higher due to perpetual record Less time due to only at the
maintain. keeping review period.
The inspiration behind the ABC analysis has been drawn from
V. Pareto, an Italian economist and sociologist
(1842-1923) who generated some highly debatable
concepts of economics and sociology.
One of the widely used techniques for control of inventories
is the ABC (always better control) analysis.
The ABC approach is a means of categorizing inventory
items into three classes ‘A’, ‘B’ and ‘C’ according to
the potential amount to be controlled.
Once inventory is classified, logically, we expect to maintain
strong controls over the ‘A’ items taking whatever special
actions needed to maintain availability of these items and hold
stocks at the lowest possible levels consistent with meeting
demands.
At the B category, we cannot afford the expenses of
rigid controls, frequent ordering, expediting, etc., because
of the low amounts in this area.
With the ‘C’ group we may maintain somewhat
higher safety stocks, order more months of supply;
expect lower levels of customer service, or all the three.
It is for selective approach, ABC analysis is often called
the
Selective Inventory Control Method (SIM).
 Category % of Items (approx.) % of Value (approx.)
A = High value items 15 65
B = Medium value 20 25
items
C = Low value items 70 10

A items B items C items

1. Very strict control 1. Moderate control 1. Loose control
2. No safety stocks (or very low) 2. Low safety stocks 2.High safety stocks
3. Frequent ordering 3. Once in 3 months 3. Bulk ordering
4. Weekly control statements 4. Monthly control 4. Quarterly reports
statements
5.Maximum follow-up 5.Periodic follow-up 5. Follow-up in exceptional
6. Rigorous value analysis 6. Moderate value analysis 6. Minimum value analysis.
7.Accurate forecasts in materials 8. Estimates based on past 8. Rough estimates
planning data
9. Minimization of waste, obsolete, 9. Quarterly review 9. Annual review
and surplus (review every 15
days)
10. Individual postings 10.Small group postings 10. Group postings
11.Central purchasing and storage 11. Combination purchases 11.Decentralized purchasing
12. Maximum efforts to reduce lead 12. Moderate 12. Minimum efforts
time
13.To be handled by senior officers. 13. To be handled by middle 13. Can be fully delegated.
management.
1. Economic Order Quantity Order
(EOQ)/Optimum Quantity
EOQ = 2𝐴𝑂
�
=…
�
Units �

𝐸𝑂
2. Optimum Number of frequency � ….Times
Orders/Order (N) = 𝑄

3. Total Costs
(i) If discount rate or price-break condition not
is � 𝐸𝑂𝑄
given
TC = 𝐸𝑂𝑄 � × O + ×C=
2 Rs….
(ii) If price-break condition is
given � 𝐸𝑂𝑄
𝐸𝑂 2
TC = A × PP � × O + ×C=
+ 𝑄 Rs….
(iii) If discount rate is given
𝐴 𝐸𝑂𝑄
TC = A × PP + ( ×O+ × C) – (A × PP × DR) =
𝐸𝑂𝑄 2
Rs….
4. Re-Order Level/Re-Order Point
(ROL/ROP)
(i) ROL = Daily Requirements × Lead Time Safety Stock = …
+
ROL 𝑊𝑜𝑟𝑘𝑖𝑛𝑔
�
(ii × Lead Time + Units Stocks = …
5. Average𝐷𝑎𝑦𝑠
) �
= Safety
Stock Units
= Minimum Stock Level or Safety Stock +2𝐸𝑂𝑄
Level
=
6.…Units
Length of Inventory/Inventory Cycle/Cycle Time/Time
Between the
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑜𝑟 𝑊𝑒𝑒𝑘𝑠
Orders
= = …Days/Weeks
𝑁
Where,
A= Annual requirements/demands/needs
O = Ordering cost per order/Set-up cost per run
C = Carrying cost per unit/ holding cost per unit (based on
PP) PP = Purchase Price/unit cost/inventory value
DR = Discount rate
Example 1: XYZ Company requires 12,000 units of material annually. If
ordering costs are Rs. 250 per order, expected lead time is 5 days, unit
cost is Rs. 25 per unit and annual inventory holding costs are charged at
20% and the company operates 250 days a year, compute, EOQ, T, N,
TC at ROL, total annual cost and ROL.
Solution
Given,
Annual requirement (A) = 12,000 units
Ordering cost per order (O) = Rs.
250 Units cost of item (P) = Rs. 25
Lead time (L) = 5 days
Annual carrying cost per unit (C) =
20% of Rs. 25 = Rs. 5
Number of working days in a year
(n) = 250 days.
2𝐴𝑂
2×12000×250
� 5
(i)
EOQCalculation of Economic= 1095.5 Units
Order
= Quantity
=� (EOQ)
Calculation of optimal length of
inventory cycle (T)
EOQ 1095.5
T = n × A  365 = 250
120 =
22.82  23
Calculation optimum00number
ofdays
of order (N)
A 12000
N =EOQ = 1095.
= 5 
10.95
11 times of total cost
Calculation
at EOQ (TC)
A EOQ 12000 10955
.
TC =EOQ O +  C1095.
=  250 +2  5 = 2,738.75 + 2,738.75 = Rs.
5,477.502
Calculation 5 level (ROL)
of re-order
A 12000
ROL=  Lead time + Safety stock = 5+
0 = 240 units Working days in a year 250
Calculation of
total annual cost
A
TC
(TC) =
EOQ A  P + O
+ C
EOQ
2 12000
= 12000 10
25 + 2
= 30000 95.5
1095.5
250 + 0 + 2,738.75
5 + 2,738.75 = Rs. 305,477.5
Example 2
A firm requires 1,00,000 units in year. Cost of placing order
is Rs. 800 carrying cost is 2% of the item cost. Cost per
unit is Rs. 12 if ordered up to 24,999 units, Rs. 10 if
ordered 25,000 units to 40,000. Identify optimum order
quantity and
total cost.
Soluti
on
Given,
Annual requirements (A) = 100,000
units Ordering cost (O) = Rs 800
Order size Price
≤ 24,999 12
25,000 – 40,000 10

Calculation of EOQ for 24999 units and less order size

is, 2AO 2 × 100000 × 800 160000000
= = = 25819
EOQ =
units
C 2% of 12 0.24
Condition is not satisfied, required order size (OS or EOQ) = 24,999
units
Total costs = Total carrying cost + Total order cost + Purchase cost
EOQ A
= ×C + × O + A × PP
2 EOQ
24999 100000
= × 0.24 + × 800 + 100,000×12
2 24999
= 2999.98 + 3200.128 + 1,200,000
= Rs 1206200
Again
, Calculation of EOQ for “25000 – 40000” order
size 2AO 2 × 100000 × 800 160000000
= = =
EOQ
28284 units
= C 2% of 10 0.2
Total costs = Total carrying costs + Total ordering cost + Purchase cost

EOQ A 28284 100000

= ×C+ × O + A × PP = × 0.2 + × 800 + 100,000
× 10 2 EOQ 2 28284
= 2828.4 + 2828.4 + 1000000
= Rs 1005656.85

Conclusion: Optimum order quantity is “25000 – 40000” order size as it has

minimum cost (i.e. 10056568
. 5 < 1206200).
Example 3: A company purchased 2000 units of a particular
item per year at a unit cost of Rs 20. The ordering cost is Rs 50 per
order, and the inventory carrying cost is 25%. Find the optimal order
quantity. If a 3% discount is offered by the supplier on lots of 1000 or
more, should the company accept the offer?
Solution:
Given
Annual requirement (A) = 2,000
units Ordering costs (O) = Rs. 50
Purchase price (PP) = Rs. 20
Carrying Costs (C) = 25% of Rs. 20
= Rs. 5

2𝐴𝑂
Calculation of optimum order
2×2000×50
� 5
quantity
EOQ (EOQ) = 200 Units
= =�
Now, for the decision, total costs should be calculated under both
conditions (i.e., EOQ and offering units)
TC at EOQ = TC = A × PP + ( 𝐴 × O + 𝐸𝑂𝑄 × C) – (A × PP × DR) = Rs….
𝐸𝑂𝑄 2
 2000 200
TC = 2000 × 20 + (200 × 50 + × 5) – (2000 × 20 × 0) = Rs.
41,000
Again, 2

TC at Offering Units = A × PP + (𝐴 × O + 𝑄
× C) – (A × PP × DR) =
𝑄 2
Rs….

2000 1000
TC = 2000 × 20 + (1000 × 50 + × 5) – (2000 × 20 ×
0.03)
= Rs. 41,400 2

Decision: discount offer should not be accepted by the company

because total cost under offering units is more than that of EOQ (i.e.,
Rs. 41,400 > Rs. 41,000).
Numerical Problems for the
Practices Problem – 1
The ABC company requires 1000 units per month
through the year at constant rate. If ordering cost are
Rs 250 per order, unit cost of the item is Rs 25 and
annual inventory holding cost are charged at 20%,
for
their the
determine the EOQ
[Ans: EOQ =
item. 1095.45]
Problem – 2
Alina Bakery uses an average of 20 kg wheat per day.
It operates 300 days a year. Storage and handling
costs for the wheat are Rs 5 per year per kg and it
costs approximately Rs 150 to order and receive a
shipment of wheat. Calculate:
i. EOQ
ii. Total annual cost
iii. Reorder level if desired safety stock 400 kg, lead
time10 days.
[Ans: EOQ = 600 units, Total Annual Cost = Rs. 3,000, and ROL
= 600 units]
Problem –
3 Assume you have a product with the following parameters:
 Demand = 360
 Holding cost per year = $ 1.00 per unit
 Order cost = $ 100 per order
 Delivery lead time = 15 days
What is the EOQ? Assuming a 300-day work year; how many
orders should be processed per year? What is the expected
time between orders? What is the total cost for the inventory
policy? What may be ROL?
[Ans: EOQ = 268 items, Number of orders = 1.34 per year, Expected
time between the order = 224 days, Total cost = $268 and ROL =
18 units]

Problem – 4
For a given item of constant demand rate, the yearly demand
is 70,000 units. The price of the item per units is Rs. 50. The
ordering cost is Rs. 200 per order and the inventory carrying
cost is 40% p.a. What is the optimal ordering policy? The
vendor offers 1% discount if 1500 units are purchased at a
time. Do you accept the discount offer?
[Ans: Discount offer should be accepted]
Problem –
5 For a given item, there is constant demand rate.
Annual demand is 60,000 nos. the price per item is
Rs. 30. The ordering cost is estimated as Rs. 300 per
order and inventory carrying cost is 30% per annum.
What should be the optimal ordering quantity? If
3000 units purchased at time, a discount of 5% on
unit price, is offered by the supplier. Do you accept
this offer?
[Ans: EOQ = 2000 units, Discount offer should be
accepted]

Problem – 6
We need 1,000 electric drills per year. The ordering
cost for these is $100 per order and the carrying cost
is assumed to be 40% of per unit cost. In orders of
lessquantity
the than 120, drills cost $78; for orders of 120 or
discount?
more,
[Ans: the order
Optimum costquantity
drops=to120$50 per
units unit.
with total Should we take
and minimum cost
of advantage
Rs. 52, 033] of
Problem
–7A supplier for St. LeRoy Hospital has introduced
quantity discounts to encourage larger order
quantities of a special catheter. The price schedule
is: Order Quantity Price per unit
0 to 299 $60.00
300 to 499 $58.80

500 or more $57.00

The hospital estimates that its annual demand for

this item is 936 units, its operating cost is $45.00
per order, and its annual holding cost is 25 percent
of the catheter’s unit price. What quantity of this
catheter should the hospital order to minimize total
Suppose price for quantities between 300 and 499
costs?
reduced
is to $58.00. Should the order quantity
change?
= $56,999, optimum order quantity =
500
[Ans:units]
EOQ 5 7 = 77 units, TC 5 7 = $57,284, EOQ 58.8 = 76 units, TC 3 0 0 = $57,382, EOQ 6 0 =
75 units, TC 5 0 0
Problem –
8 ABC company proposes to buy an item for which the
annual demand is 2,000 units. The ordering cost is
estimated at Rs. 25 per order and the inventory carrying
costs are charged at 30% p.a. The price schedule quoted
by the supplier is as below:
Order Quantity Price per Unit (Rs.)
1 to 99 50
100 to 499 45
500 & above 40

What is the optimal order quantity?

[Ans: Optimum order quantity = 500 units and TC 5 0 0 =
Rs 83,100]