Inventory Management

Lecture Outline
• Defining Inventory Management
• Importance of Inventory Management
• Stock Control Techniques
• Supply chain approach to inventory management
 Meaning and Nature of Inventory

• Inventory: ‘stock of goods, or a list of goods’. In manufacturing

concerns, it may include raw materials, work in process and
stores, etc.

a. Raw Material: The quantity of raw materials required will be

determined by the rate of consumption and the time required for
replenishing the supplies.
b. Work-in-Progress: The work-in-progress is that stage of stocks, which are in
between raw materials and finished goods. The greater the time taken in
manufacturing, the more will be the amount of work in progress.

c. Finished Goods: These are the goods that are ready for the consumers. The stock
of finished goods provides a buffer between production and the market. The
purpose of maintaining inventory is to ensure a proper supply of goods to
consumers. The need for finished goods inventory will be more when
production is undertaken in general without waiting for specific orders.
Purpose / Benefits of Holding Inventories
Although holding inventories involves blocking a firm’s funds and the cost of storage
and handling, every business enterprise has to maintain a certain level of inventories
to facilitate uninterrupted production and smooth running of business. There are
three main purposes or motives for holding inventories.
i. The Transaction Motive which facilitates continuous production and timely
execution of sales orders.
ii. The Precaution Motive which necessitates the holding of inventories for meeting
the unpredictable changes in demand and supplies of materials.
iii. The Speculative Motive which induces keeping inventories to take advantage of
price fluctuations, saving in re-ordering cost and quantity discount, etc.
 Risk And Costs of Holding Inventories
The various costs and risks involved in holding inventories are as follows:
Costs:
i. Capital Costs: Maintaining inventories results in blocking of the firm’s financial
resources. The funds may be arranged from own resources or from outside. In the
former case, there is an opportunity cost of investment, while in the latter case, the
firm has to pay interest to the outside.

i. Storage and Handling costs: The storage costs include the rental of the go down,
insurance charges, etc.
Risks

i. Risk of Price Decline: This may be due to increased market supplies, competition
or general depression in the market.

ii. Risk of Obsolescence: The inventories may become obsolete due to improved
technology, changes in requirements, changes in customer tastes, etc.

iii. Risk of Deterioration in Quality: The quality of the materials may also
deteriorate while the inventories are kept in store.
Inventory Costs
Carrying cost
-Cost of holding an item in inventory

Ordering cost
-the cost of replenishing inventory

Shortage cost
-temporary or permanent loss of sales when demand cannot be
met
Ordering costs

These are the costs which are associated with the purchasing or ordering of
materials. These costs include:
1. Costs of staff posted for ordering of goods. A purchase order is processed and then placed with
suppliers. The labour spent on this process is included in ordering costs.

2. Expenses incurred on transportation of goods purchased.

3. Inspection costs of incoming materials.

4. Cost of stationery, typing, postage, telephone charges, etc.

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Carrying Costs
These are the costs of holding the inventories. These costs will not be incurred if inventories are not
carried. These costs include:

1. The cost of capital invested in inventories. An interest will be paid on the amount of capital locked
up in inventories.

2. Cost of storage, which could have been used for another purpose.

3. Loss of materials due to deterioration and obsolescence. The materials may deteriorate with the
passage of time. The loss of obsolescence arises when the materials in stock are not usable
because of a change in process or product.

4. Insurance cost.

5. Cost of spoilage in the handling of materials.

 Inventory Management
• Inventory management is the process that ensures the adequate
availability of goods across the supply chain of a company —
manufacturing facilities, warehouses, and the last point of sale.

• Several inventory management techniques can help companies

minimize the impact of a supply chain disruption and ensure
business continuity.
 Stock control Techniques
• Setting of various level
• Economic order quantity
• ABC Analysis
• Just in Time (JIT)
• VED Analysis
• SDE Analysis
• FSN Analysis

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 Stock Level Stock Control
Maximum Stock Level

Re-order triggered
Re-order level

Minimum Stock Level

Lead Time

When the stock level reaches the re-order level, it triggers a new order.
Time The
difference between the time of re-order and delivery is the ‘lead time’.
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 Control Levels
• Re-order Level or Ordering Point or Ordering Level:
This is that level of materials at which a new order for supply of materials is
to be placed.
Ordering point or re-order level = Maximum daily or weekly or monthly
usage × Maximum Lead time
• When safety stock is provided, then the following formula will be
applicable:
Ordering point or re-order level = Safety stock + (Average Usage X Average
Lead Time)
Lead Time - the total time lapse between placement of an order and
receipt of items, including their approval by the quality control
department.
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Maximum Stock Level
The maximum stock level is that quantity above which the stock of any
item should not be allowed to exceed.
Maximum Level = Re-ordering level + Re-ordering quantity – (Minimum
consumption x Minimum re-order period)

Minimum stock Level

The minimum stock is that quantity below which the stock of any item
should not be allowed to fall. It is also known as Buffer Stock.

Minimum stock Level = Re-order level – (Average usage x Average re-

ordering period)

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Average Stock Level

There are two formulas to calculate the average stock level.

Average SL= Maximum SL + Minimum SL
2
or
Average SL = Minimum SL + Re-order quantity
2

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Economic Order Quantity (EOQ) Models
• EOQ
• Optimal order quantity that will minimize total inventory costs
• Basic EOQ model
• Production quantity model
• Planned Shortage Model
 Assumptions of Basic EOQ Model

• Demand is known with certainty and is constant over

time
• Quantity Discounts are not possible
• The only Variable cost is the cost of placing an order, the
ordering cost and the holding cost
• Lead time for the receipt of orders is constant
• Order quantity is received all at once
• No shortages are allowed
EOQ Cost Model

Co - cost of placing order D - annual demand

Ch - annual per-unit carrying cost/Holding cost Q - order quantity
CoD
Annual ordering cost =
Q
ChQ
Annual carrying cost =
2
CoD ChQ
Total cost = +
Q 2
EOQ Cost Model (cont.)

Annual
cost Total Cost
(Rs.)
Slope = 0
ChQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost = Q

Optimal order Order Quantity, Q

Qopt
EOQ Cost Model
Proving equality of costs at optimal point

CoD ChQ
=
Q 2

2CoD
Q2 =
Ch
2CoD
Qopt =
Ch
Production Lot Size Model
• An inventory system in which an order is received gradually, as
inventory is simultaneously being depleted

• Non-instantaneous receipt model

• The assumption that Q is received all at once is relaxed
Assumptions
• Demand occurs at a constant rate of D items per year.
• Production rate is P items per year (and P > D ).
• Set-up cost: Rs.Co per run.
• Holding cost: Rs. Ch per item in inventory per year.
• Purchase cost per unit is constant (no quantity discount).
• Set-up time (lead time) is constant.
• Planned shortages are not permitted.

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Production Lot size Model (cont.)
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q inventory
(1-d/p)
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period
Production Lot size Model (cont.)
p = production rate d = demand rate

Q
Maximum inventory level = Q - d
p

=Q1- d
p 2CoD
Qopt = d
Q d Ch 1 -
Average inventory level =
2
1-
p p

C o D C hQ d
TC = + 1- p
Q 2
Planned Shortage Model
• With the EOQ with planned shortages model, a replenishment order
does not arrive at or before the inventory position drops to zero.
• Shortages occur until a predetermined backorder quantity is reached,
at which time the replenishment order arrives.
• The variable costs in this model are annual holding, backorder, and
ordering.
• For the optimal order and backorder quantity combination, the sum
of the annual holding and back ordering costs equals the annual
ordering cost.

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Assumptions
• Demand occurs at a constant rate of D items/year.
• Ordering cost: Rs.Co per order.
• Holding cost: Rs.Ch per item in inventory per year.
• Backorder cost: Rs. Cb per item backordered per year.
• Purchase cost per unit is constant (no quantity. discount).
• Set-up time (lead time) is constant.
• Planned shortages are permitted (backordered demand units are withdrawn
from a replenishment order when it is delivered).

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Planned Shortage Model
 • Optimal order quantity:
2𝐷𝐶𝑜 𝐶ℎ+𝐶𝑏
Q*=
𝐶ℎ 𝐶𝑏

• Maximum number of backorders:

𝐶ℎ
• S*=𝑄
𝐶ℎ+𝐶𝑏
• Number of orders per year: D/Q

• Time between orders (cycle time): Q /D years

(𝑄−𝑆)2 𝐷 𝑆2
• Total annual cost: 𝐶ℎ + 𝐶𝑜 + 𝐶𝑏
2𝑄 𝑄 2𝑄
(holding + ordering + backordering)
Copyright 2006 John Wiley & Sons, Inc. 12-29
 ABC Analysis
Classifying inventory according to some measure of
importance and allocating control efforts accordingly.
A - very important
B - mod. important High
A
Annual
C - least important $ value B
of items

Low C
Low High
Percentage of Items

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 JUST-IN-TIME (JIT)
JIT is a philosophy that advocates the lowest possible levels of
inventory. JIT espouses that firms need only keep inventory in the
right quantity at the right time with the right quality. The ideal for
JIT is one, even though one hears lot size the term "zero inventory"
used.

In JIT system holding cost increased and ordering cost comes down.

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 VED Analysis
According to this analysis inventory items are grouped into vital, essential, and
desirable.

1-vital- items constitute such items of inventory whose in adequate supply may
substantially damage the productive activities

2. Essential- items are the items whose non-availability can not be tolerated for few
hours or one day and the cost of production lost is high.

3. Desirable- items do not have any immediate impact on production , hence these
may or may not be maintained.

Thus , VED analysis does not consider the utility of the inventory items on the
basis of value but on their impact on the production.

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 SDE ANALYSIS

1- Scarce item are those items which are in short supply and mostly such
items constitute important items

2- Difficult Items refer to such items which can not be procured easily

3- Easy- items are the items which are easily available in the market.

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 FSN ANALYSIS
1- Fast-moving items are stored in large quantities, and a close watch
on the movement of such items is kept.

2- slow-moving items are not frequently required by the production

department

3 – Non-moving items are rarely required by the production

department

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Inventory Management and Supply Chain
Success
• Effective inventory management is a critical component of successful
supply chain management.

• To supply and support the balance of demand and supply.

• By making inventory management a priority, companies can not only

reduce costs and improve cash flow but also increase customer
satisfaction and gain a competitive edge in the marketplace.
 Supply Chain Approach to Inventory Management
Considers the entire supply chain network when making decisions
related to inventory levels, procurement, storage, and distribution.

Demand Supplier Just-in-Time

Forecasting: Safety Stock:
Collaboration (JIT) Inventory

Cross-
Inventory
ABC Analysis Functional Data Analytics
Optimization
Collaboration

Green and
Continuous Risk
Sustainable
Improvement Management
Practices
key components of a supply chain approach
to Inventory Management
• Demand Forecasting: Accurate demand forecasting is essential. It involves using historical data, market
trends, and other factors to predict future demand for products. Collaborative forecasting with suppliers
and partners can improve accuracy.
• Safety Stock: Safety stock is a buffer inventory maintained to account for variability in demand and
supply lead times. It ensures that there are enough products on hand to meet unexpected demand or
supply disruptions.
• Supplier Collaboration: Collaborating with suppliers is crucial. Building strong relationships with
suppliers can lead to better lead times, pricing, and quality, reducing the need for excessive safety stock.
• Just-in-Time (JIT) Inventory: JIT principles minimize inventory levels by ensuring that products arrive
just in time for production or sale. This reduces holding costs but requires precise coordination.
• Inventory Optimization: Using mathematical models and algorithms to optimize inventory levels.
Inventory optimization tools help balance the trade-off between holding costs and stockouts.
• ABC Analysis: Classifying inventory items into categories based on their importance. "A" items are the most
critical, "B" items are moderately important, and "C" items are less important. This allows for a focus on
managing the most crucial items closely.
• Cross-Functional Collaboration: Collaborate across functions such as procurement, production, sales, and
logistics to ensure a holistic approach to inventory management.
• Data Analytics: Using data analytics to gain insights into inventory performance, detect trends, and make
informed decisions about reorder points, order quantities, and lead times.
• Continuous Improvement: Implementing a culture of continuous improvement to regularly review and
optimize inventory management practices.
• Green and Sustainable Practices: Considering environmental sustainability in inventory decisions, such as
reducing excess packaging or choosing suppliers with sustainable practices.
• Risk Management: Identifying and mitigating risks in the supply chain that could impact inventory
availability, such as natural disasters, geopolitical issues, or supplier failures.
Thank You