02a Inventory Management

Inventory Management
(Part I)
Sasadhar Bera, IIM Ranchi
Outline
Basic Inventory Concepts
Types of Inventory
Inventory Costs
Classification of Inventory Planning Techniques
Classification of Inventory System
Characteristics of Inventory System
Basic Inventory Concepts
3
What is Inventory ?
Inventory is a stock of items kept by an organization to
meet internal or external customer demand.
Internal customers are inside the organization such as
machine operator waiting for a part or partially completed
product to work on.
External customers are outside the organization for
example, customers for grocery products, retail items, and
cars.
Managing inventories is one of the most important
functions of operations management in both manufacturing
and service organizations.
4
Few Examples of Inventory

i.
Department stores or grocery stores carry inventories

of all the retail products they sell.
ii. A nursery has inventory of different plants, trees and

flowers.
iii. A rental car agency has inventory of cars.
iv. A football team maintains inventory of items such as
food, clothing, medical supplies and personal hygiene
products.
v. A small pizza business must maintain inventory of
dough, toppings, sauce, and cheese as well as supplies
such as boxes, napkins, and so on.
Inventory in Manufacturing Firm

In a manufacturing firm, inventory can take the following
form:
i.
Raw materials Purchased material, component parts

and subassemblies
ii. Work-in-progress (WIP) Partially completed parts

waiting to be worked on
iii. Finished goods Ready to be sold items held at factory
or central warehouse or distribution centers
iv. Transit inventory - Items being transported

v. Maintenance, repair and operational supplies
Include tools, spare parts, lubricants etc. These items
do not become part of the product.
6
Role of Inventory in Value Chain

Inventory before, during and after production
7
Inventory Management
Inventory managers are responsible for planning and
controlling inventory before, during and after production to
support operation and meet customer demand.
As the level of inventory increases to provide better
customer service, inventory cost increases, whereas lost
sales and loss of customers decreases. However,
maintaining large stock of inventory is costly and wasteful.
The approach to inventory management is to maintain a
level of inventory that reflects a compromise between
inventory costs and customer service.
8
Types of Inventory
9
Types of Inventory
Inventories can be classified according to the function they
perform. The categories are given below.
i. Cycle inventory
ii. Safety stock inventory
iii. Work-in-process inventory
iv. Finished goods inventory
v. Pipeline inventory
vi. Anticipation inventory
vii. Decoupling stock
viii. Dead stock
10
Types of Inventory (Contd.)

i.
Cycle inventory(also called lot size inventory): Items

purchased or manufactured in batches, may be greater
than needed immediately. Cycle inventory may take
advantage of economies of scale from quantity discounts,
volume shipments, or the allocation of manufacturing
setup costs over many units.
ii. Safety stock inventory maintained as a safeguard against

uncertainties of demand and supply. It is an additional
amount that is kept over and above the average amount
required to meet demand.
iii. Work-in-process (WIP) inventory consists of partially
finished products in various stages of completion that are
waiting further processing. For example, a pizza restaurant
might prepare a batch of pizzas with only cheese and
sauce and add other toppings when orders are placed.
11

iv. Finished goods inventory: Ready to be sold items held at
factory or central warehouse or distribution centers.
v. Pipeline inventory: Inventory that has been in transit

mode (either a semifinished or finished product) between
factories, warehouses or retail outlets, is not physically
available to the user or customer. Pipeline inventory may
be reduced by transporting goods by air rather than the
sea or rail.
vi. Anticipation inventory: Stock accumulated in advance
due to seasonal peak demand or demand due to special
event that does not occur on a regular basis.
Seasonal stock: Garments demand during festival seasons;
refrigerators and air conditioners exhibit peak demand
during summer season.
12

Speculation stock: A firm may carry certain amount of
stock to take care of certain events like labour strike or
transport strike.
vii. Decoupling stock: It is applicable to supply chain
operations. The entire supply chain is usually divided into
various decision making units. It is not uncommon for an
organizations to hold large inventories at organizational as
well as departmental boundaries. Supply chain integration
plays important role in this regard to reduce decoupling
inventory significantly.
viii. Dead stock: Dead stock essentially includes items that
have become obsolete because of changes in customer
style, technological development in design.
13
Drivers of Inventory
Type of Inventory
Driver ( Logic)
Cycle Stock
Economies of scale
Safety Stock
Uncertainty in demand &

Supply
Seasonal stock
Mismatch between demand

and supply rate
Speculation Stock
Uncertainty in price of material
Pipeline Stock
Lead-time in
production/transportation
process
Dead Stock
Judgmental error/ Change in

economic or technological
environment
14
Inventory Costs
15
Inventory Costs
Three basic costs are associated with inventory:
i.
Ordering Costs or Costs of replenishing the inventory
ii.
Inventory carrying costs
iii. Stock-out costs or Shortage costs
16
Ordering Costs
Ordering costs: The costs associated with placing an order
either within the factory or to a supplier. Ordering cost is
independent of order size. The main components of the
ordering cost include the following:
i.
Administrative costs involved in placing the order.

Preparing the purchase order will involve documentation,
getting the necessary approval and other formalities.
Electronic or online ordering can reduce the time required
by the buyer and thus reduce this component of cost.
ii. Receiving cost: Administrative cost involved on receiving

the order. For example, at the time of receipt, the receiver
will have to prepare the goods receipt note, update
inventory records, make necessary check against the
respective purchase order.
17
Ordering Costs (Contd.)

Ordering costs are normally expressed as dollar or Rs. per
order.
A significant part of the ordering cost in a purchase situation is
information intensive. By using electronic or online ordering
can substantially reduce ordering cost.
As the size of orders increases, fewer orders are required,
reducing ordering costs. In general, if order size increases,
ordering costs decrease and inventory carrying costs increase.
In production environment, ordering cost is set-up cost. The
focus is on set-up time reduction in case of production
process.
18
Inventory Carrying Costs

Inventory carrying costs: The costs of holding inventory are
known as inventory carrying costs. The greater the level of
inventory over a period of time, the higher the carrying costs.
The carrying cost increases operating cost and decreases
profit. Carrying costs can include the following:
i.
Financing cost: The inventory represents the assets and

the working capital of a firm. Some firms consider cost of
carrying inventory fund can be deployed for alternative
purpose. Financing cost is directly proportional to the
value of the item.
ii. Storage and handling costs: Space costs (rent, taxes,

insurances) are charges for storage of inventory. Storage
costs are function of size of the item. Handling costs
involve material handling equipment and labour cost.
19
Inventory Carrying Costs (Contd.)

iii. Inventory risk: Cost associated with deterioration,
spoilage, breakage, obsolescence, and pilferage. This will
depend on nature of item, for example fashion goods,
perishable goods, and high technology products are likely
to have much higher risk.
The usual way is to assign total carrying costs, determined by

summing all the individual costs just mentioned on a per-unit
basis per time period, such as a month or year.
In this form, carrying costs are commonly expressed as per
unit dollar amount on an annual basis.
Carrying costs can range from 10 to 40% of the value of
manufactured item.
20
Stock-out Costs or Shortage Costs

Stock-out costs or Shortage costs: Stock-out occurs when
customer demand cannot be met because of insufficient
inventory. Stock-out costs are intangible or difficult to
measure. There are two kinds of stock-out costs.
Lost sales cost: When customers is unwilling to wait and
purchase the item elsewhere. Company loses potential sales
because of non-availability of finish product. A lost sale
associates with opportunity cost, which may include loss of
goodwill and potential future revenue.
When demand is internal, a shortage can cause work stoppage

in the production process and create delays, resulting in
downtime costs and the cost of lost production (including
indirect and direct production costs).
21
Stock-out Costs or Shortage Costs (Contd.)

Backorder cost: Backorder cost is incurred in a situation where
the customer is willing to wait for the item. Backorder results
in additional cost for administrative, handling and
transportation when material is to be sent to customer
separately.
Most of the decision maker finds it difficult to quantify exact
value of shortage cost. Therefore instead of working with
shortage cost, firm finds it easier to work with a target service
level that the inventory system must meet.
Instead of minimizing total cost in an inventory system, firms
minimize ordering cost plus inventory carrying cost subject to
meeting target service level.
22
Stock-out Costs or Shortage Costs (Contd.)

The customer service level is the ability to meet internal or
external demand at a specified level of efficiency. High
quality service is often perceived as always being able to
meet demand, which normally requires high inventory
levels and can be costly. Efficient management of the
inventory system can meet demand most of the time.
Target service level ranges from 90 to 99 percent. High
service level is kept for the items for which shortage cost is
high.
23
Classification of Inventory Planning

Techniques
24
Classification of Inventory Planning

Most firms carry a large number of items in stock. Control
of inventory is done by controlling individual items, which is
called stock-keeping units (SKU). Each SKU has an
identifying code.
When dealing with different SKUs, the management may

not be in a position to focus attention on all SKUs. Hence
inventory is managed with aggregate level according to
their classification.
For example, a retail store has to manage thousands of
SKUs. Not all SKUs are likely to be equal importance. Hence
managers classify the SKUs so that they can pay suitable
attention to different categories of SKUs.
25
Classification of Inventory Planning (Contd.)

Three different classification schemes are given below:
ABC classification: SKUs are classified into three categories
(A, B, and C) according to their rupees (or dollar) so that
managers can focus on according to their sales value or
usage value.
VED classification: SKUs are based on criticality: vital (V),
essential (E), and desirable (D). This classification is quite
popular in maintenance management.
FSN classification: SKUs are classified based on volume of
usage: first moving (F), slow moving (S), and non-moving
(N). This classification is quite popular in the retail industry.
26
ABC Classification
ABC classification principle is based on Paretos law. The
Paretos law says that a small number of SKUs account for
most of the inventory value (or usage in terms of dollar). It is
usually found that the relationship between the percentage of
SKUs and the percentage of annual dollar value follow a
pattern in which three groups can be defined:
A-category SKUs: About 15% to 20% of the SKUs account for
about 70% to 80% of the dollar value.
B-category SKUs: About 25% to 30% of the SKUs account for

about 10% to 15% of the dollar value.
C-category SKUs: A large percentage of total SKUs account for
a small dollar value. About 50% to 55% of the SKUs account
for about 5% to 10% of the dollar value.
27
Steps for ABC Classification

Steps for ABC classification
i. Determine total number of SKUs .
ii. Each SKU is assigned a dollar value which is unit cost .
iii. Determine the annual dollar value for each SKU. Annual
dollar value is computed by multiplying the dollar cost of
one unit by the annual demand for that SKU.
iv. List the SKUs descending order according to their annual
dollar value.
v. Calculate the cumulative annual dollar value and the
cumulative percentage of SKUs.
vi. Examine the annual volume distribution in terms of
percentage usage and groups the SKUs into A, B, and C
categories based on volume distribution.
28
ABC Classification
29
Example: ABC Classification

Spare parts inventory of a small manufacturing firm
PART
UNIT COST
($)
ANNUAL USAGE
(count)
1
2
3
4
5
6
7
8
9
10
60
350
30
80
30
20
10
320
510
20
90
40
130
60
100
180
170
50
60
120
30
Example: ABC Classification (Contd.)

PART
9
8
2
1
4
3
6
5
10
7
TOTAL
VALUE
$30,600
16,000
14,000
5,400
4,800
3,900
3,600
3,000
2,400
1,700
% OF TOTAL
VALUE
35.9
18.7
16.4
6.3
5.6
4.6
4.2
3.5
2.8
2.0
% OF TOTAL
QUANTITY
6.0
5.0
4.0
9.0
6.0
10.0
18.0
13.0
12.0
17.0
% CUMMULATIVE
A
B
C
6.0
11.0
15.0
24.0
30.0
40.0
58.0
71.0
83.0
100.0
$85,400
31
Example: ABC Classification (Contd.)
CLASS
A
B
C
ITEMS
9, 8, 2
1, 4, 3
6, 5, 10, 7
% OF TOTAL
VALUE
% OF TOTAL
QUANTITY
71.0
16.5
12.5
15.0
25.0
60.0
32
Managerial Decisions on ABC Classified SKUs

A-category SKUs: Tight control including complete accurate
records, regular and frequent review by management,
frequent review of demand forecasts, and close follow-up
and expediting to reduce lead time.
B-category SKUs: Normal controls with good records,
regular attention, and normal processing.
C-category SKUs: Order large quantity and carry safety
stock. Use two-bin system or periodic review system.
33
VED Classification
VED classification: SKUs are based on criticality: vital (V),
essential (E), and desirable (D). Based on VED classification,
one can fix different service levels for different SKUs. Of
course, a firm prefers to work with a very high service level
for V-category spare SKUs. D-category SKUs have lower level
of service requirements.
34
FSN Classification
FSN classification: SKUs are classified based on volume of
usage: first moving (F), slow moving (S), and non-moving
(N). Fast-moving SKUs are usually stocked in a decentralized
fashion while slow-moving SKUs are stocked centrally.
Non-moving SKUs are candidates for disposal and the firm
will like to make sure that non-moving SKUs do not take up
a significant share of inventory investment. This
classification is quite popular in the retail industry.
35
36

An inventory system is the set of policies and controls that
monitor level of inventory and determines what level of
inventory should be maintained, how much to order and
when to place order. There are two basic types of inventory
system:
i.
Continuous review system or fixed-order-quantity

system or Q system
ii. Periodic review system or fixed-time-period system or P

system
37
Continuous Review Inventory System

In continuous review system inventory level for every item
is continuously monitored. Whenever the inventory on
hand decreases to a predetermined level, referred to as the
reorder point, a new order is placed to replenish the stock
of inventory. The order size is fixed amount whenever the
order is placed. The order size that minimizes the total
inventory cost is called economic order quantity.
However, maintaining a continual record of the amount of
inventory on hand can also be costly. Many firms use bar
code systems and handheld laser scanner to determine
inventory materials, supplies, equipment, in-process parts,
and finished goods.
38
Periodic Review Inventory System

In a periodic review system, the inventory is checked and
reordering is done only at a specified time interval weekly,
biweekly, monthly or some other time interval.
Once the inventory in stock is determined after specified
time interval, an order is placed for an amount that will
bring back to a desired inventory level. Hence for periodic
review system order quantity is variable amount.
An example of periodic review system is a college or
university book store. Textbooks are normally ordered
according to periodic system (semester), wherein a count of
textbooks in stock is done after the first few weeks of a
semester.
39
Characteristics of Inventory System
40
Characteristic of Inventory System

One of the first steps in analyzing an inventory problem
should be to describe the essential characteristics of the
environment and inventory system. This is very useful when
we develop quantitative models for making good inventory
decisions.
We will define few terms related to inventory management.
41
Characteristic of Inventory System (Contd.)

Number of items: Most firms carry a large number of items
in stock. Control of inventory is done by controlling
individual items, which is called stock-keeping units (SKU).
Each SKU has an identifying code and is held in inventory at
a particular location.
For example, two blue shirts in the same inventory but of
different sizes or styles would be two different SKUs. The
same shirt in two different inventories would be two
different SKUs.
42
Inventory Order Cycle

Order cycle: Time interval between receipt of two
successive orders.
order cycle
Inventory Level
Order quantity, Q
Average
inventory
Demand
rate
Q
2
Reorder point, R
Lead
time
Order Order
placed receipt
Lead
time
Order Order
placed receipt
Time
43

Order size or Lot size: When purchasing from a supplier, we
usually call order size as order quantity. In case of
production of items within the organization order size is
called lot size.
Economic Order Quantity (EOQ): The order size for which
total inventory cost is minimum is known as EOQ. A
calculation is made which considers demand rate, ordering
cost, holding cost, lead time, and service level.
Lead time: It is length of time between placing an order and
its receipt for actual use.
Reorder point (R): Reorder point indicates a stock level.
when inventory drops to that level or below, ordered should
be triggered or placed.
44

Time horizon: This define planning period over which
inventory is to be controlled. The planning period may be
finite or infinite. Depending on planning period demand can
be forecast reliably. Inventory planning in a firm is generally
done on annual basis.
Inventory position: It measures the SKUs ability to satisfy
customer demand.
Inventory position = On-hand inventory + schedule receipts
- Backorders
45

Service Level: Service level indirectly measure the chances of
stock-out situation. Target service level ranges from 90 to 99
percent. High service level is kept for the items for which
stock- out cost is high.
There are two popular ways of measuring the service level:

Cycle service level: It is a probability that customer demand will
be filled from stock during lead time.
Fill rate: It is a percentage of customer orders that could be filled
from stock during a given period of time (quarter or year).
Typically an organization will specify a service level of 95 percent,

suggesting that it will meet 95 percent of demand from stock,
but will not meet the remaining 5 percent of demand.
46

Demand patterns: It indicate how demand size x units
consumed over time t. There are several way to withdraw x
units.
i.
The entire x units may be withdrawn at the beginning of

the period infinite demand
ii. The entire x units may be withdrawn at the end of the
period.
iii. Withdrawn may be uniformly throughout the period.
Class of demand is represented by:
Amount of inventory at time T: Q(T) = S x (T/t)1/n
S: Amount of inventory at T = 0 (beginning)
x: demand in the time period t
n: demand pattern index.
47

Types of demand pattern
48

Replenishment patterns: How the ordered item is added to
the stock determines replenishment pattern. t/ is
replenishment period.
49
Cycle Counting
Cycle counting is a repetitive physical counting of inventory
throughout the year. It ensures that all items are counted
and higher value items (A-category) are counted more
frequently than lower-value items (B and C categories).
The benefits of cycle counting are:
i.
Errors can be detected on timely basis and causes can

be investigated and corrected.
ii. A high level of inventory accuracy can be achieved.

iii. Can have a correct statement of assets throughout the
year.
50
Perishable Item
A perishable item either deteriorates or become obsolete
after a certain period. For example fruit, milk, cheese, and
medicine have a limited life in shelf.
Cricket match or concert tickets have no value after the
game or performance.
Similarly, hotel room cannot generate revenue if they are

not rented. Inventories of perishable items must be handled
differently from non-perishable items.
51

Multi-stage inventories: When inventory is stocked at more
than one stage in the sequential production process, they
are called multi-stage inventories.
52

An inventory system consists of several stocking point
rather than one. In some cases these stocking points are
organized such that one point acts as a supply sources for
some other points. This type of operation may repeat at
different level so that a demand point may become a new
supply point. This situation is usually referred to as a
multi-echelon system.
For example, the factory supplies the products to
warehouse, and the warehouse supplies the retailer.
Retailer supplies to customer. Each level is called echelon.
Multi-echelon inventory system includes products stocked
at the various levels in the distribution system.
53

Multi-echelon supply system
54
Financial Inventory Performance Measures

Inventory turnover ratio: From financial point of view,
inventory is an asset and represents money that tied up and
cannot be used for other purposes. The inventory turnover
ratio is a common measure of the performance indicator in
material and inventory management.
The inventory turnover ratio is calculated by Cost of Goods

Sold (COGS) over a period (financial quarter or annually) in
the numerator and average aggregate inventory value over
that period in denominator.
Annual Cost of Goods Sold

Inventory turnover ratio =
Average inventory in Rupees
55
Financial Inventory Performance Measures (Contd.)

Calculation of average inventory can be complicated and is
a subject for cost accounting. The higher value of inventory
turnover ratio indicates company can generate more
revenue from less inventory holding and therefore increase
profits.
Sometimes days of supply is used as a measure of
financial inventory performance measure. days of supply
is calculated as follows:
Inventory in hand
Days of supply =
Average daily usage
56
References
i.
Operations Management: Processes and Supply Chains,

Krajewski, Ritzman, Malhotra, and Srivastava, 9th edition,
Pearson publication.
ii.
Inventory Control and Management, Donald Waters, 2nd

edition, Wiley student edition.
iii. Supply Chain Management: Text and Cases, Janat Shah,

Pearson publication.
iv. Operations Management, Russell and Taylor, 7th edition,
International student edition.
v.
Operations Management: Concepts, Techniques, and

Applications, Evans and Collier, Cengage learning India
edition.
vi. Introduction to Material Management, Arnold, Chapman,

and Clive, 6th edition, Pearson publication.
57

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Inventory Management

Sasadhar Bera, IIM Ranchi

Sasadhar Bera, IIM Ranchi

Basic Inventory Concepts

Few Examples of Inventory

Department stores or grocery stores carry inventories

ii. A nursery has inventory of different plants, trees and

Inventory in Manufacturing Firm

Raw materials Purchased material, component parts

ii. Work-in-progress (WIP) Partially completed parts

iv. Transit inventory - Items being transported

Role of Inventory in Value Chain

Types of Inventory (Contd.)

Cycle inventory(also called lot size inventory): Items

ii. Safety stock inventory maintained as a safeguard against

Types of Inventory (Contd.)

v. Pipeline inventory: Inventory that has been in transit

Types of Inventory (Contd.)

Sasadhar Bera, IIM Ranchi

Uncertainty in demand &

Mismatch between demand

Uncertainty in price of material

Judgmental error/ Change in

Sasadhar Bera, IIM Ranchi

Ordering Costs or Costs of replenishing the inventory

Inventory carrying costs

iii. Stock-out costs or Shortage costs

Administrative costs involved in placing the order.

ii. Receiving cost: Administrative cost involved on receiving

Ordering Costs (Contd.)

Inventory Carrying Costs

Financing cost: The inventory represents the assets and

ii. Storage and handling costs: Space costs (rent, taxes,

Inventory Carrying Costs (Contd.)

The usual way is to assign total carrying costs, determined by

Stock-out Costs or Shortage Costs

When demand is internal, a shortage can cause work stoppage

Stock-out Costs or Shortage Costs (Contd.)

Stock-out Costs or Shortage Costs (Contd.)

Classification of Inventory Planning

Classification of Inventory Planning

When dealing with different SKUs, the management may

Classification of Inventory Planning (Contd.)

B-category SKUs: About 25% to 30% of the SKUs account for

Steps for ABC Classification

Example: ABC Classification

Example: ABC Classification (Contd.)

Example: ABC Classification (Contd.)

Managerial Decisions on ABC Classified SKUs

Classification of Inventory System

Classification of Inventory System

Continuous review system or fixed-order-quantity

ii. Periodic review system or fixed-time-period system or P

Continuous Review Inventory System

Periodic Review Inventory System

Characteristics of Inventory System

Characteristic of Inventory System

Characteristic of Inventory System (Contd.)

Inventory Order Cycle

Sasadhar Bera, IIM Ranchi

Characteristic of Inventory System (Contd.)

Characteristic of Inventory System (Contd.)