INVENTORY MANAGEMENT

UNIT - 3

Syllabus
1. Inventory Management: Definition of

Inventory, Purposes of Inventory, Inventory

Costs
2. Independent versus Dependent Demand
3. Inventory Systems, ABC, EOQ, FSN, VED
and VMI
Text : Chapter 12

What is inventory?
1. The amount of material, a company has in

stock at a specific time is known as inventory.

2. In terms of money inventory can be defined
as the total capital investment over all the
materials stocked in the company at any
specific time.
3. Inventory is an idle resource, which has some
economic value.

What all constitutes inventory?

1. Raw material inventory
2. In process inventory

3. Finished goods inventory

4. Spare parts inventory

5. Office stationary
6. Maintenance material.

Independent vs. Dependent Demand

1. Independent Demand
Finished goods, spare parts for repair and

maintenance
Continuous Demand
Uncertainty of Demand
2. Dependent Demand
Component parts of a product
Eg. Tyres for bicycle,

Demand is certain

Types of Inventory
1. Seasonal Inventory: Organizations carry inventory to

2.

3.
4.
5.

meet fluctuations in demend. Seasonality in demand is

absorbed using inventory
Decoupling Inventory: Complexity of production control
is reduced by splitting manufacturing into stages and
maintaining inventory between these stages
Cyclic Inventory: Periodic replenishment causes cyclic
inventory
Pipeline Inventory: Exists due to lead time for order
Safety Stock: Used to absorb fluctuations in demand due
to uncertainty

Decoupling Inventory
An illustration

Production System without any decoupling inventory

1
Stage 1

5
Stage 2

3
7

10

Stage 3

Decoupling Inventory

10

Cyclic, Pipeline and Safety Stocks

A graphical illustration

Quantity

Cyclic Stock

Pipeline inventory
L

Time

Safety stock

Average Cyclic Inventory

Q0 Q

2
2

1. Order Cycle. The period between two

Successive Orders.
2. Two Methods of Inventory Management:
Fixed Order Quantity System or EOQ Model
Periodic Review Model
3. Lead Time. Time between placing an order for

replacement of an item to actually receiving the

item into stock.

Some more Terms related to Inv. Mgt.

1.

Maximum Stock.
Indicates highest stock level

2.

Safety Stock/ Buffer Stock

Additional stock provided to allow for delays in delivery or

unexpected demand
3.

Reorder Level/ Reorder Point

Stock level at which new order is placed

4.

Reorder Quantity
Quantity of replacement order

5.

Economic Order Quantity (EOQ)

Example
1.

An aerated drinks manufacturing company requires 2000 Kg

of sugar a week for its plant. The plant buys sugar from the
sugar factory directly and it takes 2 weeks for the sugar to
arrive at the plant after the order is placed. The manufacturer
places demand on a monthly basis. Determine:

Storage capacity required at the plant (maximum inventory)?

Lead time?
Average inventory (cyclic inventory)?
Pipeline inventory?

Storage capacity required at the plant (maximum inventory) = 2000 x 4 = 8000 Kg

Lead time = 2 weeks
Average inventory (cyclic inventory) = (8000 / 2) = 4000 Kg
Pipeline inventory = Lead Time x Demand/unit time = 2 x 2000 = 4000 Kg.

What decisions you need to take?

1. How much to order?
2. When to order?
3. From whom to purchase?

4. How much safety stock to be kept?

For making these decisions what information you

need?
1.
2.
3.
4.
5.
6.
7.

Demand of the item. (consumption pattern)

Costs associated
Type of item (storage requirement, perishability, availability etc)
Type of production system.
Lead time (delivery type, time)
Certainty of demand (fluctuations in demand)
Penalty of non availability of inventory

Why Inventories?
1. Inventories are needed because demand and supply

can not be matched for physical and economical

reasons.
2. To safe guard against the uncertainties in price
fluctuations, supply conditions, demand conditions,
lead times, transport contingencies etc.
3. To reduce machine idle times by providing enough
in-process inventories at appropriate locations.
4. To take advantages of quantity discounts, economy
of scale in transportation etc.

Why Inventories? (contd..)

5. To decouple operations i.e. to make one operation's supply

independent of another's supply. This helps in minimizing the

impact of break downs, shortages etc. on the performance of
the down stream operations. Moreover operations can be
scheduled independent of each other if operations are
decoupled.
6. To reduce the material handling cost of semi-finished
products by moving them in large quantities between
operations.
7. To reduce clerical cost associated with order preparation,
order procurement etc.

Why Inventory Management?

1. As a lot of money is engaged in the inventories along with

their high carrying costs, companies cannot afford to have

any money tied in excess inventories.
2. At the same time shortfalls in inventory has its damaging
effects.
3. Any excessive investment in inventories may prove to be a
serious drag on the successful working of an organization.
Thus there is a need to manage our inventories more
effectively to free the excessive amount of capital engaged
in the materials.

Inventory Management
1. Video Case Study: Inventory

Management at Pearson Education

Inventory Costs
1. Unit cost or Unit Purchase Cost: it is usually

the purchase price of the item under

consideration.
Direct Cost.
Purchase Cost = Unit cost x Demand = (C x D)
If unit cost is related with the purchase quantity,
it is called as discount price.

Inventory Costs:
Procurement costs or Ordering Cost (Co):
Search and identification of appropriate sources of supply
2. Price negotiation, contracting and purchase order generation
3. Follow-up and receipt of material
4. Eventual stocking in the stores after necessary accounting and
verification
1.

Fixed cost per order

Not dependent on quantity ordered
Total Ordering Cost = No of orders placed x Co
A larger order quantity will require less number of orders to

meet a known demand and vice versa

Inventory Costs:
Carrying costs or Holding Cost (Cc or Ch)
This represents the cost of maintaining inventories in the
plant.
It includes the interest on capital engaged
Cost of storage (power/AC/Dust free room), cost of
insurance, security, warehouse rent, taxes, spoilage,
breakage, obsolescence etc.
Depended on quantity of inventory held.
Carrying Cost = Average Inventory x Holding Cost Per
Unit
Larger the ordering quantity, higher will be the carrying
cost

Inventory Costs:
Stock out/Shortage costs or Back Order Cost (Cs)

This represents the cost of losses due to shortage in

supplies.
Penalty costs associated with delay in meeting
demand or inability to meet at all.
This includes cost of loss of profit, loss of
customer goodwill, penalty, cost of re-scheduling
production, cost of idle time of resources,
increased freight etc.
The effects of shortage are vastly intangible, it is
difficult to accurately estimate

EOQ Model

Cost of Inventory

Sum of the two costs

Total cost of carrying

Minimum Cost

Total cost of ordering

Economic
Order Qty.

Order Quantity/Level of Inventory

Total annual inventory cost

= Purchase Cost of items +
Annual procurement cost +
Annual carrying cost+
Stockout costs
= C x D + No of orders placed x Co
+ Average inventory x Cc + Stockout costs

Inventory Costs
The objective of inventory
management team is to
minimize the total annual
inventory cost. A simplified
graphical presentation in
which cost of items,
procurement cost and carrying
cost are depicted.
EOQ = Q* (Size of the order representing std qty of material)
Aggregate of the costs of procuring the inventory and costs of holding inventory are the minimum.

Inventory Control for deterministic

demand: EOQ Model
Demand during the planning period

=D

Order quantity

=Q

The cost of ordering per order

Co
Inventory carrying cost per unit per unit time = C c
The average inventory carried by an organisation=

Q
2

The cost associated with carrying inventory = * C c

2

The total ordering cost is given by * C o

Q

Total cost of the plan =

Total cost of carrying inventory + Total cost of ordering

*
C
*
C
TC(Q) =
o
c +

Inventory Control for deterministic

demand: EOQ Model
When the total cost is minimum, we obtain the most economic
order quantity (EOQ). By taking the first derivative of with
respect to Q and equating it to zero we can obtain the EOQ
Differentiating total cost equation with respect to Q we obtain,

dTC (Q) Cc Co D

2
dQ
2
Q
The second derivative is positive and hence we obtain the
minimum cost by equating the first derivative to zero.

Denoting EOQ by

Q*,

we obtain the expression of

The optimal number of orders =

Q*
Time between orders =
D

D
Q*

Q*

as: Q

2C o D
Cc

Economic Order Quantity (EOQ) Model

Assumptions
1. Demand per year is
deterministic in nature
2. Planning period is one year
3. Lead time is zero or constant
and deterministic in nature
4. Replenishment of items is
instantaneous
5. Demand/consumption rate is
uniform and known in advance
6. No stockout condition exist in
the organization

Example 1 (Deterministic model with continuous

demand and instantaneous supply. )
1.

ABC manufacturers produces 1,25,000 oil seals each year to

satisfy the requirement of their client. They order the metal for
the bushing in lot of 30,000 units. It cost them $40 to place
the order. The unit cost of bushing is $0.12 and the estimated
carrying cost is 25% unit cost. Find out the economic order
quantity? What percentage of increases or decrease in order
quantity is required so that the ordered quantity is Economic
order quantity ?

How many orders the company will be placing in a year?

What will be the average inventory?
What will be the order cycle?
What is the Total Cost of Inventory per year?
What will be the saving for the company by following EOQ?

Example 1 solution contd

No of Order per year = D/EOQ = 125000/ 18258 = 6.8 7
Average Inventory = EOQ/2 = 18258/2 = 9129
Order Cycle = 365/ N = 365/ 7 = 52 Days
Total Inv. Cost (for EOQ) = C.D + Co.D/Q + Cc. Q/2
= 0.12 x 125000 + 40 x 125000/ 18258 + 0.25 x 0.12 x 18258/2 = $15,560

Total Inv. Cost (for Q = 30000 Units) = C.D + Co.D/Q + Cc. Q/2
= 0.12 x 125000 + 40 x 125000/ 30000 + 0.25 x 0.12 x 30000/2 = $15,616

Example 2
A manufacturer uses Rs. 10,000 worth of an
item during the year. He has estimated the
ordering costs as Rs 25 per order and carrying
costs as 12.5% of average inventory value.
Find the optimal order size, number of order
per year, time period per order and total cost.
Inventory expressed in terms of cash
Deterministic model with continuous demand and
instantaneous supply

Use Excel to solve

1.

The annual Demand (D) of raw material of a company is 1000

Units. Ordering cost (S) is Rs 5 per order. Holding Cost (H) is
Rs 1.25 per Unit per year. Cost per unit is Rs. 12.50. What
would be the minimum Total Cost of Inventory per year (TC)
and the economic order quantity (Q)?
Represent the holding cost and ordering cost Vs . Order
quantity on a line graph.

Example 3
1.

An item is used at a uniform rate of 50,000 units per year. No

shortage is allowed and delivery is at an infinite rate. The
ordering, receiving and hauling costs is Rs 13 per order, while
inspection cost is Rs 12 per order. Interest costs are Rs 0.056
and deterioration and obsolescence cost Rs. 0.004 respectively
per year for each item actually held in inventory plus Rs. 0.02
per year per unit based on the maximum number of units in
inventory. Calculate EOQ. If lead time is 20 days, find re-order
level.

Model 3: Quantity Discounts

1.

2.

Avtek, wants to reduce its large stock of televisions. So it has

offered a local chain of stores a quantity discount pricing
schedule, as follows:
QUANTITY
PRICE (Rs)
1 49

14000

50 89

11000

90 +

9000

As the procurement manager for the chain of stores, you have

arrived at the following estimates. The annual carrying cost
for a TV is Rs. 1900; the ordering cost is Rs 25000 and the
annual demand for this TV is estimated as 200 units. Would
you take the discount offer or go for the EOQ?

TC (C= Rs14000)
TC (C= Rs11000)
TC (C= Rs9000)

2CoD
2 25000 200

72.5 ~ 73
Cc
1900

1.

EOQ =

2.

For 73 order qty, the price would be Rs 11000.

3.

TC (min) = Rs 2337840

For order size of 90; and C= Rs 9000; find TC

5. TC = Rs 194105.
4.

Production Quantity Model

Gradual Usage and Non-instantaneous receipt model
2. Order qty is received gradually over time.
3. Eg. Inventory user is the producer also; batch manufacturing
1.

EPQ
Qmax

t1

t2

EPQ
Qmax

t1

t2
EPQ

t1 = Duration of Production
Co = Set up cost; Cc = Holding Cost or carrying cost
p= Rate of production or Rate of Supply (item/day)
d= Rate of consumption/ Rate of demand (item/day)
Rate of inventory rise during production (during t1 ) = p- d
Production Qty or Batch size (EPQ) = p . t1
Area under ABC ( p d ).Q
Q max = (p-d) . T1

(t t )
2p
Average Inventory =
1

2.Co.D
Cc

(p

(p d)

Economic Production Qty Model

(Gradual supply and shortages not allowed).

1. A component for a product is used at the rate of 100 per

day and can be manufactured at the rate of 600 per day. It

costs Rs. 2000 to set up the manufacturing process and
Rs. 0.1 per unit per day held in inventory based on the
actual inventory any time. Shortage is not allowed.
2. Find:
Optimum number of units per manufacturing run (Economic

production quantity.
Find the minimum annual variable cost.
Time for each production run.

Economic Production Qty Model

(Gradual supply and shortages not allowed).

D = 100 x 360 = 36000 Units;

2. d = 600 / day;
p = 100/day
3. Co = Rs. 2000; Cc = 0.01
1.

2.D.Co. p
2. 3600 2000 600
EPQ

41570
Cc.( p d )
0.1 (600 100)

Selective Control of Inventories

Alternative Classification Schemes

1. ABC Analysis (on the basis of consumption value)

2. XYZ Classification (on the basis of unit cost of the item)

3. FSN Analysis (on the basis of movement of inventory)

4. VED Classification (on the basis of criticality of items)
5. On the basis of sources of supply

Significant Few
Insignificant Many

PARETOs Law

ABC Analysis
Based on the annual value of the item.
2. ABC Always Better Control
3. Procedure:
1.

Calculate Unit Price and Annual Demand of the items

Unit Price x Annual Demand = Annual Value
List in the Ascending order of Annual Value

Calculate the cumulative annual values

A Class Monitor Closely, Continuous rigourous control

5. B Class Monitor periodically, relaxed control
6. C Class Rule of thumb
4.

Sample Data for ABC Calculation

ITEM NO.

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

UNIT VALUE
(Rs)
30000
450
590
25000
600
4500
400
30
145
2300
9
11
2000
4
120
20
10
80
25
1

ANNUAL
DEMAND
80
1200
400
9
200
15
100
1000
200
12
1500
1000
5
4000
120
500
1000
100
100
1500

CONSUMTION
VALUE (Rs)
2400000
540000
236000
225000
120000
67500
40000
30000
29000
27600
13500
11000
10000
16000
14400
10000
10000
8000
2500
1500

CUMULATIVE
NUMBER OF ITEMS
(%)
0
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
45.00%
50.00%
55.00%
60.00%
65.00%
70.00%
75.00%
80.00%
85.00%
90.00%
95.00%
100.00%

CUMULATIVE
VALUE (%)

0.00%
62.96%
77.12%
83.32%
89.22%
92.37%
94.14%
95.19%
95.97%
96.73%
97.46%
97.81%
98.10%
98.36%
98.78%
99.16%
99.42%
99.69%
99.90%
99.96%
100.00%

ABC Classification

A graphical illustration
100%
90%
Class C
Class B

70%
60%
Class A

50%
40%
30%
20%
10%

No. of items (% )

0%
10

%
90

%
80

%
70

%
60

%
50

%
40

%
30

%
20

10

0%

0%

Consummption value (%)

80%

XYZ Classification
On the basis of unit cost of the item
High Unit cost (X Class item)
Medium Unit cost (Y Class item)
Low unit cost (Z Class item)

VED Analysis
1. On the basis of criticality of items
Vital
Essential
Desirable

V High level of service, safety stock

E Medium level of service, low safety

stock
D Low level of service

FSN Analysis
On the basis of movement of inventory
Fast Moving
Slow Moving
Non-moving

Selective Control of Inventories

N
S
F

V
E
D