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Inventory

An inventory is a stock of goods maintained for the purpose of


future production or sales. In broad terms, the term inventory
refers to all materials, parts, suppliers, tools, in-process or
finished products recorded in the books by an organization &
kept its stocks, warehouse or plant for some period of time. It
is a list or a schedule of materials held on behalf of an
enterprise, the quantity & value of every item is also
mentioned in such list.
According to R.L Ackoff & M.W Sasieni, Inventory
consists of useable but idle resources. The resources may be of
any type e.g. men, material, machine or money. When the
resources involved are materials or goods in any stage of
completion, inventory is referred to as stock. But every such
stock involves blockage of capital, therefore, it is important to
plan a proper level of inventory inorder to ensure continuous
production.
Types of Inventories
1. Direct Inventories (a) Raw Material
(b) Work-in Process or semi-
finished goods
(c) Finished goods
(d) Spare parts
2. Indirect Inventories

Direct inventories are those inventories that plays a major role in the
production & constitute a vital part of finished goods. These
inventories can be easily assigned to specific physical units. Indirect
inventories include those items which are necessary for
manufacturing but don't become component of the finished goods.
They normally include petrol, maintenance materials, office
materials, grease, oil, lubricants etc. These inventories are used for
ancillary purposes to the business & cant be assigned to specifical
units e.g. tools( standard & hand tools), supplies etc.
Inventory Control
Inventory control means making the desired item of
required quality & quantity and available it to various
department when needed. It is concerned with systematic
location, shortage and recording of materials in such a
manner as to furnish the desired degree of service to
operating department at the lowest cost.
It is the process of deciding what and how much of various
items are to be kept in stock. It also determines the time &
quantity of various items to be procured.
Importance
1.It avoids delays in production by providing regularly
required materials.
2.It eliminates over stocking of inventories and,
thereby, maintains the minimum investment.
3.It enables timely & continuous supply of goods to
customers by maintaining sufficient stocks of finished
goods. It results in improvement in customer relation.
4. It protects the firm against fluctuations in demand through
sufficient stock of inventories.
5. It reduces inventory losses caused by inadequate inspection of
materials received.
6. The manufacturing costs are reduced due to increase in utilization
of labour & optimization of equipment effectiveness.
Causes of poor inventory control
1. Over buying without consideration of demand estimates in
order to take advantage of favourable market conditions
leads to poor control.
2. Over production or keeping inventory stocks of finished
products without consideration of customer requirements.
3. In order to provide quick & better service to consumer over-
stocking may take place. Also to cut down the cost of
production, bulk production will result in huge inventories
both these shall lead to poor inventory control.
4. Cancellation of orders may also give rise to large
inventories thus may result in poor inventory management.
TYPES OF INVENTORY
CONTROL SYSTEMS
In a large business organization, it is essential to have
information about continuous availability of different types
of materials & stores purchased, issued & their balance in-
hand. The perpetual inventory control system enables the
manufacturer to know about the availability of these
materials and stores without undergoing the cumbersome
process of physical stock verification. Under this system,
proper information with regard to receipt, issue and
materials in-hand is kept ready. The main objective of this
system is to have accurate information about the stock
level of every item at any time.
1.ABC Analysis (Always Better Control)
2.VED Analysis (Vital Essential Desirable)
3.FSN Analysis (Fast Slow Non-moving)
4.XYZ Analysis
ABC analysis can be used as one of inventory analysis instrument.
ABC analysis is a method for dividing on-hand inventory into three
classifications based on annual dollar volume (Heizer and Render,
2004). ABC analysis is an inventory application of Pareto
principle. The Pareto principle states that there are a critical few
and trivial many.
The idea is to establish inventory policies that focus resources on
the few critical inventory parts and not the many trivial ones. It is
not realistic to monitor inexpensive items with the same intensity
ABC Analysis (Always Better Control)
Classify inventories on the basis of cost and their consumption:
Consumption Value = (Unit price of an item) (No. of units consumed
per annum)
Class A - High Consumption Value
Class B - Medium Consumption Value
Class C - Low Consumption Value

1.A-type inventory
These are high value, low volume type of inventory. In the total inventory items,
A-
items are few in number & thus represents a small percentage of the total items.
However due to high cost and high consumption, they represent a large percentage
of companys total expenditure. It has been commonly observed that 10% of the
total quantity of items represents 70% of the amount spent on these items. These
items need accurate careful records, careful handling & storage under tight control.
Such items being costly are purchased in small quantity, therefore, this increases
the procurement cost and involve little risk of non-availability.
2. B-type inventory
These are middle level items which dont require as detailed and close control as A-items
but they need more attention & control than C-items. These items usually represents 20%of
the total quantity of items and represents 15% to 20% of the total expenditure on items.
3.Ctypeinventory
These items generally represents 70% to 75% of the total quantity and 5% to 10% of the
totalexpenditureonmaterials.Bulkpurchasedecisionmaybeusefulastheitemcostisless,
therefore,lesserno.ofordersmaybeplaced.Theseitemsmaybeunderthesupervisionof
lowlevelofmanagement.
NOTE:
According to Pareto principle, inventory has been divided into the following categories
(Gupta,etal.2007):
Class A items may represent only about 10% of total inventory items, but they represent
about 70% of the total money value.
Class B items may represent about 20% of total inventory items, and they represent about
20% of the total money value.
Class C items may represent about 10% of total inventory items, but they represent only
about 10% of the total money value.
Using the classification, each category should be handled in different way, with more
attention being devoted to category A, less to B, and still less to C .
ABC Analysis
% of Consumption Value

80 A Items
70
60
50
40
30
20 B Items
10 C Items
| | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
% of inventory items
Control Policies for A-items
1. A-items are high valued items hence they should be ordered more but in
small quantities in order to reduce capital locked-up at any time.
2. The future requirement must be planned in advance so that the required
quantities arrive a little before they are required for consumption.
3. Purchases & stock control of A-items should be looked by the top
executives in purchasing department.
Control Policies for B-items
1. The policies for B-items should be in between those of A & C.
2. Order of these items must be placed less frequently.
3. The safety stock should be medium (3 months or less).
Control Policies for C-items
1. C-items are low valued items, therefore, the safety stock of such items
should be liberal.
2. In case of these items only routine check is required.
3. Annual or six- monthly orders should be placed to reduce paper work &
ordering cost
VED ANALYSIS
In ABC analysis, we have seen that annual consumption value;
quantity of materials consumed and unit cost plays a vital role.
This is to say that ABC analysis deals with the annual
consumption value of the item due to their presence but not
considering any other aspect such as the criticality of the
material or the nuisance value.
The nuisance Value is the cost associated with materials
due to their absence. Some of the materials are important
by their absence.
In case they are not available, the whole production system
may come to standstill and involve high cost of loss of
production.
The investment in these materials may be small but for non
availability of the item the costs or losses the company
going to involve will be very high. These are critical
items, which are required in adequate quantity.
The materials may be classified depending upon their
criticality that is on functional basis.
The degree of criticality can be stated as whether the
material is vital to the process of production, or essential to
the process of production or desirable for the process of
production.
This classification is known as VED analysis, V stands for
vital, E stands for essential and D stands for desirable
items.
Vital items are those without which production would come to
halt. These items would render the equipment or whole line
operation in the process. If these items are go out of stock or
are not readily available, there will be a loss of production.
Essential items are those without which the performance or
efficiency of the equipment will be reduced. Non-availability
of these items may result in temporary loss of productivity.
Desirable items are those which donot cause any immediate
loss in productivity
In hospital inventory management, VED analysis
has been commonly used together with ABC
analysis.
VED analysis is based on the criticality of an item. V is
for vital items without which a hospital can not function,
E for essential items without which a hospital can
function but may affect the quality of the services, and
D for desirable items, unavailability of which with not
interfere with functioning (Gupta, et al., 2007).
By combining ABC and VED analysis, the medicines can
be coupled into the following group (Gupta, et al., 2007):
Class I: AV+BV+CV+AE+AD
Class II: BE+CE+BD
Class III: CD
Class I is the highest priority group, needing greatest
attention. The management of class I medicines by
top management would help in keeping a check on
the annual budget and their availability.
Moderate attention should be devoted by middle level
management for class II, and the loose attention is
devoted by lower level management for class III.
After the inventory has been classified, the two
fundamental questions posed to any inventory system
are how many and when to order.
There are 2 (two) inventory system can be used to
answer the questions (Tersine, 1994):
Fixed order size system and Fixed order interval
system
In fixed order size system, the same number of units (how
many) is always ordered, and the time between orders
(when) is not expected to vary. This system is also
termed as Q-system, since the size of order (Q) is fixed
for each replenishment.
The stock level is reviewed with each transaction, and
whenever the inventory position reaches a predetermined
point, an order for a fixed number of units is placed.
Thus, the defining parameters of the system are reorder
point (B) and the size of the order (Q).
The fixed order interval system or periodic inventory
system, is based on a periodic rather than a continuous
review of the inventory stock position. It is a time based
inventory system in which orders are placed at equally
interval, predetermined points in time, and the order
quantity is dependent upon the usage between order
review periods. This system is also termed as T-system,
since the order interval is constant.
A maximum inventory level for each item is developed,
based on usage during lead time and order interval.
After a fixed period of time has passed, the stock
position of the item is determined. An order is placed to
replenish the stock with the sufficient size to bring the
present stock level up to the maximum inventory level.
Therefore, the defining parameters of the system are
fixed review period (T) and the maximum inventory
level (E).
Thawani, et al. (2004) and Gupta, et al.
(2007) proposed that in hospital
inventory management, ABC analysis
(based on cost criteria) should be
coupled with VED analysis (based on the
criticality of an item) to narrow down the
group of medicines requiring greater
managerial monitoring. Based on ABC-
VED analysis, the two fundamental
decisions that must be made then relate
to the timing and size of orders.
It was observed that 40 medicines (11.90%)
were classified into category 1
(AV+BV+CV+AE+AD) for stringent control.
Application of EOI-multiple items would also
allow effective control of annual total
expenditure.
ABC analysis for prioritization was a feasible
and efficient technique for effective
management of store in hospitals. It would
allow effective control over two-third of the
total expenditure by controlling only one-
fourth of the items.
Inventory is a necessary part of doing business
and provided by most organizations in any
sector of economy.
Inventory exists because supply and demand
are difficult to synchronize perfectly and it takes
time to perform material-related operations .
Inventory serves following purposes within the
firm:
1. It enables the firm to achieve economics of scale.
2. It balances supply and demand and it enables
specialization in manufacturing.
3. It provides protection from uncertainties in demand and
order cycle.
4. It acts as a buffer between critical interfaces within the
supply chain.
Inventory can be a source of conflict among
different managers in organization because
different managers have different roles to play
which involve the use of inventory.
The conflicting roles of managers must not be
allowed to impair the organization as a whole.
To overcome this conflict, inventory management
should be everybodys concern.
The objective of inventory management is to
have the appropriate amounts of materials in the
right place, at the right time, and at low cost.
Therefore, inventory decision problem can be
solved by using economic criteria. One of the
most important prerequisites is an understanding
of the more relevant costs to inventory system.
COMBINATION OF ABC
&VED ANALYSIS
We can combine both and classify
the materials depending on both the
consumption value and the
criticality; it will give us a fruitful
result. This can be done in nine ways
V E D

A AV AE AD

B BV BE BD

C CV CE CD
V E D

A 90% 80% 70%

B 95% 85% 75%

C 99% 90% 80%


This type of classification helps the
management to decide the materials
policy and what the service levels are
expected to see that no difficulty is
faced.
An item belongs to both A and V class is
costlier, at the same time higher
criticality, the management should see
that it is available at any time the need
arises and the stock levels to be
controlled properly to see that inventory
carrying cost are kept under control.
Inventory Models
1. Static Inventory Models
It is applicable in cases where only one order can be placed to meet the
demand. Repeat orders are either impossible or too expensive. Typical
examples are: perishable goods like bread, vegetables etc, seasonal
products like coolers, sweaters, umbrellas, rain coats etc.
2. Dynamic Inventory Models
It is applicable for items where repeat orders can be placed to replenish
stock. This model can be classified as:
a) Deterministic Models: These are based on the assumption that the
demand as well as lead time of an item are deterministic i.e. known
with certainty.
b) Probabilistic Models: The demand is not known. Demand
characteristics such as mean, standard deviation and the distribution of
demand may be known.
Inventory Costs
There are four types of inventory costs:
Item cost
Item cost is the cost of buying or producing the individual
inventory items.
The item cost is usually expressed as a cost per unit multiplied by
the quantity procured or produced.
Ordering/ setup cost
Ordering cost is associated with ordering a batch or a lot of
items. It does not depend on the number of items ordered, but
assigned to the entire batch from calling for quotations to the
point at which the item is taken into stock i.e. it includes
expenditure connected with: transportation, receiving quotations,
processing purchase requisition, receiving materials & inspection,
following-up purchase orders, processing sellers invoice and so
on.
When the item is produced within the firm, there are also costs
associated with placing an order, called setup costs, including
paperwork costs and the costs required to set up the production
equipment.
Carrying/ holding costs
This cost is associated with keeping items in inventory for a period of
time. It is typically charged as a percentage of rupees value per unit
time.
In practice, this cost typically range from 15% - 30% per year. The
carrying/ holding cost consists of three components: Cost of capital,
Cost of storage(Rent for storage facility, record keeping, salary of
personnel and Costs of obsolescence/ deterioration/ loss/ insurance/
sometimes special tax is to be paid for storing certain items etc
Stock out/shortages cost
The cost associated with either delay in meeting demands or inability to
meet it at all. Stock out cost reflects the economic consequences of
running out of stock, including back ordered cost and lost sales.
Why Holding Costs Increase
More units must be stored if more are ordered

Purchase Order Purchase Order


Description Qty. Description Qty.
Microwave 1 Microwave 1000
Order quantity Order quantity
Why Order Costs Decrease
If we order more quantity in one
Order cost $10
order, then we order fewer
times over the year. Purchase Order
Example: You expect to order Description Qty.
10 microwave ovens over a
Microwave 1
year for a retail store like Sears.
It cost $10 to place an order.

If you order 1 microwave,


how many orders will you Order Cost $10
place over the year? what is
Purchase Order
the ordering cost? What is
the ordering cost per Description Qty.
If you order 10 microwaves,
microwave? Microwave 10
how many orders will you
place over the year? What is
the ordering cost? What is the
Basic Economic Order
Quantity
In corporate finance,economic order quantity(EOQ)
is the order quantity that minimizes the total holding
costs and ordering costs. It is one of the oldest classical
production scheduling models. The framework used to
determine this order quantity is also known as
WilsonEOQModel, Wilson Formula or Andler Formula.

TheEconomic Order Quantity(EOQ) is the


number of units that a company should add to
inventory with each order to minimize the total
costs of inventorysuch as holding costs, order
costs, and shortage costs.
Basic EOQ model
Assumptions
The demand of the item is deterministic i.e it is known exactly for a given
period.
The demand of the item occurs uniformly over a given period of time i.e
demand rate is constant.
The cost of placing an order is fixed & doesnt vary with the lot size.
Similarly, set-up costs are also constant i.e all orders placed in a single lot
The inventory carrying charges are directly proportional to the order quantity
Constant lead time i.e Orders are received instantaneously.
Instantaneous receipt of material
No quantity discounts
No stockouts
Total Cost = Holding Cost + Order
Cost
Annual cost (dollars)

Lot Size (Q)


Total Cost = Holding Cost + Order Cost
Annual cost (dollars)

Holding cost (Ch)

Lot Size (Q)


Total Cost = Holding Cost + Order Cost
Annual cost (dollars)

Holding cost (Ch)

Ordering cost (Co)

Lot Size (Q)


Total Cost = Holding Cost + Order Cost

Total cost = Ch + Co
Annual cost (dollars)

Holding cost (Ch)

Ordering cost (Co)

Lot Size (Q)


Annual Total Cost = Annual Holding Cost + Annual
Ordering Cost
In the fig. total
cost is minimum
at the pt. A &
Total cost = Ch + Co hence A
represents the
Annual cost (dollars)

EOQ

Holding cost (Ch)


A
Ordering cost (Co)

Q
*Lot Size (Q)
Economic Order
On-hand inventory (units)
Quantity

Time
Economic Order
On-hand inventory (units)
Quantity

Time
Economic Order
Quantity
Receive
order
On-hand inventory (units)

Time
Economic Order
Quantity
Receive
order
On-hand inventory (units)

1 cycle
Time
Economic Order
Quantity
Receive
order
On-hand inventory (units)

1 cycle
Time
Economic Order
Quantity
Receive Inventory depletion
order (demand rate)
On-hand inventory (units)

1 cycle
Time
Economic Order
Quantity
Receive Inventory depletion
order (demand rate)
On-hand inventory (units)

1 cycle
Time
Economic Order
Quantity
Receive Inventory depletion
order (demand rate)
On-hand inventory (units)

Q Average
cycle
2
inventory

1 cycle
Time
1. EOQ Model with instantaneous stock replenishment
Receive Inventory
Let D = Annual Demand of
order depletion
parts (in units)
Q (demand rate)
Q = Quantity ordered each
On-hand inventory

time
Q* = Optimum quantity of
Q Average inventory ordered for
cycle minimum total cost
2
inventory Co = Ordering or
(units)

procurement or set-up cost


per order
Cc = Carrying cost per unit of
1 CycleTime individual item expressed as
Total
a% cost = Chcost
of unit + Co
Annual cost
Tc = Total annual cost (dollars)
I = Cost of inventory per unit
item
N = No. of orders placed per Holding cost (Ch)
annum
Cs = Cost of shortages due to Ordering cost (Co)
non-availability of inventory Q
R = Reorder point
*
Lot Size (Q)
2. EOQ Model when stock replenishment is non-
instantaneous (Production Model)
On-hand inventory

Time
2. EOQ Model when stock replenishment is non-
instantaneous (Production Model)

Production quantity
Q
On-hand inventory

Time
2. EOQ Model when stock replenishment is non-
instantaneous (Production Model)

Production quantity
Q
On-hand inventory

Demand during
production interval

pd

Time
2. EOQ Model when stock replenishment is non-
instantaneous (Production Model)

Production quantity
Q
On-hand inventory

Demand during
production interval

pd

Time
2. EOQ Model when stock replenishment is non-
instantaneous (Production Model)

Production quantity
Q
On-hand inventory

Demand during
production interval

pd

Time
Production Demand
and demand only
TBO
2. EOQ Model when stock replenishment is non-
instantaneous (Production order quantity POQ
Model)

Production quantity
Q
On-hand inventory

Demand during
production interval

pd

Time
Production Demand
and demand only
TBO
Production Order Quantity (POQ Model)

Production quantity or Inventory ordered


Q
On-hand inventory

Demand during
production interval
n
ctio

Maximum inventory
Ra Produ

d
ra = C
te o Average inventory
n su
te
P=

m
pt
io
pd n

Time
Procurement Depletion
time tp time tc
TBO
Time between orders
Let p = Production rate in unit per day
d = Demand or consumption rate in
unit per day
D = Annual demand rate(in units)
tp = Procurement time
tc = Depletion time
Assumptions
Known and constant demand i.e the item
is sold or consumed at a constant demand
rate
Known and constant lead time
Increase in inventory is not instantaneous
but it is gradual
No quantity discounts
Order (setup) cost is fixed & it doesnt
change with lot size
No stockouts
Model-III
Inventory control for deterministic
demand lead time zero,
reordering allowed and shortages allowed
When to order?
Reorder point (ROP)
Lead time amount of time from order
placement to receipt of goods
Lead time demand the demand the
occurs during the lead time
Reorder point

Order
received
On-hand inventory

OH
Reorder point

Order
received
On-hand inventory

OH

TBO Time between orders


Reorder point

Order
received
On-hand inventory

OH

L
TBO
Lead time
Reorder point

Order
received
On-hand inventory

OH

R
Order
placed

L
TBO