INVENTORY

MANAGEMENT
 Inventory Defined
 An inventory is a stock of an item or idle resource held for future use.
Inventories represent investments designed to assist in production activities
and/or serve customers.
 Inventory is simply a stock of physical assets having some economic value,
which can be either in the form of material, money or labour.
 Inventory consists of physical items moving through the production system.
The cost of storing inventory accounts for a substantial portion of
manufacturing cost, often 20% or more.
 Different departments within the organization adopt different attitudes
towards inventory.
 Why inventory is needed?
 Inventory will always exist.
 Inventory, like money, is a necessary evil.
 Inventory is a part and parcel of every facet of business life.
 Whether it’s a service organization, or production setup or even trading centre
inventories are necessary evil without which they can’t do without.

Objectives of Inventory
 To maintain the overall investments in inventory at the lowest level, consistent
with operating requirements.
 To supply the product, raw material, sub-assemblies, semi-finished good, etc. to
its users as per their requirements at the right time and at the right price.
 To keep inactive, waste, surplus, scrap and obsolete items at the minimum level.
 To minimize holding, replacement and shortage cost of inventories
Classification of Inventory
Manufacturing inventories

 Production Inventory: Items that go into final product also ensure availability of production such as
raw materials, components, sub-assemblies purchased from outside.
 Work in Process: All items in semi finished form or products at different stages of production.
 Finished Product: Final/Completed product ready for dispatch/shipment to users/distributors.
 MRO: Maintenance, Repairs and Operating supplies like spares, consumables which though needed
for final product don’t actually into it – oil, grease, cotton wastes, tools, etc.
Inventory decisions
 How much to order? Quantity.
 When to order? Time.
 How much safety stock should be kept? Level of Safety Stock.

Inventory Cost:

 Purchase Price / Production Cost:

Procurement cost / Ordering cost / Setup costs:
Carrying Cost / Holding Costs / Storage Cost:
Shortage cost /Stockout cost/Backorder cost
 Backorder Sales: In case of a backorder the sales are not lost,
they are only delayed. When the new shipment arrives, a
customer who was denied earlier would be immediately
supplied the goods. But it would involve costs like those of
expediting and, maybe, also packaging and shipment costs.

 Lost Sales: On the other hand, when the sales are lost
forever, it is difficult to assess the costs involved in terms of
the profit on potential sales lost, profit on whatever the
customer would have bought in all future periods in case he
decides not to turn to the organization for anything in
future, and so on and so forth. Such costs are exorbitantly
high.
 2. Demand
 Demand is a key component affecting an inventory policy.
 Projected demand patterns determine how an inventory problem is modeled.
 The demand for the period of time may be satisfied instantaneously at the
beginning of the period or uniformly during that period.
 Constant over time (Deterministic Inventory Models)
 Variable (randomly) over time (Probabilistic Inventory Models)
 3. Ordering Cycle: It is identified by the time period between two successive
placement of orders and is concerned with the time measurement of the
inventory situation.
 Continuous review – Q System and Periodic review – P System:
 4. Delivery Lag or Lead Time: The time between placement of the requisition
of an item and its receipt for actual use is called lead time. This again can be
deterministic or probabilistic.
 5. Time Horizon: This is the planning period over which inventory is to be
controlled. This may be finite or infinite. Usually it is done on yearly basis.
Inventory Mgt. Systems
 ABC
 FSN
 VED
 SDE
 HML
 XYZ
 ABC Classification
 Class A
5 – 15 % of units
 70 – 80 % of value

 Class B
 30 % of units
 15 % of value

 Class C
 50 – 60 % of units
 5 – 10 % of value
ABC Classification
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
 ABC Classification:
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 40 11.0
2 14,000 16.4 4.0
A 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 B60 30.0
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 % OF TOTAL
18.0 % OF TOTAL
180 58.0
CLASS ITEMS VALUE QUANTITY
5 3,000
7 3.510 13.0 170 71.0
10 2,400
A 9, 8,2.8
2 12.0
71.0 C 83.0
8 320 50 15.0
7 1,700
B 1, 4,2.0
3 17.0
16.5 100.0
25.0
9
C 5107
6, 5, 10, 12.5 60 60.0
$85,400
10 20 120
Example 10.1
Economic Order Quantity Model - Assumptions
 Demand for the product is uniform, continuous, constant and deterministic
 The item is replenished in lots or batches, and the quantity need not be an
integral number of units, and there are no restrictions on its size.
 The unit variable cost does not change appreciably with time;
 The unit variable cost does depend on the replenishment quantity; and there are
not bulk discounts on unit cost or transportation cost.
 The item is treated entirely independently of other items; i.e. benefits from the
joint review or replenishment do not exist or are simply ignored.
 The lead time is zero and the entire ordered quantity is delivered as soon as the
order is placed.
 Delivery is instantaneous, so that all the order arrive at the same time and can be
used immediately.
 No shortages are allowed. (Shortage cost is prohibitive or very large or infinite)
 The planning horizon is very long and we assume that all parameters will
continue at the same value for a long time.
Economic Order Quantity Model

Order quantity, Q
Demand
rate
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt
BASIC EOQ MODEL
 In determining the appropriate order quantity, we use the criterion of minimization of
total relevant costs; relevant in the sense that they are truly affected by the choice of the
order quantity.
D or d - Demand (or demand rate) of the item. units/unit time.
Q - Order size / replenishment quantity in units
Cu - Purchase price / Production cost - unit variable cost of the item. Rs./unit
Co - Ordering costs / cost of replenishment / setup cost of manufactured items.
The fixed cost component independent of the magnitude of the replenishment
quantity. Rs / order
Ch - Cost of holding the stock. The cost of having one rupee item tied up in the
inventory for a unit time interval usually one year. Rs/unit/unit time. Also
expressed as %charge of purchase price of the item.
t - Cycle time is the time between two consecutive replenishments. This depends on
the order size, with large orders leading to a longer cycle times.
LT - Lead time (delivery lag)
TC (Q) - Total relevant costs Rs. per unit time influenced by the order quantity.
For this model the various levels of stock are as follows:

 Minimum level = safety stock (buffer) = zero

 Maximum level = min level + order quantity = zero + EOQ = Q
 Reorder level = min level + consumption during lead time = zero + LT * D
 Average inventory per cycle = (max level + min level) / 2 = (Q + 0 )/ 2

TC = PC + OC + HC + SC = purchase + ordering + holding + shortage

 PC = price/unit * quantity purchased = Cu * D

 OC = cost of ordering per order * number of orders = Co * D/Q
 HC = cost of carrying one unit * average number of units in stock = Ch * Q/2
 SC = zero (no shortage allowed)

TC = Cu * D + Co * D/Q + Ch * Q/2

 The EOQ is the quantity which minimizes the total costs. Total cost is the sum of fixed cost and
variable cost. Fixed cost component C*D is independent of order size, while the variable
component is dependent on the order size.
Cycle Time:
The cycle time, t, represents the time that elapses between the placement of orders.
t=Q/D
Note, if the cycle time is greater than the shelf life, items will go bad, and the model
must be modified.

Number of Orders per Year:

To find the number of orders per years take the reciprocal of the cycle time.
n=D/Q=1/t
Example: The demand for a product is 1000 units per year.
The order size is 250 units under an EOQ policy.
How many orders are placed per year? N = 1000/250 = 4 orders.
How often orders need to be placed (What is the cycle time)?
t = 250 / 1000 = ¼ years. t = ¼ years * 365 days = 91 days
{Note: The four orders are equally spaced}.
Cost Equation for the EOQ Model

Total Annual = Total Annual + Total Annual + Total Annual

Inventory Costs Holding Costs Ordering Costs Procurement Costs

TC(Q) = (Q/2)*Ch + (D/Q)*Co + D*Cu

The Optimal Order Size

2D C o
Q* =
Ch
 TVC(Q) and EOQ*

*
TVC(Q)

* * o
* *

Q
Q*
Optimal Order Size
1. A manufacturer uses Rs. 10000 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, no. of orders per year, time
period per order and total cost.

2. An item is required at a rate of 18000 units per year. Storage cost is Rs. 0.10
per unit per month. If the cost of placing an order is Rs. 400, find EOQ, no. orders
per year, cycle period, total annual cost if the unit price is Rs. 2.00

3. Easton Electronics produces 2000 TV sets in a year for which it needs an equal
number of tubes of certain type. Each tube costs Rs. 10 and the cost to hold a
tube in stock for a year is Rs. 2.40. Besides, the cost of placing an order is Rs.
150, which is not related to the size. No of working days in the year 250 days.
Lead-time is 15 days.
Now if an order of 2000 tubes is placed, only one order per annum is required.
When 1000 units are ordered there are two orders per annum, etc. Naturally, as
the no. of orders increases the ordering costs goes up. More orders however
would also imply smaller order quantity and, therefore, decreasing holding costs.
Show the trade-off between the ordering and the holding cost, by considering
various quantity levels, and find EOQ, ROL, TVC, inventory cycle, no. of orders,
and rupee value of EOQ.
4. An item is used at a uniform rate of 50000 units per year. No shortages
are allowed and delivery is at infinite rate. The ordering, receiving and
hauling cost is Rs. 13 per order, while inspection cost is Rs. 12 per order.
Interest cost Rs. 0.056 and deterioration cost and obsolescence cost Rs.
0.004 resp. per year for each item actually held in inventory plus Rs. 0.02
per unit based on the maximum no. of units in inventory. Calculate the
EOQ and if lead time is 20 days, find the reorder level.

5. A Mng. Company has determined form an analysis of its accounting and

production data for a certain part that its demand is 9000 units per annum
and is uniformly distributed over the year, its cost price is Rs. 2 per unit,
its ordering cost is Rs. 40 per order, the inventory carrying charge is 9% of
its inventory value. Further, it is also known that the lead-time is uniform
and is 8 working days, and that the working days in a year are 300. Find all
the parameters. (EOQ, No., TVC, ROL, T) a. when Q=3000 b. Q is 20%
more and also c. 40% less, find TVC.
Sensitivity Analysis in EOQ Models
As shown in cost curves the total cost curve is quite flat near the point of
minimum cost ie Q* and TC*. This indicates small variations in optimal order
size will have little impact on total system cost. With this sensitivity analysis, we
try and prove that costs are insensitive to errors in selecting the exact size of a
replenishment quantity.

Q*
 Sensitivity Analysis in EOQ Models
The insensitivity of total costs to the exact values of Q has two major
implications:
Use of an inaccurate value of Q can result from inaccurate estimates of one or
more parameters like holding costs, ordering costs, or even demand levels.
The conclusion is that its not worth making accurate/exact estimates of these
input parameters if considerable efforts and/or resources (capital) are involved.
In most cases, inexpensive crude estimates would suffice.
Certain order quantities may have additional appeal over the EOQ , because of
certain non-financial, physical, logistical reasons like pallet size, truck size,
container shape, etc.
The shallow nature of total cost curve indicates that such values can be used
provided they are reasonably close to Q*.
This seemingly trivial result is one of the cornerstone of operational inventory
control.
Lead Time and the Reorder Point:
In reality lead time always exists, and must be accounted for when deciding when to
place an order.
The reorder point, R, is the inventory position when an order is placed.
R=L*D
L and D must be expressed in the same time unit.

Safety Stock:
Safety stocks act as buffers to handle:
 Higher than average lead time demand.
 Longer than expected lead time.
With the inclusion of safety stock (SS), R is calculated by
R = L * D + SS
The size of the safety stock is based on having a desired service level.

Service Level:
 Lead Time and the Reorder Point:
Graphical demonstration: Short Lead Time

Reorder
Point

Place the order now L

R = Inventory at hand at the beginning of Lead Time

Quantity Discount Model / Price Break Model:

A number of assumptions have been made to arrive at Basic EOQ

Model. One of the most unreal and impractical was that the unit
variable cost of the item did not depend on the size of the order.
In many practical situations, quantity discounts do exists, and taking
advantage of this results in substantial savings.
When discount is applicable to all units, it is known as All-units
Discount.
However, if discounts are offered only for the items which are in excess
of the specified quantity, it is known as Incremental Discount.
Lets discuss All-units Discount…
Finite Replenishment Rate/ Economic Production
Run/ Economic Manufacturing Quantity/ Economic
Run Quantity:
One of other assumption inherent in the derivation of basic EOQ Model
was that the whole replenishment quantity arrives at the same time. As
soon as the order is made, the replenishment is received i.e. the lead time
was supposed to be zero.
If instead, we assume that the items become available at a rate of P units
per unit of time (or we can also take this to be a manufacturing set up
where the items, instead of being purchased from outside are produced
inside, then this P is the rate of production per unit of time).
The other considerations in this case is that the rate of production or the
supply rate of the items is always greater than that of
demand/consumption rate.
 Basic EOQ Model with Planned Shortages
(Back-orders):
One of the earlier assumptions which had been considered during the
development of the basic EOQ Model was there were no stockouts i.e.
shortages were not allowed. Only in case of very ideal scenario, this
assumption works out well. In real life situations, there are so many
variations in the affecting parameters that shortages do come into
picture.
There are two type of reactions towards the shortages from the potential
customer:
1. Either he/she withdraws the order and shifts to another source for
requirement - which is the case of lost sales
2. Or he/she waits until the next shipment arrives, this is the case of
backordering.
Basic EOQ Model with Planned Shortages
(Back-orders):
With the assumption of back-ordering, shortages may in fact be
deliberately planned to occur.
The planned shortages can sometimes be a sound decision based on
certain economic considerations, specially when the value of the item in
question is very high with consequent high cost of holding it in the
inventory.
Generally, it’s a trade off between the cost of shortages as against the cost
of holding the item.
T1 - the time when inventory is on hand and orders filled as and when
they occur
T2 - when there is a stockout and all the orders are placed on back-orders.
Q SYSTEM/ FIXED QTY - VARIABLE INTERVAL
This also known as perpetual inventory system, reorder inventory system or
Q system. In this system, the count of the number of units in inventory
is continuously maintained.
With lead time less than the reorder cycle, an order for a fixed quantity Q
(mostly EOQ) is placed when the inventory level drops to a
predetermined reorder level R.

P SYSTEM / FIXED PERIOD SYSTEM

The system involves the reviewing of stock levels at a fixed interval of time
known as review period and placing replenishment orders at the end of
each period.
The replenishment quantity is variable and corresponds to the amount of
stock required to bring the stock ordered and the stock on hand up to a
target inventory level.