ECONOMIC ORDER QUANTITY

INVENTORY CONTROL
INVENTORY The term inventories may be divided into two classes, direct inventories and indirect inventories. Direct inventories include those items which play a direct role in manufacture and become integral part of finished goods.

Inventory
Inventory may be defined as quantity of goods, commodities or other economic resources that are stored or reserved at any given point of time for the purpose of smooth and efficient running of business affairs.

Components
I. Raw-materials II. Work in Progress inventories/ semi- finished goods III. Finished goods IV. Spare parts and Components V. Repairs, maintenance

Types
2 Types a) Direct Inventories: Items which play a direct role in the manufacturing and become an integral part of finished goods. Eg: Raw-materials, Work in- Progress inventories, Finished goods inventories b) Indirect Inventories: Items which are necessary for manufacturing but do not become a component of the finished product Eg: Lubricants, grease, oil, petrol etc.

 Depending on nature of materials, classified into four a) Production inventory b) MRO Inventory c) In-Process Inventory d) Finished goods inventory

a) Production inventory Includes raw materials, parts and components that are directly used in production process and go into making the final product. b)MRO Inventory Stands for maintenance, repair and operating supplies. These items are required in the process although they do not go into making the final product. Includes Consumables, Spare parts and packing materials

c) In-process Inventory Also called work in Process (WIP) inventory. It comprises of the semi-finished products formed at various stages of production process.

d) Finished goods Inventory Comprises all the final products made by the company ready for shipment and sale.

Inventory Catalogue
List of items in inventory Catalogue helps to identify the items in the and helps in standardization and variety reduction. Catalogue number is mandatory for computerization of the inventory records. By logging the catalogue number, history of the item can be known.

 This list should contain: - An identifiable code or number - Description of the item - Annual consumption of atleast the last three years - Names of suppliers who have supplied the item - Average life of the item - Stock of the item

Classification of Inventory
The various way in which inventory can be classified are: 1. ABC Analysis 2. XYZ Analysis 3. VED Analysis 4. FSN Analysis 5. PQR Classification 6. SDE Classification 7. GOLF Classification 8. SOS Classification 9. HML Classification

1) ABC Analysis
Also called Pareto analysis, developed by Italian economist Vilfredo Pareto. ABC-Always Better Control This is based on cost criteria. About 10 % of materials consume 70 % of resources About 20 % of materials consume 20 % of resources About 70 % of materials consume 10 % of resources

 A ITEMS

Small in number, but consume large amount of resources

Must have: Tight control Rigid estimate of requirements Strict & closer watch Low safety stocks Managed by top management

B ITEM Intermediate
Must have: Moderate control Purchase based on rigid requirements Reasonably strict watch & control Moderate safety stocks Managed by middle level management

 C ITEMS Larger in number, but consume lesser amount of resources Must have: Ordinary control measures Purchase based on usage estimates High safety stocks

2. VED ANALYSIS
Based on critical value & shortage cost of an item
It is a subjective analysis.
Items are classified into:

Vital:

Shortage cannot be tolerated.

Essential:

Shortage can be tolerated for a short period.

Desirable:
Shortage will not adversely affect, but may be using more resources.

3) SDE ANALYSIS
Based on availability
Scarce
Managed by top level management Maintain big safety stocks

Difficult
Maintain sufficient safety stocks

Easily available
Minimum safety stocks

4) FSN ANALYSIS
Based on utilization.
Fast moving. Slow moving. Non-moving.

5) HML ANALYSIS
Based on cost per unit Highest Medium Low This is used to keep control over consumption

6) XYZ Analysis
Classification based on stock value of items. I. X- Items having high stock value II. Y- Items having medium stock value III. Z- Items having least stock value

7) PQR Classification
Classification based on shelf life of items I. P- Items having low shelf life and requires frequent attention. II. R- Items having long shelf life and requires least attention. III. Q- Items which are not P or R

8) GOLF Classification
Based on nature of the source for an item. I. G-Government II. O-Open Market III. L-Local Market IV. F-Foreign sources of supply

 G-items - which are channeled through the state trading corporations, minerals and metals trading corporation - Requires special procedures for procurement and require more paper work and lead times are longer.

 O Items: - no.of suppliers - Quantity and availability is good L Items: - Low value procurement - Big org depend only for emergency supplies F Items - Source of supply is abroad. - Lead time is high

9) SOS Classification
Classification based on the nature of the time of availability for an item. More relevant for items which are derived from nature such as jute, cotton etc. I. S- Seasonal II. O- Off Seasonal

Objectives Of Inventory Control

1. To minimise the financial investment in inventories. 2. To ensure that the value of materials consumed is minimum. 3. To maintain timely records of inventories of all items and to maintain the stock within the desired limits. 4. To ensure timely action for replenishment. 5. To protect from pilferage, theft, waste, loss, damage etc. 6. To meet demand fluctuations. 7. To provide a safeguard for variations in delivery time of raw materials by maintaining safety stock. 8. To allow flexibility in production scheduling.

Causes for maintaining inventory

Inventory acts as a buffer stock when raw materials are received late. Inventory reduces production cost. It helps in meeting fluctuations in demand.

Terms Defined
1. Holding Cost (Inventory carrying cost) The cost associated with carrying or holding the goods in stock is known as holding cost. Holding cost varies directly with the size of inventory as well as the time when the item is held in stock.

2. Set up cost (Order cost or acquisition cost)

This includes the fixed cost associated with obtaining goods through placing of an order or purchasing or manufacturing or setting up a machinery before starting production.

3.ECONOMIC ORDER QUANTITY

Economic order quantity is that ordering quantity which minimizes the total inventory cost. It balances ordering cost against holding cost.

Inventory models
A) Deterministic model B) Probablistic models

DETERMINISTIC MODEL
In these models demands are known and are constant.the stock levels are deplinished with time.therefore new items are ordered for replinishing them. The quantity by which the items are ordered is known as EOQ. The inventory models used in these problems are known as economic lot size models.

 Various economic lot size models are: 1)infinite production rate with no shortages. 2)finite rate of production with no shortages. 3)infinite rate of production with shortages. 4)finite rate of production with shortages

Formulae
1. 2. 3. 4. 5. 6. Q- Ordering Quantity Q*- EOQ or optimal order quantity D- Annual demand C - Cost of one unit of item C0 ordering cost I-Inventory carrying charge as percentage of price per year

7. C h holding cost per item per year. = (C*I) 8. TIC Total inventory cost(annual) 9. TIC* - Optimal total inventory cost (annual) 10. C*D- Total annual purchase cost 11. (TIC) + (CD) Total annual cost 12. t=Q/D Time interval between two orders 13. N = D/Q No. of orders placed during the year. 14. Average Inventory- Q/2

15. Co total annual ordering cost 16. Ch - total annual holding cost 17. TIC =
Co

+ Ch

Exercise
1) Annual demand for an item is 600 units. Per unit price is Rs.15. Setup cost is Rs.50. Annual inventory carrying cost is estimated to be 10% of the cost of items in the inventory. Every time when an order is placed, the quantity ordered is 200. Find 1) Average inventory 2) No. of orders per year 3) Total annual set up cost 4) Total annual holding cost 5) Total annual inventory cost 6) Total annual cost

2) Find optimal economic quantity for an item A with no. of orders 1, 10, 20,40,80,100 using following data. Annual Demand: 160000units, Price per unit : Rs.20, Carrying cost: Rs 1 per unit, cost per order: Rs.50

Inventory Models
Inventory models may be classified into two categories a) Deterministic models b) Probabilistic models Deterministic model-Demand is fixed for subsequent periods Probabilistic model: Demand is a random variable , following a probability distribution

Deterministic Model (Economic lot size models)

The inventory models used in these problems are known as Economic lot size models. 1. Infinite production rate with no shortages 2. Finite rate of production with no shortages 3. Infinite production rate with shortages 4. Finite rate of production with shortages

Case 1: EOQ models with uniform demand and infinite production rate, shortages not allowed (Purchase models)

EOQ or Q* =

Total Inventory Cost* (TIC)* = 2 Total Annual cost = 2 + C x D N* =

t* =

1)The annual demand for an item is 3200 units. The unit cost is Rs.6/- and inventory carrying charges 25% per annum. If the cost at one procurement is Rs.150/- determine: 1. Economic order quantity 2. Number of orders per year 3. Time between two consecutive orders 4. Total inventory cost (TIC*) 5. The total optimal cost including purchase cost

2) You have to supply your customers 100 units of certain product every Monday an only then. Shortages are not allowed. You obtain the product from a local supplier at Rs.60 per unit. The costs of ordering and transportation from the supplier are Rs.150 per order. The cost of carrying inventory is estimated at 15 % per year of the cost of the product carried. i. Find the lot size which will minimize the cost of the system ii. Determine the optimal cost including cost of material

When quantity discount is allowed

Let C-Price of an item, D-Annual Demand, Q- order quantity when cash discount is allowed C-price of item when discount is allowed When ordering quantity is Q,

Total cost =

Co +

Ch 2

+ C x D

When EOQ is followed, Total cost = TC (Q*) = 2 + C x D Accept discount if TC (Q) <TC (Q*) , otherwise order Q*

Terms
1) Lead Time: The time between the placement of an order and its actual arrival in the inventory. 2) Re-order level: Point fixed in between maximum and minimum stock levels at which time it is essential to initiate purchase requisition for fresh supplies of the material. ROL = Buffer Stock + Normal lead time consumption BS +( Monthly Consumption * lead time)

3) Buffer Stock (Safety Stock) Additional stock needed to allow for delay in delivery or for any higher than expected demand that may arise during the lead time. Buffer Stock (BS) = (Maximum lead time-Normal lead time ) x r Where r=consumption rate during lead time/ avg demand

 Maximum inventory = BS + Q* Minimum inventory = BS Average Inventory = BS + I/2 Q*

2.EOQ models with no shortages, Uniform demand and finite production rate and Production> demand rate (Production Models) Q* =
2 2

TIC* =

P- Production rate, D- Demand rate (or usage rate)

3. EOQ models with shortages, demand rate is uniform and production rate is infinite (Purchase Models)
EOQ =

TIC* =

2 + 2 +

units

where Cs- Shortage Cost

Optimal remaining units after the back order is satisfied, S* = Q* x

+

No. of shortages = Q* -S*

4. EOQ Models with shortages, finite production rate

and uniform demand (Production models) (Production rate > demand rate)
EOQ =
2 +
+

TIC* = 2

units

B) Probabilistic Models
Also called Stochastic models, news paper boy problems or Christmas tree problem. Let C1 Over Supplying cost (Inventory Carrying Cost), C2-Under Supplying Cost (Shortage costs) P (D)- Probability for demand r P (D) = Sum of Probabilities upto the demand r. Find the range of P (D) within which lies. Then D corresponding to this range is the answer.
2 1+2