Inventory Management
Inventory
• Inventory is list of tangible goods or items.
• Inventory refers to the goods and materials that a
business holds for ultimate purpose of resale.
• Inventory is most important assets of a business
– Turnover of inventory is one of the primary sources of
revenue generation
– Which results earnings for the company and their
major business partners.
• The essential role of inventory is to act as a
buffer, allowing for the smooth functioning of the
production and order fulfilment processes.
Types of Inventory
• Raw material inventory
• Components and Parts
• Work-in-process (WIP) inventory
• Finished goods
• Transit Inventory
• Buffer Inventory
Types of Inventory
• Raw material inventory: Raw materials are inventory
items that are used to produce finished products after
conversion process. Example: wood
For example, gold is a raw material that is
transformed into jewellery
• Components and Parts: Components and parts is
inventory which is helpful to produce finished
products.
For example, a transformer is a component in an
electronic product.
screws, nails are components for producing furniture
• Work-in-process (WIP) inventory: WIP inventory
is components or raw material that have
undergone some change but are not completed.
In case of furniture business, work-in-process
inventory would include any unfinished chairs on
hand that your business has made.
• Finished-goods inventory: Finished goods
inventory includes any finished goods that are
ready to sell. For Example: Chair, Bed, bicycles,
bike.
• Transit Inventory: Transit inventories result from the
need to transport items or material from one location
to another.
For example finished furniture shipped by truck
or rail can sometimes take days or even weeks to go
from a regional warehouse to a retail facility
• Buffer Inventory: inventory is sometimes used to
protect against the uncertainties of supply and
demand.
Buffer inventory is any amount inventory held on
hand to meet unexpected demand.
Transit
Inventory
Buffer
Inventory
Inventory Management
• Inventory Management is the management of
inventory in stock.
i.e.
• To determine the amount of inventory to keep in
stock, how much to order and when to order
• Basically it deals with
ØHow much to order
ØWhen to order
Reasons companies maintain inventories
• To meet an unexpected increase in demand.
• Taking advantage of quantity discounts for
ordering raw materials/ finished product in bulk
• To minimize idle time due to component and
material shortages
• Using buffer stock to assure smooth production
flow
Categorization of Inventory
• Based on the demand pattern inventory is
categorized in two parts
– Dependent demand
– Independent demand
• Dependent demand: Dependent demand are the
components, parts or raw materials used in the
process of producing final product.
• Independent demand: Independent demand items
are final or finished products that are not a
function of internal production activity.
Classification of Inventory
• ABC Analysis
• VED Analysis
• FSN Analysis
• XYZ Analysis
• SDE Analysis
ABC Analysis
• ABC analysis is an inventory categorization
technique based on annual consumption value.
• It is divide items into three categories
– A-items
– B-items
– C-items
A-items
• Category A represents the most valuable products that
you have.
• A-items are goods which annual value is 70%.
• A-items consists of 20% of total inventory.
Ø Example: A software company producing different
pieces of software, but one software can be sold at a
significantly higher price than the others.
Ø That’s why it accounts for about 70% of the overall
revenue, although the company sells far less of these
products compared to other software categories.
Ø Hence, this specific software is a category A product.
B-items
• It is moderate valuable product.
• B-items are goods which annual consumption
value is 25%.
• B-items consists of 30% of total inventory
C-items
• It is least valuable items.
• C-items are goods which annual consumptions is
5%.
• C items consists of 50% of total inventory.
A-items B-items C-items
High annual Moderate annual Low annual
consumption value consumption value consumption value
(70%) (25%) (5%)
Consists of 20% of Consists of 30% of Consists of 50% of
total inventory total inventory total inventory
Most valuable Moderate valuable Least valuable
items items items
Engine of Car Tyre of Car Nut and bolt
Example: 1
• The maintenance department for a small
manufacturing firm has responsibility for
maintaining an inventory of spare parts for the
machinery it services. The parts inventory, unit
cost, and annual usage are in Table:
The department manager wants to classify the
inventory parts according to the ABC system to
determine which stocks of parts should most
closely be monitored.
Example: 2
• AAU is considering doing an ABC analysis of its
entire inventory but has decided to test the
technique on a small sample of 15 of its stock
keeping units. The annual usage and unit cost for
these items are shown in the table.
(a) Calculate the annual dollar volume for each item.
(b) List the items in descending order based on annual
dollar usage.
(c) Calculate the cumulative annual dollar volume.
(d) Group the items into classes.
VED Analysis
• VED analysis are the another method for
inventory categorization.
– Vital Inventory
– Essential Inventory
– Desirable Inventory
• This categorization technique is based on
criticality of inventory
• Criticality means without these inventory your
business will operate or not.
• Vital inventory: Inventory that consistently need
to be kept in stock.
• Essential inventory: Keeping minimum stock of
this inventory is enough.
• Desirable inventory: Operations can run with or
without this i.e. it is optional.
• In hospital inventory management, VED analysis has
been commonly used.
• VED analysis is based on the criticality of medicine
for patient.
• “V” is for vital items without which a hospital can
not function.
• These items critically needed for the survival of the
patients and must be available at all times.
• “E” for essential items without which a hospital can
function but may affect the quality of the services.
• “D” for desirable items, unavailability of which will
not affect the hospital service.
Inventory Costs
• Inventory costs is the cost associated with
purchasing and holding the inventory.
• Three basic costs are associated with inventory
– Carrying (holding) cost
– Ordering cost
– Shortage cost
Carrying (holding) cost
• Holding costs are the various costs associated
with holding or carrying inventory over time.
– Insurance
– Security
– Rent
– Depreciation
• Godrej Interio produces furniture that is stored in
a warehouse and then shipped to retailers.
– Require warehouse space
– Insurance and
– Security for the location
– Staff to move inventory into the warehouse
– Material handling equipment
– Load the sold product onto trucks for shipping
– spoilage, breakage of product
Ordering cost
• Ordering cost includes costs associated with
placing a order with a supplier for a purchasing
component or raw material
• When you buy an item, the ordering costs include
the cost of the clerical activities for placing order
i.e. prepare, release, monitor, and receive orders,
postage, phone calls, internet charges and so on
Shortage cost
• It is also referred to stock-out costs.
• It occur when customer demand cannot be met
because of insufficient inventory.
• Shortage costs include the loss of profits.
• Shortage of inventory may results
– Customer dissatisfaction and
– Loss of goodwill
that can result in a permanent loss
of customers and future sales
Inventory model
• Inventory model is a mathematical model that
helps to determine the optimum level of
inventories that should maintained for production
of goods.
ØBasic Economic Order Quantity (EOQ) Model
ØProduction Order Quantity Model
ØQuantity Discount Model
Economic Order Quantity (EOQ) Model
This Model is based on several assumptions, which
are as follows:
– Demand for an item is known and constant.
– Lead time (the time between placement and receipt of
the order) is known and constant.
– Quantity discounts are not considered.
– Stock-outs are not allowed.
– The quantity ordered arrives at once.
– Ordering cost and holding cost are variable cost.
– Inventory level is zero when new order is just received.
Derivation for EOQ
Variables for EOQ
D = Annual demand in units for the inventory item
S = Set-up cost (ordering cost) / order
H = Holding cost / unit product / year
Q = Order quantity i.e. number of units per order
Annual Set-up cost:
Annual holding cost:
Total annual Inventory cost:
Economic Order Quantity:
Example:1
• Sharp, Inc., a company, has a 250-day working in a
year, markets painless hypodermic needles to
hospitals, would like to reduce its inventory cost by
determining the optimal number of hypodermic
needles to obtain per order. The annual demand is
1,000 units; the setup or ordering cost is $10 per
order; and the holding cost per unit per year is $.50.
Identify
i. Determining the optimal number of hypodermic
needles to obtain per order.
ii. Find the number of orders.
iii. Expected time between orders.
iv. Determine the total inventory cost.
Example:2
• The e-Paint Store, stocks paint in its warehouse
and sells it online on its Internet Web site. The
store stocks several brands of paint; however, its
biggest seller is Sharman-Wilson Iron-coat paint.
The company wants to determine the optimal
order size and total inventory cost for Iron-coat
paint given an estimated annual demand of 10,000
gallons of paint, an annual carrying cost of $0.75
per gallon, and an ordering cost of $150 per order.
They would also like to know the number of orders
that will be made annually and the time between
orders (i.e., the order cycle).
Re-order point
• We have decided how much to order,
• Now we will look at the second inventory
question, when to order.
• Re-order point is the inventory level (point) at
which action is taken to replenish the stocked
item.
• Consider
L = Lead time of delivery
d = Usage rate i.e. demand / day
n = Number of working day / year
Where
Example:3
• An Apple store has a demand for 8,000 i-Phones
per year. The firm operates a 250-day working
year. On average, delivery of an order takes 3
working days. The store wants to calculate the
reorder point without a safety stock and then with
a one-day safety stock.
Example:4
• A Tyre Company uses 3000 air-cap a week.
Delivery of an order takes 4 working days. The
company has decided to have two days of safety
stock. Identify the reorder point.
Production Order Quantity Model
• Economic order quantity (EOQ) is an equation
for inventory that determines the ideal order
quantity.
• A company should purchase its inventory (raw
materials) from supplier for production of
goods for a given demand rate and other
variables with minimum ordering cost and
holding cost.
• Therefore every times order has to be placed
and inventory has to stored.
• Production order quantity (POQ) is a model in
which we producing an items and
simultaneously supplying to the retailers.
• It used when units are produced and sold the
same time.
• It suited for only production environment.
• It is also called production and consumption
model.
Derivation for EPQ
Variables for EOQ
D = Annual demand in units
S = Set-up cost (ordering cost) / order
H = Holding cost / unit product / year
Q = Order quantity i.e. number of units per order
p = rate of production
d = rate of depletion (usage rate)
t = time of production run in day
Annual Set-up cost:
Annual holding cost:
Total annual Inventory cost:
Economic Batch Size:
Example:5
• Nathan Manufacturing, Inc., makes and sells specialty
hubcaps for the retail automobile aftermarket.
Nathan’s forecast for its wire-wheel hubcap is 1,000
units next year. The setup cost is $10, and the annual
holding cost is $0.50 per unit. However, the
production process is most efficient at 8 units per day.
The company wants to solve for the optimum number
of units per order. (Note: This plant schedules
production of this hubcap only as needed, during the
250 days per year the shop operates.). If Nathan can
increase its daily production rate from 8 to 10, how
does batch quantity change?
Example:6
• Ashlee’s Beach Chairs Company produces upscale
beach chairs. Annual demand for the chairs is
estimated at 18,000 units. The frames are made in
batches before the final assembly process. Ashlee’s
final assembly department needs frames at a rate of
1500 per month. Ashlee’s frame department can
produce 2500 frames per month. The setup cost is
$800, and the annual holding cost is $18 per unit.
The company operates 20 days per month. Lead
time is 5 days. Determine the optimal order
quantity, maximum inventory level, the total
annual costs.
Example
• Discount Carpets manufactures Cascade carpet,
which it sells in its adjoining showroom store near
the interstate. Estimated annual demand is 20,000
yards of carpet with an annual carrying cost of
$2.75 per yard. The manufacturing facility
operates the same 360 days the store is open and
produces 400 yards of carpet per day. The
cost of setting up the manufacturing process for
a production run is $720. Determine the optimal
order size, total inventory cost, length of time to
receive an order, and maximum inventory level.
Quantity Discount Model
• Quantity discounts is a price discount for an item
when it is purchased in bulk.
• For example: A supplier charges your company
100 Rs. per product if your company’s order is
less than 500 products.
• If your order is for 500 to 999 products, the price
per product is Rs. 98.
• On orders of 1000 products or more, the supplier
charges Rs. 96 per product.
• 500 quantity and 1000 quantity are called price-
break-quantities, because they represent the first
order amount that would lead to a new price.
• Whenever the price per unit is not fixed but
varies based on the size of your order, the total
annual cost formula for any inventory policy used
must include the cost of material.
• Where
Q = Quantity ordered in units
D = Annual demand in units
S = Ordering cost per order
H = Holding cost per unit per year
P = Price per unit
Example: 7
• Avtek, a distributor of audio and video equipment, wants
to reduce a large stock of televisions. It has offered a local
chain of stores a quantity discount pricing schedule, as
follows:
• The annual carrying cost for the stores for a TV is
$190, the ordering cost is $2,500, and annual demand
for this particular model TV is estimated to be 200 units.
The chain wants to determine if it should take advantage
of this discount or order the basic EOQ order size.
Example: 8
• Ye Old Shoe Repair has customers requesting leather soles
throughout the year. The owner, Warren, buys these soles
from The Leather Company (TLC) at a price of $8 per
pair. In an effort to improve profitability by selling in
greater quantities, the sales representative for TLC has
made the following offer to Ye Old Shoe Repair: If Warren
orders from 1 to 50 pairs at a time, the cost per pair is
$8.00. If the order is between 51 and 100 pairs at a time,
the cost is $7.60. On orders for more than 100 pairs at a
time, the cost per pair is $7.40. The owner estimates
annual demand to be 625 pairs of soles. Holding costs are
20 percent of unit price. The cost to place an order is $10.
Determine the most cost-effective ordering policy for Ye
Old Shoe Repair.
Example
• VGHC operates its own laboratory on-site.
The lab maintains an inventory of test kits for
a variety of procedures. VGHC uses 780 A1C
kits each year. Ordering costs are $15 and
holding costs are $3 per kit per year. The new
price list indicates that orders of fewer than
73 kits will cost $60 per kit, 73 through 144
kits will cost $56 per kit, and orders of more
than 144 kits will cost $53 per kit. Determine
the optimal order quantity and the total cost.
Example
• A manufacturing firm has been offered a
particular component part it uses according to the
following discount pricing schedule provided by
the supplier.
• The manufacturing company uses 700 of the
components annually, the annual carrying cost is
$14 per unit, and the ordering cost is $275.
Determine the amount the firm should order.
Inventory Control System
• An inventory control system is a system that
encompasses all aspects of managing a company's
inventories like:
– Purchasing,
– Shipping,
– Tracking,
– Receiving,
– Warehousing and storage,
– Turnover, and
– Re-ordering.
• The popular Inventory Control Systems that are
– Fixed Quantity System (Q-System)
– Periodic Review System (P-System)
– Just-in-Time (JIT) System
– Kanban System
Fixed Order Quantity System (Q-System)
• This is also called continuous review system.
• In this system a fixed quantity (Q) of the material is
ordered every time when inventory drops to a certain
level.
• That certain level is called the reorder point.
• The reorder point (ROP) depends on the lead time for
delivery and usage rate.
• The order quantity (Q) is fixed and depends on the
ordering cost and the holding cost.
• In this system the maximum and minimum inventory
levels are fixed.
Periodic Review System (P-System)
• In periodic review system, orders are placed after a
fixed interval of time.
• Inventory is reviewed at periodic intervals irrespective
of the levels to which inventory drops.
• The order quantity is different at each time.
• For example a vendor will visit the store in person and
check the inventory of the products and re-supply the
products based on the inventory in-hand.
• This kind of ordering is done in small format stores
like pharmaceuticals and grocery stores.
Just-in-time (JIT) System
• The objective of JUST IN TIME method is to reduce the
inventory holding cost.
• Just in time as name suggest, is a philosophy that aims to
produce goods to meet customer demand exactly.
• It work on demand-driven concept (pull system).
• In this philosophy items are produced to meet demand
not surplus.
• The purpose of JIT is to avoid the waste associated with
overproduction, excess inventory.
• Example: Toyota (JIT is first implemented by Toyota),
Dell, Restaurant.
Kanban system
• Kanban is inventory control system to control the
supply of inventory.
• It is Japanese word which means visual signal or
card.
• When raw materials or stocked items runs low
during the manufacturing process, an employee takes
item’s reorder card to manager, who order the needed
amount of materials.
• The new supplies arrived before stock has run out
and production continue without hindrance.
