Unit III
Learning Objectives
What are Inventories?
Material Inbound Production Outbound Finished goods Customers
sources transportation transportation warehousing
Receiving
Production
materials
Inventories
in-process
Shipping
Finished goods
Inventory
locations
4
The Material Flow Cycle
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Meaning & Nature of Inventory
link b/w manufacturing production distribution
6
Meaning & Nature of Inventory Contd..
“ total material stock(stock of goods)
capital investment materials /
components stocked for efficient, smooth & un-
interrupted sales operations at
specific time to maximize profitability.
for Production
in Production
Consumed
for Sale
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Keeping Inventory Free?
“we need inventory, but it is not desirable
to have inventory.”
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Why do we Hold Inventories? [Motives]
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Type of Inventory
Inventory of Raw Materials
Types of Inventory
Others:
Inventory of Work in Progress 1. Goods in Transit
2. Buffer Inventory
3. Anticipatory Stock
Inventory of Finished Goods 4. Decoupling Stock
5. Cycle/ Seasonal Inv.
Inventory of Consumables
(Maintenance, Repairs & Operations)
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Inventory Management
act of keeping track stocked goods
minimize the cost of holding
when time to replenish buy
more materials
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Importance of Inventory Management
in business losing money
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Objectives of Inventory Management
continuous supply uninterrupted
production
Maintain sufficient stock short supply
anticipate price
smooth sales operations
inventory costs
investment
13
Inventory Management/Control Techniques
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Inventory Cost Structures
cost of replenishing inventory
cost of holding an item in inventory
temporary / permanent loss of sales when
demand cannot be met
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Order Point (OP) = Lead time X Daily usage (Certain)
Order Point Safety stock
(Uncertain)
Service level
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Order quantity, Q
Demand rate
Inventory Level
(Consumption
rate)
Reorder point, R
0 Lead Lead Time
time time
Order Order Order Order
placed receipt placed receipt
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Employ a cost-benefit analysis
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How much inventory is enough?
Marketing department
Finance department
Production department
balance these cost so as to minimize the total cost.
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Economic Order Quantity (EOQ)
EOQ is the order size that minimizes the sum of ordering and holding costs related to
raw materials or merchandise inventories.
It is the quantity of a product that should be ordered so as to minimize the total cost that
includes ordering costs and inventory holding costs.
In other words, it is the optimal inventory size that should be ordered with the supplier
to minimize the total annual inventory cost of the business.
Also known as optimal order size and optimal order quantity.
The economic order quantity is computed by both manufacturing companies and
merchandising companies.
Manufacturing companies compute it to find the optimal order size of raw materials
inventory
Merchandising companies compute it to find the optimal order size of ready to use
merchandise inventory.
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Assumptions for Basic EOQ Model
1. Demand of the inventory is known & uniform thought-out the year.
2. Annual or total requirement is known and does not fluctuate.
3. Ordering cost per order is fixed and known.
4. Carrying Cost of the inventory is known.
5. No shortages are allowed
6. Lead time for the receipt of orders is constant
7. Order quantity is received all at once
8. Purchase price of the inventory is known .
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To know how much we should order in one time, we need to know our:
1. Annual Usage(Demand) Should always be in No. of Units (qty) per annum
2. Order Cost/Placement Cost Should always be per order
in Per unit, per annum
3. Storage Cost/Holding Cost
Example (EOQ 1):
Annual Usages =1600 Units
Order Cost/Placement Cost= 100 per order
Storage Cost/Holding Cost= Nu. 8 Per unit per annum
How Many units should we purchase/order in one time??
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EOQ Basic Cost Model (Understanding various costs)
Co - cost of placing order D - annual demand
Cc - annual per-unit carrying cost Q - order quantity
Annual ordering cost = Co D
Q
Annual carrying cost = CcQ
2
Co D Cc Q
Total cost = +
Q 2
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Solution: Eg. EOQ 1 (Using Trail & Error Approach)
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EOQ Basic Model (Using Formula Approach)
The EOQ or × ×
optimal =
quantity =
(Q*) is: = = 200 Units
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EOQ Basic Model (Using Graphic Approach)
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Example 2 EOQ:
2 (10,000) (200)
Q* = 1
Q* = 2,000 Units
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EOQ Lot Size Choice
There is a trade-off between lot size and inventory level.
higher ordering cost
lower holding cost
lower ordering higher
holding cost.
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EOQ Inventory Order Cycle
Demand
Order qty, Q Order qty, Q
rate
Inventory
Level
avg = Q/2
Reorder point, R
0 Lead Lead Time
time time
As Q increases, average inventory Order Order Order Order
level increases, but number of Placed Received Placed Received
orders placed decreases
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Answer to Inventory Management Questions -EOQ Model
Keeping Track of Inventory
Implied so that we track continuously
How much to order?
Solve for when the derivative of total cost with respect to Quantity (EOQ)
When to order?
Order when inventory falls to the “Reorder Point-level” R, so we will just
sell the last item as the new order comes in
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Stock Level
31
Reorder Level
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Re-order level
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Contd…
x
x +
x +
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Re-order Level/Point Example
**Don’t forget to convert to consistent time units!
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Reorder Quantity
quantity of order
placed for particular item
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Re-order Quantity Contd…
– +
x
37
Note
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Minimum Stock Level
'buffer stock safety stock
minimum stock
must be kept in hand at all times
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Variable Demand with a Reorder Point
Q
Inventory level
Reorder
point, R
0
LT LT
Time
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Reorder Point with a Safety Stock
Inventory level
Q
Reorder
point, R
Safety Stock
0
LT LT
Time
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The following points should be considered to determine the
minimum stock level:
1. Lead time:
2. Consumption rate:
3. Re-order level:
4. Disruption of supply
5. Nature of material:
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Maximum Stock Level
peak level 'maximum
limit' maximum stock
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Average Stock Level
Average Stock Level = Minimum Level + (1/2 Re-order Quantity)
OR
Average Stock Level = (Minimum Level + Maximum Level)/2
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Danger level
x
45
Quantity Discount
Many suppliers encourage their customers to place large orders by
offering them quantity discount.
With quantity discount, the firm will save on the per unit purchase
price.
Firm will have to increase its order size more than the EOQ level to avail
the quantity discount
46
Determination of Optimum Order Size with Quantity Discount
Total cost = Product cost+ Setup cost + Holding cost
TC =PD + D S + QH
Q 2
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Contd…
− ∗
∆ = + − − −
∗ ′
4. If the change in profit is positive, Q’ represents the optimal order quantity. If
the change in profit is negative, Q* represents the optimal order quantity.
OR…… Alternatively we can use the following formula 48
d× P× Where:
d =Percentage Discount;
P =Purchase Price Per Unit;
O − A =Annual Quantity Demand;
′
O = Ordering Cost;
c c =Carrying Cost;
= ′− EOQ = Q*=Economic Order Quantity;
Q’ = Quantity Discount Units.
Therefore, when putting the above three steps together, we get the
c
d× P× +O − − ′−
′
A typical quantity discount schedule 49
Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75
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Steps in analyzing a quantity discount
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Quantity Order Model
Total cost curve for discount 2
Total cost
curve for
discount 1
Total cost Nu.
Total cost curve for discount 3
b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b
1st price 2nd price
break break
0 1,000 2,000
Order quantity
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Inventory Valuation Methods
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1. Specific Identification Method
Under the specific identification method, the firm must identify each unit in
inventory, unless it is unique, with a serial number or identification tag.
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2. First-in-First-Out Method (FIFO)
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3. Weighted Average Cost Method,
Total Cost of Goods in Inventory
Weighted Average Cost Per Unit=
Total Units in Inventory
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4. Last-in-First-Out Method (LIFO)
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Inventory Control System
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References
