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Chapter 16
Inventory Management
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16-2
INVENTORY MANAGEMENT
Objectives
Techniques
Solved Problems
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Inventory
Inventory refers to the stockpile of the products a firm
would sell in future in the normal course of business
operations and the components that make up the product.
The firm stores three types of inventories, namely, raw
materials, work-in-process/semi-finished goods and
finished good.
The management of inventory is different from the
management of other current assets in that virtually all the
functional areas are involved. The job of the finance
manager is to reconcile the conflicting viewpoints of the
various functional areas regarding the appropriate inventory
levels.
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Objectives
The objectives of inventory management consists of two
counterbalancing parts:
1) to minimise investments in inventory and
2) to meet the demand for products by efficiently
organising the production and sales operations.
In operational terms, the goal of inventory management is to
have a trade-off between these two conflicting objectives
which can be expressed in terms of costs and benefits
associated with different levels of inventory.
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Costs of Holding Inventory
The costs of holding inventory are ordering costs and
carrying costs.
Ordering cost is the fixed cost of placing and receiving an
inventory order.
Carrying costs are the variable costs per unit of holding an
item in inventory for a specified time period.
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The cost of holding inventory may be divided into two categories:
(1) Those that Arise Due to the Storing of Inventory The main components of this
category of carrying costs are
1. storage cost, that is, tax, depreciation, insurance, maintenance of the
building, utilities and janitorial services;
2. insurance of inventory against fire and theft;
3. deterioration in inventory because of pilferage, fire, technical obsolescence,
style obsolescence and price decline;
4. serving costs, such as, labour for handling inventory, clerical and
accounting costs.
(2) The Opportunity Cost of Funds This consists of expenses in raising funds
(interest on capital) to finance the acquisition of inventory
Benefits of Holding Inventory
The second element in the optimum inventory decision deals with the benefits
associated with holding inventory. The major benefits of holding inventory are the
basic functions of inventory. The basic function of inventories is to act as a
buffer to decouple or uncouple the various activities of a firm so that all do not
have to be pursued at exactly the same rate.
The key activities are (1) purchasing, (2) production, and (3) selling. The term
uncoupling means that these interrelated activities of a firm can be carried on
independently. The effect of uncoupling (maintaining inventory) are as follows.
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Benefits in Purchasing If the purchasing of raw materials and other goods is not
tied to production/sales, that is, a firm can purchase independently to ensure the
most efficient pur-chase, several advantages would become available. In the first
place, a firm can purchase larger quantities than is warranted by usage in
production or the sales level. This will enable it to avail of discounts that are
available on bulk purchases. Moreover, it will lower the ordering cost as fewer
acquisitions would be made.
Benefits in Production Finished goods inventory serves to uncouple production
and sale. This enables production at a rate different from that of sales. That is,
production can be carried on at a rate higher or lower than the sales rate. This
would be of special advantage to firms with seasonal sales pattern
Benefits in Work-in-Process The inventory of work-in-process performs two
functions. In the first place, it is necessary because production processes are not
instantaneous. The amount of such inventory depends upon technology and the
efficiency of production. In a multi-stage production process, the work-in-process
inventory serves a second purpose also. It uncouples the various stages of
production so that all of them do not have to be performed at the same rate. The
stages involving higher set-up costs may be most efficiently performed in
batches with a work-in-process inventory accumulated during a production run.5
Benefits in Sales The maintenance of inventory also helps a firm to enhance its
sales efforts. For one thing, if there are no inventories of finished goods, the level
of sales will depend upon the level of current production.
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Techniques
1) ABC Analysis
2) Economic Order Quantity
3) Reorder-Point
4) Safety Stock
16-9
ABC Analysis
The ABC system is a widely-used classification technique for the
purpose. On the basis of the cost involved, the various
items are classified into three categories:
1) A, consisting of items with the largest investment.
2) C, with relatively small investments, but fairly large number
of items.
3) B, which stands mid-way between category A and C.
Category A needs the most rigorous control, C requires minimum
attention, and B deserves less attention than A but
more than C.
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TABLE 1 Inventory Breakdown between Number of Items and Inventory Value
Group Number of items (per cent) Inventory value (per cent)
A 15 70
B 30 20
C 55 10
Total 100 100
Some points stand out from Table 1. While group A is the least important in
terms of the number of items, it is by far the most important in terms of the
investments involved. With only 15 per cent of the number, it accounts for as
much as 70 per cent of the total value of inventory. The firm should direct most
of its inventory control efforts to the items included in this group. The items
comprising B group account for 20 per cent of the investments in inventory.
They deserve less attention than A, but more than C, which involves only 10
per cent of the total value although number-wise its share is as high as 55 per
cent. The A B C analysis is illustrated in Example 1.
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Example 1 A firm has 7 different items in its inventory. The average number of
each of these items held, alongwith their units costs, is listed below. The firm
wishes to introduce an A B C inventory system. Suggest a breakdown of the
items into A, B, and C classifications.
Item number Average number of units in inventory Average cost per unit
1
2
3
4
5
6
7
20,000
10,000
32,000
28,000
60,000
30,000
20,000
Rs 60.80
102.40
11.00
10.28
3.40
3.00
1.3
Solution The A B C analysis is presented in Table 2.
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TABLE 2 ABC Analysis
Item Units Per cent of
total
Unit cost Total cost Per cent of
total
(1) (2) (3) (4) (5) (6)
1 20,000 10 Rs 60.80 Rs 12,16,000 38.00 70
2 10,000 5 15 102.40 10,24,000 32.00
3 32,000 16 11.00 3,52,000 11.00 20
4 28,000 14 30 10.28 2,88,000 9.00
5 60,000 30 3.40 2,04,000 6.38 10
6 30,000 15 55 3.00 90,000 2.80
7 20,000 10 1.30 26,000 0.82
Total 2,00,000 100 32,00,000 100.00
The A B C system of classification should, however, be used with caution. For
example, an item of inventory may be very inexpensive. Under the A B C system it
would be classified into C category. But it may be very critical to the production
process and may not be easily available. It deserves the special attention of
management. But in terms of the A B C framework, it would be included in the
category which requires the least attention. This is a limitation of the A B C
analysis.
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Economic Order Quantity (EOQ)
EOQ refers to the level of inventory at which the total cost of
inventory comprising
1) Order/Setup cost, and
2) Carrying cost is the minimum.
Carrying Costs are cost associated with the
maintenance/holding
of inventory.
Ordering Costs are costs associated with acquisition
of/placing
order for inventory.
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Solution
Table 3: Inventory Cost for Different Order Quantities
1. Size of order (units)
2. Number of orders
3. Cost per order
4. Total ordering cost (2 3)
5. Carrying cost per unit
6. Average inventory (units)
7. Total carrying cost (5 6)
8. Total cost (4 + 7)
1,600
1
Rs 50
50
1
800
800
850
800
2
Rs 50
100
1
400
400
500
400
4
Rs 50
200
1
200
200
400
200
8
Rs 50
400
1
100
100
500
100
16
Rs 50
800
1
50
50
850
Example 2
A firms inventory planning period is one year. Its inventory requirement for this period is 1,600
units. Assume that its acquisition costs are Rs 50 per order. The carrying costs are expected to be
Re 1 per unit per year for an item.
The firm can procure inventories in various lots as follows: (i) 1,600 units, (ii) 800 units, (iii) 400
units, (iv) 200 units, and (v) 100 units. Which of these order quantities is the economic order
quantity?
Working Notes
(i) Number of orders = Total inventory requirement/ Order size, (ii) Average inventory = Order size/2
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Example 3 The following details are available in respect of a firm:
1. Inventory requirement per year, 6,000 units
2. Cost per unit (other than carrying and ordering costs), Rs 5
3. Carrying costs per item for one year, Re 1
4. Cost of placing each order, Rs 60
5. Alternative order sizes: (units) 6,000, 3,000, 2,000, 1,200, 1,000, 600 and 200.
Determine the economic order quantity.
Solution The EOQ is determined in Table 4.
TABLE 4 Determination of Economic Order Quantity
1.

2.
3.
4.
5.
6.
7.

8.
Cost of items purchased
each year (Rs)
Order size (units)
Number of orders
Average inventory (units)
Total carrying costs (Rs)
Total ordering costs (Rs)
Total cost (carrying plus
ordering cost) (Rs)
Total cost (Rs)
30,000

6,000
1
3,000
3,000
60
3,060

33,060
30,000

3,000
2
1,500
1,500
120
1,620

31,620
30,000

2,000
3
1,000
1,000
180
1,180

31,180
30,000

1,200
5
600
600
300
900

30,900
30,000

1,000
6
500
500
360
860

30,860
30,000

600
10
300
300
600
900

30,900
30,000

200
30
100
100
1,800
1,900

31,900
Clearly, the EOQ is 1,000 units.
Working Notes
(i) Number of orders = Demand per year/order size
(ii) Average inventory = Order size/2
(iii) Total carrying cost = Average inventory Carrying cost per unit
(iv) Total ordering cost = Number of orders Cost per order
(v) Total cost = Cost of items purchased + Total carrying and ordering costs
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Mathematical (Short-cut) Approach
The economic order quantity can, using a short-cut method, be
calculated by the following equation:
EOQ = 2 AB/C
Where A = Annual usage of inventory in units,
B = Buying cost per order,
C = Carrying cost per unit per year.

Example 4 Using the facts in Example 2, find out the EOQ by
applying the short-cut mathematical approach.
EOQ =
2 1,600 50
= 400 units.
1

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Reorder Point
The re-order point is that level of inventory when a fresh order
should be placed with suppliers. It is that inventory level which is
equal to the consumption during the lead time or procurement time.
Re-order level = (Daily usage Lead time) + Safety stock.
Minimum level = Re-order level (Normal usage Average delivery
time).
Maximum level = Reorder level (Minimum usage Maximum delivery
time) + Re-order quantity.
Average stock level = Minimum level + (Re-order quantity)/2.
Danger level = (Average consumption per day Lead time in days for
emergency purchases).
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Safety Stock
The safety stock are the minimum additional inventory which serve
as a safety margin to meet an unanticipated increase in usage.
The first step is to estimate the probability of being out of stock,
as well as the size of stock-out.
Stock-out costs are costs associated with the shortage
(stock-out) of inventory.
After the determination of the size and probability of stock-out,
the next step is the calculation of the stock-out cost.
Then, the carrying cost should be calculated.
Finally, the carrying costs and the expected stock-out costs at each safety
level should be added.
The optimum safety stock would be that level of inventory at which the
total of these two costs is the lowest.
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Example 5 The experience of a firm being out of stock is summarised below:
(a) Stock-out (number of units) Number of times
500
400
250
100
50
0
Total
1(1)
2(2)
3(3)
4(4)
10(10)
80(80)
100(100)
Figures in brackets represents percentage of time the firm has been out of
stock.
(b) Assume that the stock-out costs are Rs 40 per unit.
(c) The carrying cost of inventory per unit is Rs 20.
Determine the optimum level of stock-out inventory.
Solution
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TABLE 5 Computation of Expected Stock-out Costs
Safety stock
level (units)
Stock-out
(units)
Stock-out
costs
(Rs 40 per
unit)
Probability
of stock-out
Expected
stock-out
cost at
this level
Total
expected
stock-out
cost
(1) (2) (3) (4) (5) (6)
500 0 0 0 0 0
400 100 Rs 4,000 0.01 Rs 40 Rs 40
250 250 10,000 0.01 100
150 6,000 0.02 120 220
100 400 16,000 0.01 160
300 12,000 0.02 240
150 6,000 0.03 180 580
50 450 18,000 0.01 180
350 14,000 0.02 280
200 8,000 0.03 240
50 2,000 0.04 80 780
0 500 20,000 0.01 200
400 16,000 0.02 320
250 10,000 0.03 300
100 4,000 0.04 160
50 2,000 0.10 200 1,180
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Working Notes
(i) The determination of the optimum safety stock involves dealing with
uncertain demand. The first step, therefore, is to estimate the probability of
being out of stock as well as the size of stock-out in terms of the shortage of
inventory at different levels of safety stock.
Size of stock-out (units) The shortage of inventory at different levels of safety
stock can be computed as follows:
a) The firms experience has been that it has been short of inventory by 500
units only once in 100 times. If, therefore, the level of safety stock is 500
units, it will never be short of inventory. It means that with 500 units of
safety stock, the size of stock-out would be zero.
b) When the firm has a safety stock of 400 units, it could be short by 100
units.
c) Further, with 250 units of safety stock, the firm could be short by 250
units if the actual demand turns out to be 500 units greater than
expected; 150 units short if the demand turn out to be 400 units greater
than expected. Thus, the size of stock-out could be 250 units or 150 units
depending upon the level of actual demand.
d) It should be obvious that the size of stock-out increases with a decrease
in the level of safety stock. The size of the stock-out for safety stock
levels of 100 units, 50 units and 0 units can be computed on the lines of
step (c).
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The stock-out size at different safety stock levels is computed in column (2) of Table 5.
Probability of Stock-out The probability of stock-out at different levels of safety stock
can be computed as follows:
a) If the safety stock of the firm is 500 units, there is no chance of the firm being out
of stock. The probability of stock-out is, therefore, zero.
b) When the safety stock is 400 units, there is 1 per cent chance that the firm will be
short of inventory. The probability of stock-out is, therefore, 0.01.
c) The probability of stock-out for other levels of safety stock is similarly computed
in column (4) of Table 5.
(ii) After the determination of the size and probability of stock-out, the next
step is the calculation of the stock-out cost. The expected stock-out cost can
be found out by multiplying the stock-out cost and the probability of stock-out.
When the stock-out is expected to be 100 units (safety stock being 400 units),
the stock-out cost would be 100 Rs 40 = Rs 4,000. But the probability of
stock-out of this size is only 0.01. Therefore, the expected cost stock-out
would be Rs 4,000 0.01 = Rs 40. For other levels of safety stock, the expected
stock-out cost can be similarly computed (column 5 of Table 5).
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(iii) The next step is to compute the total expected stock-out costs (column 6
of Table 5).
(iv) Then, the carrying costs should be calculated. The carrying costs are
equal to the safety stock multiplied by the carrying costs per unit. (Table 6
column 3).
TABLE 6 Computation of Total Safety Stock Costs
Safety stock
level (units)
Expected stock-
out costs*
Carrying costs
(Rs 20 per unit)
Total safety
stock cost
(1) (2) (3) (4) (2 + 3)
0
50
100
250
400
500
Rs 1,180
780
580
220
40
0
0
Rs 1,000
2,000
5,000
8,000
10,000
Rs 1,180
1,780
2,580
5,220
8,040
10,000
*from Table 5 column 6.
(v) Finally, the carrying costs and the expected stock-out costs at each safety
stock level should be added (Table 6, column 4). The optimum safety stock
would be that level of inventory at which total of these two costs is the lowest.
Thus, the optimum safety stock is zero units.
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SOLVED PROBLEMS
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SOLVED PROBLEM 1
M/s Tubes Ltd are the manufacturers of picture tubes for T.V. The following are
the details of the operation during the current year.
Average monthly market demand (tubes) 2,000
Ordering cost (per order) Rs 100
Inventory carrying cost (per cent per annum) 20
Cost of tubes (per tube) 500
Normal usage (tubes per week) 100
Minimum usage (tubes per week) 50
Maximum usage (tubes per week) 200
Lead time to supply (weeks) 6-8
Compute from the above:
1. Economic order quantity. If the supplier is willing to supply quarterly 1,500
units at a discount of 5 per cent, is it worth accepting?
2. Maximum level of stock
3. Minimum level of stock
4. Reorder level
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Solution
1. Economic order quantity
Annual demand (A) = Normal usage per week 52 weeks = 100 tubes 52 =
5,200 tubes. Ordering cost per order (B) = Rs 100 per order
Inventory carrying cost per unit per annum (C) = Rs 500 0.20 = Rs 100 per unit
per annum

If supplier is willing to supply 1,500 units at a discount of 5 per cent:
Total cost (When order size is 1,500 units) = Cost of 5,200 units + Ordering cost
+ Carrying cost
= [5,200 (500 0.95)] +[ (5,200/1,500) Rs 100) + ((1/2) 1,500 0.20 475)]
= Rs 24,70,000 + Rs 346.67 + Rs 71,250 = Rs 25,41,596.67
Total cost (when order size is 102 units) = (5,200 500) + (5,200/102 Rs 100) +
(1/2 102 0.20 500)
= Rs 26,00,000 + Rs 5,098.03 + Rs 5,100 = Rs 26,10,198.03
Since the total cost under quarterly supply of 1,500 units with 5 per cent
discount is lower than when order size is 102 units, the offer should be
accepted. While accepting this offer, consideration of capital blocked on order
size of 1,500 units per quarter has been ignored.
tubes 102 100 Rs 100 Rs units 200 5, 2 AB/C 2 EOQ
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2. Maximum level of stock = Reorder level + Reorder quantity
(Minimum usage Minimum reorder period)
= 1,600 units + 102 units (50 units 6 weeks) = 1,402 units
3. Minimum level of stock = Reorder level (Normal usage Average
reorder period)
= 1,600 units (100 units 7 weeks) = 900 units
4. Reorder level = Maximum consumption Maximum reorder period =
200 units 8 weeks = 1,600 units.
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SOLVED PROBLEM 2
The purchase department of an organisation has received an offer of quantity
discounts on its order of materials as under:
Price per tonne Tonnes
Rs 1,400 Less than 500
1,380 500 and less than 1,000
1,360 1,000 and less than 2,000
1,340 2,000 and less than 3,000
1,320 3,000 and above
The annual requirement of the material is 5,000 tonnes. The delivery cost per
order is Rs 1,200 and the annual stock holding cost is estimated at 20 per cent
of the average inventory.
The purchase department wants you to consider the following purchase
options and advise which among them will be the most economical order
quantity, presenting the information in a tabular form:
The purchase quantity options to be considered are: 400 tonnes, 500 tonnes,
1,000 tonnes, 2,000 tonnes, and 3,000 tonnes
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Solution
Determination of economic order quantity (EOQ)
1. Annual requirements (tonnes) 5,000 5,000 5,000 5,000 5,000
2. Order size (tonnes) 400 500 1,000 2,000 3,000
3. Number of orders (1 2)* 12.5 10 5 2.5 1.67
4. Price per tonne (Rs) 1,400 1,380 1,360 1,340 1,320
5. Cost of inventory (1 4) Rs lakh 70 69 68 67 66
6. Ordering cost (Rs) (No. of orders
Rs 1,200)
15,000 12,000 6,000 3,000 2,004
7. Average inventory (tonnes) 200 250 500 1,000 1,500
8. Average inventory (Rs lakh) 2.8 3.45 6.8 13.4 19.8
9. Carrying cost
(0.20 Average inventory) (Rs
lakh)
0.56 0.69 1.36 2.68 3.96
10. Total cost (5 + 6 + 9) (Rs lakh) 70.71 69.81 69.42 69.71 69.98
* Number of orders can be in fraction figure as per going concern concept.
Recommendation The purchase department is advised to have order size of 1,000
tonnes as at this order size total cost is minimum.