Inventory Management

Dr. T Kachwala

Brief Outline
1.

Meaning of the term Inventory, Inventory Control

2.

Functions of Inventory

3.

Effectiveness Measures of Inventory Management

4.

Inventory Counting Systems

5.

Inventory Classifications: ABC, VED, FSN, HML, SDE, XYZ

Analysis etc.

6.

Economic Order Quantity: Basic Economic Order Quantity,

EOQ for Production Lots, EOQ with Quantity Discounts

Meaning of the term Inventory

An inventory is a stock or store of goods. Firms stock hundreds of items ranging

from small items such as nuts & bolts to large items such as machines and trucks.

Inventory for a manufacturing plant means all the materials, parts, supplies,
expense tools & in-process or finished products recorded in the books of account of
an organization and kept aside in its stock either in the factory or at the warehouse
for a defined period of time.

Service firms carry inventories of supplies & equipment:

Inventory for Department Stores includes clothing, furniture, stationery, appliances, toys,
gifts, cards etc.

Inventory for Hospitals includes drugs, surgical supplies, life monitoring equipment,
sheets & pillow cases etc.

Inventory for Supermarkets includes fresh foods, canned foods, frozen foods, household
supplies, baked goods, dairy products, groceries etc.

Meaning of the term Inventory

Good inventory management is important for the successful operation of most
businesses & their supply chains. Operation, Marketing & Finance have interests in
Good Inventory Management. Poor inventory management hampers operations,
diminishes customer satisfaction & increases operating costs.
One widely used measure of Managerial performance relates to ROI which is PAT
divided by Total assets. Reduction of Inventories reduces total assets & therefore
indirectly increases ROI.
Inadequate control of inventories can result in both under & overstocking of items.
Under-stocking results in missed deliveries, lost sales, dissatisfied customers and
production bottlenecks. Over-stocking unnecessarily ties up funds that might be
productive else where.

Meaning of the term Inventory

Inventory control process consists of four steps:
1.

Setting objectives (defining inventory levels)

2.

Measuring actual levels of inventory

3.

Comparing actual levels with set standards

4.

If there is a deviation, taking appropriate corrective actions

Inventory management has two main concerns: level of customer service (right
goods, in the right quantity, in the right place, at the right time) & cost of
ordering & carrying inventories.
Inventory manager tries to achieve a balance in stocking with two fundamental
decisions: when to order & how much to order.

Functions of Inventory
1.

To meet anticipated customer demand (anticipation stock).

2.

To smooth production requirements (seasonal inventories).

3.

To decouple operations {buffers between successive operations to

maintain continuity of production, buffers of raw materials to insulate
production from disruptions in deliveries from suppliers (to protect against
stock outs due to delayed deliveries), and finished goods inventory to
buffer sales operations from manufacturing disruptions (to protect against
stock outs due to unexpected increases in demand)}.

4.

To hedge against price increases.

5.

To take advantage of quantity discounts.

Effectiveness Measures of Inventory Management

Managers can use a number of measures to judge the effectiveness of inventory

management.

1.

Customer satisfaction; which is measured by the number and quantity of

backorders and / or customer complaints.

2.

Inventory turnover; which is the ratio of annual cost of goods sold to average
inventory investment. The turnover ratio indicates how many times a year the
inventory is sold.

3.

Days of inventory on hand; a number that indicates the expected number of days of
sales that can be supplied from existing inventory.

Inventory Counting Systems

Inventory counting systems can be:
(i)Perpetual (Fixed Order Quantity
Models also called EOQ or Q System)
(ii)Periodic (Fixed time Period Model
also referred as Periodic system or P
system)
1.

Under a periodic system, (P system) a physical count of items in inventory is made at periodic
intervals (e.g. weekly, monthly) in order to decide how much to order of each item.

2.

A perpetual inventory system (also known as a continual system) keeps track of removals from
inventory on a continuous basis, so the system can provide information on the current level of
inventory for each item. When the amount on hand reaches a predetermined minimum, a
fixed quantity Q (optimal order quantity) is ordered (Q System)

Classification of Inventory

Large number of Material are used in production. All items held in

inventory are not of equal importance in terms of dollars invested,
criticality to production, lead time of procurement etc. It is therefore
desirable to classify materials according to the amount of analysis that
can be justified. Control efforts can be allocated according to the
relative importance of various items in inventory. Some of the
schemes for classification of the material are:
1.

ABC based on value of item

2.

VED based on criticality to production

3.

HML based on value

4.

SDE based on lead time of procurement

5.

FSN based on requisition of material

6.

XYZ based on general classification

Classification of Inventory A-B-C Approach

A-B-C Approach is a classification of inventory into three classes: A, B and C, based on their
value. This analysis is based on the popular Pareto Principle, which states that 80% of the
value of the material or items is on account of 20% of the items.

The analysis is done by rearranging the item in the order of value and identifying the three
categories as given in the table below (Approximate percentages):
Value of consumption
of items

No. of items

Class

70% of value

10% of no. of items

A (very Important)

20% of value

20% of no. of items

B (moderately Imp)

10% of value

70% of no. of items

C (least Important)

a.

Rigid control for A-Class items.

b.

Moderate control for B-Class items

c.

Loose control is adequate for C-Class items.

Classification of Inventory - VED Analysis

VED analysis is a classification of inventory into three classes: Vital,

Essential and Desirable based on their importance. The analysis is done
by rearranging the items in the order of importance and identifying the
three categories as explained in the example below :

Example: Inventory classification of spare parts in Maintenance

1.

V Vital items are those items the absence of which will result in total
stoppage of the production line. Rigid control is required for these items.

2.

E Essential items are those items the absence of which results in partial
stoppage of the production line. Moderate control is required for these items.

3.

D Desirable items are those items the absence of which does not affect the
production line. Loose control is adequate for these items.

Classification of Inventory - HML Analysis

HML analysis is a classification of inventory into three classes: High value

items, Medium value items, and Low value items based on their value
(similar to ABC Analysis). The analysis is done by rearranging the items in
the order of value and identifying the three categories as explained in the
example of Inventory classification of Purchase Order (contractual
document and hence very critical for an organization) below:

The purchase orders can be classified according to their value, so that

only the high value purchase order are monitored by the manager. The
other smaller value purchase orders can be delegated to the lower
authorities.

Classification of Inventory - SDE Analysis

SDE analysis is a classification of inventory into three classes: Scarce, Difficult & Easy based
on the lead time of procurement. The analysis is done by rearranging the items in the order of
the lead time of procurement and identifying the three categories as explained in the example
of regular purchased items below:
1.S Scarce items, which are the items that are in short (limited) supply & very difficult to

procure. e.g. Imported items, where the lead time is very high. Rigid control is required.
2.D Difficult items, which are available but difficult to procure because there are limited

suppliers, where the lead time is moderate. Moderate control is required

3.E Easy items, which are items that are easily available. E.g. standard items available off

the shelf. There is no lead time of procurement for these items. Loose control is adequate

Classification of Inventory - FSN Analysis

FSN analysis is a classification of inventory into three classes: Fast moving, Slow moving &
Non moving based on the frequency of issue of items from Stores. The analysis is done by
rearranging the items in the order of the frequency of issue of items and identifying the three
categories as explained in the example of items issued by stores below:
1.F Fast moving items, which are the items that are required frequently; for example all

direct items. Rigid control is required.

2.S Slow moving items are issued limited number of times in a given period; for example

indirect items like machine oil. Moderate control is required

3.N Non moving items are not issued for the period of time under consideration. These

items may have become obsolete due to product or process changes

Classification of Inventory - XYZ Analysis

The XYZ category is a general category of classification for the three classes:
Example1: Categorization of the items in terms of size.
1.

X items are those items that are heavy & bulky.

2.

Y items are those items that are moderate bulky.

3.

Z items are those items that are not bulky.

Example2: Categorization of the items in terms of shelf-life.

1.

X items are those items that have very short shelf-life

2.

Y items are those items that have moderate shelf-life.

3.

Z items are those items that do not have a shelf-life

Rigid control is required on X-Category items,

Moderate control is required on Y-Category items
Loose control is adequate on Z-Category items

Categories of Inventory Cost

Ordering Cost is incurred for processing the purchase order, expediting,

record keeping, and receiving the order into the warehouse.

Stock out costs - In raw-materials inventory, stock out costs can include
the cost of disruptions to production. In finished-goods inventory, stock out
costs can include lost sales and dissatisfied customers.

Acquisition costs is the unit cost of the item. For purchased materials,
ordering larger batches may lower unit costs because of quantity discounts
and lower freight and materials-handling costs.

Carrying costs - Interest on debt, interest income foregone, warehouse

rent, cooling, heating, lighting, cleaning, repairing, protecting, shipping,
receiving, materials handling, taxes, insurance, and management are
some of the costs incurred to insure, finance, store, handle, and manage
larger inventories.

Categories of Inventory Cost

Cost of production problems - Higher in-process inventories

camouflage

underlying

production

problems.

Problems

like

machine breakdowns, poor product quality, and material shortages

never get solved.
Cost of coordinating production - Because large inventories clog

the production process, more people are needed to unsnarl traffic

jams,

solve

congestion-related

production

problems,

and

coordinate schedules.
Cost of Obsolescence - Large inventories of items that are

obsolete due to design and / or process changes

Opposing Views on Inventory

If the order quantity is small (i.e. If the inventory is too little) then the
following cost are high:

1.

Ordering Costs

2.

Stock out Costs

3.

Acquisition Costs

If the order quantity is large (i.e. If the Inventory is too much) then the
following cost are high:
1.

Carrying Costs

2.

Cost of Production Problem

3.

Cost of Coordinating Production

4.

Cost of Obsolescence

Concept of Economic Order Quantity (EOQ)

Materials are ordered so that the cost of ordering too little is

balanced against the cost of ordering too much on each order.

Two classes of cost are graphed. Carrying cost represents all the
annual costs associated with ordering too much. Ordering cost
represents all the annual costs associated with ordering too little.
When annual carrying cost curve is added to the annual ordering

costs curve, an annual total stocking cost curve results. The order
quantity where total stocking cost is minimum is traditionally called
Economic Order Quantity (EOQ)

Determining Order Quantities (EOQ Models)

Three Order size Models being used are :
1.

Model I Basic Economic Order Quantity (EOQ).

2.

Model II-EOQ for Production Lots.

3.

Model III-EOQ with Quantity Discounts.

Model I Basic Economic Order Quantity (EOQ)

Assumptions:
1.

Annual demand, carrying cost, and ordering cost for a material can be estimated.

2.

Average inventory level for a material is order quantity divided by 2. This implicitly
assumes that no safety stock is utilized, orders are received all at once (instantaneous
replenishment), materials are used at a uniform rate, and materials are entirely used up
when the next order arrives.

3.

Stock out, customer responsiveness, and other costs are inconsequential.

4.

Quantity discounts do not exist.

Slide 21

Replenishment Cycle
Instantaneous Replenishment
Material Received all at once (Instantaneous Replenishment)
Consumption of
material at a
constant rate

Quantity

The same cycle

repeats

Q
2
Time

Average inventory when the material is received all at once is

Q
2

Slide 22

Model II-EOQ for Production Lots

Assumptions:
1.

Annual demand, carrying cost, and ordering cost for a material can be estimated.

2.

No safety stock is utilized, materials are supplied at a uniform rate (p) and used at a
uniform rate (d), and materials are entirely used up when the next order begins to
arrive.

3.

Stock out, customer responsiveness, and other costs are inconsequential.

4.

Quantity discounts do not exist.

5.

Supply rate (p) is greater than usage rate (d)

Variable Definitions
1.

All the definitions in Model I apply also to Model II. Additionally

2.

d = rate at which units are used out of inventory (units per time period)

3.

p = rate at which units are supplied to inventory (same units as d)

Slide 24

Replenishment Cycle
Material received uniformly at a constant rate
The rate at which the inventory is increasing is the difference between
production rate and demand rate (p-d)
The rate at which the inventory is decreasing is the
function of the demand rate (d)
The same cycle
repeats

Quantity

Q
Q
2

1-

d
p

Time
Average inventory when the material is gradually received at a constant rate is Q
2

1-

d
p

Slide 25

Model II-EOQ for Production Lots

Cost Formulas -

Annual carrying cost Average inventory level x Carrying cost C

Annual ordering cost Orders per year x Ordering cost S

d
p

Total annual stocking cost TSC A

nnual carrying cost Annual ordering cost C

Equating annual carrying cost & annual ordering cost : EOQ

2 SD

C 1

d
p

Q
2

Model III EOQ with Quantity Discounts

Assumptions:
1.

Annual demand, carrying cost, and ordering cost for a material can be
estimated.

2.

Average inventory levels can be estimated at either:

a.

Q/2 if the assumption of Model I prevail : no safety stock, orders are received
all at once, materials are used a uniform rate, and materials are entirely used
up when the next order arrives.

b.

Q/2 [(p d)/p] if the assumption of Model II prevail : no safety stock, materials
are supplied at a uniform rate (p) and used at a uniform rate (d), and materials
are entirely used up when the next order arrives.

3.

Stock out, customer responsiveness, and other costs are inconsequential.

4.

Quantity discounts do exist. As larger quantities are ordered, price breaks

apply to all units ordered.

Slide 27

Concept of Quantity Discount

Quantity discount signifies the discount that the manufacturer can avail if he
places a large order on the vendor. This is because a large order offers economy of
scale for the vendor which can be explained on the break even chart drawn below

Profit

s
Sale

Sales / Cost

os
C
l
a
t
To
le
Variab

C ost

Fixed Cost

Quantity
It can be observed in the above break-even chart, that as the output (quantity)
increases, the profit increases.

Model III-EOQ with Quantity Discounts

Variable Definitions :
1.

All the definitions in previous models apply to Model III. Additionally,

2.

TMC = Total annual material costs (rupees per year)

3.

ac = Acquisition cost of either purchasing or producing one unit of a material

(rupees per unit)

Formulas
1.

The EOQ and TSC formulae from either Model I or Model II are applied to Model III,
depending on which assumption best fit the inventory situation.

2.

Annual acquisition costs = Annual demand x Acquisition cost = (D) * ac

3.

Total annual material costs (TMC) = Total annual stocking costs + Annual acquisition cost
1.

= TSC + (D) * ac

Slide 29

Model III EOQ with Quantity Discounts

Model I
Order Delivered
All at One Time

EOQ

Model II
Gradual Deliveries

TMC C

2 SD
C

Q
2

EOQ

D ac

TMC C

2 SD
C 1 pd

Q
2

d
p

D ac

Procedures
1. Compute the EOQ using each of the sales prices.
2. Determine which EOQ from Step I above is feasible. In other words, is the computed EOQ
in the quantity range for its price ?
3 The total annual material cost TMC is computed for the feasible EOQ and the quantity at any
price break with lower sales prices.
4. The order quantity with the lowest total annual material cost TMC is the economic order
quantity for the material.