Chapter Five

Inventory Management
5.1. Nature of Inventories
Inventories as you know are stock of the product a company is manufacturing for sale and
components that make up the product. Various forms in which inventories exist in a
manufacturing company are: raw materials, work-in-process and finished goods.

Raw materials inventories are those basic inputs that are converted into finished product
through the manufacturing process. Thus, raw materials inventories are those units, which have
been purchased and stored for future production.

Work-in-process inventories are semi-manufactured products. They represent products that

need more work before they become finished products for sale.

Finished goods inventories are those completely manufactured products, which are ready for
sale. Stocks of raw materials and work-in-process facilitate production, while stock of finished
goods is required for smooth marketing operations. Thus, inventories serve as a link between the
production and consumption of goods.

The levels of three kinds of inventories for a firm depend on the nature of its business. A
manufacturing firm will have substantially high levels of all three kinds of inventories, while a
retail or wholesale firm will have a very high level of finished goods inventories and no raw
material and work-in-process inventories. Within manufacturing firms, there will be differences.
Large heavy engineering companies produce long production cycle products; therefore, they
carry large inventories. On the other hand, inventories of a consumer product company will not
be large because of short production cycle and fast turnover.

A fourth kind of inventory, supplies (or stores and spares), is also maintained by firms.
Supplies include office and plant cleaning materials like soap, brooms, oil, fuel, light bulbs etc.
These materials do not directly enter production, but are necessary for production process.
Usually, these supplies are small part of the total inventory and do not involve significant
investment. Therefore, a sophisticated system of inventory control may not be maintained for
them.

Now the question that arises is, why at all do we need to hold inventory? Do you have any idea?
The question of managing inventories arises only when the company holds inventories.
Maintaining inventories involves tying up of the company's funds and incurrence of storage and
handling costs. If it is expensive to maintain inventories, have you ever wondered why companies
hold inventories.

There are three general motives for holding inventories:

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 Transactions motive emphasizes the need to maintain inventories to facilitate smooth
production and sales operations. For uninterrupted and proper running of any firm it is
necessary to have an appropriate level of inventory.
 Precautionary motive necessitates holding of inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors.
 Speculative motive influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.

5.2 Objectives of Inventory Management

The objectives of inventory management consists of two counter balancing parts(i) to minimize
the firm’s investments in inventory, and (ii) to meet a demand for the product by efficiently
organizing the firm’s production and sales operations. These two conflicting objectives of
inventory management can also be expressed in terms of cost and benefits associated with
inventory. That the firm should minimize investments in inventory implies that maintaining an
inventory involves costs, such that the smaller the inventory, the lower the cost to the firm. But
inventories also provide benefit to the extent that they facilitate the smooth functioning of the
firm: the larger the inventory, the better it is from this view point. Obviously, the financial
manager should aim at a level of inventory which will reconcile these conflicting elements. That
is to say, an optimum level of inventory should determined thon the basis of the trade-off
between costs and benefits associated with the levels of inventory.
Firms should always avoid a situation of over investment or under-investment in inventories. The
major dangers of over investment are:
 Unnecessary tie-up of the firm's funds and loss of profit,
 Excessive carrying costs, and
 Risk of liquidity.
The excessive level of inventories consumes funds of the firm, which cannot be used for any
other purpose, and thus, it involves an opportunity cost. The carrying costs, such as the costs of
storage, handling, insurance, recording and inspection, also increase in proportion to the volume
of inventory. These costs will impair the firm's profitability further.

You have to understand that excessive inventories carried for long-period increase chances of
loss of liquidity. It may not be possible to sell inventories in time and at full value. Raw materials
are generally difficult to sell as the holding period increases. There are exceptional circumstances
where it may pay to the company to hold stocks of raw materials. This is possible under
conditions of inflation and scarcity. Work-in-process is far more difficult to sell. Similarly,
difficulties may be faced to dispose off finished goods inventories as time lengthens. The
downward shifts in market and the seasonal factors may cause finished goods to be sold at low
prices.

Another danger of carrying excessive inventory is the physical deterioration of inventories while
in storage. Such loss is as you know a complicated issue for any business. Goods or raw
materials deterioration occurs with the passage of time, or it may be due to mishandling and

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improper storage facilities. These factors are within the control of management; unnecessary
investment in inventories can, thus, be cut down maintaining an inadequate level of inventories is
also dangerous.
The consequences of underinvestment in inventories are:
 Production hold-ups and
 Failure to meet delivery commitments. Inadequate raw materials and work-in-process
inventories will result in frequent production interruptions. Similarly, if finished goods
inventories are not sufficient to meet the demand of customers regularly, they may shift
to competitors, which will amount to a permanent loss to the firm.

The aim of inventory management, thus, should be to avoid excessive and inadequate levels of
inventories and to maintain sufficient inventory for the smooth production and sales operations.
Efforts should be made to place an order at the right time with the right source to acquire the
right quantity at the right price and quality.
As you can gather from our discussion, inventory management to be effective should:
 Ensure a continuous supply of raw materials to facilitate uninterrupted production,
 Maintain sufficient stocks of raw materials in periods of short supply and anticipate price
changes,
 Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service,
 Minimize the carrying cost and time, and
 Control investment in inventories and keep it at an optimum level.
Till now, we have discussed the need & nature of inventory management. Let’s move on to
discuss the various techniques of inventory management.

5.3. Inventory Management Techniques

Every management technique should be in consonance with the shareholders, wealth
maximization principle. To achieve this, the firm should determine the optimum level of
inventory.

The ultimate goal of an inventory management program is to provide maximum customer service
at a minimum cost. Effective inventory management requires effective techniques of inventory
control. A proper inventory control not only helps in solving the acute problem of liquidity but
also increases profits and causes substantial reduction in working capital requirement of a firm.
Techniques that are commonly used in managing inventory are:
 Materials Requirement Planning (MRP) System
 ABC system
 Just-In-Time (JIT) system
 Economic Order Quantity (EOQ) Model

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Dear learner, under this section let us discuss more about MRP system, ABC system and JIT
system. EOQ model will be discussed on the next section.

1. Materials Requirement Planning (MRP) System

In many manufacturing organizations, production requirements are based directly on the sales
forecast. In turn, for each of its products, the company prepares a bill of materials- a list of the
parts (and their quantities) needed for various products in the production process. To determine
overall material requirements, each sub-assembly or part on the bill of materials is extended or
multiplied by the planned number of finished products. This yields the total materials
requirement for each product. This is called materials requirement planning (MRP) system.
Many companies use a materials requirement planning (MRP) system to determine what to
order, when to order, and in what quantity to order materials. The advantage of the MRP system
is that it forces the firm to more thoroughly consider its inventory needs and plan accordingly.
The objective is to lower the firm’s inventory investment without impairing production.

2. ABC System
One of the most widely recognized concepts of inventory management is referred to as ABC
inventory control system. It maintains appropriate control according to the potential savings
associated with each category of inventory. For example an item having an inventory cost of Br.
10,000 has a much greater potential for saving of expenses related to maintaining inventories
than an item with a cost of Br. 200.
The ABC system is a means of categorizing inventory items into three classes “A," "B" and "C"
according to the potential amount of investment to be controlled. The "A" group inventory
includes those items that require the largest birr investment. The "B” group inventory consists of
the items accounting for the next largest investment. The "C" group typically consists of a large
number of items accounting for relatively small birr investment.
Dividing its inventory into "A," "B" and "C" items allows the firm to determine the level and
types of inventory control procedures needed. Control of the "A" items should be most intensive
because of the high birr investment involved; the perpetual inventory record keeping that allows
daily monitoring of these inventory levels is appropriate. "B" items are frequently controlled
through periodic checking, possibly weekly, of their levels. "C" items could be controlled by
using simple procedures. In general, the ABC inventory control system is an inventory

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technique, which controls expensive inventory items more closely than less expensive inventory
items.

3. Just-In- Time (JIT) Inventory System

Just-in-time inventory management system is part of a manufacturing approach that seeks to
reduce the company's operating cycle and associated costs by eliminating wasteful procedures.
As its name implies, the idea is that all inventories are acquired and used in production at the
exact time and at the right quantity they are needed. While raw materials inventory and work-in-
process inventory can never be reduced to zero, the notion of JIT is one of extremely tight
control so as to minimize inventory size as low as possible.
However, the use of JIT inventory system requires close coordination between a company and its
suppliers, because any interruption in the flow of parts and raw materials from the supplier can
result in costly production delays and lost sales. A JIT system requires extensive cooperation
among all parties involved in the process - suppliers, shipping companies, and the firm’s
employees. Because its objective is to minimize inventory investment, a JIT system uses no, or
very little, safety stocks.
4. Economic Order Quantity (EOQ) Model
Efficiently controlled inventories make the firm flexible. Inefficient inventory control results in
unbalanced inventory and inflexibility-the firm may sometimes run out of stock and sometimes
may pile up unnecessary stocks. This increases the level of investment and makes the firm
unprofitable. To manage inventories efficiently, we should seek answers to the following two
questions:
 How much should be ordered?
 When should it be ordered?
The first question, how much to order, relates to the problem of determining economic order
quantity (EOQ), and is answered with an analysis of costs of maintaining certain level of
inventories. The second question, when to order, arises because of uncertainty and is a problem
of determining the re-order point.

i. Determining the EOQ

Economic Order Quantity. If a company buys in large quantities, the cost carrying the
inventory is high because of the sizable investment. If purchases are made in small quantities,
frequent orders with corresponding high ordering costs will result. Thus, the appropriate or
optimum level of the order to be placed should be determined.
Therefore, the quantity to order at a given time must be determined by balancing two factors:
 the cost of carrying materials and

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  the cost of acquiring or ordering materials. The optimum level of inventory is popularly
referred to as the Economic Order Quantity (EOQ). The EOQ may be defined as that
level of inventory order that minimizes the total cost associated with inventory
management.
Determining ordering costs generally considers several factors into account like:
 salaries and wages of employees engaged in purchasing, receiving, and inspecting
materials;
 communications costs associated with ordering, such as telephone charges, postage, and
forms or stationery; and
 materials accounting and record keeping.
A variety of factors must be considered in determining carrying costs:
 material storage and handling costs;
 interest, insurance, and property taxes;
 loss due to theft, deterioration, or obsolescence; and
 records and supplies associated with carrying inventories.
Order cost and carrying costs move in opposite directions-annual order costs decrease when the
order size increases, while annual carrying costs increases when the order size increase. The
optimal quantity to order at one time, called the economic order quantity, is the order size that
minimizes total order and carrying costs over a period of time, for example, one year. Economic
order quantity can be calculated by table, graph or formula.

Quantitative models or formulas have been developed for calculating the economic order
quantity. One formula that can be used is the following:
2×C×N 2×C×N
EOQ =
Where
√ K Or, √ C∗P where, C*= Carrying cost %

EOQ = Economic order quantity

C=cost of placing an order
N=number of units required annually
K= carrying cost per unit of inventory
P= Purchasing cost per unit of Inventory

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Assumption: The EOQ model, as a technique to determine the economic order quantity is based
on three restrictive assumptions, namely:
 The firm knows with certainty the annual usage (consumption) of a particular item.
 The rate at which the firm uses inventory is steady over time.
 The orders placed to replenish inventory stocks are received at exactly that point in time
when inventories reach zero.

In addition, it may be assumed that ordering and carrying costs are constant over the range of
possibility inventory level being considered.

Example 1. Nati Printing has determined that the cost to place an order for papers is Br.15 and
the cost to carry this item in inventory is Br.0.75 per unit.1,000 dozen of papers are required for
production each year.
Instruction:
a. What is the most economical order quantity (EOQ)?
b. Calculate the total cost of ordering and carrying at the EOQ point.
Solution:
Method 1. Tabular determination of EOQ. An approximate value for EOQ can be determined
using a tabular analysis like that shown in Table 4-1. Varying order size are arbitrarily used to
satisfy the annual requirements of 1, 000 units. Since it is assumed that the inventory level is
zero when each purchase is received, and the inventory level increases to the order size upon the
order’s arrival, the average inventory is computed as one half of the order size.

Table 4.1: Tabular Determination of EOQ

Order size(selected arbitrarily) 100 200 400 600 800 1, 000
Average inventory 50 100 200 300 400 500
Number of orders 10 5 2.5 1.67 1.25 1
Total order cost (a) Br.150 Br. 75 Br.38 Br.25 Br.19 Br.15
Total carrying cost (b) 38 75 150 225 300 375
Total costs(a + b) Br 188 Br 150 Br 188 Br 250 Br 319 Br 390

Note the following:

 Average inventory = Order size 2
Annual requirements
 Number of orders = Order Size
 Total order costs = No of orders x Br 15
 Total carrying cost = Average inventory x Br 0.75

Method 2. Graphic Determination of EOQ. Rather than calculating the EOQ using a tabular
analysis, a company can prepare graphs. Figure 4-1 illustrates the graphic method of determining
EOQ. The ordering cost curve shows that total order costs decrease as the order size increases.

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Carrying costs move in the opposite direction; they increase as the order size increase because
there is more inventory on hand. The curve representing the total costs of carrying and ordering
begins to flatten between 200 and 400 units. After this range is found, an order size is chosen in
this area at the lowest point. In Figure 4-1, the lowest point is 200 units, which is considered to
be the EOQ.

Fig. 4. 1: EOQ Graph

Method 3. EOQ Formula. A method of determining EOQ which is even more accurate and
time saving than either the tabular or graphic approaches is the formula method. The EOQ
formula is widely used and can be expressed in several ways using a variety symbols. One
simple variation of the formula is as follows:
2×C×N 2×C×N
EOQ = √ K OR, √ C∗P
Using the data presented earlier with N= 1, 000, C=Br 15 and K= Br 0.75, the EOQ is
determined as 200 units below:
2×15×1 , 000
EOQ = √ 0 .75
= 200units

The formula method is generally preferred because of ease of application. However, even if the
formula method is used, the graphical analysis provides a useful visual representation of the
relationship between carrying and ordering costs and gives some appreciation of the
consequences of ordering some amount greater or less than optimal. In addition, the tabular
presentation can be used as a conventional form of communicating such relationships to some
party not involved in the analysis.

Using an EOQ of 200 units, the total carrying and ordering costs can be calculated as follows:
Carrying costs = EOQ /2 X Carrying cost per unit
= 200/2 x 0.75
= Br 75
Ordering costs = 1000/200 x 15
= Br 75

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Example 2. Ganta Company predicts that it will use 25, 000 units of material during the year.
The expected daily usage is 200 units; there is an expected lead time of five days and a safety
stock of 500 units. The material is expected to cost Br 5 per unit. Ganta anticipates that it will
cost Br 50 to place each order. The annual carrying cost is Br 0.10 per unit.

Instruction:
a. Compute the order point.
b. Determine the most economical order quantity by use of the formula.
c. Calculate the total cost of order and carrying at the EOQ point.
Solution:
a. Computations of reorder point
Estimated usage during lead time
= daily usage  Lead Time
= 200  5= 1, 000 units
Order point = Expected usage during lead time + Safety stock
= 1, 000 units + 500 units = 1, 500 units
b. Calculations of EOQ using the formula method
2×C×N 2×50×25 , 000
EOQ = √ K = √ 0 .10= 5, 000 units
c. Using an EOQ of 5, 000 units, the total carrying and ordering costs can be calculated as
follows:
EOQ
2
Carrying costs = (Carrying cost per unit)
= 5000/2 x 0.10 = Br 250
Ordering costs = 25, 000/5, 000 x 50 = Br 250
Example 3. Jose Company estimates that it will need 12, 500 cartons next year at a cost of Br 8
per carton. The estimated carrying cost is 25% of average inventory investment, and the cost to
place an order is Br 20.
Instructions: Compute
a. the economic order quantity and
b. the number of orders that should be placed to satisfy the annual demand, based on a 365-
day year.
Solution:
2×C×N 2×C×N
a) EOQ =
cost
√ K = √ C∗P Where, C* = carrying cost % and P= purchasing

2×200×12 , 500
= √ 8×0. 25 = 500 units

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 Annual requirment 12 ,500
=
b) Number of Orders = EOQ 500 = 25 orders
ii. Determining the Reorder Point
Order Point. Once the firm has calculated its EOQ, it must determine when to place orders. The
point at which an item should be ordered, called the reorder point, occurs when the
predetermined minimum level of inventory on hand is reached. Assuming a constant usage rate
of inventory, the reorder point can be determined by the following equation.
Reorder Point = Lead time usage + Safety stock

Calculating the reorder point is based on the following data:

 Usage-the anticipated rate at which the material will be used.
 Lead time-the estimated time interval between the placement of an order and receipt of
the material.
 Safety stock-the estimated minimum level of inventory needed to protect against stock
outs (running out of stock). Stock outs may occur due to inaccurate estimate of usage or
lead time or various other unforeseen events, such as the receipt of damaged or inferior
materials from the supplier.
Example 1. Addis Furniture Factory uses 45, 000 units of Material X102 every day in
production. It takes 10 days for an order to be delivered. The factory always wants to have a
four-day supply on hand (or safety stock); what is the point at which it should reorder Material
X102?
Solution: Estimated usage during lead time
= daily usage X Lead Time
= 45, 000 x 10= 450, 000 units
Safety stock = 45, 000 x 4
= 180, 000 units
Reorder point = Expected usage during lead time + Safety stock
= 450, 000 units + 180, 000 units
= 630, 000 units

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