12

Inventory
Management

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives
 Define the term inventory and list the major
reasons for holding inventories; and list the main
requirements for effective inventory management.
 Discuss the nature and importance of service
inventories
 Discuss periodic and perpetual review systems.
 Discuss the objectives of inventory management.
 Describe the A-B-C approach and explain how it
is useful.
 Learning Objectives
 Describe the basic EOQ model and its
assumptions and solve typical problems.
 Describe the economic production quantity
model and solve typical problems.
 Describe the quantity discount model and
solve typical problems.
 Describe reorder point models and solve
typical problems.
 Describe situations in which the single-
period model would be appropriate, and
solve typical problems.
 Definitions
 Inventory-A physical resource that a firm holds in
stock with the intent of selling it or transforming it
into a more valuable state.

 Inventory System- A set of policies and controls

that monitors levels of inventory and determines
what levels should be maintained, when stock
should be replenished, and how large orders
should be
 Inventory
Inventory: a stock or store of goods

Different kinds of inventories -

 Raw materials and purchased parts (Clay used in tiles production firms)

 Work in Progress - WIP (Tiles under production)

 Finished good inventories (Ready tiles)

 Replacement parts, tools and supplies (Replacing defective tiles)

 Goods in transit to warehouses or customers - Pipeline inventory

(Tiles for sale)
 Expensive Stuff
 The average carrying cost of inventory
across all mfg.. in the U.S. is 30-35% of its
value.
 What does that mean?
 Savings from reduced inventory result in
increased profit.
 Zero Inventory?
 Reducing amounts of raw materials and
purchased parts and subassemblies by having
suppliers deliver them directly.

 Reducing the amount of works-in process by

using just-in-time production.

 Reducing the amount of finished goods by

shipping to markets as soon as possible.
 Inventory Positions in the
Supply Chain

Raw Works
Materials Finished Finished
in Goods Goods
Process in Field
 Inventory
Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
 Inventory Models
 Independent demand – finished goods, items
that are ready to be sold
 E.g. a computer
 Dependent demand – components of
finished products
 E.g. parts that make up the computer
 Types of Inventories
 Raw materials & purchased parts
(Clay used in tiles production firms)

 Partially completed goods called

work in progress (Tiles under production)
 Finished-goods inventories (Ready tiles)
(manufacturing firms or merchandise)
(retail stores)
 Types of Inventories (Cont’d)
 Replacement parts, tools, & supplies
(Replacing defective tiles)

 Goods-in-transit to warehouses or
customers - Pipeline inventory (Tiles for sale)
 Functions of Inventory
 To meet anticipated demand - A customer can
be a person who walks in off the street to buy a new
product (Rangs Showrooms)

 To smooth production requirements - Firms

that experience seasonal patterns in demand often build
up inventories during pre-season periods to meet overly
high requirements during seasonal periods (IGLOO and
other ice cream companies)
 Functions of Inventory
 To decouple operations - Manufacturing firms
keep buffer stock to tackle any disruption in the operation.
The buffers permit other operations to continue
temporarily while the problem is resolved (Cement
factories)

 To protect against stockout - Unexpected

increases in demand increase the risk of shortages.
Delays can occur because of weather condition, delayed
deliveries, quality problem etc. The risk of shortage can
be reduced by holding safety stock.
 Functions of Inventory (Cont’d)
 To take advantage of order cycles - To take
advantage of order cycles – To minimize purchasing cost,
firms often buy more than current requirement. They use
this additional quantity for later production. This enables
the firms to buy or produce in economic lot sizes without
trying to match purchases or production with demand
requirements in the short run. This results in order cycle

 To help hedge against price increases - When

firms sense any possibility of price increase they purchase
larger than normal amounts to beat the increase. The
ability to store extra goods allow the firms to take the
advantage of discount for larger orders
 Functions of Inventory (Cont’d)

 To permit operations - Inventory of raw material,

semi-finished goods and finished goods as well as goods
stored in warehouses allow the operation to continue at
different stages.

 To take advantage of quantity discounts -

Suppliers give discount on large orders.
 Types of Inventory

 Cycle Stock

 It is the inventory that results from the replenishment

process and is required in order to meet demand under
conditions of certainty- that is, when the firm can predict
demand and replenishment times (lead times) perfectly.

 e.g. If the rate of sales for a product is a constant 20

units per day and the lead time is always 10 days, no
inventory beyond the cycle stock would be required.


 Types of Inventory

 In-Transit inventories

 in- transit inventories are items that are en route from

one location to another.

 Should be considered as inventory at the place of

shipment origin since the items are not available for use,
sale, or subsequent shipment.
 Types of Inventory

Safety or Buffer Stock

 Safety or buffer stock is held in excess of cycle stock

because of uncertainty in demand or lead time.

 The notion is that a portion of average inventory should

be devoted to cover short-range variations in demand and
lead time variability.
 Types of Inventory

Speculative Stock

Speculative risk is inventory held for reasons other than

satisfying current demand

 e.g. Materials may be purchased in volumes larger than

necessary in order to receive quantity discount, because of
a forecasted price increase or material shortage or to
protect against the possibility of a strike.

 Production economics may also lead to the manufacture

of products at times other than when they are demanded.

 Goods may be produced seasonally for consumption

throughout the year.
 Types of Inventory

Seasonal Stock

 It is a form of speculative stock that involves the

accumulation of inventory before a season begins in order
to maintain a stable labour force and stable production runs
or, in the case of agricultural products, inventory
accumulated as the result of a growing season that limits
availability throughout the year.
 Types of Inventory

 Dead Stock

 Dead stock is the set of items for which no demand has

been registered for some specified period of time
 Objective of Inventory Control
 To achieve satisfactory levels of customer
service while keeping inventory costs within
reasonable bounds
 Level of customer service
 Costs of ordering and carrying inventory

Inventory turnover is the ratio of average

cost of goods sold to average inventory
investment.
 Example of an Inventory Turnover Calculation

 For fiscal year 2019, Walmart Stores reported annual sales of

$514.4 billion, year-end inventory of $44.3 billion, beginning inventory of
$43.8 billion, and an annual COGS of $385.3 billion.2

Walmart's inventory turnover for the year equaled:

$385.3 billion ÷ ($44.3 billion + $43.8 billion)/2 = 8.75

Its days inventory equals:

(1 ÷ 8.75) x 365 = 42 days

This indicates that Walmart sells its entire inventory within a 42-day period,
which is impressive for such a large, global retailer.

12-24
Effective Inventory Management
 A system to keep track of inventory
 A reliable forecast of demand
 Knowledge of lead times
 Reasonable estimates of
 Holding costs
 Ordering costs
 Shortage costs
 A classification system
 Inventory Counting Systems
 Periodic System
Physical count of items made at periodic intervals
(e.g. weekly, monthly) to determine how much to
order.
 Many small retailers use this approach.
 An advantage of this system is that orders for many items occur at
the same time and helps to save ordering and shipping cost.
 One of the major disadvantage is the shortages between review
periods .
 Inventory Counting Systems
 Perpetual Inventory System
System that keeps track of removals from
inventory continuously, thus monitoring current
levels of each item
 An obvious advantage is continuous monitoring of
inventory withdrawals. Also helps to order optimum
quantity.
 One disadvantage of this system is added cost of
record keeping.
 Inventory Counting Systems
(Cont’d)
 Two-Bin System - Two containers of
inventory; reorder when the first is
empty
 Universal Bar Code - Bar code printed
on a label that has information about the
item to which it is attached
Identifies this product
as a grocery item 0

214800 232087768

Identifies the Indicates the

manufacturer specific item
 Key Inventory Terms
 Lead time: time interval between ordering
and receiving the order
 Holding (carrying) costs: cost to carry an
item in inventory for a length of time,
usually a year
 Ordering costs: costs of ordering and
receiving inventory
 Shortage costs: costs when demand
exceeds supply
 Basic Inventory Management

Ordering Costs

 Ordering costs for products purchased from an outside

supplier typically include:

 the cost of transmitting the order

 the cost of receiving the product

 the cost of placing it in storage

 the cost associated with processing the invoice for

payment.
 ABC Classification System
Figure 12.1

Classifying inventory according to some

measure of importance and allocating control
efforts accordingly.
A - very important
B - mod. important High
A
C - least important Annual
$ value B
of items

Low C
Low High
Percentage of Items
 Classifying Inventory Items
 ABC Classification

 A Items: very tight control, complete and accurate

records, frequent review

 B Items: less tightly controlled, good records,

regular review

 C Items: simplest controls possible, minimal

records, large inventories, periodic review and
reorder
 Benefits of ABC Classification System

Area of use Benefit of ABC classification system

Cycle Counting Using ABC classification in cycle counting, A class items will be counted more
Frequency frequently than B or C class items.

Order quantity and safety stock levels are established according to the criticality
Customer Service and cost of each item. Generally this is approached from a dollar accuracy
perspective.

The engineering department may use ABC classification to identify items of high
Engineering
cost or high usage and concentrate their efforts accordingly. There is little point re-
Priorities
engineering products of little value or low usage.

Inventory replenishment systems will vary according to the importance of the

Replenishment inventory items. For example, C class items may be controlled with a simple two-
Systems bin system if they are not particularly bulky. This minimizes the cost of control and
replenishment and does not significantly increase inventory carrying costs.

As A class items form a larger investment in inventory, these items are closely
analyzed to ensure appropriate order quantities and safety stocks are used. A
Investment
class items are always the focus of attempts to improve inventory turns as
Decisions
changes in the way A class items are procured and managed will have the most
significant effect on the overall inventory investment level
 ABC Classification

Annual unit Percentage of total

Item Unit cost ($) Usage in dollar
usage dollar usage
PA 01 5,000 1.50 7,500 2.94
PA 02 1,500 8.00 12,000 4.71
PA 03 10,000 10.50 105,000 41.22
PA 04 6,000 2.00 12,000 4.71
PA 05 7,500 0.50 3,750 1.47
PA 06 6,000 13.60 81,600 32.03
PA 07 5,000 0.75 3,750 1.47
PA 08 4,500 1.25 5,625 2.21
PA 09 7,000 2.50 17,500 6.87
PA 10 3,000 2.00 6,000 2.36
Total 254,725 100
 ABC Classification

Percentage of total dollar usage

45.0
41.2
40.0

35.0 32.0
30.0

25.0

20.0

15.0

10.0 6.9
4.7 4.7
5.0 2.9 2.4 2.2 1.5 1.5
0.0
PA 03 PA 06 PA 09 PA 02 PA 04 PA 01 PA 10 PA 08 PA 05 PA 07
Cl
Class as Class C
A s
B
 ABC Classification

Unit Usage in Percentage of total

Item Usage
Cost($) dollar dollar usage

1 50 1200 60000 21.4

2 20 400 8000 2.8

3 72 300 21600 7.71

4 160 400 64000 22.86

5 40 600 24000 8.5

6 60 1600 96000 34.28

6400 2.3
7 40 160 280000 100
 Exercise: ABC Classification

Annual unit Percentage of total

Item Unit cost ($) Usage in dollar
usage dollar usage
PA 01 25 360
PA 02 10 70
PA 03 24 500
PA 04 15 100
PA 05 7 70
PA 06 10 1000
PA 07 2 210
PA 08 10 4000
PA 09 80 10
PA 10 5 200
Total 100
Exercise: ABC Classification

12-38
 Cycle Counting

 A physical count of items in inventory

 Cycle counting management
 How much accuracy is needed?
 When should cycle counting be performed?
 Who should do it?