Inventory Management

Dr. T Kachwala

Brief OutlineMeaning of the term Inventory, Inventory ControlFunctions of InventoryEffectiveness Measures of Inventory ManagementInventory Counting SystemsInventory Classifications: ABC, VED, FSN, HML, SDE, XYZ Analysis etc.Economic Order Quantity: Basic Economic Order Quantity, EOQ for Production Lots, EOQ with Quantity Discounts

Meaning of the term InventoryAn 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 InventoryGood 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 InventoryInventory control process consists of four steps:Setting objectives (defining inventory levels)Measuring actual levels of inventoryComparing actual levels with set standardsIf there is a deviation, taking appropriate corrective actionsInventory 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 InventoryTo meet anticipated customer demand (anticipation stock). To smooth production requirements (seasonal inventories). 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)}. To hedge against price increases. To take advantage of quantity discounts.

Effectiveness Measures of Inventory ManagementManagers can use a number of measures to judge the effectiveness of inventory management. Customer satisfaction; which is measured by the number and quantity of backorders and / or customer complaints. 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. 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

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. 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)Inventory counting systems can be: Perpetual (Fixed Order Quantity Models also called EOQ or Q System) Periodic (Fixed time Period Model also referred as Periodic system or P 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:ABC based on value of item VED based on criticality to production HML based on value SDE based on lead time of procurement FSN based on requisition of material XYZ based on general classification

Classification of Inventory A-B-C ApproachA-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):

Rigid control for A-Class items.Moderate control for B-Class itemsLoose control is adequate for C-Class items.

Value of consumption of itemsNo. of itemsClass70% of value10% of no. of itemsA (very Important)20% of value20% of no. of itemsB (moderately Imp)10% of value70% of no. of itemsC (least Important)

Classification of Inventory - VED AnalysisVED 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 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. 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. 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 AnalysisHML 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 AnalysisSDE 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: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.D Difficult items, which are available but difficult to procure because there are limited suppliers, where the lead time is moderate. Moderate control is requiredE 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 AnalysisFSN 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:F Fast moving items, which are the items that are required frequently; for example all direct items. Rigid control is required.S Slow moving items are issued limited number of times in a given period; for example indirect items like machine oil. Moderate control is requiredN 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 AnalysisThe XYZ category is a general category of classification for the three classes:Example1: Categorization of the items in terms of size.X items are those items that are heavy & bulky.Y items are those items that are moderate bulky.Z items are those items that are not bulky.

Example2: Categorization of the items in terms of shelf-life.X items are those items that have very short shelf-lifeY items are those items that have moderate shelf-life.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 CostOrdering 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 CostCost 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 InventoryIf the order quantity is small (i.e. If the inventory is too little) then the following cost are high:Ordering CostsStock out CostsAcquisition CostsIf the order quantity is large (i.e. If the Inventory is too much) then the following cost are high:Carrying CostsCost of Production ProblemCost of Coordinating ProductionCost 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 : Model I Basic Economic Order Quantity (EOQ).Model II-EOQ for Production Lots.Model III-EOQ with Quantity Discounts.

Model I Basic Economic Order Quantity (EOQ)Assumptions:Annual demand, carrying cost, and ordering cost for a material can be estimated.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.Stock out, customer responsiveness, and other costs are inconsequential.Quantity discounts do not exist.

TimeQuantityReplenishment CycleMaterial Received all at once (Instantaneous Replenishment)Consumption of material at a constant rateThe same cycle repeatsQInstantaneous ReplenishmentAverage inventory when the material is received all at once isQ2Q2Slide *

Slide *

Model II-EOQ for Production LotsAssumptions: Annual demand, carrying cost, and ordering cost for a material can be estimated.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.Stock out, customer responsiveness, and other costs are inconsequential.Quantity discounts do not exist.Supply rate (p) is greater than usage rate (d)

Variable DefinitionsAll the definitions in Model I apply also to Model II. Additionallyd = rate at which units are used out of inventory (units per time period)p = rate at which units are supplied to inventory (same units as d)

QuantityTimeReplenishment CycleMaterial received uniformly at a constant rateThe 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 repeatsQAverage inventory when the material is gradually received at a constant rate is -1-dpQ21-dpQ2Slide *

Model II-EOQ for Production LotsCost Formulas -

Slide *Slide *

Model III EOQ with Quantity DiscountsAssumptions:Annual demand, carrying cost, and ordering cost for a material can be estimated.Average inventory levels can be estimated at either: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.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.Stock out, customer responsiveness, and other costs are inconsequential.Quantity discounts do exist. As larger quantities are ordered, price breaks apply to all units ordered.

Concept of Quantity DiscountQuantity 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 belowSalesVariable CostTotal CostFixed CostProfitQuantitySales / CostIt can be observed in the above break-even chart, that as the output (quantity) increases, the profit increases. Slide *

Model III-EOQ with Quantity DiscountsVariable Definitions : All the definitions in previous models apply to Model III. Additionally,TMC = Total annual material costs (rupees per year) ac = Acquisition cost of either purchasing or producing one unit of a material (rupees per unit)FormulasThe 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.Annual acquisition costs = Annual demand x Acquisition cost = (D) * acTotal annual material costs (TMC) = Total annual stocking costs + Annual acquisition cost = TSC + (D) * ac

Model III EOQ with Quantity DiscountsSlide *