INVENTORY CONTROL

Inventory refers to stock of goods, commodities, or other economic resources that are stored or
reserved at any given period for future production or for meeting future demand.

Inventory planning is the determination of the type and quantity of inventory items that would be
required at future points for maintaining production schedules. Inventory planning is generally
based on information from the past and also on factors that would arise in future.

Inventory management is the function of directing the movement of goods through the entire
manufacturing cycle from the requisition of raw materials to the inventory/stock of finished
goods in such a manner as to meet the objectives of maximum customer service with minimum
investment and efficiency.

In inventory control is primarily concerned with the inventory cost control. The objectives of
inventory control are: -

1. To minimize financial investments in inventories.

2. To ensure availability of the supply of stock at all time.
3. To allow flexibility in production scheduling.
4. To ensure that the value of the material consumed is minimum.
5. Reduce surplus stock.

Types of inventories
1. Direct inventories – these include items which play a direct role in the manufacturing process and
become an integral part of the finished goods, e.g. raw materials, work in progress inventories,
finished goods inventories, spare parts.
2. Indirect inventories – include those items necessary for manufacturing but do not become an
integral component of the finished product e.g.
a. Lubricants
b. Machinery/equipment
c. Labour
Inventory decisions
1. How much of an item to order?
2. When to replenish the inventory of the item?

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INVENTORY CONTROL TERMINOLOGY
1. Inventory or stock cost
There are several:
i) Purchase/Production cost – cost of purchasing a unit of item
ii) Ordering/Acquisition/Set-up cost – costs related to acquisition of purchased items i.e. those of getting
an item to a firm’s store e.g. transport, loading and off-loading, inspection.
iii) Inventory carrying/ holding costs – costs associated with holding a given level of inventory e.g.
warehousing, spoilage, security, pilferage, administrative, insurance, depreciation.
iv) Stock-out cost/ shortage costs – incurred due to a delay in meeting demand or inability to meet
demand at all because of shortage of stock loss of future sales, cost associated with future
replenishment.
2. Order cycle – the time period between placement of 2 successive orders.
3. Lead time – time between placing an order and actual replenishment of item. Also referred to as
procurement time.
4. Time horizon – this is the period over which the inventory level will be controlled.
5. Maximum stock – the level beyond which stocks should not be allowed to rise.
6. Minimum stock level/buffer stock/safety stock – level below which stock should not be allowed to
fall. It is the additional stock needed to allow for delay in delivery or for any higher than expected
demand that may arise due to lead time.
7. Reorder level – point at which purchased order must be sent to supplier for the supply of more stock.
The level of stock at which further replenishment order should be placed.
8. Reorder quantity – the quantity of the replacement order.

9. Average stock level

Minimum stock level  Maximum stock level

Average stock level 
2

10. Physical stock – no. of items physically in stock at any given time.
11. Stock replenishment – rate at which items are added to the inventory.
12. Free stock – the physical stock plus the outstanding replenishment orders minus the unfulfilled
requirements.
13. Economic order quantity (EOQ) – the quantity at which the cost of having stocks is minimum.
14. Economic batch quantity – quantity of stock within the enterprise. Company orders form within its
own warehouses unlike in EOQ where it is ordered from elsewhere.

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INVENTORY COSTS

There are four major elements of inventory costs that should be taken for analysis, such as

(1) Item cost, Rs. C1/item.

(2) Ordering cost, Rs. C2/order.
(3) Holding cost Rs. C3/item/unit time.
(4) Shortage cost Rs. C4/item/Unit time.
Item Cost (C1)

This is the cost of the item whether it is manufactured or purchased. If it is manufactured,

it includes such items as direct material and labor, indirect materials and labor and overhead
expenses. When the item is purchased, the item cost is the purchase price of 1 unit. Let it be
denoted by Rs. C1 per item.
Purchasing or Setup or Acquisition or Ordering Cost (C2)
Administrative and clerical costs are involved in processing a purchase order, expediting,
follow up etc., It includes transportation costs also. When a unit is manufactured, the unit set up
cost includes the cost of labor and materials used in the set up and set up testing and training
costs. This is denoted by Rs. C2 per set up or per order.
Inventory holding cost (C3)

If the item is held in stock, the cost involved is the item carrying or holding cost. Some of the
costs included in the unit holding cost are
(1) Taxes on inventories,
(2) Insurance costs for inflammable and explosive items,
(3) Obsolescence,
(4) Deterioration of quality, theft, spillage and damage to times,
(5) Cost of maintaining inventory records.
This cost is denoted by Rs. C3/item/unit time. The unit of time may be days, months,
weeks or years.

Shortage Cost (C4)

The shortage cost is due to the delay in satisfying demand (due to wrong planning); but
the demand is eventually satisfied after a period of time. Shortage cost is not considered as the
opportunity cost or cost of lost sales. The unit shortage cost includes such items as,
(1) Overtime requirements due to shortage,
(2) Clerical and administrative expenses.
(3) Cost of expediting.
(4) Loss of goodwill of customers due to delay.
(5) Special handling or packaging costs.
(6) Lost production time.

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 This cost is denoted by Rs. C4 per item per unit time of shortage.

3 Types of inventory control systems

1. Reorder level system

2. Periodic review system
3. Economic order quantity (EOQ)

Economic order quantity (EOQ)

This is the ordering quantity which minimizes the balance of cost between inventory holding cost
and ordering costs. It is based on the following assumptions:

1. A known constant stock holding cost.

2. A known constant ordering cost.
3. The rate of demand is known (is deterministic).
4. A known constant price per unit.
5. Inventory replenishment is done instantaneously.
6. No stock-out is allowed.
7. Quantity discounts are not allowed – purchase price is constant.
8. Lead time is known and fixed.

Deriving EOQ can be done using three methods:

1. Graphical method.
2. Tabular method.
3. Algebraic method.

ALGEBRAIC METHOD

Variables used:

Q = number of units per order

Q* = economic order quantity or optimal no. of units per order to minimize total cost

D = annual demand requirement (units per year)

C = cost of 1 unit of item

C0 = ordering (preparation or set-up) cost of each order

Ch = Cc = holding or carrying cost per unit per period of time

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T = length of time between two successive orders

N = no. of orders or manufacturing runs per year

TC = Total Inventory cost

The optimal order quantity (EOQ) is at a point where the ordering cost = holding cost

1. Annual ordering cost

Annual ordering cos t  (no. of orders placed per year )  (ordering cos t per order )
 
  order cos t per order 
Annual Demand
 
 no. of units in each order 
D
  Co
Q

2. Annual holing ( or carrying) cost

Annual ordering cos t  ( Average inventory level )  (carrying cos t per order )
Q
  Ch
2

3. Equating (1) and (2) above

Since the minimum TC occurs at the point where the ordering cost and the inventory carrying
costs are equal, we equate the 2 equations above.

D Q
 Co   C h
Q 2

Solve for Q

2 DC o  Q 2 C h
2 DC o
Q2 
Ch
2 DC o
Q* 
Ch
2 DC o
EOQ 
Ch

Note:

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1. Inventory holding or carrying costs are often expressed as annual percentage(s) of the unit
cost or price.
Co or Ch as % of unit cost or price

I = annual inventory carrying charge (cost) as 1% of price

Ch = IC where C is the unit price of inventory item

2 DC o
EOQ = Q* =
Ch

2. Total cost is sum of annual Cc and annual ordering cost.

D Q
TC  .Co  .C h
Q 2

Example 1:

A manufacturer has to supply his customers with 1200 units of his product per annum. The
inventory carrying cost amounts to ₤ 1.2 per unit. The set-up cost per run is ₤ 160. Find:

i) EOQ
ii) Minimum average yearly cost
iii) Optimum no of orders per year
iv) The optimum time between orders (optimum period of supply per optimum order)

Solutions

i) Economic order quantity

2 DC o
EOQ 
Ch
2(1200)(160)

1.2
 565.69 or 566 units

ii) Minimum average yearly cost

Total cost = ordering cost + holding cost

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 D Q
TC  .C o  .C h
Q 2
DC o Q *C h
TC (Q * )  
Q* 2
1200(160) 566(1.2)
 
566 2
 339.22  339.6
 £ 678.82 or £ 679

iii) Optimum no. of orders per year (N*)

Demand
N* 
EOQ
1200

566
 2.1 orders  3 orders

iv) Optimum time between orders

no. of working days in a year
T* 
N*
365

3
 122

Example 2:

The annual demand per item is 6400 units. The unit cost is ₤ 12 and the inventory carrying
charges 25% per annum. If the cost of procurement is ₤ 300 determine:

i) EOQ
ii) No. of orders per year
iii) Time between 2 consecutive orders
iv) Optimal cost

Solution

i) EOQ

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 2 DC o
EOQ 
Ch
C h  IC
2 DC o
EOQ 
IC
2(6400)(300)

(0.25)(12)
 1131 units

ii) N*
Demand
N* 
EOQ
6400

1131
 5.65 orders  6 orders

iii) Time between 2 consecutive orders

no. of working days in a year
T* 
N*
365

5.65
 64.60

OR

EOQ
T*   12 months
Demand
1131
  12 months
6400
 2 months 4 days

iv) Optimal cost

optimal cos t  unit cos t  demand   2 DC o C h

 12  6400  2(6400)(300)(0.25  12)
 80194.11

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