Inventory Management

Muhammad Faisal
Muhammad Faisal
Chapter 7 Inventory Management
• Distinguish dependent from independent demand inventories
• Describe the four basic types of inventories and their functions
• Understand the costs of inventory and inventory turnovers
• Understand ABC classification
• Understand the EOQ model and its underlying assumptions
Reference
• Chapter 7 ; Principles of Supply Chain Management- A balanced Approach
by Joel D. Wisner (3rd Edition)
• Chapter 13, Operations and Process Management by Nigel Slack Alistair
Brandon-Jones (5th Edition)
Introduction
• Inventory can be one of the most expensive assets of an organization
• It may account for more than ten percent of total revenue or total assets for
some organizations
• Companies in the manufacturing sector usually carry more inventory than
service firms
• Inventory management policy affects how efficiently a firm deploys its assets
in producing goods and services
Introduction
• Most companies are trying to minimize their raw material inventories in an effort to
reduce costs and improve cash flow.
• But at the same time, they need to balance their ability to respond to customer
trends, so there is a need to have the right inventory on hand at the right time
• Inventory requires capital investment, handling and storage space, and it is also
subject to deterioration and shrinkage.
• Although a firm’s operating costs and financial performance can be improved by
reducing inventory, the risk of stock outs can be devastating to customer service.
Therefore, companies must strike a delicate balance between inventory investment
and customer service.
Daily Life Example
• Holding a variety of food ingredients in stock in the kitchen cupboard or
freezer
Dependent Demand and Independent Demand
• Dependent demand is the internal demand for parts based on the demand
of the final product in which the parts are used. Subassemblies, components
and raw materials are examples of dependent demand items.
• Material requirements planning (MRP) software is often used to compute
exact material requirements
Dependent Demand and Independent Demand
• Independent demand is the demand for a firm’s end products and has a
demand pattern affected by trends, seasonal patterns and general market
conditions
• Must be forecasted based on market conditions.
The Functions of Inventory
• Inventory includes all the materials and goods that are purchased, partially
completed materials and component parts and the finished goods produced
• The primary functions of inventory are to
1. Buffer
2. Decouple
The Functions of Inventory
Buffer Inventory: is also called safety inventory. Its purpose is to compensate
for the unexpected fluctuations in supply and demand.
• For example, a retail operation can never forecast demand perfectly, even
when it has a good idea of the most likely demand level.
• Can be used to cushion uncertainties due to fluctuation in supply, demand
and/or delivery lead time
• Buffer inventory levels should be determined by balancing carrying cost
against stockout cost
The Functions of Inventory
Decoupling inventory involves separating inventory within a manufacturing
process so that the inventory associated with one stage of a manufacturing
process does not slow down other parts of the process.
It is used in work-in-process inventories and act as the buffer against increased
internal demand.
Four Categories of Inventories
• Raw materials are unprocessed purchased inputs or materials for manufacturing the
finished goods. Raw materials become part of finished goods after the manufacturing
process is completed. There are many reasons for keeping raw material inventories,
including volume purchases to create transportation economies or take advantage of
quantity discounts; stockpiling in anticipation of future price increases or to avoid a
potential short supply; or keeping safety stock to guard against supplier delivery or
quality problems.
• Work-in-process (WIP) describes materials that are partially processed but not yet ready
for sales. One reason to keep WIP inventories is to decouple processing stages or to break
the dependencies between work centers.
Four Categories of Inventories
• Finished goods are completed products ready for shipment. Finished goods inventories
are often kept to buffer against unexpected demand changes and in anticipation of
production process downtime; to ensure production economies when the setup cost is very
high; or to stabilize production rates, especially for seasonal products.
• Maintenance, repair and operating (MRO) supplies are materials and supplies used
when producing the products but are not parts of the products. Solvents, cutting tools and
lubricants for machines are examples of MRO supplies. The two main reasons for storing
MRO supplies are to gain purchase economies and to avoid material shortages that may shut
down production.
Inventory Costs
• The bottom line of effective inventory management is to control inventory costs and minimize
stockout
• Inventory costs can be categorized in many ways: as direct and indirect costs; fixed and variable
costs; and order (or setup) and holding (or carrying) costs
• Direct costs are those that are directly traceable to the unit produced
• Indirect costs are those that cannot be traced directly to the unit produced
• Fixed costs are independent of the output quantity, but variable costs change as a function of
the output level
• Order costs are the direct variable costs associated with placing an order with the supplier
• Holding or carrying costs are the costs incurred for holding inventory in storage
Inventory Turnover
• A widely used measure to determine how efficiently a firm is using its inventory to
generate revenue is the inventory turnover ratio or inventory turnovers
• This ratio shows how many times a company turns over its inventory in an
accounting period
• Faster turnovers are generally viewed as a positive trend because it indicates the
company is able to generate more revenue per dollar in inventory investment
• Moreover, faster turnovers allow the company to increase cash flow and reduce
warehousing and carrying costs. Conversely, a low inventory turnover may point to
overstocking or deficiencies in the product line or marketing effort.
Cycle Counting
• A common problem with many inventory management systems is the
challenge to maintain accurate inventory records
• Many organizations use cycle counting to reconcile discrepancies between
their physical inventory and inventory record on a monthly or quarterly basis
• Cycle counting, or physically counting inventory on a periodic basis, also
helps to identify obsolete stocks and inventory problems so that remedial
action can be taken in a reasonable amount of time
• Cycle counting can be costly and time-consuming and can disrupt operations
The ABC Inventory Control System
• The ABC inventory control system is a useful technique for determining which inventories
should be counted more frequently and managed more closely and which others should not
• ABC analysis is often combined with the 80/20 rule or Pareto analysis
• The 80/20 rule suggests that 80 percent of the objective can be achieved by doing 20
percent of the tasks
• The ABC inventory control system prioritizes inventory items into Groups A, B and C
• A items are given the highest priority, while C items have the lowest priority and are typically
the most numerous (the B items fall somewhere in between
Inventory Models
• The deterministic inventory models are discussed that assume demand,
delivery lead time and other parameters are deterministic
• These models use fixed parameters to derive the optimum order quantity to
minimize total inventory costs
• Thus, these models are also known as the fixed order quantity models
The Economic Order Quantity Model
• The basic order decision is to determine the optimal order size that
minimizes total annual inventory costs—that is, the sum of the annual order
cost and the annual inventory holding cost
• The issue revolves around the trade-off between annual inventory holding
cost and annual order cost
• The EOQ model thus seeks to find an optimal order size that minimizes the
sum of the two annual costs
Assumptions of the EOQ Model
• The demand is known and constant
• Order lead time is known and constant
• Replenishment is instantaneous
• The entire order is delivered at one time and partial shipments are not allowed
• Price is constant
• Quantity or price discounts are not allowed
• The holding cost is known and constant. The cost or rate to hold inventory must be known and constant
• Order cost is known and constant. The cost of placing an order must be known and remains constant for all
orders
• Stockouts are not allowed. Inventory must be available at all times
Deriving the Economic Order Quantity
• TAIC=Annual purchase Cost +Annual holding cost + Annual order cost
• TAIC=APC + AHC + AOC
• TAIC= (R*C) + (Q/2)*(K*C) + (R/Q)*S
• TAIC= Total annual inventory cost
• APC=annual purchase cost
• AHC=Annual holding cost
• AOC=annual order cost R=annual requirement or demand
C=purchase cost per unit S=cost of placing one order
k=holding rate; where annual holding cost per unit= K × C Q=order quantity
Deriving the Economic Order Quantity
• Since R, C, k and S are deterministic
• Put dTAIC / dQ = 0

• EOQ = 2𝑅𝑆/𝐾𝐶
• The managerial implication here is that purchase cost does not affect the
order decision if there is no quantity discount
• Thus, the annual purchase cost is ignored in the classic EOQ model
Economic Order Quantity And Total Cost
Physical Inventory with EOQ Model
The Quantity Discount Model
• The quantity discount model or price-break model is one variation of the classic EOQ
model
• It relaxes the constant price assumption by allowing purchase quantity discounts
• Unlike the EOQ model, the annual purchase cost now becomes an important factor in
determining the optimal order size and the corresponding total annual inventory cost
• The quantity discount model must consider the trade-off between purchasing in larger
quantities to take advantage of the price discount (while also reducing the number of orders
required per year) and the higher costs of holding inventory
• A price break point is the minimum quantity required to get a price discount
EOQ Numericals
1. The annual requirement of a part is 360,000 units. The order cost is $120 per
order, the holding rate is 12 percent and the part cost is $2,500 per unit. What are
the (a) EOQ, (b) annual holding cost, (c) annual order cost, and (d) annual total
inventory cost?
2. The weekly requirement of a part is 950 units. The order cost is $85 per order, the
holding cost is $5 per unit per year and the part cost is $250 per unit. The firm
operates fifty-two weeks per year. Compute the (a) EOQ, (b) annual holding cost,
(c) annual order cost, and (d) annual total inventory cost.
3. The monthly demand for a part is 1,500 units. The order cost is $285 per order,
the holding cost is $56 per unit per year and the part cost is $850 per unit. The
firm operates twelve months per year. Compute the (a) EOQ, (b) annual holding
cost, (c) annual order cost, and (d) annual total inventory cost.