Inventory Planning

Introduction
Types and number of items held in the stock to feed the
production process or Service process. Equally applicable to
Service industry (Hotels, Hospitals, etc..).
It is an Idle stock, with an intention to be used in future.
Inventory Types: Types of Demand:
• Raw material Direct Demand: TV’s, FMCG
• Parts for assembly Derived demand: In Industrial
• WIP- Work in progress market, demand for Bearings and
• Finished goods Tires is dependent on the cars
manufactured.
On average % of Material cost is about ????

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Inventory Planning
Independent demand items
• Finished goods and spare parts typically belong to independent demand items in
manufacturing organizations. Mass Production items.
•
• Two attributes characterize and distinguish independent demand items:
– Timing of demand: Independent demand items have a continuous demand
– Uncertainty of demand: There is considerable element of uncertainty in the
demand in the case of independent demand items. Planning depends on
correctness of FORECASTING .

• Inventory planning of independent demand items (mass production items) must

address the following two key questions:
– How much?
– When?

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Types of Inventory
• Seasonal Inventory: Seasonality in demand is absorbed using inventory. Produce
more to supply in peak season. Ex: Warm clothes, Festival season sale.

• Decoupling Inventory: Complexity of production control is reduced by splitting

manufacturing into stages and maintaining buffer inventory between these stages.

• Cyclic Inventory: Periodic replenishment causes cyclic inventory. Purchasing once

in a month. On 1st of month, stock is highest.

• Pipeline Inventory: Exists due to lead time to accommodate transportation delays

• Safety Stock: Used to absorb fluctuations in demand due to uncertainty

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Inventory- Terms
•Inventory level – Weeks or Months

•Re-order level: stock level at which fresh

order is placed.

•Lead time: Duration time between placing

an order & receipt of material

•Obsolescence: Due to change in design or

material specs, items becomes unusable.

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Costs in Inventory Planning
Types of Cost
• Carrying cost
• Ordering cost
• Shortage cost

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Costs in Inventory Planning
Carrying Cost
• Interest for short-term loans for working capital
• Cost of stores and warehousing
• Administrative costs related to maintaining and
accounting for inventory
• Insurance costs, cost of obsolescence, pilferage,
damages and wastage
• All these costs are directly related to the level of
inventory

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Costs in Inventory Planning
Ordering Cost
• Search and identification of appropriate sources of supply
• Price negotiation, contracting, purchase order generation, and
Sample study
• Follow-up and receipt of material
• Eventual stocking in the stores after necessary accounting and
verification

• A larger order quantity will require less number of orders to

meet a known demand & vice versa
Cost of carrying and cost of ordering are fundamentally two
opposing cost structures in inventory planning.
A good inventory planning aims at balancing these two costs.
Method is called EOQ- Economic Order Quantity.

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Costs in Inventory Planning
Shortage Cost
Due to shortage of material, company has to adjust its
production schedule.
• Costs arising out of pushing the order back and rescheduling
the production system to accommodate these changes
• Rush purchases, uneven utilisation of available resources and
lower capacity utilization (if machines are idle for some time)
• Missed delivery schedules leading to customer dissatisfaction
and loss of good will and image in the market
• Cost of lost sales
• The effects of shortage are vastly intangible, it is indeed
difficult to accurately estimate

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Inventory Control for deterministic demand:
EOQ Model
EOQ model aims at balancing Ordering cost and Carrying cost.

This does not include Material Unit cost.

Total Carrying cost

Cost

Total Ordering cost

Units, Order Quantity

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
Inventory Control for deterministic demand:
EOQ Model
Demand during the planning period =D
Order quantity =Q
The cost of ordering per order =Co
Inventory carrying cost per unit per unit time =C
c

Q
The average inventory carried by an organization =
2
Q 
A. The cost associated with carrying inventory =  * Cc 
2 
D 
B. The total ordering cost is given by  * C o 
Q 
Total cost of the plan = A+B
= Total cost of carrying inventory + Total cost of ordering
Q  D 
TC(Q) =  * C c  +  * C o 
2  Q 

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 EOQ Model
A graphical representation
Sum of the two costs
Cost of Inventory

Total cost of carrying

Minimum Cost

Total cost of ordering

Economic Level of Inventory

Order Qty.

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Issues in using EOQ Model
assumptions

1. The demand is known with certainty and demand is continuous over

time
2. There is an instantaneous replenishment of items
3. The items are sourced from an outside supplier
4. Assumptions about order quantity
a) There are no restrictions in the quantity that we can order
b) There are no preferred order quantities for the items
c) No price discount is offered when the order size is large

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Economic order of quantity

EOQ = Balances the Ordering cost and Carrying cost on annual basis

ECONOMIC ORDER OF
QUANTITY(EOQ)

PURCHASING CARRYING
COST COST

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 EOQ Calculation

2C o D
Q *

Cc

D= Annual Demand
Co= Ordering cost per order
Cc= Carrying cost per unit cost per year
Q* = EOQ in units

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Inventory Planning Models
Example 17.5.(EOQ)
Mean of weekly demand : 200
Unit cost of the raw material : Rs. 300/-
Ordering cost : Rs. 460/- per order
Carrying cost percentage : 20% per annum
Number of weeks per year : 52

Given:
Weekly demand = 200
Annual demand, D = 200*52 = 10,400
Carrying cost, Cc = Rs. 60.00 per unit per year (20% of Unit cost)

Economic Order Quantity = 2Co D 2 * 460 *10,400

  399.33  400
Cc 60

Number of orders per year= 10,400/400= 26

Order in every 2 weeks ( 52 weeks in a year)

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Inventory Planning Models
Example 17.1.(EOQ)
Annual demand : D= 2500
Unit cost of the raw material : Cu= Rs. 750
Ordering cost : Co= Rs. 1080 per order
Carrying cost percentage : Cc= Rs.135 per unit per annum
Some times Cc is given as % of Unit cost.

Calculate EOQ and how many times orders have to be placed in an year.
2C o D
Q 
*

Cc

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
EOQ Calculation – Practice questions
2C o D
Q 
*

Cc Try to solve example 17.3 from

book.
D= Annual Demand
Co= Ordering cost per order
Cc= Carrying cost per unit cost per year
Q* = EOQ in units

1. An auto industry purchases spark plugs at the arte of Rs

25 per piece. The annual consumption is 18,000 nos. If
ordering cost is Rs 250 and Inventory carrying cost is 25%
per annum, calculate the EOQ.
2. A factory uses 2000 units of raw material monthly. Unit
cost is Rs 1.25. Order placing cost is Rs 25 and inventory
carrying cost is 6% per year. Calculate the EOQ.
Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 EOQ Calculation
2C o D
Q *

Cc

D= Annual Demand
Co= Ordering cost per order
Cc= Carrying cost per unit cost per year
Q* = EOQ in units

1. An auto industry purchases spark plugs at the arte of Rs 25 per piece. The
annual consumption is 18,000 nos. If ordering cost is Rs 250 and Inventory
carrying cost is 25% per annum, calculate the EOQ. ( Ans 1.2K).
2. A factory uses 2000 units of raw material monthly. Unit cost is Rs 1.25.
Order placing cost is Rs 25 and inventory carrying cost is 6% per year.
Calculate the EOQ. (4k)

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
Inventory control-Inventory control systems and techniques.

Inventory classification Models

The control can be for order quality, Quantity and order frequency.
The different techniques of inventory control are:

(1) ABC analysis

(2) HML analysis,
(3) VED analysis
(4) FSN analysis
(5) SDE analysis
(6) GOLF analysis

The most widely used method is ABC analysis. In this technique,

the total inventory is categorised into three sub-heads and then
proper exercise is exercised for each sub-heads.

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Selective Control of Inventories
Alternative Classification Schemes
• ABC Classification (on the basis of consumption value)

• XYZ Classification (on the basis of unit cost of the item)

– High Unit cost (X Class item)
– Medium Unit cost (Y Class item)
– Low unit cost (Z Class item)

• FSN Classification (on the basis of movement of inventory)

– Fast Moving
– Slow Moving
– Non-moving

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Selective Control of Inventories
Alternative Classification Schemes
• VED Classification (on the basis of criticality of items)
– Vital
– Essential
– Desirable

• On the basis of sources of supply

– Imported
– Indigenous (National Suppliers)
– Indigenous (Local Suppliers)

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 Inventory control- ABC Analysis

ABC analysis:

In this analysis, the classification of existing inventory is based on

• annual consumption and
• annual value of the items

Hence we obtain the quantity of inventory item consumed during

the year and multiply it by unit cost to obtain annual usage cost.
The items are then arranged in the descending order of such
annual usage cost. The analysis is carried out by drawing a graph
based on the cumulative number of items and cumulative usage of
consumption cost. Classification is done as follows:

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 ABC ANALYSIS
(ABC = Always Better Control)

This is based on cost criteria.

It helps to exercise selective control when confronted with large number

of items it rationalizes the number of orders, number of items & reduce
the inventory.

High
A
Annual
₹ value B
of items

Low C
Few Many
Number of Items

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 ‘A’ ITEMS
Small in number, but high in value
Must have:
•Tight control
•Rigid estimate of requirements
•Strict & closer watch
•Low safety stocks
•Managed by top management

20% of Items contribute to 70% of procurement cost

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 ‘B’ ITEM
Intermediate
Must have:
•Moderate control
•Purchase based on rigid requirements
•Reasonably strict watch & control
•Moderate safety stocks
•Managed by middle level management

30% of Items contribute to 20% of procurement cost

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 ‘C’ ITEMS
Larger in number, but less in value
Must have:
•Ordinary control measures
•Purchase based on usage estimates
•High safety stocks

50% of Items contribute to 10% of procurement cost

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
 VED ANALYSIS

• Based on critical value & shortage cost of an item

Items are classified into:

Vital:
•Shortage cannot be tolerated.

Essential:
•Shortage can be tolerated for a short period.

Desirable:
Shortage will not adversely affect, but may be using more
resources. These must be strictly Scrutinized

Used in managing Spare parts inventory

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
Based on availability
Scarce
Managed by top level management
Maintain big safety stocks

Difficult
Maintain sufficient safety stocks

Easily available
Minimum safety stocks

GOLF analysis – Based on supplier type/location:

• Government : May involve lengthy procurement procedure

• Local : Local suppliers -Private
• Foreign : Sources from other countries. Involves longer lead time and
extensive documentation.

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education
FSN ANALYSIS
Based on utilization.
• Fast moving.
• Slow moving.
• Non-moving.
Non-moving items must be periodically reviewed to prevent expiry &
obsolescence

HML ANALYSIS
Based on cost per unit
• Highest
• Medium
• Low
This is used to keep control over consumption
at departmental level for deciding the frequency of physical verification.

Mahadevan (2015), “Operations Management: Theory & Practice”, 3rd Edition © Pearson Education