UNIVERSITY OF MAKATI

J. P. Rizal Ext., West Rembo, Makati City

COLLEGE OF BUSINESS AND FINANCIAL SCIENCE
Department of Marketing Management
Course Title Title
Module No. 5
Inventory Management
Operations Management Module Leader Ambrosio L. Yalong Jr.
with TQM
Module
Contributors
Timeframe Two weeks
Complete the reading of the Module
How to Complete this
Watch Video Lecture (Module 1 Part 1 and Part 4)
Module?
Participate in Face-to-Face or Online Discussion
Face-to-Face or Online Discussion
Teaching Strategies Upload Video Recorded Lecture to LMS and/or Google Classroom
Give Assignment and Q & A during discussion
Inventory management is a core operations management activity. Effective inventory
management is important for the successful operation of most businesses and their supply chains.
INTRODUCTION

Inventory management impacts operations, marketing, and finance. Poor inventory management
hampers operations, diminishes customer satisfaction, and increases operating costs.

Any organization which is into production, trading, sale and service of a product will necessarily
hold stock of various physical resources to aid in future consumption and sale. While inventory is a
necessary evil of any such business, it may be noted that the organizations hold inventories for
various reasons, which include speculative purposes, functional purposes, physical necessities etc.
At the end of this module, students will be able to:
LEARNING OUTCOMES

1. Define the term inventory, list the major reasons for holding inventories.
2. Discuss the main requirements for effective inventory management.
3. Appreciate the basic EOQ model and its assumptions and solve typical problems.
4. Explain periodic and perpetual review systems.
5. Discuss the nature and importance of service inventories.
 MODULE 5
Inventory Management

What is an Inventory?

Inventory is an accounting term that refers to goods that are in various stages of being made ready
for sale, including:

• Finished goods (that are available to be sold)

• Work-in-progress (meaning in the process of being made)
• Raw materials (to be used to produce more finished goods)

Functions of Inventory:

1. Meeting customer demand: Maintaining finished goods inventory allows a company to

immediately fill customer demand for product. Failing to maintain an adequate supply of
FGI can lead to disappointed potential customers and lost revenue.
2. Protecting against supply shortages and delivery delays: A supply chain is only as strong as
its weakest link, and accessibility to raw materials is sometimes disrupted. That’s why some
companies stockpile certain raw materials to protect themselves from disruptions in the
supply chain and avoid idling their plants and other facilities.
3. Smoothing production requirements: Businesses that produce nonperishable products
and experience seasonal customer demand often try to build up inventory during slow
CONTENT

periods in anticipation of the high-demand period. This allows the company to maintain
thruput levels during peak periods and still meet higher customer demand.
4. To decouple operations. Historically, manufacturing firms have used inventories as buffers
between successive operations to maintain continuity of production that would otherwise
be
disrupted by events such as breakdowns of equipment and accidents that cause a portion
of the operation to shut down temporarily. The buffers permit other operations to
continue temporarily while the problem is resolved.
5. To protect against stockouts. Delayed deliveries and unexpected increases in demand
increase the risk of shortages. Delays can occur because of weather conditions, supplier
stockouts, deliveries of wrong materials, quality problems, and so on. The risk of shortages
can be reduced by holding safety stocks, which are stocks in excess of expected demand to
compensate for variabilities in demand and lead time.
6. To hedge against price increases. Occasionally a firm will suspect that a substantial price
increase is about to occur and purchase larger-than-normal amounts to beat the increase.
7. Taking advantage of quantity discounts: Many suppliers offer discounts based on certain
quantity breaks because large orders tend to reduce total processing and shipping costs
while also allowing suppliers to take advantage of economies of scale in their own
production processes.

https://www.dummies.com/business/operations-management/the-purpose-of-inventory-in-
operations-management/
 “For Academic Discussion Purposes Only”
Requirements for Effective Inventory Management:

Management has two basic functions concerning inventory. One is to establish a system to
keep track of items in inventory, and the other is to make decisions about how much and when to
order. To be effective, management must have the following:

A. A system to keep track of the inventory on hand and on order.

B. A reliable forecast of demand that includes an indication of possible forecast error.
C. Knowledge of lead times and lead time variability.
D. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
E. A classification system for inventory items.

Let’s take a closer look at each of these requirements.

A. Inventory Counting Systems:

A.1 Periodic 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.2 Perpetual inventory System (also known as a continual system) – it 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.
A.3 Two-Bin system - a very elementary system, uses two containers for inventory. Items
are withdrawn from the first bin until its contents are exhausted. It is then time to reorder.
Sometimes an order card is placed at the bottom of the first bin. The second bin contains
enough stock to satisfy expected demand until the order is filled, plus an extra cushion of
stock that will reduce the chance of a stockout if the order is late or if usage is greater than
CONTENT

expected.
A.4 Point-of-Sale (POS) Systems - electronically record actual sales. Knowledge of actual
sales
can greatly enhance forecasting and inventory management: By relaying information about
actual demand in real time, these systems enable management to make any necessary
changes to restocking decisions.

B. Demand Forecasts and Lead-Time Information:

Inventories are used to satisfy demand requirements, so it is essential to have reliable

estimates of the amount and timing of demand. Similarly, it is essential to know how long it
will take for orders to be delivered.

B.1 Lead Time - refers to time interval between ordering and receiving the order, (the time
between submitting an order and receiving it) might vary; the greater the potential
variability, the greater the need for additional stock to reduce the risk of a shortage
between deliveries.\
 C. Inventory Costs:

C.1 Purchase Cost - is the amount paid to a vendor or supplier to buy the inventory. It is
typically the largest of all inventory costs.
C.2 Holding (carrying) Cost – a cost to carry an item in inventory for a length of time,
usually a year.
C.3 Ordering costs - are the costs of ordering and receiving inventory. They are the costs
that
vary with the actual placement of an order.
C.4 Shortage costs – this cost resulting when demand exceeds the supply of inventory;
often unrealized profit per unit.

D. Classification System:

An important aspect of inventory management is that items held in inventory are not of
equal
importance in terms of dollars invested, profit potential, sales or usage volume, or stockout
penalties. It would be unrealistic to devote equal attention to each of these items. Instead,
a more reasonable approach would be to allocate control efforts according to the relative
importance of various items in inventory.

D.1 A-B-C approach - classifying inventory according to some measure of importance, and
allocating control efforts accordingly.
Example
CONTENT
 Inventory Ordering Policies:

Inventory ordering policies address the two basic issues of inventory management, which are
how much to order and when to order. In the following sections, a number of models are
described that are used for these issues.

1. Cycle stock - the amount of inventory needed to meet expected demand.

2. Safety stock - extra inventory carried to reduce the probability of a stockout due to
demand and/or lead time variability.

Source: Operations Management 11th Edition by William Stevenson

“For Academic Discussion Purposes Only”
CONTENT

Economic Order Quantity (EOQ) formula

EOQ is the optimum number of products you should purchase to minimize the total cost of
ordering or holding stock. Figuring out EOQ can potentially save you a significant amount of
money.

Where:
D = Setup or order costs (per order, generally includes shipping and handling)
K = Demand rate (quantity sold per year)
H = Holding or carrying costs (per year, per unit)
 https://www.tradegecko.com/inventory-management/techniques-process
(For class discussion purposes only)

Days Inventory Outstanding (DIO) formula

Days inventory outstanding (DIO), also known as days sales of inventory (DSI), refers to the
number of days it takes for inventory to turn into sales. The average inventory days outstanding
varies from industry to industry, but generally a lower DIO is preferred. Determining whether
your DIO is high or low depends on the average for your industry, your business model, the types
of products you sell, etc.

https://www.tradegecko.com/inventory-management/techniques-process

Reorder Point Formula

The reorder point formula answers the age-old question: When is the right time to order more
stock? Calculating your reorder point takes three steps:
1. Determine your lead time demand in days
2. Calculate your safety stock in days
3. Sum your lead time demand and your safety stock
CONTENT

https://www.tradegecko.com/inventory-management/techniques-process
(For class discussion purposes only)

Safety Stock Formula

Safety stock acts as an emergency buffer you can break out when it looks like you’re on the verge
of selling out. You want to have enough safety stock to meet demand, but not so much that
increased carrying costs end up straining your finances.
While this sounds like common sense, the trick is to decide on how much safety stock to carry:
1. Multiply your maximum daily usage by your maximum lead time in days
2. Multiply your average daily usage by your average lead time in days
3. Calculate the difference between the two to determine your safety stock
 https://www.tradegecko.com/inventory-management/techniques-process
(For class discussion purposes only)

Fixed-Order Interval Model:

The fixed-order-interval (FOI) model - an arrangement whereby STOCK is reordered at regular intervals in
variable quantities. It is used when orders must be placed at fixed time intervals (weekly, twice a month,
etc.): The timing of orders is set. The question, then, at each order point, is how much to order. Fixed-
interval ordering systems are widely used by retail businesses. If demand is variable, the order size will tend
to vary from cycle to cycle.

Single-Period Model:

1. Single-period model - a model for ordering of perishables and other items with limited
useful lives.
2. Shortage cost – it is generally, the unrealized profit per unit.
3. Excess cost - the difference between purchase cost and salvage value of items left over at
the end of a period.
4. Service Level - is the probability that demand will not exceed the stocking level, and
computation of the service level is the key to determining the optimal stocking level.
 Source: Operations Management 11th Edition by William Stevenson
“For Academic Discussion Purposes Only”

MODULE 5: LEARNING CHECK

ASSESSMENT

1. What are the primary reasons for holding inventory?

2. Briefly describe each of the costs associated with inventory.

MODULE 5: ASSIGNMENT
ASSIGNMENT

1. Explain how a decrease in setup time can lead to a decrease in the average amount of
inventory a firm holds, and why that would be beneficial.
 RUBRICS

Montoya, Rome Sheriff G. (2017). Strategic Production and Operations Management, First Edition.
Unlimited Books Library Services and Publishing Inc., Manila
Fitzsimmons, James A., Fitzsimmons, Mona J. and Bordoloi, Sanjeev. Service Management:
Operations, Strategy, Information Technology. New York. McGraw Hill. 2019
REFERENCES

Stevenson, William; Operations Management Eleventh Edition, 2012 by McGraw-Hill Book, Inc.
https://www.dummies.com/business/operations-management/the-purpose-of-inventory-in-
operations-management/
https://www.tradegecko.com/inventory-management/techniques-process
https://www.coursehero.com/file/p7ahr60/Requirements-for-Effective-Inventory-Management-
Effective-inventory-management/
https://www.youtube.com/watch?v=uhMcWdlkWxE