INVENTORY MANAGEMENT

Prepared by Dr.Richard Tuyiragize

Email: [email protected]

What to Inventory?
An inventory is a stock or store of goods held by a firm for use in the future.
(A) Raw materials and purchased parts
(B) Partially completed goods
(C) Finished-goods inventories or merchandise
(D) Replacement parts, tools, and suppliers
(E) Goods-in-transit to warehouses or Goods-in-progress
An inventory problem exists when it is necessary to stock physical goods for the
purpose of satisfying demand over a specified period of time. An inventory
system is the set of policies and controls that monitors levels of inventory and
determines what levels should be maintained, when stock should be replenished,
and how large orders should be.

Almost every organization must stock goods to ensure smooth and efficient
running of its operations. Decisions regarding ‘how much’ and ‘when’ to order are
typical of every inventory problem. The required demand (which must be
satisfied) may be satisfied by stocking once for the entire period or by stocking
separately for every time period. These two cases correspond to overstocking
(with respect to one time unit) and understocking (with respect to the entire
period).

An overstock requires higher investment capital per unit time but less frequent
occurrences of shortages and placement of orders.

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An understock decreases the investment capital per unit time but increases the
frequency of ordering as well as the risk of running out of stock.

These two situations are costly, hence the need for the Operation Manager to
achieve a balance with stocking decisions avoiding both overstocking as well as
understocking. The fundamental decisions that must be made relate to “timing”
and “size” of orders.

Functions of Inventory
1. To meet anticipated customer demand. These inventories are referred
to as anticipation stocks because they are held to satisfy planned or
expected demand.

2. To smooth production requirements. Firms that experience seasonal

patterns in demand often build up inventories during off-season to meet
overly high requirements during certain seasonal periods. Companies that
process fresh fruits and vegetable deal with seasonal inventories.

3. To decouple operations. The buffers permit other operations to continue

temporarily while the problem is resolved. Firms have used buffers of raw
materials to insulate production from disruptions in deliveries from
suppliers, and finished goods inventory to buffer sales operations from
manufacturing disruptions.

4. To protect against stock-outs. Delayed deliveries and unexpected

increases in demand increase the risk of shortages. The risk of shortages
can be reduced by holding safety stocks, which are stocks in excess of
anticipated demand.

5. To take advantage of order cycles. Inventory storage enables a firm to

buy and produce in economic lot sizes without having to try to match
purchases or production with demand requirements in short run.

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 6. To hedge against price increase. The ability to store extra goods also
allows a firm to take advantage of price discounts for large orders.

7. To permit operations. Production operations take a certain amount of

time means that there will generally be some work-in-process inventory.

Objectives of inventory management

Any manager in charge of inventory control should have two objectives.

1. To maximize the level of customer satisfaction. This refers to having right
goods in sufficient quantities in the right place and at the right time.
2. To minimize the cost of providing that high level of customer satisfaction

These two objectives are generally in opposition. High levels of customer

satisfaction lead to high cost and vice versa. Consequently, most inventory
decisions are tradeoffs involving a compromise between customer satisfaction
and cost of providing the service.

Requirements for an effective control

An effective inventory control system should have the following;

1. Inventory Accounting System
It is necessary to keep track of the inventory at hand or on order. This system
may be periodic or continuous. Under a periodic system, account of items in
stock is made at periodic intervals. A continuous accounting system keeps
track of removal of items of stock on a continuous basis so that a current level
of inventory for each item is provided.

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2. Knowledge of lead-time variability
The lead-time of an item refers to how long it will take an ordered item to be
delivered. The higher the variability, the higher the need for additional stocks
to guard against shortages between deliveries.

3. Cost information
Effective inventory control should have reasonable estimates of the ordering
costs, holding costs and other costs.
 Ordering costs are the costs associated with ordering and receiving
of items. They include determining how much is needed, typing of
invoices, inspecting goods upon arrival for quality and quantity, and
moving the goods to temporary stores.
 Holding costs relate to physically holding goods in storage. They
include taxes, interest, insurance, depreciation, etc. They also include
opportunity costs associated with having funds tied up in inventory but
which could be used elsewhere.
 Shortage costs result when demand exceeds supply of inventory at
hand. They can include the opportunity cost of not making a sale, loss
of customer good will, etc. Shortage costs are usually difficult to
measure, so they are subjectively estimated.

4. A reliable forecast
Since inventories are kept to satisfy future demand requirements, it is
essential to have estimates of the amount and timing of demand
requirements.

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Inventory Counting Systems

1) Periodic System
This is 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.
Major users: Supermarkets, discounts stores, and department stores.
Advantage
Orders for many items occur at the same time, which can result in economies in
processing and shipping orders
Disadvantages
a) Lack of control between reviews.
b) The need to protect against shortages between review periods by carrying
extra stock.
c) The need to make a decision on order quantities at each review

2) Perpetual Inventory System (also known as a continual system)

This 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.
Advantages
1. The control provided by the continuous monitoring of inventory withdrawals.
2. The fixed-order quantity; management can identify an economic order size.
Disadvantage
1. The added cost of record keeping.

Two-bin-system method
Is two containers of inventory; reorder when the first is empty. The advantage of
this system is that there is no need to record each withdrawal from inventory; the
disadvantage is that the reorder card may not be turned in for a variety of
reasons.

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Tracking System
Universal Product Code (UPC) bar code printed on a label that has information
about the item to which it is attached. Bar coding represents an important
development for other sectors of business besides retailing. In manufacturing, bar
codes attached to parts, subassemblies, and finished goods greatly facilitate
counting and monitoring activities.

Demand Forecast and Lead time Information

Managers need to know the extent to which demand and lead time might vary; the
greater the potential variability, the greater the need for additional stock to reduce
the risk of a shortage between deliveries.

Inventory Cost (Three Basic Costs)

1. Holding or Carrying Cost is the costs to carry an item in inventory for a length of
time usually a year. Cost includes interest, insurance, taxes, depreciation,
obsolescence, deterioration, spoilage, pilferage, breakage, etc.

2. Ordering Cost is cost of ordering and receiving inventory. These include

determining how much is needed, preparing invoices, inspecting goods upon arrival
for quality and quantity, and moving the goods to temporary storage.

3. Storage Cost is cost resulting when demand exceeds the supply of inventory on
hand. These costs can include the opportunity cost of not making a sale, loss of
customer goodwill, late charges, and similar costs

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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 stock-out penalties. Example: A producer of electrical equipment might
have electric generators, coils of wire, and miscellaneous nuts and bolts among the
items carried in inventory. It would be unrealistic to devote equal attention to each of
these items.

A-B-C Approach
A-B-C Approach classifies inventory items according to some measure of
importance, usually annual dollar usage, and then allocates control efforts
accordingly.
The key questions concerning cycle counting for management are:
1. How much accuracy is needed?
2. When should cycle counting be performed?
3. Who should do it?

ECONOMIC ORDER QUANTITY MODELS

Economic Order Quantity (EOQ) is the order size that minimizes total cost. EOQ
models identify the optimal order quantity in terms of minimizing the sum of certain
annual costs that vary with order size.
The ultimate objective of any inventory model is to answer two question;
 How much to order?
 When to order?
The answer to the first question is expressed in terms of order quantity. This is
the optimum amount that should be ordered every time an order is placed. The
second question depends on the type of inventory system; periodic review (i.e. at
equal time intervals) or continuous review (ate reorder point place a new order
equal to the order quantity).

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Developing EOQ Mathematical Model
This is a mathematical model that determines the amount of goods to order to
meet projected demand while minimizing inventory costs.

Assumptions
 There is only one commodity
 The planning period is known
 The demand for the commodity in the planning period is known
 The demand rate is reasonably constant
 There are no shortages
 There is immediate delivery of the ordered quantity
 Holding costs are proportional to stock level and holding time
 There are no restrictions on capital, storage space, etc

Basis of EOQ model formulation

If the order quantity is small, then the placement of new orders is more frequent
and the average inventory level held in stock is correspondingly low. On the other
hand, ordering a large quantity leads to a higher inventory level but less frequent
placement of new orders.

Since placing orders and holding inventory in stock involves costs, the optimum
order quantity should be a tradeoff between these two types of costs. The more
frequent new orders are made, the higher the ordering costs (OC) but the
average inventory in stock will be low resulting in low holding costs (HC).

Conversely, ordering larger quantities at less frequent intervals can reduce the
higher OC, but this would increase the average inventory levels and therefore
increase HC.

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It is therefore desirable to find an optimum order quantity that compromises the
two costs.

Holding Costs (HC)

These are computed by multiplying the average amount of inventory at hand with
the HC per unit per planning period.
Let h be the holding cost per unit and assume that the order quantity q decreases
steadily to zero so that the average inventory is
1 1
(0  q) = q
2 2
Therefore, the holding cost is given by
1
HC = qh
2
The holding cost function is linear in q as shown below;

Holding
Cost

1
qh
2

Quantity

Thus, the holding cost will increase as q increases.

Ordering Costs (OC)

These are obtained by multiplying the number of orders per planning period with
the cost per order.

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Let the cost per order be denoted by s. Since demand in the planning period is
d
known and denoted by d, the number of orders is equal to q ; where q is the
order quantity.
d
Thus OC = q .s
Ordering cost

d
s
q

0 Quantity

d
Since the number of orders q decreases as q increases, then the OC is

inversely proportional to the order quantity. It therefore follows that:

Total Cost (TC) = Holding Costs + Ordering Costs
1 d
i.e. TC = qh + .s
2 q
TC
1 d
 qh
TC  s
2 q
1
qh
2

d
q

Quantity
q*

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The TC function is a U-shaped curve, which has its minimum quantity at the point
where OC and HC are equal.

To obtain the optimal order quantity q*, we minimize the TC function with respect
to q. Assuming that q is a continuous variable,

TC 1 d
= h - q 2 .s
q 2
To minimize the TC function, set the first order condition to zero.
1 d
h - 2 .s = 0
2 q

d 1
2
.s = h
q 2

2ds 2ds
q2 = *
from which q =
h h
/*compute the second order condition*/

Example
A hardware company expects to sell approximately 810 water tanks during the
coming year. Annual holding costs are shs.15000 per tank and ordering costs are
shs.75000 per tank. This company expects to operate for 270 days during the
coming year.
a) Determine the optimal order quantity.
b) How many times per year does the store re-order?
c) Determine the length of an order cycle in days.

Solution
2ds
a) Optimal order quantity =
h

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 2*810
*75000
=
15000
= 90 tanks

d
b) No. of times =
q
810
= = 9 times
90

270
c) Length of order cycle = = 30 days
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Revision Question

Westside Auto Company purchases a component used in the manufacture of

automobile generators directly from the supplier. Westside’s generator
production operation, which is operated at a constant rate, will require 1000
components per month throughout the year. Assume that the ordering costs are
$25 per order, the unit cost is $2.50 per component, and annual holding costs
are 20% of the value of the inventory. Westside has 250 working days per year
and a lead time of 5 days.
i. What is the EOQ for this component?
ii. What is the reorder point?
iii. What is the cycle time?
iv. What are the total annual holding and ordering costs associated
with your recommended EOQ?

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Economic Production Lot Size (EPLS) model

The basic EOQ model assumes that the lead time is zero. However, in some
cases, particularly in those where the firm is a producer and user, inventories
build up gradually over time. This is the case when consumption of a product
starts during its production. The EPLS model is designed for production
situations in which, once an order is placed, production begins and a constant
number of units is added to inventory each day until the production run has been
completed. The lot size is the number of units in an order. In such a case, the
approach to inventory decisions is to build a model that expresses the total cost
as a function of the production lot size. Then attempt to determine the production
lot size that minimizes the total cost i.e. optimal lot size.

Let u = production rate and v =Usage rate.

If u=v, then there will not be an inventory built up since all output will be used up.
Hence, the question of lot size does not arise.

If u>v, then it makes sense to produce since there will be an inventory built up
thus the determination of the optimal lot size.

Basis of formulation
Since production rate, u, is greater than demand rate, v, then during the
production period, the inventory builds up at a slower rate than the production
rate, i.e. at a rate equal to the difference between production and demand rate,
u-v. As long as production occurs, the inventory level will continue to build; when
production ceases, the inventory level will begin to decrease. Hence the
inventory level will be a maximum at the point where production ceases. When
the amount of inventory on hand is exhausted, production is resumed and the
cycle repeats itself.

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Considering only one lot, the variation of the inventory level is as follows:

I(t)

Production+Usage Usage
q P

D
q(1-v/u)

Time
0 t=q/u t=q/v
Production begins at t=0 and since u>v, then production and usage take place
 q q q
during the interval 0,  and demand occurs during the interval  , 
 u  u v 
The maximum inventory = q/u(u-v) = q(1-v/u)

The average inventory is given by

1
2

q 1 v
u

Assuming that h is the holding cost per unit, then,

Holding cost =
1
2

q 1 v h
u

Since the firm makes the product itself there are no ordering costs as such but
every lot is associated with a production set-up cost. These are costs incurred in
preparation for a new lot.

If d is the demand for the product and s is the set-up cost per lot, then the
d d
number of lots in the planning period is q and the total set-up cost is q .s

Total Cost (TC) = Holding cost + Set-up cost

=
1
2
  d
q1v h + .s
u q

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The objective is to minimize the total cost function.
 2
So, q TC  = 0 and TC> 0
q2
1
  2
 
Therefore, q * =  2 ds 
  v
 h1   
  u

Example

A toy manufacturer uses 48000 rubber wheels per year for his trucks. The firm
makes its own wheels which it can produce at a rate of 800 per day. The toy
trucks are assembled uniformly over the entire year. The holding cost is $1 per
wheel per year and the set-up cost of a production lot of wheels is $45. The firm
operates for 240 days in a year.
a) Determine the optimal lot size.
b) Determine the cycle time.
c) Determine the lot time.

Solution
v = 48000/240 = 200
1
 2
 
*
a) q =  2 ds 
  v
 h1   
  u
1
 2
 
=  2 * 48000* 45
= 2,400 wheels
  200 
 11   
  800 

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 q q
b) Cycle time = * 240 or
d v
2400 2400
= *240or
48000 200
= 12 days

q
c) Lot time =
u
2400
= = 3 days
800

Question
StarBat Manufacturing Company supplies baseball bats to all league baseball
teams. After an initial order in January, demand over the 6-month baseball
season is approximately constant at 1000 bats per month. Assuming that the bat
production process can handle up to 4000 bats per month, the bat production
set-up costs are $150 per setup, the production cost is $10 per bat, and that
holding costs have a monthly rate of 2%.
a) What production lot size would you recommend to meet the demand
during the baseball season?
b) If StarBat operates 20 days per month, how often will the production
process operate?
c) What is the length of the production run?

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