Management Science

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Inventory Management

Module 006 Inventory Management

At the end of this module you are expected to:

1. Discover inventory management
2. Learn the reasons for holding inventory
3. Classify inventory models
4. Differentiate the types of costs of inventory models
5. Identify inventory control systems

A. Definition of Inventory Management

By this time, we should already understand that every management problem is a

problem that would involve making decisions. Making decisions is a necessary and
important task of all organizations. Much like our Hot Tubs example, decisions on
acquiring, allocating, and controlling the factors of production are necessary for the
business to achieve its objectives. One of the key variables in the supply chain that needs to
be managed is inventory.

Inventory being one of the most important assets of an organization can make or
break a business if not properly managed. Inventory has been defined somewhat
differently by different authors and by different areas of management like materials
management, production/operations management, inventory management, and financial
management. Nonetheless, all of the different definitions revolve around pretty much the
same thing that inventory is the term used for raw materials and supplies, goods or items
in the process of manufacturing or production, the finished goods, items or products,
finished products in transit, on-hand products or merchandise in a store, or the list that
contains these materials, supplies, or goods.

Inventory Management is thus the management of these assets of an organization or

business. Generally speaking, and to put it simply, inventory management is managing and
making decisions on raw materials and supplies, goods in the process of being produced,

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and finished goods. Those are the three main areas. Finished goods can then be transported
or stored and it is indeed still a form of inventory, but its general form is that of being a
finished product.

B. Reasons for Holding Inventory

Another term for inventory is stocks. Stocks are goods, materials, or supplies that
are stored by an organization. For example, when a gas station gets a delivery of petroleum
from a tanker it is held as a stock until it gets sold to customers, when finished goods of a
factory gets shipped or transported to a warehouse they are put into stock or inventory,
when a restaurant gets delivered its vegetables they are put into stock until it gets served
to customers in the form of a meal. Its main purpose is to act as a buffer (of supply)
between demand and supply particularly in unexpected times where demand is bigger than
expected.

There are other reasons for holding stock and these are:

• Be a buffer between different operations

• Withstand delayed deliveries or when delivery is too small
• Take advantage of price discount from large orders
• Buy plenty while prices are low but expected to rise
• Buy items which are hard to find or items which are to be discontinued
• Maximize full loads and minimize transport costs
• Cover for emergencies

The purpose of the existence of inventory is to meet the demands of customers.

Customers can come from outside or inside the organization. An individual purchasing
medicines or groceries is an example of an outside customer. A customer from inside the
organization can be a branch mechanic waiting for spare parts to be delivered to the
branch. Therefore, for inventory management to be effective, the essential determinant is
an accurate forecast of demand.
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C. Categories of Inventory Models

The categories of inventory models are interwoven with the inventory control
systems to be implemented. The purpose of inventory management aside from making
decisions about inventory is employing a system of inventory control that indicates how
much should be ordered and when to make these orders in order to minimize the sum of
the three inventory costs (we will discuss later on).

The inventory control systems will be discussed much deeper later on but for the
purpose of setting a foundation and laying the ground for us to understand how the
inventory models arise the following are the general categories (at the same time inventory
control systems) of where inventory models arise out from:

• Continuous or Perpetual Model/System

• Periodic Model/System

D. Types of Costs of Inventory Models

Inventory has been associated with three basic costs, namely, carrying or holding
costs, ordering costs, and shortage costs.

Carrying costsare the costs of keeping (or holding) items in storage. Its actual value
is highly dependent on the level of inventory and in some cases, in the length of time it is
held or stored. This means that there is higher carrying costs when there is a greater level
of inventory over time. Holding costs or carrying costs include direct storage costs like
lighting, heating, cooling, refrigeration, record keeping, security, rent, and logistics; cost of
losing fund use tied up to inventory; depreciation; loan interest for purchasing inventory;
product spoilage and deterioration, pilferage; breakage; obsoleteness of products with
decreasing demand or markets; and taxes. The sum of all of these mentioned is the total
carrying cost. This is the first basic cost.

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Normally, carrying costs are specified in one of two ways. Assigning carrying costs
on a per unit basis per time period like a month or a year is the most general form. Carrying
costs in this form is commonly expressed as a per-unit currency (dollar for the US) amount
on an annual basis. For example, $30 per year. The other way to normally specify carrying
costs is to sometimes express it as a percentage of average inventory value or percentage of
the value of an item. The general estimate is that carrying costs range from 10% to 40% of
the manufactured value of an item.

The second basic cost is ordering costs. These are costs that are associated with
replenishment of stocks being held as inventory. These are independent of the order size.
Ordering costs are expressed as a currency amount per order. For example, if a firm needs
50,000 units annually and one order would cost $100 but they decide to order 2 times at
25,000 units then the firm’s ordering cost is $200. This means that ordering costs change
along with the number of orders made or as the orders increase, the ordering costs
increases with it. Each time an order is made the costs incurred may include on or all of the
following: accounting and auditing, purchase orders, requisition costs, transportation and
shipping, inspection, receiving, handling and placing in storage, among others.

Carrying costs and ordering costs generally have an inverse relationship. When
order sizes increase, only fewer orders are required, thereby creating a reduction in annual
ordering costs. Ordering larger amounts makes way for higher inventory levels and would
result to higher carrying costs. In general, when you increase order size, annual ordering
costs decrease but annual carrying costs increase.

The third basic cost associated with inventory is shortage costs. Another term for
shortage costs is stockout costs, this happens when there is insufficient inventory on hand
and customer demand cannot be met because of it. When there is permanent loss of sales
for demand that is not met due to insufficiency of stocks, these shortage costs will definitely
include loss of profits. Another more understandable business term for this, especially in
the Philippine setting is opportunity costs. A prevalence of stockouts will most certainly
have a negative long-term effect on the business as it can cause customer dissatisfaction. A
loss of goodwill to the customers may lead the business into permanently losing its
customersand consequently future sales. In some cases, the delay in fulfilling customer
demand can be grounds to giving rebates or discounts just to be able to move the product.
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Internally or when demand is within the organization, work stoppages can be a result of
shortages as it hampers the production process and creates delays. Thus, cost of lost
production which includes direct and indirect production cost; and downtime cost which
ultimately compounds the shortage costs. These opportunity costs which are brought
about by the inefficiency to meet customer demand is harder to determine than carrying or
ordering costs. Because of this, shortage costs become no more than educated guesses most
of the time. They frequently are in the realm of subjective estimates when it comes to
forecasting them. Actual values can only be gathered once the delays, the shortages, the
downtime, or the work stoppage has occurred.

For some organizations, they deliberately perform or conduct stockouts because

carrying too much inventory in stock is costly. Let us not confuse though the term
shortages or shortage costs as it is discussed here but again it just pertains to stockouts. In
the real world setting especially in the Philippine business setting, when we say
“shortages”, it could mean a cash shortage from the cash register or cash vault and it could
also mean discrepancies or variance (negative) from an actual inventory count.

Shortage costs are inversely related to carrying costs. When the on-hand inventory
increases, the carrying costs increase while the shortage costs decrease.

E. Inventory Control Systems

We have discussed that the purpose of inventory management aside from making
decisions about inventory is employing a system of inventory control that indicates how
much should be ordered (level of replenishment) and when to make these orders. To do
this we would need to have a system to control the level of inventory. There are two basic
types of inventory control systems and these are: a continuous system otherwise known as
fixed-order quantity system and a periodic system also known as fixed-time period system.
The same constant amount of order is placed when the on-hand inventory decreases to a
certain level.On the other hand, in a periodic system, a variable amount of an order gets
placed after an established time frame.
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Continuous Inventory Systems

Perpetual System is the alternative name for a continuous inventory system

or a fixed-order quantity system. In this system, every item has a continual record of
its level of inventory. A predetermined level is set and whenever the on-hand
inventory decreases and reaches the said level also known as the reorder point, a
new order is made to replenish the inventory. This order is a constant or “fixed”
amount and it minimizes the total carrying, ordering, and shortage costs of
inventory. It is therefore a fixed-order quantity also termed as economic order
quantity.

The great thing about the continuous system is the close and continuous
monitoring of the inventory level which keeps management updated of the
inventory status. This is especially beneficial for critical inventory items like raw
materials and supplies, and even replacement parts. However, the disadvantage of
having this kind of system is the cost of maintaining a continual record of on-hand
inventory.

A ledger-style checkbook is a simple example of a continuous system. The

checkbook contains 300 checks; after using 200 checks (100 checks are left), an
order form for a new batch of checks. When turned in at the bank, this triggers an
order of 300 checks from the printer. Reorder cards are widely used by many office
inventory systems to indicate their reorder points and amounts of their inventory.

A more sophisticated perpetual system example is that which is used by a lot

of supermarkets and retail stores, a computerized checkout system with a laser
scanner. The laser scanner reads the bar code on the product packaging and is
recorded in an instant and the inventory level updated. This system is quick and
accurate and provides a continuously up-to-date information on inventory levels for
management review. Unlike the visibility of supermarket systems, manufacturing
companies, distributors, and suppliers also use laser scanners or bar code systems
to inventory, supplies, materials, in-process parts, equipment, and finished goods.

Let us note that continuous or perpetual inventory systems are a lot more
common that periodic systems.
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The BasicEconomic Order Quantity Model

The economic order quantity model also termed as the economic lot
size modelin a continuous system is the traditional and most widely used
means for determining how much to order. EOQ model’s function is
determining optimal order size to minimize total inventory costs.

The basic EOQ model is the foundation for all other versions of EOQ
models. It is aimed to determine the optimal order size that minimizes the
sum of carrying and ordering costs by essentially using a single formula.

The following is the set of simplifying and restrictive assumptions

where the model formula has been derived from:

• The demand is certain and is relatively constant over time.

• Lead time for receiving the orders is constant.
• Shortages are not allowed.
• Order quantity is received all at the same time.
,

Figure 1 Inventory Order Cycle

Source: p.777 Taylor, B. (2013). Introduction to Management Science (11th ed.)

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The basic model assumptions are reflected by Figure 1. Figure 1 also

describes the system of continuous inventory order cycle that is inherent to
the EOQ Model. Q represents the order quantity which is received and used
up over time at a constant rate. When the level of inventory drops to the
reorder point, R, a new order is placed, where a period of time is required for
delivery. This period of time called the lead time.This new order when
delivered is received all at once, at that exact moment when demand
consumes the entire stock of inventory (at that moment when inventory level
hits zero) allowing no chance for shortages. This cycle is perpetually
repeated for the exact same order quantity, reorder point, and lead time.

That which minimizes the sum of carrying costs and holding costs is
the order size Q. Carrying costs and holding costs are inversely related to
each other in response to an increase in Q. As the order size Q increases,
fewer orders are needed, which causes the ordering cost to decline. With the
increase in Q, the average amount of on-hand inventory increases thereby
increasing carrying costs. In essence, a compromise between these two
conflicting costs is represented by the optimal order quantity.

Carrying Cost

An annual basis or a per year basis is the traditional reference

for the carrying cost. Sometimes it is shown as a percentage of
average inventory but is usually expressed on a per-unit basis for
some time period.

The amount of on-hand inventory during the year is the

determinant of the total carrying cost. Figure 2 illustrates the amount
of available inventory during the year. In Figure 2, Q depicts the order
size needed to replenish inventory, and this is what the manager or
wants to determine. The rate at which inventory or stock is depleted
or the demand during the time period, t, is represented in Figure 2 by
the line connecting Q to time t. Demand is constant which means that
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it is assumed that it is known with certainty, this is the reason why the
demand line is straight.

Figure 2 Inventory Usage

Source: p.778Taylor, B. (2013). Introduction to Management Science (11th ed.)

It is very important to note that in Figure 2, inventory never

goes below zero and therefore, shortages do not exist. And then when
the level of inventory reaches zero, it is assumed that an order
immediately arrives with virtually no time has elapsed. The
terminology used for this condition is instantaneous receipt which is a
simplifying assumption.

As shown in Figure 2, Q is the order size and at the same time

the amount of inventory but only for a very small amount of time as it
is always depleted by demand. In the same manner that inventory
amounts to zero for only a very brief unnoticeable period in time
which is the specific time t. We can therefore safely say that the
amount of available inventory is somewhere in between these two
points or extremes. With a logical deduction, we can define the
average inventory level, or the amount of available inventory is:

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average inventory = _Q_

2

Over the entire time period, t, we can designate any number of

values of Q and then divide by the number of points just to verify this
relationship. Figure 3 depicts our example that if Q = 5,000, and 6
points designated between 5,000 and 0 will be summed and divided
by 6:

average inventory = _5,000 + 4,000 + 3,000 + 2000 + 1000 + 0_

6

= 2,500

Figure 3 Inventory Levels (Q)

Source: p.778Taylor, B. (2013). Introduction to Management Science (11th ed.)

As an alternative, add the sum of the two extremes as it also

encompasses t, 5,000 + 0, divided by 2 and you still get 2,500. So, in
principle, it still is Q + 0 divided by 2. The relationship for average
inventory is maintained regardless of the frequency and size of the
orders. Therefore, on an annual basis, the average inventory would
still be Q/2.
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Figure 4 Annual Average Inventory

Source: p.779Taylor, B. (2013). Introduction to Management Science (11th ed.)

Given that we now know the annual average inventory, Q/2,

we can finally determine the total annual carrying cost by multiplying
the carrying cost per unit per year (Cc) by the average number of units
in inventory:

Q
average inventory = Cc -----
2

Ordering Cost

Since Demand or annual demand for that matter is assumed to

be known and is constant, we can compute for the total annual
ordering cost by multiplying the number of orders per year
(represented by D/Q, where D is the constant demand and Q is the
order size) by the cost per order designated as Co:

D
annual ordering cost = Co ------
Q

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Both D and Co are constant parameters and the only variable in

the equation is Q. Thus, the relative extent of the ordering cost will be
dependent on the size of the order.

Total Inventory Cost

Simply put, the total annual inventory cost is the sum of the
ordering and carrying costs:

D Q
TC = Co ------ + Cc -------
Q 2

Figure 5 shows the inverse relationship between the cost

functions or ordering cost and carrying cost which results in a convex
total cost curve.

Figure 5 EOQ Cost Model

Source: p.779Taylor, B. (2013). Introduction to Management Science (11th ed.)

The total carrying cost curve shows a general upward trend. As

the order size Q (horizontal axis) increases, the total carrying cost
(vertical axis) also increases, a very logical outcome because larger
orders will create more units to be carried in inventory. The ordering
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cost curve on the other hand goes the other direction and shows a
downward curve. As the order size Q increases, the ordering cost
decreases. This is also logical in the sense that an increase in the order
sizes will result in fewer orders annually. A convex total cost curve is
the result of summing two costs (ordering cost and carrying cost) that
are inversely related.

The lowest point of the total cost curve as shown in Figure 5

corresponds to the optimal order quantity or optimal value of Q. And
this point also coincides with the point where the ordering cost and
the carrying cost intersect. With this we can determine Q’s optimal
value by equating the two cost functions and solving for Q in this
manner:

For the total minimum cost, it can be determined by replacing

the value for the optimal order size, Qopt into the total cost equation:

The EOQ Model with Shortages

The basic EOQ Model does not allow for shortages and back ordering
but in this EOQ Model with Shortages it relaxes the former assumption. And
in case of shortages, all demand that is not met due to shortages can be back-
ordered and subsequently delivered to the customer. This would mean that
all demand is eventually met. Figure 6 shows this model.

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Figure 6 EOQ Model with Shortages

Source: p.785Taylor, B. (2013). Introduction to Management Science (11th ed.)

In this model, the maximum inventory level does not reach Q because
of shortages or back-ordered demand. Instead, a level equal to Q – S will be
where actual on-hand inventory will be located shown in Figure 6. The
amount of on-hand inventory decreases as the amount of shortage increases
and vice versa. The cost of lost customer goodwill and cost of lost sales – the
costs associated with shortages – has an inverse relationship to carrying
costs. When Q (the order size) increases, the carrying cost increases and
subsequently the shortage cost declines. The relationship of these three costs
are shown in Figure 7.

,
Figure 7 Cost Model with Shortages
Source: p.786Taylor, B. (2013). Introduction to Management Science (11th ed.)
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The three cost functions are as follows, where S is equal to the

shortage level and Cs is equal to the annual per-unit cost of shortages:

Combining these individual cost functions will result to the total

inventory cost formula:

Notice that the three individual cost component curves, unlike the
basic EOQ Model, do not intersect at a common point. Therefore, the only
way to determine the optimal shortage level S and the optimal order size is to
differentiate the total cost functionwith respect to Q and S, setting them (the
two resulting equations) to zero and solving them simultaneously. This
would result in the following formulas for the shortage level and optimal
order quantity.

Reorder Point

Having tackled one of the primary questions in inventory

management, “how much should be ordered?”, we will now discuss the other
question or aspect of inventory management, “when to order?”. The reorder

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point in a continuous inventory system determines when to order. The

reorder point is the level of inventory at which a new order is placed.Before
the time that inventory falls to zeroan order must be made, this is the
concept of lead time, graphically illustrated in Figure 8. Demand naturally
and constantly consumes inventory while the order is being shipped, an
order must already be made while there are still sufficient stocks to meet the
demand during the lead-time period. This level of inventory that should last
or should cover the lead-time period is the reorder point.

Figure 8 The Reorder Point and Lead Time

Source: p.794Taylor, B. (2013). Introduction to Management Science (11th ed.)

In our basic EOQ Model where demand and lead time are constant, the
reorder point is pretty straightforward. Reorder point is equal to the amount
demanded during the lead-time period, and is thus computed using the
following formula:

R = dL

Legend:

d = Demand Rate per time period (e.g. monthly)

L = Lead Time
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Safety Stocks

We have learned that an order is made when the levels of inventory

reach a reorder point. We have also learned that with constant demand the
remaining stock in inventory is depleted during the lead time and the new
order quantity arrives at exactly the same time the inventory level reaches
zero. In the real world though, lead timeand to an even larger extent demand
is uncertain. The level of inventory may be consumed or depleted at a slower
or faster rate within the lead time period. Figure 9 depicts this uncertain
demand and a constant lead time.

Figure 9 Inventory Model with uncertain demand

Source: p.794Taylor, B. (2013). Introduction to Management Science (11th ed.)

It can be seen in the second order cycle that demand exceeds the
available stock in inventory which means a stockout occurs. A buffer stock or
safety stock is added to the demand most of the time during the lead time
period to act as a hedge against stockouts in times when demand is
uncertain. This addition of a safety stock is depicted by Figure 10.

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Figure 10 Inventory Model with Safety Stock

Source: p.795Taylor, B. (2013). Introduction to Management Science (11th ed.)

PeriodicInventory Systems

Counting the inventory on hand at specific time intervals is the process

conducted in a periodic inventory system. This system is also referred to as periodic
review system or fixed-time period system. For example, counting can be conducted
weekly or at the end of each month. Once the amount of stock in inventory has been
determined an amount of order to bring the inventory back up to the desired
levelwill be placed.

During the interval time between orders the inventory level is not monitored
at all in this type of inventory system.Its advantage therefore is having little or no
record keeping but it has the disadvantage of lesser direct control. And because of
this the periodic inventory system would have larger inventory levels early in the
fixed period to guard against stockouts versus that of a continuous system. Every
time a periodic order is made the system would require that a new order quantity
would be determined.

An example where a periodic inventory system is used is in a college or

university bookstore when the textbooks are ordered. Textbooks are counted for
every course after the first few weeks or month during a semester. The new order
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for textbooks would depend on the remaining number of stocks and the estimated
demand (course enrollments). It is actually worthy to note that a lot of businesses
use a periodic inventory system like retail stores of different industries, groceries,
drugstores, and even offices wherein they check their level of inventory weekly, bi-
monthly, or monthly to see how much (if any) needs to be ordered.

Order Quantity for a Periodic Inventory System

Unlike the fixed-order quantity system, the less common periodic

inventory system uses an order quantity that varies and the time between
orders is constant. A supermarket is one example of a business that uses
periodic inventory system. Supermarkets stock varied items from fresh
produce like herbs and vegetables, personal hygiene like toothpaste,
toothbrush, and health related products among others. Vendors or suppliers
would normally conduct periodic visits weekly or monthly and conduct a
physical count of their on-hand products. At some reorder point or especially
when stocks are zero, a new order is placed to bring the inventory back up to
desired levels. Supermarket managers in general will not monitor the
inventory level between vendor visits but they will instead rely on the
supplier or vendor to do the inventory at the time of their visit.

Inventory can therefore be exhausted or depleted way before the next

visit of the vendor and thus will result in a stockout. The said stockout will
only be remedied by the vendor in the next visit and scheduled order.This
would mean that a larger safety stock would be required by this fixed-
interval system as opposed to the fixed-order system.

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Order Quantity with Variable Demand

In the event that the lead time and demand rate are constant, the
fixed-period model will now have a fixed-order quantity made at specific
time intervals. Thus, making it the same as the fixed quantity model under
similar conditions. But when there is variable demand, the fixed-period
model will react differently from a fixed-order quantity model.

Given a daily variable demand that is normally distributed, the fixed-

period model’s order size will be determined by the following formula:

The first side or half of the equation reflects the amount of inventory
needed to protect against shortages during the lead time period until the
next order is received. The second half or side of the equation is the safety
stock for a specific service level.
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References and Supplementary Materials

Books and Journals
1. Taylor, B. (2013). Introduction to Management Science (11th ed.). Upper Saddle River,NJ:
Prentice Hall.

Online Supplementary Reading Materials

1. INVENTORY MANAGEMENT : CONCEPT, PRACTICES, TECHNIQUES, POLICIES AND
ACTUAL PRACTICES; Retrieved from http://shodhganga.inflibnet.ac.in/bitstream
/10603/76163/11/11_chapter%203.pdf; September 9, 2018
2. Inventory Management as a Determinant for Improvement of Customer Service;
Retrieved from https://repository.up.ac.za/bitstream/handle/2263/30508/
dissertation.pdf?sequence=1; September 9, 2018
3. Inventory; Retrieved from https://www.investopedia.com/terms/i/inventory.asp;
September 9, 2018
4. Inventory Models; Retrieved from https://www.slideshare.net/bilalnaimshaikh3
/inventory-models-55864877; September 9, 2018
5. Inventory: What are some examples of ordering, holding and shortage costs?;
Retrieved from http://www.astab.com.sg/latest-news/inventory-what-are-some-
examples-of-ordering-holding-and-shortage-costs; September 9, 2018

Online Instructional Videos

1. Inventory II: The Economic Order Quantity Model; https://www.fox.temple.edu/
vault/video/inventory-ii-the-economic-order-quantity-model/; September 12, 2018

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