5.

0 INVENTORY MANAGEMENT:

5.1 DEFINITION OF INVENTORY:

Inventory is a supply of resources specifically materials, goods and commodities held for the
purpose of future utilization/use.

Inventory is the stock of any item or resource used in an organization. Inventory could also
refer to goods which an organization pools in its warehouses or stockyards.

5.2 BASIC FORMS OF INVENTORY:

By convention, manufacturing inventory generally refers to items that contribute to or
become part of a firm’s product output. Manufacturing inventory typically classified into:

a) Raw Materials: These are the basic materials to be converted through manufacturing
processes into finished products. Examples include cotton, rubber or timber.

b) Finished Products: These are the items which have gone through all the necessary
manufacturing operation and are ready either for sale or use.

c) Component Parts: These are finished parts or assemblies which are finished by
specialists and are bought by the manufacturing firm to be incorporated into their own
manufactured goods or to be resold as spares or accessories.

d) Supplies/Equipment and Spares: These include machine installations, vehicles and

their associated spare parts etc. which are mostly used in extractive industries,
agriculture utility undertakings and the armed services.

e) Work-in Progress: These are also known as semi-manufactured goods. They are
incomplete items where part of manufacturing operations are yet to be done. Most of
these goods are found on the factory shop floor.

f) Jerks and Fixtures: These are those items used in manufacturing industries for
holding materials or parts as they are being worked on during the time of
manufacture.
 g) Packaging Materials: These are materials which are used for packing or providing
protective coating for items.

h) Scrap & Residues: These are the waste materials or the surplus materials arising out
of manufacturing processes or other activities.

i) Free Issues: These are items or materials provided by a customer to a manufacturer to

be incorporated in the items being manufactured for the customer.

In services, inventory generally refers to the tangible goods to be sold and the supplies
necessary to administer the service.

5.3 TYPES OF INVENTORY:

Inventory can be categorized into the following types:
i. Cycle Inventory: - This is the average amount of inventory used to satisfy demand
between receipts of supplier shipment. The size of the cycle inventory is as a result of
the production or purchase of materials in large lots. The cycle inventory decisions
firms must make are how much to order for replenishment and how often.

ii. Safety Stock Inventory: - It is the extra supply of goods to protect against uncertainty
or unforeseen events. These uncertain events could be as a result of uncertainty about
customer demand, lead time delays (i.e. delays from the time one places an order to
the time he/she receives the delivery) or disruption in supply.

iii. Anticipatory/Seasonal Inventory: - This is inventory built up to counter predictable

variability in demand. Firms using seasonal inventory will build up seasonal
inventory during periods of low demand and store it for periods of high demand. In
determining how much seasonal inventory to build, a trade-off is made between the
cost of carrying

the additional seasonal inventory and the cost of having a more flexible production
rate. It is therefore a buffer against planned disruptions or anticipated demand. The
anticipation is as a result of scheduled shutdowns, seasonal weather disruptions.
 iv. Pipeline Inventory: - Inventory found in the pipeline system.

5.4 THE PURPOSE OF INVENTORY MANAGEMENT:

The basic issues in inventory analysis for manufacturing and stock-keeping services are to
specify:
a) When items should be ordered/delivered.
b) How large the order/delivery should be.

The major goal is to minimize total inventory costs. Ironically the best inventory policy is to
keep no inventory at all. However all firms keep a supply of inventory for the following
reasons:

1) To maintain independence of operations i.e. a supply of materials at a work centre allows

that centre flexibility in operations.

2) To meet variation in product demand i.e. usually demand is not completely known with
certainty, and a safety or buffer stock should be maintained to absorb variation.

3) To allow flexibility in production scheduling i.e. stock of inventory relieves the pressure
on the production system to get the goods out. This causes longer lead times, which
permit production planning for smoother flow and lower-cost operations through larger
lot-size production.

4) To provide a safeguard for variation in raw material delivery time. When materials are
ordered from a vendor, delays can occur for a variety of reasons: a) Normal variation in
shipping time
b) Shortage of stock at the vendor’s plant causing backlogs
c) An unexpected strike at the vendor’s plant or at one of the shipping companies

d) A lost order
e) A shipment of incorrect or defective materials.
f) Breakdown or interruption of production at the vendor’s factory etc.
5) To take advantage of economic purchase order size i.e. there are costs such as labour,
phone calls, typing postage etc in placing an order. Therefore the larger each order is, the
fewer the orders that need to be written. Similarly shipping costs favour larger orders i.e.
the larger the shipment, the lower the per-unit cost.

6) Some items appreciate in value the longer they stay in stores e.g. wines. Hence it is
necessary to store them over long periods of time up to more than 100 years.

7) To take advantage of discounts or improved prices because of bulk purchases.

In general though inventory is costly and large amounts are generally undesirable. Long cycle
times are caused by large amounts of inventory and are undesirable as well.

5.5 INVENTORY COSTS:

In making any decision that affects inventory size, the following costs must be considered:

a) Purchase/Procurement Cost: The actual price for which we procured or purchased the
inventory per unit cost.

b) Holding/Carrying Costs: This broad category includes the costs for storage facilities,
handling, insurance, pilferage, breakage, obsolescence, depreciation, taxes, and
opportunity cost of capital. In general high holding costs tend to favour low inventory
levels and frequent replenishment.

c) Ordering Costs: These costs refer to the managerial and clerical costs to prepare the
purchase or production order. Ordering costs include all the details, such as counting
items and calculating order quantities. The costs associated with maintaining the
system needed to track orders are also included in ordering costs.

d) Shortage/Outage Costs: When the stock of an item is depleted, an order for that item
must either wait until the stock is replenished or be cancelled. There is a trade-off
between carrying stock to satisfy demand and the costs resulting from the stock-out.
This balance is sometimes difficult to obtain, because it may not be possible to
estimate lost profits, the effect of lost customers, or lateness penalties. Frequently the
 assumed shortage cost is little more than a guess, although it is usually possible to
specify a range of such costs.

Note:
1. Setup/Production Change Costs: To make each different product
involves obtaining the necessary materials, arranging specific
equipment setups, filling out the required papers appropriately
charging time and materials, and moving out the previous stock of
materials. In general, if there were no costs or loss of time in
changing from one product to another, many small lots would be
produced. These would reduce inventory levels, with a resulting
saving in cost. One challenge today is to reduce these setup costs to
permit smaller lot sizes.

2. Establishing the correct quantity to order from vendors or the size

of lots submitted to the firm’s productive facilities involves a
search for the minimum total cost resulting from the combined
effects of four individual costs i.e. holding costs, setup costs,
ordering costs, and shortage costs. Importantly, the timing of these
orders is a critical factor that may impact inventory costs:

5.6 INVENTORY SYSTEMS:

An inventory system is the set of policies and controls that monitor levels of inventory and
determine what levels should be maintained, when stock should be replenished, and how
large orders should be.

These can be divided into single-period systems and multiple-period systems.

Single-Period Systems:
These are useful for a variety of service and manufacturing applications. The major issues of
concern for a Single-Period System is to determine how much to order within that period.
The cost of overestimating demand is the cost that results when the merchandise is
discounted while the cost of underestimating demand is the lost profit due to sales not made.
Examples of single period decisions include:
1. Any type of one time order: Ordering T-shirts for a sporting event or printing maps
that become obsolete after a certain period of time.
2. Ordering of fashion items: A problem for a retailer selling fashion items is that often
only a single order can be placed for the entire season. This is often caused by long
lead times and limited life of the merchandise.
3. Overbooking of airline flights: It is common for customers to cancel flight
reservations for a variety of reasons. Thus the cost of underestimating cancellations is
the revenue lost for having an empty seat on the plane, while the cost of
overestimating cancellations is the free tickets and awards given back to customers
unable to board the flight.

Multi-Period Systems:
These are designed to ensure that an item will be available on an on-going basis. Usually the
item will be ordered multiple times throughout the year where the logic in the system dictates
the actual quantity ordered and the timing of the orders. The two general types of multi-
period systems are:

a) Fixed- Order Quantity/Q-Model: These are “event triggered” i.e. they initiate an
orderwhen the event of reaching a specified re-order level occurs. This may take place
any time depending on the demand for the item in consideration.

b) Fixed-Time Period/Fixed Order Interval/Periodic Review/P-Model: These are

“timetriggered” i.e. they are limited to placing an order at the end of a predetermined
time period; only the passage of time triggers the model.

c) Fixed –Time Period/Fixed Order Quantity Model. This is otherwise known as

theEconomic Order Quantity (EOQ) Model.

COMPARISON OF FIXED ORDER QUANTITY AND FIXED TIME PERIOD

INVENTORY SYSTEMS:

FEATURE FIXED-ORDER QUANTITY FIXED-TIME PERIOD MODEL

 MODEL
Order Quantity The same amount is ordered each The amount ordered varies each time i.e.
time i.e. Q- remains constant Q – is variable.
When To Place Orders are placed when the re- The order is placed when the review Order.
order position drops to the re-order period is due. level
Recordkeeping This is done each time a Items are counted only at the review withdrawal
or addition is made period.
Size of The size tends to be less than that The size tends to be more than that of inventory of
fixed time period model. fixed-order quantity because it must
protect against stock-out.
Time to Requires more time to maintain Requires less time to maintain.
maintain due to perpetual recording
Types of items Favors higher priced, critical, or Favors lower priced items. important
items.

5.7 ECONOMIC ORDER QUANTITY MODEL:

The economic order quantity model’s objective is to determine the optimal quantity to order
each time that will minimize the total inventory cost. The model assumes the following:
1. Demand for the item occurs at a constant known rate over time.
2. The item is ordered several times and each time the order is for the same size.
3. Replenishment is scheduled in such a way that shipments arrive exactly when
inventory level reaches zero and therefore there are no shortages or surpluses.
4. The lead-time is constant.
5. The order is placed when the stock level reaches the re-order point or level.
6. Within the range of quantities to be ordered, the per unit holding costs and ordering
costs are independent of the quantities ordered.
7. All costs are constant i.e. the system does not enjoy economies of scale.
8. Since only one item is being considered orders for different items are independent of
each other.
9. The maximum inventory level is always equal to the amount ordered.

ILLUSTRATIONS:
a) A firm’s annual demand is estimated to be 150,000 units. Ordering costs have
beenestablished as Kshs. 1,500/= per order, while the holding costs are estimated as
 Kshs 200/= per unit per year. The lead time is given as 24 hours and the per unit cost
of the item is Kshs 1,000/=.

Required:
Advice the firm on the following:
i. Economic Order Quantity (EOQ), ii. The
inventory policy the firm should adopt and iii.
The firm’s total cost of maintaining
inventory.

b) A firm’s annual demand is estimated to be 1,250 units. Ordering costs have

beenestablished as Kshs. 500/= per order, while the holding costs are estimated as
Kshs 125/=

per unit per year. The lead time is given as 5 days and the per unit cost of the item is
Kshs 1250/=.

Required:
Advice the firm on the following:
i. Economic Order Quantity (EOQ), ii. The
inventory policy the firm should adopt and iii.
The firm’s total cost of maintaining
inventory.

c) A firm’s annual demand is estimated to be 10,000 units. Ordering costs have

beenestablished as Kshs. 2000/= per order, while the holding costs are estimated at
10% of cost. The lead time is given as 5 days and the per unit cost of the item is Kshs
50/=.

Required:
Advice the firm on the following:
 i. Economic Order Quantity (EOQ), ii. The
inventory policy the firm should adopt and iii.
The firm’s total cost of maintaining
inventory.

There are two approaches for determining the EOQ. These are:
1. The Trial and Error or Tabular Approach
2. The Algebraic Approach

The Trial and Error/Tabular Approach:

For this method to be employed the following needs to be done:
a) Select a number of possible order sizes to purchase.
b) Determine the total cost for each order size.
c) Select the order quantity that minimizes the total cost. This is then assumed to be the
EOQ.

The Algebraic Method:

For this method to be employed the following needs to be done:
a) Determine the equation for inventory carrying cost.
b) Determine the equation for ordering costs.
c) Equate the two equations and solve to get the EOQ.

Where:
Q = the EOQ or the optimum number of units to order that will minimize the total
inventory costs. C = Cost per unit.
I= Inventory carrying cost expressed as a percentage of the value of the average
inventory.
R= Total number of units required annually.
S= The ordering cost per order.

Therefore:

Q = 2RS/CI
The Total Cost of Inventory is thus given as:

T = RC + QCI/2 + RS/Q

5.8 ESTABLISHING SAFETY STOCK LEVELS:

In the majority of the cases, demand is not constant but varies from day to day. Safety stock
must therefore be maintained to provide some level of protection against stock-outs. Safety
stock can be defined as the amount of inventory carried in addition to the expected demand.
In a normal distribution, this would be the mean. For example, if our average monthly
demand is 100 units and we expect next month to be the same, if we carry 120 units, then we
have 20 units of safety stock.

There are various approaches to determining the level of safety stock. These include:

a) Common Approach: Here the firm simply states that a certain number of weeks of
supply be kept in safety stock.

b) Probability Approach: Here we assume that the demand over a period of time is
normally distributed with a mean and a standard deviation.

5.9 ABC ANALYSIS:

This is a method for classifying inventory items into three groups in terms of importance. For
Example:
Class A: about 20% of items but about 80% of monetary value
Class B: about 30-50% of items but about 15% of monetary value
Class C: about 30-50% of items but about 5% of monetary value
The idea is to establish inventory policies that focus on the few critical items and not the
many trivial ones.
– Pareto’s Law (80 – 20 rule)
– “trivial many” versus “vital few”

ILLUSTRATION:
The store of an oil engine repair shop has 10 items whose details are shown in the following table:
 Code Description Price/Unit (Kshs) Units/Year
A2001 Drill bit 60 1000
A2002 Fixture 5000 120
A2003 Fuel Pump 7000 500
A2004 Bearing (small) 1000 50
A2005 Bearing (big) 3000 30
A2006 Coupling 500 1000
A2007 Bush 300 400
A2008 Hexagonal nut 50 700
A2009 Tower bolt 20 300
A2010 Packing thread 100 100

Required:
Apply the ABC Inventory classification method to the store.