INVENTORY MODELS

One of the basic functions of management is to employ capital efficiently so as to yield the maximum returns. This is known as Return on Capital Employed (ROIC). This can be done in either of two ways or by both, i.e. Increasing fixed asset productivity Increasing current asset productivity

The importance of materials management / inventory control arises from the fact that materials account for 60 to 65 percent of the sales value of a product, that is to say, from every rupee of the sales revenue, 65 paisa are spent on materials. Hence, small change in material costs can result in large sums of money saved or lost. Inventory control should, therefore, be considered as a function of prime importance for our industrial economy.

Sales Revenue Spent

20% Materials 15% 65% Wages & Salaries

Overheads

By careful financial analysis, it is shown that a 5% reduction in material costs will result in increased profits equivalent to a 36% increase in sales. Inventory control provides tools and techniques, to reduce/control the materials cost substantially.

 Inventory of resources is held to provide desirable services to customers and to achieve sales turnover target. Investment in large inventories adversely affects the organizations cash flow and working capital as investment in inventory represents substantial portion of total capital investment in any business. It is therefore essential to balance the advantage of having inventory of resources and the cost of maintaining it so as to determine an optimal level of inventory of each resources so that the total inventory cost is minimum.

DEFINITION OF INVENTORY The word inventory means a physical stock of material or goods or commodities or other economic resources that are stored or reserved or kept in stock or in hand for smooth and efficient running of future affairs of an organization at the minimum cost of funds or capital blocked in the form of materials or goods (Inventories).

Forms of Inventory
Type of organization Manufacturer Types of inventories held Raw materials; semi-finished goods; finished goods; spare parts etc. Number of beds; stock of drugs; specialized personnel etc. Cash reserves; tellers etc. Seating capacity; spare parts; specialized maintenance crew etc.

Hospital
Bank Airline company

DEFINITION INVENTORY CONTROL

Inventory control systems appear complicated, however, there are only a few basic questions to answer for an efficient control of inventory and the most important of these are:
1. What items should be stocked?
Criticality Availability Movement

2. When should an order be placed to replenish inventory?

Periodic review system Fixed order quantity system Optional replenishment system

DEFINITION INVENTORY CONTROL

Inventory control systems appear complicated, however, there are only a few basic questions to answer for an efficient control of inventory and the most important of these are:
3. How much should be ordered in each replenishment?
Demand pattern Price of an item, discount option, total budget, warehouse space Lead time

Classification of Inventories
Inventories which play direct role during manufacture (or which can be identified on the product) is labelled as direct inventories Inventories which are needed for manufacturing, but not as a part of production (or cannot be identified on the product) are labelled as indirect inventories.

Reasons for carrying inventory

1. 2. 3. 4. 5. 6. Improve customer service Reduce costs Maintenance of operational capability Irregular supply and demand Quantity discounts Avoiding stock-outs (shortages)

 Direct Inventories
1. Raw material inventories
Bulk purchase of materials to save the investment, To meet the changes in production rate, To plan for buffer stock or safety stock to serve against the delay in delivery of inventory against orders placed and also against seasonal fluctuations.

2. Work-in -process inventories

Provide economical lot production, Cater to the variety of products, Replacement of wastages, To maintain uniform production even if sales varies.

3. Finished goods inventories

To ensure the adequate supply to the customers To allow stabilization of the production level and To help sales promotion programme

4. Spare parts inventories

To provide after sales service to the customer To utilize the product fully and economically by the customer.

5. Scrap or waste inventory

 Indirect Inventories
Anticipation (Seasonal) inventory
When there is an indication that the demand for companys product is going to be increased in the coming season, a large stock of material is stored in anticipation. Examples: Fashion items, agricultural products, childrens toys, etc.

Lot size inventory or Cycle inventories

It is the inventory necessary to meet the average demand during the successive replenishments. The amount of such inventory depends upon production lot size, economical shipment quantities, warehouse space available, replenishment lead time, price-quantity discounts, inventory-carrying cost

 Decoupling inventories
If various manufacturing processes (stages) operate successively, then in the event of the breakdown of one, the whole system could get affected. Thus stocking points of inventory could act as buffer to take care of such eventualities. Decoupling inventories could classified into four groups: 1. Raw materials and components 2. Work-in-process inventory 3. Finished goods inventory 4. Spare parts inventory
Decouple 1 (RM Store) Decouple 3 (FG Store)

Decouple 2

Supplier

Manuf. Stage 1

Manuf. Stage 2

Distributor

 Safety inventory
A specific level of extra inventory is maintained for protection against uncertainties of demand and supply (lead time). The demand and lead time both are random variables with known probability distribution. The level of buffer stock is determined by trade-off between protection against demand and supply uncertainties and the level of investment in additional stock.

Transportation Inventories
Since movement of inventory cannot be instantaneous, optimal inventory level is required for shipment of inventory to distribution centres and customers from production centres. Such an inventory is called process inventory, as it consists of materials actually being worked on or moving between work centres. Hence for satisfying demand without delay, it is essential to keep extra stock of inventory at various work places to meet the demand while the supply is in transit. The amount of pipeline inventory depends on the time required for shipment and the nature of the demand.

Factors Involved in Inventory Problem Analysis

A number of factors must be considered in the analysis of inventory problems:
1. 2. 3. 4. 5. Relevant inventory costs Demand for inventory items Replenishment lead time Length of the planning period Constraints on the inventory system

 Decisions regarding the size and timing of replenishment orders are influenced by four factors:
1. 2. 3. 4. The forecast of demand for the item Replenishment lead time Inventory related costs Management policy

Factors affecting the inventory level

Inventory models can be classified according to the following factors:

1. Inventory related costs

Inventory related costs are classified as

a) Purchase (or production) cost

It is the cost at which an item is purchased, or if an item is produced, it is the direct manufacturing cost.

c) Carrying (or holding) cost (Ch)

The cost associated with maintaining the inventory level is known as Holding Cost. It is directly proportional to the quantity to be kept in stock and the time for which an item is held in stock. It includes the cost of money, handling cost, maintenance cost, depreciation, insurance, warehouse rent, taxes, etc. This cost may be expressed either as cost per unit of item held per unit of time or as a percentage of average rupee value of inventory held.

Shortage (or stock out) cost (Cs) It is the cost, which arises due to running out of stock (i.e., when an item can not be supplied on the customer's demand). It includes the cost of production stoppage, loss of goodwill, loss of profitability, special orders at higher price, overtime/idle time payments, expediting, loss of opportunity to sell, etc.

Total Inventory Cost

Total Inventory cost = Purchase cost + Ordering cost + Carrying cost + Shortage cost
Demand
The size of demand is referred to the number of the item required in each period (cycle or season). The demand pattern may be either deterministic or probabilistic.

Factors affecting the inventory level

3. Ordering cycle
An ordering cycle is defined as the time period between two successive placement of orders. The order may be placed on the basis of following two types of inventory review systems: a) Continuous review: In this case, record of the inventory level is updated continuously until a specified point (known as reorder point) is reached, at this point a new order is placed. Sometimes, this is referred to as the twobin system.

Factors affecting the inventory level

Periodic review : In this case, the orders are placed at equally spaced intervals of time. The quantity ordered each time depends on the available inventory level at the time of review.

Factors affecting the inventory level

4. Lead time or delivery lag The time gap between the moment of placing an order and actually receiving the material is referred to as lead time. The lead time can be deterministic, constant or variable, or probabilistic.

Factors affecting the inventory level

5. Buffer (or safety) stock
Normally, demand and lead time are uncertain and cannot be predetermined completely. So to absorb the variation in demand and supply, some extra stock is kept. This extra stock is known as buffer stock.

6. Available space
Generally, an inventory system involves more than one commodity. The number of items held in inventory affect the situation when these items compete for limited floor space or limited total capital.

Inventory Control Models without Shortages (Deterministic)

In this model demand is assumed to occur at constant rate. The objective is to select an inventory policy, i.e. to choose an economic order quantity Q* (EOQ) and ordering frequency (time when the order must be placed) in such a way that the total yearly inventory cost is minimized.

 Assumptions
1. The inventory system involves one type of item. 2. The demand is known and constant and is resupplied instantaneously. 3. The inventory is replenished in single delivery for each order ( One order, one delivery) 4. The Lead Time (LT) is constant and known. 5. Shortages are not allowed. 6. Purchase price and reorder cost do not vary with quantity ordered. 7. Carrying cost per year and ordering cost are known and constant. 8. One order, One type of item.

 The figure shows the behavior of an inventory system which operates on the assumptions listed . At the beginning of the inventory cycle time we start with a maximum amount of inventory equal to the order quantity D. As this amount is consumed, the level of inventory drops at a constant rate equal to the demand rate D. When the level reaches a specific level called the reorder level (ROL), enough inventory is available to cover expected demand during the lead time LT. At this point, an order is placed equal to Q which arrives at the end of the lead time, when the inventory level reaches zero.

 This quantity arrived is placed in stock all at once and the inventory level goes up to its maximum value. Obviously, during the reorder cycle, the amount of order quantity received and consumed are equal as the stock level at the start and finish of the order cycle is zero. That is, Order quantity replenished in one inventory cycle = = Annual demand consumed in one inventory cycle

 In order to determine optimal order size (Q), we need to calculate the total variable inventory cost for each order cycle. Total variable cost = Annual carrying cost + Annual ordering cost = {Average inventory level x Carrying cost/unit/year) +
{Number of orders placed per year x Ordering cost/order}

= {(Imax + Imin)/2}Ch + (D/Q)Co

 As the figure shows, the total variable inventory cost is minimum at the value of Q which appears to be at the point where inventory carrying cost and ordering costs are equal. (D/Q)Co = (Q/2)Ch Q2 = (2DCo)/Ch Q* (EOQ) = Sqrt (2DCo/Ch = Sqrt (2 x Annual demand x Ordering cost) Carrying cost
(The above formula is also known as the Wilson or Harris Lot Size formula)

Other Important Formulae

Optimal interval between successive orders (t*) =
= (Q*/Demand per day) days

Optimal number of orders (N*) to be placed in the given period =

= (Annual demand / Optimal Order quantity) = (D/Q*)

Optimal total variable inventory cost (TVC) = = (D/Q*)Co + (Q* /2)Ch Optimal total inventory cost = Variable cost + Fixed cost = TC = (D x C) + TVC

Problem
Company XYZ needs 5,400 units/year of a bought-out component which will be used in its main product. The ordering cost is Rs.250 per order and the carrying cost per unit per year is Rs.30. Find: the economic order quantity (EOQ), the number of orders per year and the time between successive orders.

Solution
D = 5400 units per year Co = Rs.250/order Cc = Rs.30/unit/year

EOQ (Q*) = Q* = 2CoD Ch Number of orders per year

= 2 x 250 x 5400 30

= 300 units

= (D/Q*) = 5400/300 = 18

The time between successive orders = (Q*/D) x 360 = 20 days

Problem
Alpha industry needs 15,000 units per year of a bought-out component which will be used in its main product. The ordering cost is Rs.125 per order and the carrying cost per unit per year is 20% of the purchase price per unit. The purchase price per unit is Rs.75. Find: economic order quantity, number of orders per year and the time between successive orders.

Solution
D = 15,000 units per year Co = Rs.125/order Purchase price per unit = Rs.75 Cc = Rs.75 x 20% = Rs.15/unit/year EOQ (Q*) = Q* = 2CoD Ch = 2 x 125 x 15000 15 = 500 units

Number of orders per year

= (D/Q*) = 15000/500 = 30

The time between successive orders = (Q*/D) x 360 = 12 days

Problem
XYZ Company buys in lots of 500 boxes which is a 3 month supply. The cost per box is Rs.125 and the ordering cost is Rs.150. The inventory carrying cost is estimated at 20% of unit value. What is the total annual cost of the existing inventory? How much money could be saved by employing the economioc order quantity?

Solution
D = 500 x 4 = 2000 units per year Co = Rs.150/order Q = Number of units per order = 500 Purchase price per box= Rs.125 Cc = Rs.125 x 20% = Rs.25/box/year Total annual cost of existing inventory policy TIC = (D/Q) Co + (Q/2) Ch = (2000/500)*150 + (500/2)*25 = Rs.6850 EOQ (Q*) = Q* = 2CoD Ch = 2 x 150 x 2000 = 155 units 25

TIC* = (D/Q*) Co + (Q*/2) Ch = (2000/155)*150 + (155/2)*25 = = Rs.3872.98