Operations Management with TQM

Module 5
Part 1
Inventory Management

Video Lecture

FOR CLASS DISCUSSION PURPOSES ONLY

 Introduction
Inventory management is a core operations
management activity. Effective inventory
management is important for the successful
operation of most businesses and their supply
chains. Inventory management impacts operations,
marketing, and finance. Poor inventory
management hampers operations, diminishes
customer satisfaction, and increases operating costs.

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 Introduction
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.

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 What is Inventory Management
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)

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 Functions of Inventory:
• 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.

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 Functions of Inventory:
• 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.

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 Functions of Inventory:
• Smoothing production requirements:
Businesses that produce nonperishable products
and experience seasonal customer demand often
try to build up inventory during slow 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.

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 Functions of Inventory:
• 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.

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 Functions of Inventory:
• 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.
• 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.
FOR CLASS DISCUSSION PURPOSES ONLY
 Requirements for Effective
Inventory Management:
• 1. A system to keep track of the inventory on
hand and on order.
• 2. A reliable forecast of demand that includes an
indication of possible forecast error.
• 3. Knowledge of lead times and lead time
variability.
• 4. Reasonable estimates of inventory holding
costs, ordering costs, and shortage costs.
• 5. A classification system for inventory
items. FOR CLASS DISCUSSION PURPOSES ONLY
 A. Inventory Counting Systems:
• 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.
• 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.
FOR CLASS DISCUSSION PURPOSES ONLY
 A. Inventory Counting Systems:
• 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 expected.
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 A. Inventory Counting Systems:
• 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.

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 B. Demand Forecasts and Lead-
Time Information:
• 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.

FOR CLASS DISCUSSION PURPOSES ONLY

 C. Inventory Costs:
• Purchase Cost - is the amount paid to a vendor
or supplier to buy the inventory. It is typically the
largest of all inventory costs.
• Holding (carrying) Cost – a cost to carry an item
in inventory for a length of time, usually a year.
• Ordering costs - are the costs of ordering and
receiving inventory. They are the costs that vary
with the actual placement of an order.

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 C. Inventory Costs:
• Shortage costs – this cost resulting when
demand exceeds the supply of inventory; often
unrealized profit per unit.

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 D. Classification System:
• A-B-C approach - classifying inventory according to
some measure of importance, and allocating control
efforts accordingly.

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D. Classification System:

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 Inventory Ordering Policies:
• Cycle stock - the amount of inventory needed to
meet expected demand.
• Safety stock - extra inventory carried to reduce
the probability of a stockout due to demand
and/or lead time variability.

FOR CLASS DISCUSSION PURPOSES ONLY

 Inventory Ordering Policies:
• 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)
FOR CLASS DISCUSSION PURPOSES ONLY
 Inventory Ordering Policies:
• Economic Order Quantity (EOQ) formula

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 Inventory Ordering Policies:
• 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.

FOR CLASS DISCUSSION PURPOSES ONLY

 Inventory Ordering Policies:
• Days Inventory Outstanding (DIO) formula

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 Inventory Ordering Policies:
• 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
FOR CLASS DISCUSSION PURPOSES ONLY
 Inventory Ordering Policies:
• Reorder Point Formula

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 Inventory Ordering Policies:
• 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
FOR CLASS DISCUSSION PURPOSES ONLY
 Inventory Ordering Policies:
• Safety Stock Formula

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 Inventory Ordering Policies:
• 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.
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 Inventory Ordering Policies:
• Fixed-Order Interval Model:

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