Inventory Management

By
Dr. G. Somasekhar
Associate Professor
VSB, VIT-AP University
[email protected]
1
9885509766
 Inventory Management
• What is inventory?
• 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)
⮚Maintenance/Tools inventory (to be used for repairing/fixing
machinery/regular checkup for maintenance and setting up machinery)
⮚Raw materials (to be used to produce more finished goods)

Inventory is generally the largest current asset – items expected

to sell within the next year – a company has.

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 Importance of Inventory Management

⮚Reduce cost by reducing inventory

⮚Avoid out of stock

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 Objective of Inventory Management
• The objective of inventory management is to strike a balance
between inventory investment and customer service.
• Satisfy customer service by keeping the inventory cost low

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 Types of inventory
• There are four types of inventory management.
1. Raw material inventory: Materials that are usually purchased but have yet
to enter the manufacturing process.
2. Work in progress inventory: Products or components that are no longer
raw materials but have yet to become finished products.
3. Maintenance/repair/operating (MRO) inventory: Maintenance, repair, and
operating materials.
4. Finished goods inventory: An end item ready to be sold, but still an asset on
the company’s books.

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 1.Raw material inventory

Raw Copper Raw Wood

Raw Steel
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 2.Work in progress inventory

Shaped wooden
Copper rope for
Steel Roll sheets sticks
wire 7
3. Maintenance/repair/operating (MRO) inventory

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4.Finished goods

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 Inventory Turnover Ratio
⮚ It is the ratio of annual cost of goods sold to average inventory investment.

⮚ The turnover ratio indicates how many times a year the inventory is sold.

⮚ Generally, the higher the ratio, the better, because that implies more
efficient use of inventories.

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 Managing inventory

ABC Analysis is a method for dividing on-hand

inventory into three classifications based on
annual dollar volume.
• Class A: items are those on which the annual
dollar volume is high. Which represents only
15% of the total inventory items.
• Class B: items are those on which the annual
dollar volume is medium. Which represents
only 30% of the total inventory items.
• Class C: items are those on which the annual
dollar volume is very low. Which represents
only 55% of the total inventory items.

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 Managing inventory cont.
Record Accuracy: Inventory Record Accuracy
(IRA) is a measure of how closely official
inventory records match the physical inventory.

Cycle counting is a sampling technique where

the count of a certain number of items infers the
count for the whole warehouse.
A items will be counted frequently, perhaps
once a month;
B items will be counted less frequently, perhaps
once a quarter; and
C items will be counted perhaps once every 6
months. 12
 Cycle count problem
Cole’s Trucks, Inc., a builder of high-quality refuse trucks, has about 5,000 items in its
inventory. It wants to determine how many items to cycle count each day. After hiring
Matt Clark, a bright young OM student, for the summer, the firm determined that it has
500 A items, 1,750 B items, and 2,750 C items. Company policy is to count all A items
every month (every 20 working days), all B items every quarter (every 60 working days),
and all C items every 6 months (every 120 working days). The firm then allocates some
items to be counted each day.

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 Advantages of Cycle count
1. Eliminates the shutdown and interruption of production
necessary for annual physical inventories.

2. Eliminates annual inventory adjustments.

3. Trained personnel audit the accuracy of inventory.

4. Allows the cause of the errors to be identified and remedial

action to be taken.

5. Maintains accurate inventory records.

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 Inventory Loss
Shrinkage is the loss of inventory that can be attributed to factors such
as employee theft, shoplifting, administrative error, vendor fraud,
damage in transit or in store, and cashier errors that benefit the
customer.

Inventory theft is also known as pilferage .

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 Inventory Control
1. Good personnel selection, training, and discipline:

2. Tight control of incoming shipments:

3. Effective control of all goods leaving the facility:

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 Inventory Models
Independent vs. Dependent Demand cont.
Basis of
Dependent Demand Independent Demand
Comparison
An inventory of an item is
categorized independent
An inventory of an item is
demand when the demand for
categorized as dependent when
Definition such an item is not dependent
demand for such an item is
upon the demand for another
dependent upon another item.
item.

Raw materials and component Finished goods items, which are

inventories are dependent upon ordered by external customer or
Categorization the demand for finished goods manufactured for stock and sale,
and hence are referred to as are referred to as independent
dependent demand inventories. demand items.
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 Inventory Models
Independent vs. Dependent Demand (Cont.)
Basis of
Dependent Demand Independent Demand
Comparison
Independent demands for
A business will have to look at what the
Basis of inventories (goods) are based
forecast customers will demand for their
inventory on confirmed customer orders,
finished products and order the goods to fulfill
Demand forecasts, estimates and past
that order.
historical data.
Dependent demand inventories (raw materials
and components to manufacture the finished Finished goods inventories
goods) are computed and managed using a (independent demands) are
Management of system known as Material Resources managed with sales order
Demand Planning (MRP), which considers not only the process and supply chain
quantities of each of the component parts management processes
needed, but also the lead times needed to based on sales forecasts.
produce and receive the items.

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 Inventory Models
Independent vs. Dependent Demand (Cont.)

Basis of
Comparis Dependent Demand Independent Demand
on
Dependent demand, on the other
hand, is demand for component parts Independent demand is
or subassemblies. For example demand for a finished
Example
microchips in the computer, wheels on product such as bicycle,
s
bicycle, the cheese on the pizza, and computer, television, pizza,
switch for television or mouthpiece for car or phone.
phone.

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 Costs involved in Inventory Models
Holding, Ordering, and Setup Costs
• Purchase Cost: The amount paid to buy the inventory

• Holding costs are those associated with storing inventory that remains unsold.
These costs are one component of total inventory costs.

• Ordering cost includes costs of supplies, forms, order processing, purchasing,

clerical support, and so forth.

• In manufacturing, setup cost is the cost incurred to get equipment ready to

process a different batch of goods. Setup cost is considered to be a non-value-
added cost that should be minimized.
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Costs factors
Inventory Models Independent Demand

1. Basic Economic Quantity model (EOQ)

2. Production Order Quantity Model (POQ)
3. Quantity Discount Model (QDM)

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 Inventory Models
• The basic economic order quantity model
• An inventory-control technique that minimizes the total of
ordering and holding costs.
The economic order quantity is derived from the total cost equation,

where p is a unit price, D is annual demand quantity, K is ordering cost, H is holding cost per
unit, and Q is order quantity.

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 Assumptions of EOQ model
If the economic order quantity model is applied, the following assumptions should
be met:
1.The rate of demand is constant, and total demand is known in advance.
2.The ordering cost is constant.
3.The unit price of inventory is constant, i.e., no discount is applied depending on
order quantity.
4.Delivery time is constant.
5.Replacement of defective units is instantaneous.
6.There is no safety stock level, i.e., the minimum stock level is zero.
7.Restocking is made by the whole batch. 24
Assumptions of EOQ model

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 EOQ model

the optimal order quantity occurs at the point where the ordering-cost curve
and the carrying-cost curve intersect.
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EOQ model variables

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EOQ model formulas

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EOQ model formulas

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EOQ model formulas

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A company manufacturing building materials has
an annual demand in concrete of 150,000 tons.
The price is $425 per ton, the ordering cost is
$3,750, and the annual holding cost per ton is
$48.25.

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 EOQ model
A company manufacturing building materials has an annual demand in concrete
of 150,000 tons. The price is $425 per ton, the ordering cost is $3,750, and the
annual holding cost per ton is $48.25.
Let’s put all the data available in the formula above.

Thus, the economic order quantity of 4,829 tons provides the minimum total
holding and ordering cost. To prove this, we calculate the total cost for EOQ and
order quantity of 4,500 tons and 5,500 tons using the total cost equation above.

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EOQ model

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 EOQ model
Sumco, a company that buys pump housings from a manufacturer and
distributes to retailers. Sumco would like to reduce its inventory cost by
determining the optimal number of pump housings to obtain per order.
The annual demand is 1,000 units, the ordering cost is $10 per order, and
the carrying cost is $0.50 per unit per year. Each pump housing has a
purchase cost of $5. How many housings should Sumco order each time?

=√2*(1000)*(10)/0.50=200 Units
 EOQ model Problem
Sharp, Inc., a company that markets painless hypodermic needles to hospitals, would
like to reduce its inventory cost by determining the optimal number of hypodermic
needles to obtain per order. The annual demand is 1,000 units; the setup or ordering
cost is $10 per order; and the holding cost per unit per year is $.50.

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 EOQ model Problem
Sharp, Inc. has a 250-day working year and wants to find the number of orders ( N ) and
the expected time between orders ( T ).

The company now knows not only how many needles to order per order but that
the time between orders is 50 days and that there are five orders per year.
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EOQ model Problem 2

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 EOQ model Problem 2
List down the given data and apply EOQ formula

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 EOQ model Problem 2 cont.
List down the given data and apply suitable formula

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 EOQ model Problem 2 cont.
List down the given data and apply suitable formula

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 EOQ model Problem 2 cont.
List down the given data and apply suitable formula

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 EOQ model Problem 3

List down the given data and apply suitable formula

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EOQ model Problem 3 cont.

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 Key Terminologies

Lead time
In purchasing systems, the time between placing an order and receiving it;
in production systems, the wait, move, queue, setup, and run times for
each component produced.

Reorder point (ROP)

The inventory level (point) at which action is taken to replenish the stocked
item.

Safety stock ( ss )
Extra stock to allow for uneven demand; a buffer.
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 EOQ model Problem
The inventory level (point) at which action is taken to replenish the stocked item.

Re ordering Point = Demand per day * Lead time for a new order in
days
ROP = d * L

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 EOQ model Problem
An Apple store has a demand (D) for 8,000 iPhones per year. The firm operates a 250-day
working year. On average, delivery of an order takes 3 working days, but has been known
to take as long as 4 days. The store wants to calculate the reorder point without a safety
stock and then with a one-day safety stock.

First compute the daily demand

When iPhone inventory stock drops to 96 units, an order should be placed. If the safety
stock for a possible one-day delay in delivery is added, the ROP is 128 (= 96 + 32).
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ROP

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 Example ROP

When iPhone inventory stock drops to 96 units, an order should be placed. If the safety
stock for a possible one-day delay in delivery is added, the ROP is 128 48
 POQ production order quantity model
This model is applicable under two situations: (1) when inventory continuously flows or
builds up over a period of time after an order has been placed or (2) when units are
produced and sold simultaneously.

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POQ model variables

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 POQ model formulas

Where Qp*= Production Order Quantity

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 POQ production order quantity model
Nathan Manufacturing, Inc., makes and sells specialty hubcaps for the retail automobile
aftermarket. Nathan’s forecast for its wire-wheel hubcap is 1,000 units next year, with an
average daily demand of 4 units. However, the production process is most efficient at 8 units
per day. So the company produces 8 per day but uses only 4 per day. The company wants to
solve for the optimum number of units per order. ( Note: This plant schedules production of
this hubcap only as needed, during the 250 days per year the shop operates.)

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 POQ production order quantity model

The difference between the production order quantity model and the basic EOQ
model is that the effective annual holding cost per unit is reduced in the
production order quantity model because the entire order does not arrive at once. 53
POQ production order quantity model
Problem 2

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 POQ production order quantity model
Problem 2
List down the given data and apply suitable formula

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POQ production order quantity model Problem 2
cont.

=√2*48000*45/1*[1-(200/800]

=2400 Wheels

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 Quantity Discount model
A quantity discount model is simply a reduced price ( P ) for an item when it is
purchased in larger quantities.

A reduced price for items purchased in large quantities.

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 Quantity Discount model

For example, suppose that D= 5,200, S= $200, and I= 28%.

Using the formula the EOQ for the $96 price equals

Because 278 , 1,500 (the price-break quantity needed to receive the $96 price),
the EOQ for the $96 price is not feasible . On the other hand, the EOQ for the $98
price equals 275 units. This amount is feasible because if 275 units were actually
ordered, the firm would indeed receive the $98 purchase price. 58
 Quantity Discount model
Chris Beehner Electronics stocks toy remote control flying drones. Recently, the store has
been offered a quantity discount schedule for these drones. This quantity schedule was
shown in Table below. Furthermore, setup cost is $200 per order, annual demand is
5,200 units, and annual inventory carrying charge as a percent of cost, I , is 28%. What
order quantity will minimize the total inventory cost?

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 Quantity Discount model

First we calculate the Q * for the lowest possible price of $96, as we did earlier:

Because 278 , 1,500, this EOQ is infeasible for the $96 price. So now we calculate Q * for the
next-higher price of $98:

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 Quantity Discount model Problem 2

D = 816 cases per year

S = $12
H = $4 per case per year

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Quantity Discount model Problem 2 cont.

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