Module 5: Inventory

Concepts and Models

1. Inventory – An Essential
Requirement
Inventory refers to the stock of materials or goods that an organization holds to support its operations,
ranging from raw materials to finished products. The purpose of inventory is to balance the supply and
demand of goods, ensuring that a business can smoothly operate and meet customer demands without
overstocking or running out of essential items.
Types of Inventory:
• Raw Materials: The basic, unprocessed materials used to produce goods. Examples include steel for
manufacturing car parts or grains for food production.
• Work-in-Progress (WIP): Items that are in the process of being manufactured but are not yet finished
products. These could be partially assembled items on an assembly line.
• Finished Goods: These are products that have been completed and are ready for sale or distribution.
Examples include cars, clothing, or electronics.
• Maintenance, Repair, and Overhaul (MRO): Inventory consisting of spare parts, maintenance tools,
and other equipment needed for the upkeep of production machinery and assets.
• Transit Inventory: Goods that are in transit from suppliers to manufacturers or from manufacturers to
customers. Although they are physically moving, they are still part of the overall inventory.
1. Inventory – An Essential
Requirement
• Importance of Inventory:
• Ensures uninterrupted production: Raw materials and WIP ensure
continuous manufacturing processes.
• Facilitates customer service: Finished goods inventory ensures timely delivery
to customers.
• Risk management: Provides a buffer against supply chain disruptions or
unexpected demand spikes.
• Cost optimization: Helps businesses take advantage of bulk purchasing and
economies of scale.
2. Objectives of Inventory
The management of inventory serves several key objectives to balance costs, production, and customer demand. These
objectives aim to optimize both operational efficiency and financial performance.
Meeting Customer Demand:
The primary objective is to ensure that products are available when customers demand them. Insufficient inventory can result in
stockouts, while excessive inventory leads to increased holding costs.
Just-in-Time (JIT) inventory practices can help meet this objective by ensuring inventory levels are optimized.
Reducing Lead Times:
Reducing the time it takes to produce and deliver products. Shorter lead times mean quicker response to customer demand, leading
to higher customer satisfaction.
Smooth Production Process:
Maintaining a continuous flow of production without interruptions. Stockouts in raw materials or components can halt production
lines, making inventory management a critical function.
Economies of Scale:
Buying or manufacturing in larger quantities often reduces unit costs. Efficient inventory management allows businesses to benefit
from bulk purchasing or production runs, leading to lower costs per unit.
Handling Demand Fluctuations:
Inventory allows businesses to cushion themselves against fluctuations in demand, such as seasonal changes or unforeseen market
shifts.
Ensuring Availability of Parts for Maintenance and Repairs:
In industries where machines and equipment are critical to operations, MRO items serve as a safeguard to avoid downtime.
3. Functions of Inventory
Inventory serves several functional purposes across various stages of production, operations, and distribution.
Proper management of these functions can lead to optimized performance.
Buffer Against Demand Fluctuations:
Inventory helps businesses deal with uncertainties in demand, ensuring product availability even during unexpected spikes.
Example: A toy manufacturer may keep extra stock ahead of the holiday season to meet the surge in demand.
Facilitates Production Scheduling:
Proper inventory management ensures that raw materials and semi-finished goods are available for production, minimizing
production delays.
Enables Bulk Purchasing:
Inventory allows companies to purchase goods in bulk, reducing procurement costs.
This is particularly relevant for raw materials or components where unit costs drop with larger orders.
Seasonal Stocking:
Businesses often need to stock up ahead of peak seasons (e.g., retail stores before the holiday season). Inventory provides the
means to anticipate and prepare for these cycles.
Reduces Lead Times:
With inventory available at strategic points (warehouses, production lines), goods can be quickly moved into the next phase of
the supply chain, reducing waiting times.
Strategic Stocking:
Businesses can store strategic or high-demand items to protect against supply chain disruptions or geopolitical issues (e.g., raw
materials sourced from unstable regions).
4. Classification of Inventory
Classification helps in categorizing inventory to apply different management techniques and ensure efficient
handling.
By Type:
Raw Materials: These are purchased for processing or manufacturing. For example, raw cotton for textile manufacturers.
Work-in-Progress (WIP): This is inventory that has undergone some processing but is not yet a finished product. It may
include partially completed goods like partially assembled vehicles.
Finished Goods: Products that are complete and ready for sale or delivery to customers.
Maintenance, Repair, and Overhaul (MRO): Spare parts, lubricants, tools, and other items used to maintain production
machinery or infrastructure.
By Value (ABC Classification):
A-items: High-value items that require tight control and regular monitoring. Typically, these make up a small percentage of
total inventory but have a high cost impact.
B-items: Items of moderate value that require medium-level management.
C-items: Low-value items that can be ordered in bulk and require less frequent monitoring. These items typically represent a
large portion of inventory but have little impact on costs.
By Function:
Transit Inventory: Items that are in transit between stages in the supply chain.
Cycle Stock: The regular stock that is used for normal operations. This stock is replenished regularly to meet demand.
Safety Stock: Extra inventory held to buffer against unforeseen fluctuations in demand or supply chain disruptions.
Anticipatory Stock: Inventory held in anticipation of a known future demand spike (e.g., for holidays or promotions).
5. Factors Affecting Inventory
Various internal and external factors influence inventory management decisions, requiring businesses to adapt strategies
for effective control.
Demand Variability:
Fluctuations in customer demand can influence the amount of inventory a company needs. Products with highly variable demand
require larger safety stock or more frequent reordering.
Lead Time:
The amount of time it takes for inventory to be delivered after an order is placed. Longer lead times require higher levels of inventory
to ensure production is not disrupted.
Holding Costs:
Costs incurred for storing inventory, including warehousing, insurance, taxes, and inventory depreciation.
Stockout Costs:
The costs associated with running out of stock, including lost sales, customer dissatisfaction, and potential damage to brand
reputation.
Order Costs:
Costs involved in placing an order, including administrative costs, transportation, and any procurement-related expenses.
Seasonality:
Some products experience seasonal demand spikes. Inventory management must adjust for these fluctuations to ensure adequate
stock during peak periods without overstocking during off-seasons.
Market Conditions:
Changes in market trends, such as a sudden increase in consumer preference for a specific product, may affect inventory levels.
6. Inventory Management
Models
• Inventory models help businesses optimize inventory levels to minimize costs
while meeting demand effectively. Some common inventory models include:
• Economic Order Quantity (EOQ):
• Economic Order Quantity (EOQ) is a fundamental inventory management concept used
to determine the optimal order quantity that minimizes the total cost of inventory. EOQ
is designed to balance the trade-off between ordering costs (costs related to placing
and receiving orders) and holding costs (costs associated with storing inventory). The
objective is to find the order quantity that minimizes the sum of these two costs.
• EOQ is a formula used to determine the ideal order quantity that minimizes the total
cost of inventory, balancing ordering and holding costs.
• The formula is:
where:
D = Demand rate (units per period, e.g., annual demand)
S = Ordering cost per order (fixed costs per order, including shipping, handling, etc.)
H = Holding cost per unit per year (storage costs, insurance, depreciation, etc.)
Economic Order Quantity (EOQ):
Key Concepts:
Ordering Costs (S): Costs associated with ordering inventory, such as shipping fees, purchase order
preparation, and receiving costs.
Holding Costs (H): Costs related to holding or storing inventory, such as warehouse space, insurance,
and spoilage.
Demand Rate (D): The number of units required per period (typically per year), which can be
constant or variable.
EOQ Assumptions:
Constant demand rate (deterministic).
Constant ordering and holding costs.
Instantaneous replenishment (inventory arrives all at once).
No stockouts.
EOQ Objective:
Minimizing the total inventory cost, which is the sum of ordering costs and holding costs:

By adjusting the order quantity, EOQ helps minimize the total cost by finding the optimal balance.
6. Inventory Management
Models
• Just-in-Time (JIT):
• JIT is an inventory strategy that aims to reduce inventory levels by ordering only what is
needed when it's needed. This method focuses on minimizing waste and costs while
ensuring products are available for production and customer demand.
• Reorder Point (ROP):
• The reorder point determines when to place an order for inventory based on the lead
time and demand.
• The formula is: .
• This helps prevent stockouts and ensures inventory is replenished in time.
• ABC Analysis:
• This method classifies inventory into three categories (A, B, C) based on their importance
and value. It helps prioritize management efforts on high-value, high-impact items.
Inventory Modeling
Inventory modeling refers to the mathematical or computational approach to manage inventory
effectively by determining the best strategy for ordering, holding, and managing stock. The goal is to
optimize inventory levels to minimize costs while ensuring that products are available to meet
customer demand.
Common inventory models include:
Basic EOQ Model: Assumes constant demand, no quantity discounts, and instantaneous
replenishment.
Reorder Point (ROP) Model: Determines the inventory level at which a new order should be placed
to avoid stockouts. ROP depends on the demand rate and lead time.
ROP formula:
• The formula is: .
Production Order Quantity Model (POQ): Used for manufacturing scenarios where inventory is
replenished gradually rather than instantly. This model works well when production and
consumption occur simultaneously.
Multi-Echelon Inventory Models: These models consider inventory across multiple levels of the
supply chain (e.g., warehouses, distributors, and retailers) and help optimize the inventory flow
across the network.
Quantity Discount Models
Quantity discount models address the impact of price reductions
(discounts) for ordering larger quantities. The goal is to find the optimal
order quantity that balances the benefits of price discounts with the
costs of increased inventory levels and holding costs.
Basic Assumptions in Quantity Discount Models:
• A discount is applied when a certain quantity threshold is met.
• The larger the order, the lower the price per unit.
• Holding costs increase with the amount of inventory, and ordering costs are
fixed.
Model for Quantity Discounts
Let’s consider the situation where the unit price depends on the order quantity.
The supplier offers a discount based on order size. The total cost for the discount
model is the sum of ordering costs, holding costs, and purchase costs.
Purchase Cost:

The unit price decreases as the order quantity increases, providing a discount.
Total Cost:

The optimal order quantity in this model is determined by evaluating total costs at
different discount levels and finding the order quantity that minimizes the total
cost.
Steps to Apply Quantity Discount Models:
• Calculate the EOQ for each price tier (with and without discounts).
• Compare the total costs for each order quantity (with and without the
discount).
• Choose the quantity that minimizes the total cost, taking the discount into
account.
Example:
• If a company faces the following pricing structure:
• Q≤100: Price = $10/unit
• 100<Q≤500 Price = $9/unit
• Q>500: Price = $8/unit
The company must calculate the total costs for each pricing tier and
choose the optimal order quantity that minimizes the total cost,
factoring in both ordering and holding costs as well as the discounts.
Deterministic Models
Deterministic models in inventory management assume that demand, lead time, and
other key factors are known with certainty. These models are particularly useful for
situations where demand is stable and predictable.
Key Characteristics of Deterministic Models:
• Known demand: The demand rate is constant and predictable. It is not subject to randomness.
• Known lead time: The time it takes for an order to arrive is constant.
• No variability: There are no surprises in terms of stockouts, order delays, or demand shifts.
Examples of Deterministic Inventory Models:
• Economic Order Quantity (EOQ): As mentioned earlier, EOQ is a deterministic model that
assumes constant demand and lead time. The goal is to determine the optimal order quantity
that minimizes the total inventory cost.
• Reorder Point (ROP) Model: The ROP is also deterministic, relying on fixed demand and lead
time to determine the point at which an order should be placed.
Applications of Deterministic Models:
• Manufacturing: Where demand for products is known and the supply chain is
predictable.
• Retail: When stocking products with steady sales patterns and established
reorder cycles.
Advantages:
• Simplicity and clarity in the calculations.
• Useful when the demand and supply conditions are stable and predictable.
Limitations:
• Inflexible in real-world scenarios where demand or lead time can vary
unpredictably.
• Does not account for uncertainty or randomness in demand, which is often
the case in practice.
Case Study 1: Optimizing Inventory
for a Retail Store Using EOQ
Background: A retail store sells electronic gadgets like smartphones, tablets,
and accessories. The demand for smartphones is relatively constant, but
fluctuates slightly around special sales events. The store wants to optimize
its inventory to minimize both ordering and holding costs.
Problem: The store needs to calculate the optimal order quantity for
smartphones, given the following information:
Annual demand (D) = 12,000 units
Ordering cost (S) = ₹8,200 per order (₹100 * 82)
Holding cost (H) = ₹410 per unit per year (₹5 * 82)
Unit price = ₹16,400 per unit (₹200 * 82)
Solution:
Calculate EOQ: Using the EOQ formula:

Therefore, the optimal order quantity (EOQ) is 693 units.

Total Cost Calculation:
Ordering Cost:

Holding Cost:

Total Cost =
Conclusion: By ordering 693 units at a time, the store minimizes its total inventory
costs. Regular reviews can help adjust the EOQ if demand, costs, or other factors
change.
Case Study 2: Quantity Discount
Model for Bulk Purchasing of Raw
Materials
Background: A manufacturing company uses a specific type of steel in the
production of its products. The supplier offers discounts for larger orders, which the
company can take advantage of to reduce costs. The company wants to determine
whether it should increase its order quantity to take advantage of the discount.
Problem: The company faces the following pricing structure for steel:
Order Quantity 1-100 tons: ₹16,400 per ton (₹200 * 82)
Order Quantity 101-200 tons: ₹15,580 per ton (₹190 * 82)
Order Quantity 201 tons or more: ₹14,760 per ton (₹180 * 82)
Other information:
Annual demand (D) = 2,000 tons
Ordering cost (S) = ₹41,000 per order (₹500 * 82)
Holding cost (H) = ₹2,460 per ton per year (₹30 * 82)
Solution:
Calculate EOQ for each price tier:
For Order Quantity 1-100 tons (price = ₹16,400):

This order quantity exceeds 100 tons, so this tier is not optimal.
For Order Quantity 101-200 tons (price = ₹15,580):

The EOQ still exceeds 200 tons, so this tier is also not optimal.
For Order Quantity 201 tons or more (price = ₹14,760):

As 258 tons is within this tier, the optimal order quantity would be 258 tons.
Total Cost for the Bulk Order:
Order Cost:
Holding Cost:
Purchase Cost:
Total Cost = Ordering Cost + Holding Cost + Purchase Cost = ₹3,17,538.4 +
₹3,77,580 + ₹2,95,20,000 = ₹3,02,15,118.4 per year
Conclusion: Ordering 258 tons at a time results in significant cost savings,
taking advantage of the discount. This bulk purchase lowers the overall cost
compared to ordering smaller quantities at higher prices.
Case Study 3: Deterministic
Inventory Model for a Bookstore
Background: A bookstore sells a popular novel, and the store wants to
ensure they have enough stock on hand to meet customer demand
without overstocking. The store operates under deterministic
conditions, where demand is fixed and predictable.
Problem:
Annual demand (D) = 1,000 books
Ordering cost (S) = ₹4,100 per order (₹50 * 82)
Holding cost (H) = ₹164 per book per year (₹2 * 82)
Lead time = 10 days
Working days in a year = 365
Solution:
Calculate EOQ:

So, the optimal order quantity is 224 books.

Calculate Reorder Point (ROP): Since the demand is deterministic, the ROP is simply
the lead time demand:

The store should reorder when inventory reaches 28 books.

Total Cost:
Ordering Cost:
Holding Cost:
Total Cost =
Conclusion: By ordering 224 books each time, the bookstore optimizes its inventory
and minimizes both ordering and holding costs, ensuring it meets customer demand
without overstocking.
Case Study 4: Managing Seasonal
Demand with EOQ for a Clothing Retailer
Background: A clothing retailer specializes in seasonal apparel, such as
winter jackets. The company anticipates high demand during winter
and lower demand during off-season months. The retailer wants to
optimize inventory levels to avoid stockouts during peak season and
minimize overstocking during the off-season.
Problem:
Annual demand (D) = 10,000 jackets
Ordering cost (S) = ₹5,100 per order (₹62.2 * 82)
Holding cost (H) = ₹820 per jacket per year (₹10 * 82)
Unit price = ₹4,100 per jacket (₹50 * 82)
Case Study 5: Optimizing Inventory for a
Pharmaceutical Company Using Quantity
Discount
Background: A pharmaceutical company sources raw materials for manufacturing
various medicines. The company faces a price reduction for purchasing larger
quantities of a certain ingredient. The company is evaluating whether taking
advantage of this discount will reduce its overall costs.
Problem: The company faces the following pricing structure for a critical ingredient:
Order Quantity 1-500 kg: ₹12,300 per kg (₹150 * 82)
Order Quantity 501-1,000 kg: ₹11,660 per kg (₹142 * 82)
Order Quantity 1,001 kg or more: ₹11,020 per kg (₹134 * 82)
Other information:
Annual demand (D) = 5,000 kg
Ordering cost (S) = ₹8,200 per order (₹100 * 82)
Holding cost (H) = ₹410 per kg per year (₹5 * 82)
Case Study 6: Managing
Perishable Inventory with
Deterministic Model for a
Grocery Store
Background: A grocery store sells fresh produce that has a limited shelf
life. The store must manage its inventory in such a way that it avoids
spoilage due to overstocking while ensuring it doesn't run out of
popular items during high-demand periods.
Problem:
Annual demand (D) = 8,000 kg of apples
Ordering cost (S) = ₹3,300 per order (₹40 * 82)
Holding cost (H) = ₹410 per kg per year (₹5 * 82)
Lead time = 7 days
Working days in a year = 365