What is inventory?

Inventory is the raw materials, component

parts, work-in-process, or finished products
that are held at a location in the supply chain.

Inventory: a stock or store of goods

Independent Demand

Dependent Demand

C(2)

B(4)

D(2)

E(1)

D(3)

F(2)

Independent demand is uncertain.

Dependent demand is certain.

Inventory Models
Independent demand finished goods, items that are
ready to be sold
E.g. a computer
Dependent demand components of finished products
E.g. parts that make up the computer

12-4

Inventories in the Supply

Chain

Types of inventory
RAW MATERIAL: They are required to carry out production activities
uninterruptedly. The factors like the availability of raw materials and government
regulations, etc. too affect the stock of raw materials.
WORK-IN-PROGRESS: It is a stage of stocks between raw material & finished
goods. The greater the time taken in manufacturing, the more will be the amount
of work in progress.

 CONSUMABLES: These are needed to smoothen the process of production.

These materials do not directly enter production but they act as catalyst, etc. The
fuel oil may form a substantial part of cost.

FINISHED GOODS: These are the goods which are ready for the consumers. The
purpose of maintaining inventory is to ensure proper supply of goods to
consumers.
SPARES: Form a part of inventory. Some industries like transport will require
more spares than the other concerns. The costly spare parts like engines,
maintenance spares etc. are not discarded after use, rather they are kept in ready
position for further use.

Inventory Management
An efficient system of inventory management will
determine

What to purchase
How much to purchase
From where to purchase
Where to store

Objectives of Inventory
Management
Provide acceptable level of customer service (on

time delivery)
Allow cost-efficient operations
Minimize inventory investment
To avoid both over-stocking and under-stocking
of inventory
To ensure right quality goods at reasonable prices

BENEFITS OF HOLDING INVENTORIES

Meet variation in Production Demand : Production plan changes in response to the

sales, estimates, orders and stocking patterns. Holding inventories at a nearby
warehouse helps issue the required quantity and item to production just in time.

Economies of Scale in Procurement : Buying raw materials in larger lot and holding
inventory is found to be cheaper for the company than buying frequent small lots. In
such cases one buys in bulk and holds inventories at the plant warehouse.

To guard against price increases : Manufactures sometimes use large purchase,

or large production runs, to achieve savings when they expect price increases for raw
materials or component parts.

 To protect against stock outs : Manufacturers use safety stock to protect against
uncertainties in either the demand or supply of an item. Delayed deliveries and
unexpected increases in demand increase the risk of shortages
Reduce Transit Cost and Transit Times : In case of raw materials being imported from
a foreign country or from a far away vendor within the country, one can save a lot in
terms of transportation cost buy buying in bulk.
There could be a lot of factors resulting in shipping delays and transportation too, which
can hamper the supply chain forcing companies to hold safety stock of raw material
inventories.
Long Lead and High demand items need to be held in Inventory : The particular
item is in high demand and short supply one can expect disruption of supplies. In such
cases it is safer to hold inventories and have control.

RISK AND COSTS OF HOLDING

INVENTORIES

Purchase Cost : The actual price paid for the procurement of items is called purchase
cost. The purchase cost becomes relevant if a quantity discount is available. This
becomes an incentive to order greater quantities
Inventory Holding Cost : The holding, carrying or storage cost is the cost associated
with maintaining an inventory until it is used or sold. Holding or storage cost includes the
cost of maintaining storage & handling facilities, the cost of insuring the inventory, taxes
attributed to storage, costs associated with obsolescence etc.
Ordering cost : Each time a company places a purchase order with a supplier or a
production order, it incurs an ordering cost.

 Set-Up Cost : The setup cost is the cost involved in changing a machine over to produce
a different part or item. While someone is adjusting a machine, it is idle and the company
incurs the additional costs.
Shortage Cost : The stock out or shortage cost occurs when the demand for an
item exceeds its supply. The cost associated with a stock out or shortage depends on
how the company handles the problem, the size of the shortage and how long the
shortage lasts .
Total Inventory Cost : If price discounts are available, then we should formulate total
inventory cost by taking sum of purchase cost (PC), Inventory Holding Cost (IHC),
Shortage Cost (SC) and Ordering Cost (OC). Thus, the total inventory cost; TC, is
given by

TC = PC + IHC + SC + OC

Economic Ordering Quantity or EOQ Formula

Economic Order Quantity is one of the techniques of inventory control which
minimizes total holding and ordering costs for the year.
It is also known as standard order quantity , optimum quantity or economic lot size
Definition of EOQ :EOQ is essentially an accounting formula that determines at which the combination of
order costs and inventory carrying cost are at the least.

The EOQ Formula

Q OPT =

2DS
=
H

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost

Assumptions of EOQ Model

Only one product is involved

Annual demand requirements known
Demand is even throughout the year
Lead time does not vary
Each order is received in a single delivery
There are no quantity discounts
Ordering costs are constant per order

An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
H

2(1,000)(10)

0.50

40,000 200 units

An EOQ Example
Economic Enterprises require 90,000 units of a certain item annually. The
cost per unit is Rs.3, the cost per purchase order Rs. 300 and the inventory
carrying cost Rs. 6 per unit per year. What is the Economics Order Quantity?

Q
*

2DS
H

EOQ

Where, A = Annual Usage in units = 90,000

S = Cost of placing an order = Rs. 300
I = Inventory carrying costs of one unit. = Rs. 6

2 90,000 300
90,000 3,000 units
6

Stock Control Levels

Reorder Level
Reorder level is the inventory level at which a company would place a new order or start a
new manufacturing run. The reorder level is:
(ROL)=Lead Time in Days Daily Average Usage

Lead time is the gap between when an order is placed and when it is
received.
Example : ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous
brand daily. Its supplier takes a week to deliver the order.
The inventory manager should place an order before the inventories drop below
3,500 units (500 units of daily usage multiplied with 7 days of lead time) in order
to avoid a stock-out

Minimum Stock Level

It is the minimum level of stock that can be reached in inventory. The stock should
never be allowed to go below this level.

Minimum Stock Level = Reorder level - (Average rate of

consumption X Average time of inventory delivery)
Example : A factory uses maximum 100 units per day. The maximum lead
time is 5 days. The average usage of inputs is 80 units, average lead time is
3 days. What is the minimum inventory level?

Reorder level = 100*5 = 500 units

Minimum stock level = 500 - (80*3) = 260 units

Maximum Inventory Level

It is the level of stock, beyond which a firm should not maintain the stock.

Maximum Stock Level = Reorder level + Reorder Quantity(Minimum Usage X Minimum Delivery Time)
Example : The maximum usage is 100 units per day and maximum lead
time is 10 days. The reorder quantity is 500 units. The minimum delivery
usage is 50 units per day and minimum delivery time is 5 days. Calculate
maximum level?

Reorder Level =
Maximum Usage X Maximum Lead Time
100X 10= 1000
Maximum Stock Level = Reorder Level+
Reorder Quantity-( Minimum Usage X
Minimum Lead Time)
=
1000+500-(50X5)
1250 units

JUST-IN-TIME PHILOSOPHY
Toyota Motor Company- first to implement fully
functioning and successful JIT system, in 1970s
An inventory system designed to produce efficient
output with minimum lead time at the lowest possible
cost, minimizing waste, with great consistency.

The focus of JIT is to improve the

system of production by eliminating
all forms of waste.

FOLLOWERS
Adopted by General Electrical in the USA in the 1980.
Some companies referred JIT with different names:
i. TOYOTA Toyota System
ii. IBM Continuous flow manufacturing
iii. GE- Management by sight
iv. HEWLETT- PACKARD- stockless production &
repetitive manufacturing system

JIT Goals

Eliminate disruptions
Make the system flexible
Reduce set up times & lead time
Minimize inventory
Eliminate waste
Increase productivity
Give the customer the products they want, when and
where they want them at the minimum cost

Waste according to JIT

ADVANTAGES OF JIT

High quality
Flexibility
Reduced the cost of production
Less waste
Low warehouse cost
Reduced space requirements
Increased productivity
Improved vendor relations

DISADVANTAGES OF JIT

Time consuming

No spare product to meet un expected order

High dependence on suppliers.
Danger of disrupted production due to nonarrival of supplies
Supply Shock : If products do not reach on time
High risk factor

Inventory Turnover Ratio

It means how many times a companys inventory is sold and replaced (finished product)
This ratio is used to evaluate the performance of the inventory function :-

where,
cost of goods sold means sales minus gross profit and
avg. stock indicates yearly avg.(average of opening and closing inventory)
Analysis - it is used to measure the inventory management efficiency of a business.
- a higher value indicates better performance and lower value means inefficiency in
controlling inventory levels.

Inventory Ratio Inventory Turnover Ratio (contd)

Example:
During the year ended December 31, 2010 Loud Corporation sold goods
costing $324,000. Its average stock of goods during the same period was
$23,432. Calculate the company's inventory turnover ratio.
Formula - ITR = Cost of sales during the period/Avgrage stock held during the
period
Solution
Inventory Turnover Ratio = $324,000 / $23,432 = 13.83