Chapter-8 (Inventory Management)

Definition of Inventory
Inventory refers to the stock of goods and materials that a business holds for the purpose of
production, sale, or internal use. It includes raw materials, work-in-progress items, finished
goods, and maintenance supplies.

Definition of Inventory Management

Inventory Management is the process of overseeing and controlling a company's inventory
levels, ensuring that the right amount of stock is available at the right time. It involves tracking
inventory quantities, ordering new stock, managing storage, and forecasting demand to optimize
operational efficiency and minimize costs.

Inventory management is a crucial aspect of business operations that significantly impacts

success across various areas, including operations, marketing, and finance. Effective inventory
management ensures smooth processes and meets customer needs, while poor management can
lead to delays, decreased customer satisfaction, and increased costs. Many organizations perform
well or adequately in inventory management, but a significant number struggle with issues like
having too much or too little stock, inaccurate tracking, and misaligned priorities. To enhance
performance, businesses must adopt effective inventory management practices.

Types of Inventories
1. Raw Materials: Basic materials used in the production process.

2. Work-in-Progress (WIP): Items that are partially completed during manufacturing.

3. Finished Goods: Completed products ready for sale to customers.

4. Maintenance, Repair, and Operations (MRO) Supplies: Items used in production but not
part of the final product, such as tools and cleaning supplies.

5. Transit Inventory: Goods that are in transit between suppliers and warehouses or between
warehouses and customers.

6. Cycle Inventory: The portion of inventory that is regularly sold or used and replenished.

7. Safety Stock: Extra inventory held to prevent stock outs due to demand variability or supply
delays.
Functions of Inventory
Inventories serve several important functions in business operations:

1. To Meet Anticipated Customer Demand: Inventories are held to satisfy expected customer
needs, known as anticipation stocks. This includes products for retail customers and tools for
mechanics.

2. To Smooth Production Requirements: Seasonal inventories are built up during off-peak

times to meet high demand during peak seasons, helping businesses manage fluctuations,
such as those in fresh produce or holiday items.

3. To Decouple Operations: Inventories act as buffers between production stages, allowing

operations to continue despite disruptions like equipment breakdowns or delivery delays.

4. To Reduce the Risk of Stockouts: Safety stocks are maintained to guard against shortages
caused by unexpected demand spikes or supply delays.

5. To Take Advantage of Order Cycles: Firms often purchase in bulk to reduce costs, leading
to excess inventory that can be stored for later use, allowing for economic order sizes.

6. To Hedge Against Price Increases: Companies may stock up on materials when they
anticipate significant price hikes.

7. To Permit Operations: Work-in-process inventory is necessary due to the time it takes for
production. This includes raw materials and finished goods, which contribute to pipeline
inventories.

Understanding these functions helps businesses effectively manage their inventory to enhance
efficiency and meet customer needs.

Effective Inventory Management

Management has two basic functions concerning inventory. One is to establish a system to keep
track of items in inventory, and the other is to make decisions about how much and when to
order. To be effective, management must have the following:

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.
Inventory Counting Systems
Inventory counting systems come in two main types: Periodic and Perpetual.

 In a Periodic Inventory System, businesses count their inventory at fixed intervals, such as
weekly or monthly. For instance, a small retail store might check its stock every month and
estimate future needs to place orders. While this method allows for simultaneous ordering of
multiple items, it has drawbacks, including limited control between counts and the necessity
to carry extra stock to avoid shortages.
 On the other hand, a Perpetual Inventory System continuously tracks inventory levels in
real time, updating counts with each sale or receipt. When stock reaches a predetermined
minimum, a fixed quantity is ordered automatically. This system facilitates better control and
decision-making but requires more detailed record-keeping and still necessitates periodic
physical counts to ensure accuracy.

Understanding these systems helps businesses choose the most effective method for managing
their inventory.

Perpetual inventory systems can vary from simple to sophisticated. A basic example is the

 Two-bin system, which uses two containers for inventory. Items are taken from the first bin
until it’s empty, signaling the need to reorder. The second bin holds enough stock to meet
demand until the new order arrives, plus a safety cushion to prevent stockouts. This system
simplifies tracking since it doesn’t require recording each withdrawal, but it can fail if
reorder cards are misplaced or forgotten.
 Many supermarkets and discount stores have transitioned to computerized systems using
Universal Product Codes (UPC). These barcodes, scanned at checkout, provide real-time
sales data, enhancing inventory management and forecasting.
 Point-of-sale (POS) systems electronically record sales, helping managers adjust restocking
decisions efficiently.
 Barcoding offers significant advantages, including faster inventory tracking and improved
customer service. It’s also beneficial in manufacturing and healthcare, where it streamlines
production control and minimizes errors in drug dispensing. Additionally, Radio Frequency
Identification (RFID) tags are employed in some settings for inventory tracking.

Lead time
Inventories are crucial for meeting demand, so accurate estimates of both the amount and timing
of that demand are essential. Managers also need to know how long it takes for orders to be
delivered, known as lead time. If demand or lead time varies significantly, more stock may be
needed to prevent shortages. Therefore, effective forecasting is closely linked to successful
inventory management.
Inventory Costs (Inventory Terms)
Four basic costs are associated with inventories: purchase, holding, ordering, and shortage costs.

1. Purchase costs are the amounts paid to suppliers for inventory and are typically the largest
expense. For example, if a store buys $10,000 worth of merchandise, that’s its purchase cost.
2. Holding costs relate to the expenses of storing inventory, which can include interest,
insurance, taxes, depreciation, and potential losses from spoilage or theft. For instance,
holding a $100 item might cost $20 to $40 annually due to these factors.
3. Ordering costs are incurred when placing and receiving orders. This includes costs for
determining inventory needs, preparing invoices, inspecting goods, and moving items to
storage. These costs are usually fixed per order. For example, a business might spend $200
every time it places an order, regardless of the quantity.
4. Shortage costs occur when demand exceeds supply, leading to lost sales and customer
dissatisfaction. If a bakery runs out of bread, it not only loses sales but may also damage its
reputation. These costs can be significant, sometimes amounting to hundreds of dollars per
minute during production downtime. Understanding these costs is crucial for effective
inventory management.

ABC Classification System

An important aspect of inventory management is recognizing that not all items are equally
significant in terms of cost, profit potential, or usage. For example, a company selling electrical
equipment may have high-value items like generators and low-cost items like nuts and bolts. To
manage this effectively, the A-B-C approach classifies inventory based on annual dollar value,
which is calculated by multiplying the unit price by the annual usage rate.

Items are categorized into three classes:

 A items (very important) typically make up 10-20% of the inventory but account for 60-70%
of the total dollar value.
 B items (moderately important) fall in the middle.
 C items (least important) represent 50-60% of the inventory but only 10-15% of the dollar
value.
While C items may seem less critical, running out of them can disrupt operations, such as halting
an assembly line. Therefore, A items should receive close monitoring and frequent reviews, B
items moderate control, and C items minimal oversight, often using simpler methods like bulk
ordering.

 Economic Order Quantity (EOQ) Models

The Basic Economic Order Quantity (EOQ) model is a straightforward tool used to determine
the optimal order size that minimizes the total costs of holding and ordering inventory. It
generally excludes the unit purchase price unless quantity discounts apply, as the focus is on
balancing holding and ordering costs.

The model is based on several assumptions:

1. Only one product is involved.

2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year so that the demand rate is reasonably constant.
4. Lead time is known and constant.
5. Each order is received in a single delivery.
6. There are no quantity discounts.

The optimal order quantity balances carrying costs and ordering costs. A smaller order size leads
to lower average inventory and carrying costs but increases the frequency of orders, raising
ordering costs. Conversely, larger orders reduce ordering frequency and costs but increase
average inventory and carrying costs. Thus, the EOQ model helps businesses find the most cost-
effective order size.
The total cost curve reaches its minimum where the carrying and ordering costs are equal

 Economic Production Quantity (EPQ) Model

The Economic Production Quantity (EPQ) model is used in batch production, where parts are
produced in lots rather than continuously. This approach is beneficial when the production
capacity exceeds the demand rate, allowing inventory to build up while production occurs. The
EPQ model shares assumptions with the EOQ model but involves incremental unit deliveries
during production. Key assumptions include:

1. Only one product is involved.

2. Annual demand is known.
3. The usage rate is constant.
4. Usage occurs continuously, while production happens periodically.
5. The production rate remains constant during production.
6. Lead time is known and constant.
7. There are no quantity discounts.

These assumptions help businesses determine the optimal batch size to minimize costs while
managing inventory effectively.

 Quantity Discounts Model

Quantity discounts are price reductions offered for larger orders to encourage customers to
purchase in bulk. For example, a surgical supply company may lower the price per box of gauze
strips as the order quantity increases. When considering quantity discounts, several key questions
need to be addressed:

1. Is there enough storage space for the additional items?

2. Will there be issues with obsolescence or deterioration?
3. Can we afford to tie up extra funds in inventory?

If a decision is made to take advantage of the discount, the goal is to select an order quantity that
minimizes total costs, which include carrying costs, ordering costs, and purchasing costs. This
approach helps businesses maximize savings while effectively managing inventory.

Recall that in the basic EOQ model, determination of order size does not involve the pur chasing
cost. The rationale for not including unit price is that under the assumption of no quantity
discounts, price per unit is the same for all order sizes. Inclusion of unit price in the total-cost
computation in that case would merely increase the total cost by the amount P times D. A graph
of total annual purchase cost versus quantity would be a horizontal line. Hence, including
purchasing costs would merely raise the total-cost curve by the same amount (PD) at every point.
That would not change the EOQ. (See Figure 13.7)
When carrying costs are constant, there will be a single minimum point. All curves will have
their minimum point at the same quantity. Consequently, the total-cost curves line up vertically,
differing only in that the lower unit prices are reflected by lower total-cost curves as shown in
Figure 13.9 (For purposes of illustration, the horizontal purchasing cost lines have been omitted.)

When to Reorder with EOQ Ordering

 Reorder Point (ROP) Ordering helps determine when to place an order, complementing
the Economic Order Quantity (EOQ) model, which focuses on how much to order. The
reorder point is reached when the inventory level drops to a predetermined amount, which
typically includes expected demand during lead time plus a safety cushion to reduce the risk
of stockouts. To effectively manage inventory, continuous monitoring is necessary to know
when the reorder point is reached. The goal is to order when there’s enough stock to meet
demand during the lead time. Four key factors influence the reorder point quantity:

1. The rate of demand (usually forecasted).

2. The lead time for receiving orders.

3. Variability in demand and lead time.

4. The acceptable level of stockout risk for management.

By considering these factors, businesses can ensure timely orders and maintain adequate
inventory levels.
 Safety stock is extra inventory held to protect against the risk of stockouts due to variability
in demand or lead time. When actual demand may exceed expected demand, carrying safety
stock helps ensure that there is enough inventory available during the lead time.
Figure 13.12 illustrates how safety stock can reduce the risk of a stockout during lead time
(LT). Note that stockout protection is needed only during lead time. If there is a sudden surge
at any point during the cycle, that will trigger another order. Once that order is received, the
danger of an imminent stockout is negligible.
The reorder point increases by the amount of safety stock, but holding this extra inventory
incurs costs. Therefore, managers must balance the cost of carrying safety stock with the
benefits of reducing stockout risk. As safety stock increases, the customer service level
improves because the likelihood of running out of inventory decreases.

 Service level is the probability that demand will not exceed supply during lead time,
meaning there is enough stock on hand to meet demand. For example, a service level of 95%
indicates a 95% chance that demand will be satisfied without running out of inventory.
It's important to note that this does not mean 95% of total demand will be met; instead, it
signifies that in 95% of cases, there will be sufficient stock available. The risk of a stockout is
the opposite of the service level; thus, a 95% service level corresponds to a 5% stockout risk.

Fixed-Order-Interval Model
The fixed-order-interval (FOI) model is used when orders are placed at regular time intervals,
such as weekly or biweekly. In this system, the timing of orders is predetermined, and the main
question is how much to order each time.

FOI models are commonly used by retail businesses. If demand varies, the order size will change
from one cycle to the next, unlike the EOQ/ROP approach where the order size remains
consistent, while the cycle length adjusts based on demand. In EOQ/ROP, cycles are shorter
when demand is high and longer when demand is low.

Benefits of the Fixed-Interval System

1. Tight Control: Provides strong oversight of inventory levels.

2. Cost Savings: Grouping orders from the same supplier can reduce ordering, packing, and
shipping costs.

3. Practicality: Useful when inventory withdrawals cannot be closely monitored.

Disadvantages of the Fixed-Interval System

1. Higher Safety Stock: Requires more safety stock to cover the entire order interval plus
lead time, increasing carrying costs.

2. Periodic Review Costs: Incur costs related to regular inventory reviews and assessments.

Single-Period Model
The single-period model helps businesses decide how much to order for items that spoil quickly,
like fruits or newspapers. It focuses on goods that can’t be saved for later without losing value.

 Shortage Cost

Shortage cost is the loss a business faces when it runs out of stock. This includes unhappy
customers and lost sales, which is the profit that could have been made if the item was available.

 Excess Cost

Excess cost refers to the leftover items that didn’t sell by the end of the period. It measures the
loss from these items, calculated as the difference between what was paid for them and what they
can be sold for later.
 Continuous Stocking Levels

Continuous stocking levels involve finding the best amount of inventory to keep on hand. This
optimal level balances the costs of running out of stock (shortage costs) and the costs of having
too much inventory that doesn’t sell (excess costs).

 Discrete Stocking Levels

Discrete stocking levels refer to specific inventory targets rather than a smooth range. In this
approach, the goal is to meet or exceed a set service level, ensuring that enough stock is available
to satisfy customer demand without running out.

Operations Strategy for Inventories

Inventories are often a significant investment, and improving inventory processes can lead to
cost savings and better customer satisfaction. Here are some key areas to focus on:

1. Record Keeping: Keep accurate and updated inventory records. Regularly review and
update estimates of holding, ordering, and setup costs, as well as demand and lead times.

2. Variation Reduction: Minimize variations in lead times and forecast errors. Reducing these
variations can greatly improve inventory management.

3. Lean Operation: Lean systems are based on actual demand, pulling goods through the
system rather than pushing them without considering demand. They use smaller lot sizes to
lower holding, ordering, and setup costs. Benefits include:

 Lower average inventory levels and carrying costs.

 Fewer workflow disruptions.

 Reduced space requirements.

 Easier identification of problems.

 Closer placement of machines and workers, enhancing teamwork and communication.

4. Supply Chain Management: Collaborate closely with suppliers to coordinate shipments,

reduce lead times, and lower inventory levels. This can help reduce stockouts and carrying
costs. Strategies include:

 Blanket orders and vendor-managed inventories to lower transaction costs.

 Consignment agreements, where payment for inventory occurs only after items are sold.

 Cross-docking, which allows goods to move directly from incoming to outgoing trucks,
minimizing storage costs.