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Basics of Inventory Management

This document provides an overview of inventory management. It discusses the objectives of reducing inventory costs while maintaining customer service levels. The key types of inventory include raw materials, work in process, and finished goods. Inventory is also classified using ABC analysis to prioritize the most important items. The costs associated with inventory include holding, ordering, and setup costs. The basic economic order quantity (EOQ) model is presented to determine the optimal order quantity to minimize total costs based on demand, ordering costs, and holding costs. Safety stock is also discussed to protect against uncertainties in demand or lead times.

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158 views4 pages

Basics of Inventory Management

This document provides an overview of inventory management. It discusses the objectives of reducing inventory costs while maintaining customer service levels. The key types of inventory include raw materials, work in process, and finished goods. Inventory is also classified using ABC analysis to prioritize the most important items. The costs associated with inventory include holding, ordering, and setup costs. The basic economic order quantity (EOQ) model is presented to determine the optimal order quantity to minimize total costs based on demand, ordering costs, and holding costs. Safety stock is also discussed to protect against uncertainties in demand or lead times.

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saurav_edu
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We take content rights seriously. If you suspect this is your content, claim it here.
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Basics of Inventory Management

Summer Placements 2013


Compiled by

Operations Interest Group, IIM Lucknow

Objective of Inventory Management:


To strike a balance between inventory investment and customer service levels.
2 Key performance indicators for inventory management:
1) Reduction of inventory cost related to holding, ordering and transporting materials, supplies and
finished goods at various points along the supply chain
2) Achievement of customer service, targets related to quality, availability and on time delivery of
products and services

Functions of inventory:
a) Anticipation inventory: Inventory kept in stock at each location to cover the demand projected
in the organizations demand plan. The demand plan will include anticipation of demand peaks
and valleys due to promotions or changes in seasonal demand
b) Fluctuation inventory: (Safety stock) Fluctuation inventory is used to decouple the firm from
fluctuations in demand and provide a stock of goods that will provide a selection for customers
In case of production process, fluctuation inventory is the additional inventory that is kept for
protection against forecast errors and short term changes in backlog.
http://en.wikipedia.org/wiki/Safety_stock
c) Decoupling inventory: It is used to separate various parts of production process and allow
supply functions and demand functions to operate at differing independent rates. Decoupling
inventory saves the production line from delay if there is any shortage in the upstream
processes.
d) Hedge inventory: This inventory is used to hedge risk of inflation and upward price changes due
to factors like calamities, labor strikes, political and economic events
e) Lot size inventory: It is purchased to take advantage of quantity discounts offered for larger
quantities.

Types of inventory:
a) Raw material inventory: materials that have been purchased but not still processed
b) Work in process inventory: components or materials that have undergone some change but not
completely processed
c) Finished goods inventory: materials that have been completely processed but not sold
d) MRO (maintenance/repair/operations): supplies necessary to keep machinery and processes
productive or in simple words, supplies used for maintenance and repair works .eg: spare parts,
lubricants, hand tools and cleaning agents MRO is expensed rather than being kept an asset
on the balance sheet like other types of inventory

Inventory classification (ABC analysis):


Inventory must be classified to differentiate critical few from trivial many as per Pareto principle
Accordingly inventory is classified into 3 categories
Class A: These items are those for which dollar volume is high. They represent 15 to 20% (remember as
80-20 rule) of the total inventory items but represent 70-80% of dollar value
Class B: Those items of medium annual dollar volume. They may represent 30% of inventory items and
15 to 25% of total value
Class C: They represent 5% of dollar value but count as 55% of total inventory items.
Implications:
1) Forecasting A items more carefully and meticulously keeping track of purchase and usage.
2) Putting more time, effort and money into cultivating relationships with the suppliers of A items
3) Warehousing the A items in the most secure part of facilities and taking more care in
transporting them

Control of Inventory:
Control of inventory is extremely important to reduce shrinkage.
Shrinkage: Inventory that is unaccounted for between receipt and time of sale. Shrinkage occurs from
damage and theft as well as from sloppy paper work.
Inventory theft is also known as pilferage.
Retail inventory loss of 1% of sales is considered good. In some stores losses as high as 3%.
Mechanisms of inventory control:
1) Good personnel selection, training and discipline

2) Tight control on incoming shipments and goods leaving the facility This task is effectively
handled by many firms using techniques like bar code reading and RFID.

Costs associated with inventory (management)


Holding cost or carrying cost (H): It is associated with holding inventory over time. This cost arises from
factors like obsolescence (depreciation) and costs related to storage, insurance, material handling cost,
shrinkage staffing and interest payment
Usually it is expressed in percentage terms of the dollar value of inventory per unit of time. It ranges
from 15 to 40% of value of inventory annually.
Ordering cost (S): It includes costs of order processing, purchasing, clerical support, supplying of goods
etc. In manufacturing context, ordering costs is a part of setup cost.
Setup cost: It is the cost to prepare the machine or process to manufacture an order (a batch or a lot of
WIP material). It includes time and labor to clean the machines and change tools and holders.

Inventory models:
1) Basic Economic order quantity model (EOQ)
Assumptions:
a) Demand and lead time are known and constant
b) Receipt of inventory is instantaneous and complete
c) Quantity discount is not possible
Optimal order quantity (Q*) = 2/
Where
D: Annual demand in units for the item
S: Set up/ ordering cost for each lot
H: Holding/ inventory carrying cost per unit per year
H is also expressed as H= CI
where C= Unit cost of the item and I= Inventory carrying cost in percentage of C
Expected no. of orders per annum (N)= D/Q*
Expected time between orders (T)= Nos. of working days per year/ N
Total annual cost, TC= Set up (order) cost + Holding cost + Cost of goods
= DS/Q + QH/2 + DC
Average inventory (units) = Q/2
To get minimum TC, differentiate TC with respect to Q and equate to 0
We will get Optimal order quantity (Q*) = 2/

Refer to page no. 454 of Operations management text book (Heizer and Render) for derivation in detail

Lead time: The time between placing an order and receiving the goods
Re-order point: The inventory level at which a new order should be placed
Re-order point = (demand/day) * Lead time
2) Production order quantity model
3) Quantity discount model
Safety stock: If demand or lead time is not constant, then some amount of inventory has to be kept
always to avoid stoppage of production line or stock outs in retails store. This amount of inventory is
called safety stock. It depends on service level

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