CHAPTER 17

Inventory Planning and Control

CRITICAL QUESTIONS
After going through this chapter, you will be able to answer the following questions:

• What are the various types of inventory found in an organization?

• What are the costs and decisions related to inventory management?
• How is economic order quantity computed?
• How can one model demand uncertainty and compute appropriate levels of
investment to be made in inventory?
• What are the alternative inventory management systems in use in
organizations?
• What are the alternative approaches available for selective control of
inventories?
• How is inventory planning done in the case of a single-period demand?

Organizations need to spend a considerable amount of money to carry inventory. The

cost of stores and warehousing and the administrative costs related to maintaining
inventory and accounting for it form a significant part of this cost.

Source: MTR Foods Pvt. Ltd.

ideas at Work 17.1

 Inventory Management in a Consumer Products Company

A consumer products company dealing in cosmetics and other personal-care products

was exploring ways to reduce inventory levels across their outbound supply chain and
improve inventory record accuracy at their storage points. The company had a supply
chain network of three factories with bonded stock rooms (BSRs) attached for dispatch
to the depots and 35 depots for servicing distributors. Goods moved from the factory to
the BSRs. The BSRs dispatched stocks to one centralized depot. Other depots received
stocks from this depot and sold them to distributors.

These depots were holding high levels of inventory of old/withdrawn stocks and
damaged stocks for a long time (over three months). The total average inventory
holding at the BSRs was 8.2 weeks of sales and at the depots was 6.5 weeks of sales.
There were several reasons for high levels of inventory. Some of them are discussed
here.

Sales and dispatch forecasts were not in line with actual sales. Furthermore, there
was no process to periodically review and refine the annual forecasts utilizing market
feedback. Stocking across all points in the distribution chain was driven by a push-
oriented system that did not have any provision for factoring in market requirements.
Actual safety stocks maintained at depots were significantly higher than the target
safety stocks agreed on at the beginning of the operating year. No system was in place to
monitor and correct this practice. There was also a high level of old/damaged/slow-
moving stocks. Dead stock was allowed to accumulate in the system mainly because
there was an absence of visibility into inventory details across stocking points. The
process to monitor and act on dead stock was not adhered to and records of slow-
moving/old/damaged stocks were not maintained methodically at the stocking points.

A study was conducted focusing on the inventory-related issues at the BSRs and
depots. This included inventory holding as a proportion of sales, practices employed for
tracking goods in the warehouse, and the proportion of fast- and slow-moving stocks to
the total inventory. The study also looked at the inventory planning process pertaining
to forecast accuracy, the process of reviewing and revising forecasts, the level of safety
stock at each location, combined with the process to review and reset the same

An IT solution was implemented for computing the forecast using consolidated

orders, with factoring for promotions and seasonality. The IT solution also enabled the
organization to calculate safety stock levels based on the number of weeks of sales
target. Demand planning and forecasting were made a periodic activity using the IT
solution to align forecasting with market orders and actual sales. The process of setting
safety stocks at depots was made periodic and dynamic, based on updated sales data.
Furthermore, norms were set to act on damaged/old and other dead stocks. Clear steps
were laid down regarding the liquidation or destruction of these stocks. An
accountability chain was set up in the organization to monitor and authorize activities
in this regard, based on the visibility provided by the IT solution.

The overall benefit of the exercise was that the organization was able to ensure
availability of fresh stocks in the market. This was achieved mainly by reducing
inventory levels across the chain and also through better stock management at the
depots. The company achieved a stock-level reduction from 8.2 weeks to 5.5 weeks at
the BSRs and from 6.5 weeks to 4 weeks at the depots. Transparency of saleable and
damaged stocks quantities across the supply chain resulted in more accurate demand
planning, stock allocation, and production.

Source: K. Ravichandran and Debjyoti Paul, “Best Practices in Inventory

Management,” http://forumcentral.sify.com/athena/login/casestudyinventory.pdf. Last
accessed on 15 December 2008.

The term inventory refers to any idle resource that can be put to some future use.
Manufacturing and several service organizations have significantly invested in
inventory. Often, investment in inventory has a direct bearing on the profitability of a
firm. Experiences in the last twenty years suggest that the world-class performance of a
firm hinges on the firm’s ability to cut investment in inventory to very low levels.
Automobile assembly plants and component manufacturers are known to carry very
little inventory and yet provide good quality finished goods at the right time. In addition
to cutting down cost, reduced inventory levels help an organization improve quality,
planning systems, and supply chain coordination. They also reduce wastage and
obsolescence. Hence, inventory planning and control continues to derive considerable
attention of the management in organizations.

The term inventory denotes any idle resource that could be put to some
future use.

17.1 INVENTORY PLANNING FOR INDEPENDENT DEMAND ITEMS

In manufacturing organizations, finished goods and spare parts typically belong to the
category of independent demand items. While planning for a dependent demand item is
done to meet manufacturing requirements, in the case of independent demand items, it
is done to meet customer requirements. Two attributes characterize and distinguish
independent demand items: They are in continuous demand, and there is an element of
considerable uncertainty in the demand for such items.

In manufacturing organizations, finished goods and spare parts typically

belong to the category of independent demand items.

Continuous Demand

Independent demand items are in continuous demand. Consider the sale of consumer
appliances of manufacturers such as Videocon or LG. The demand for 32” LCD colour
television panels in a particular city will be continuous. When there is a continuous
demand for an item, constant availability of items and periodic replenishment of stock
are important elements of the planning process. Non-availability of items translates into
lost sales, poor customer goodwill, and additional costs in servicing the promised
deliveries.

Uncertainty of Demand

There is an element of considerable uncertainty of demand in the case of independent

demand items. On the other hand, in the case of dependent demand items, the demand
is always derived and hence known with certainty. For example, the number of tyres
required per month for new vehicles is known accurately once the monthly production
is finalized. However, the number of spark plugs required for sale as spare parts needs
to be estimated on some basis. Therefore, inventory planning for independent demand
items should include some cushion for handling uncertainties whenever they are
significant.

Given these requirements, inventory planning of independent demand items must

address the following two key questions:

1. How much? Good inventory planning must devise means by which the planner
can continuously replenish the stock as it depletes over time. The replenishment
could be of a fixed quantity or variable. It could be based on the costs associated with
inventory. It could also satisfy certain practical considerations such as truck capacity,
quantity discounts, and minimum order quantity restrictions posed by the supplier.
2. When? The other issue is the timing of replenishment. Since demand is
continuous and uncertain, the timing of replenishment is equally crucial. There are
numerous ways of addressing the timing. It could be based on consumption patterns,
the value of the item, managerial preferences for review, and other practical
considerations.

Inventory planning of independent demand items must address the two key
questions: how much, and when?

17.2 TYPES OF INVENTORY

Before planning for inventory, it is important to know why organizations carry

inventory and what factors influence the level of investment. Five types of inventory are
normally found in most organizations.

Seasonal Inventory

Organizations carry inventory to meet fluctuations in demand arising out of seasonality.

During festival periods, the demand for consumer durables may be high due to an
increase in disposable income in the hands of consumers. In order to meet this surge in
demand, there is inventory build-up during non-peak periods. Similarly, in a fast-food
restaurant, a certain amount of inventory build-up happens during non-peak hours to
handle the increase in demand during peak hours. In both these cases, inventory plays
the crucial role of addressing short-term capacity issues in an organization.1
 Five types of inventory are normally found in organizations: seasonal
inventory, decoupling inventory, cyclic inventory, pipeline inventory, and safety
stock.

Decoupling Inventory

Manufacturing systems typically involve a series of production and assembly

workstations. Raw material passes through these stages before it is converted into
finished goods. Each stage behaves idiosyncratically on account of varying process
times, downtimes, and resource availability. Therefore, the planning and control of such
multi-stage production processes becomes very complex. One way to simplify the
production planning and control problem is to decouple successive stages using
inventory at some intermediate points. Each stage will have an input buffer and an
output buffer. The output buffer of the preceding stage becomes the input buffer of the
succeeding stage. Inventory decisions in this case require analysis of workstation
capacities, resource availability, and bottlenecks.

Figure 17.1 illustrates the use of decoupling inventory. In the first case, there is no
decoupling inventory. In this case, all the ten stations of production are to be closely
monitored and flow balance is to be ensured on a continuous basis. If there is a problem
in one of the stations, it will affect all upstream and downstream stations. Further, the
vagaries of demand uncertainty will directly affect the system’s performance. Planning
and control is challenging, especially when the number of stations is very large. On the
other hand, the second case in Figure 17.1 has decomposed the production into three
major stages. Each stage is linked to the other using decoupling inventory. This enables
each stage to work with reasonable levels of independence. Further, the adverse impact
of one stage will not immediately affect the others. Therefore, a certain amount of
decentralized planning and control is possible.

FIGURE 17.1 An illustration of the use of decoupling inventory

FIGURE 17.2 Cyclic inventory

Cyclic Inventory

It is customary for organizations to order inventory in repeated cycles and consume

them over time. For example, a hospital may order disposable syringes in quantities of
10,000. If the average consumption rate is 500 per day, then it takes 20 days to deplete
one order. On the twenty-first day, another order of 10,000 will arrive and it will be
consumed over the next 20 days, and so on. Cyclic inventory goes through a saw-
toothed pattern as shown in Figure 17.2. Each cycle begins with replenishment and
ends with complete depletion of the inventory.

If Q is the order quantity per cycle,

Pipeline Inventory

Pipeline inventory pertains to the level of inventory that organizations carry in the long
run due to non-zero lead time for order, transport, and receipt of material from the
suppliers. Because of the geographical distances between the buyers and the suppliers
and the host of business processes involved in ordering and receiving material, there is
a time delay between order placement and order receipt. The inventory carried to take
care of these delays is known as pipeline inventory.

Consider the example of the hospital. Suppose it takes three days to supply disposable
syringes. Then the hospital should place an order at the end of Day 17 in order to
replenish the stock to 10,000. This means that an order will be placed when the
inventory level reaches 1,500 (3 days at the rate of 500 syringes per day).2 In general, if
the lead time for supply is L, and the mean demand per unit time is μ, then the pipeline
inventory is L × μ.
 In the long run, the system will always have this inventory in order to take care of
lead time for supply. The only way organizations can reduce this inventory is to cut
down lead time for procurement, production, and distribution. Locating suppliers
nearby, re-engineering the business processes related to procurement and distribution
of materials, and using efficient alternatives for logistics are some of the ways in which
an organization can reduce lead time and pipeline inventory.

FIGURE 17.3 Cyclic inventory, pipeline inventory, and safety stock

Safety Stock

Organizations also have additional investment in inventory to buffer against

uncertainties in demand and supply of raw material and components. We know from
the elementary theory of probability distributions that when demand is stochastic,
carrying average inventory will ensure that the demand is met only 50 per cent of the
time (in the long run). However, in order to improve the availability to meet uncertain
demand, an additional quantity known as safety stock is kept. Greater investment in
safety stock leads to a lower probability of inventory going out of stock. Similarly, the
higher the uncertainty, the greater is the need for safety stock. Safety stock only serves
to prevent shortages in the short run. However, in the long run, the demand will tend
toward an average value and the safety stock will not be consumed. Figure
17.3 represents an inventory system with safety stock and other types of inventory.

EXAMPLE 17.1

A manufacturer of transformers requires copper (both in plate and wire form) as a key
ingredient. The average weekly requirement of copper is 200 tonnes. The lead time for
the supply of copper is two weeks. If the manufacturer places monthly orders of copper,
analyse the various types of inventory in the system.

Solution

Order quantity Q = 1 month requirement = 800 tonnes.

Cyclic inventory in the system .

Lead time L = 2 weeks

Average weekly demand μ = 200 tonnes

Pipeline inventory = L × μ = 200 × 2 = 400 tonnes.

Reducing safety stock calls for reducing uncertainty in the system. Investment in
superior planning and forecasting systems and good supplier development practices
will help organizations reduce uncertainty in the system. In the case of components
manufactured in-house, better production planning and improved maintenance of
resources will help reduce uncertainty in the system.

Reducing safety stock calls for reducing uncertainty in the system.

Cyclic inventory, pipeline inventory, and safety stock are critically linked to both the
“how much” and “when” questions in inventory planning. Lead time influences the
“when” decision directly and determines the level of pipeline inventory in the system.
Similarly, cyclic inventory is the outcome of the “how much” decision that an inventory
planner makes. Safety stock influences both “how much” and “when” in an indirect
sense. However, in order to understand how these decisions are made, one needs to
understand various costs associated with inventory planning and control.

Cyclic inventory, pipeline inventory, and safety stock are critically linked to the
“how much” and “when” questions in inventory planning.

17.3 INVENTORY COSTS

There are several costs associated with inventory planning and control. These costs
could be classified under three broad categories:

• The cost of carrying inventory. All costs related to maintaining inventory in

organizations will be classified under this.
• The cost associated with ordering material and replenishing it in cyclic
intervals.
• The cost arising out of shortages.
Inventory control models should take these into consideration and aim at minimizing
the sum of all these costs. Sometimes, the unit cost of the item for which inventory
planning is done is also a relevant cost for decision making. This is because when large
quantities are ordered, there could be some discount in the unit cost of the item.

Inventory-carrying Cost

Organizations need to spend a considerable amount of money to carry inventory. The

most significant component is the interest for the short-term borrowals for the working
capital required for inventory investment. The second significant cost relates to the cost
of stores and warehousing and the administrative costs related to maintaining
inventory and accounting for it. The elements of storing and warehousing costs include
the following:

• Investment in store space and storage and retrieval systems

• Software for maintaining the inventory status
• Managerial and other administrative manpower to discharge various activities
related to stores
• Insurance costs
• Cost of obsolescence, pilferage, damages, and wastage

TABLE 17.1 Computation of Carrying Cost: An Illustration

Sl. No. Item of Expenditure (Annual)

1 Stationary 75,

2 Insurance premium 375

3 Establishment expenses and overheads 275

4 Salary of stores personnel 1,1

Total expenditure 1,7

Average value of the inventory in stores 35,

Warehousing cost (in % inventory value) 5.0

a Cost of warehousing 5.0

b Cost of capital (assumed) 15.

c Obsolescence (estimated historically) 2.0

d Damages, spoilage, etc. (estimated historically) 1.0

 Sl. No. Item of Expenditure (Annual)

Carrying cost (%) 23.

In the case of high-tech electronics and short-shelf-life items, such as active chemical
compounds, food items, and pharmaceutical formulations, obsolescence costs could be
significant. Table 17.1 shows a sample computation of carrying cost for a company. The
components of inventory-carrying costs exert considerable pressure on an organization
to keep inventory levels low. However, the ability of an organization to reduce
inventory depends on the nature of business processes in place, the lead time for
procurement, and the quality of planning, as pointed out in the earlier section.

Note that all the costs related to carrying inventory are directly related to the level of
inventory. Graphically, it can be shown as a simple linear relationship (Figure 17.4).
Let Cc denote the inventory-carrying cost per unit per unit time. Since the interest
component is the predominant part of Cc, the usual practice is to represent Cc as a
percentage of the unit cost of the item. Thus, if Cu is the unit cost of the item,
then Cc = iCu, where i is in percentage. For example, if the unit cost of an item is ₹5,000,
the annual interest charges are 12 per cent, and the other annual costs related to
carrying inventory are 3 per cent, then the inventory-carrying cost is 15 per cent of the
unit cost, that is, ₹750 per unit per year.

For an order quantity of Q, the average inventory carried by an organization is Q/2.

Therefore,

Cost associated with carrying inventory

Cost of Ordering

Replenishment of cyclic inventory is achieved by ordering material with the suppliers.

Organizations perform a series of tasks related to ordering material. These include
search and identification of appropriate sources of supply, price negotiation, contracting
and purchase-order generation, follow-up and receipt of material, and eventual stocking
in the stores after necessary accounting and verification. In Chapter 7, we have
discussed several aspects pertaining to this in some detail. All these tasks involve
manpower, resources, and time that can be classified under cost of ordering. Since
several of these costs are fixed in nature, ordering a larger quantity could reduce the
total costs of ordering. A larger order quantity Q will require fewer orders to meet a
known demand D, and vice versa. The relationship between Q and the total cost of
ordering is graphically shown in Figure 17.4. Table 17.2 shows a sample computation of
ordering cost for a company.

The number of orders to be placed to satisfy a demand of D = D/Q. If C0 denotes the

cost of ordering per order, then:
FIGURE 17.4 Behaviour of ordering and carrying costs of inventory

Sometimes, components required for use in an organization are sourced from within. A
division or a department of the organization may be specially manufacturing the
required components for internal consumption. In such situations, the costs associated
with setting up the required machinery will represent the cost of ordering. For example,
let us assume that a component is produced in-house. In order to manufacture the
component, two machines are to be set up and it takes 60 minutes and 120 minutes
respectively in these machines. It also requires consumables and tools for the purpose
of setting up the machine. Finally, direct labour time and supervisor time needs to be
devoted for the activity. By estimating the cost of all these factors, we can arrive at the
cost of set-up.

The cost of carrying and the cost of ordering are fundamentally two opposing cost
structures in inventory planning. For instance, when the order quantity becomes
smaller, the total cost of carrying inventory decreases. On the other hand, since a large
number of orders are to be placed to satisfy the demand, the total ordering costs will go
up. Conversely, when the order quantity is increased, while the total cost of ordering
will come down owing to fewer orders being placed, the total cost of carrying inventory
will increase due to an increase in the average cyclic inventory in the system. Balancing
these two opposing costs will be central to inventory planning and control in any
organization. Figure 17.4gives a graphical representation of the sum of these two costs.

TABLE 17.2 Computation of Ordering Cost: An IIustration

 Sl. No. Item of Expenditure (Annual)

1 Stationary 80,

2 Telephone 40,

3 Other communication expenses 60,

4 Salary of purchase department personnel 1,1

5 Inwards goods inspection section expenses 350

6 Other expenses and overheads 200

Total expenditure 1,8

No. of purchase orders generated 600

Average cost of ordering 3,0

Cost of Shortages

Despite careful planning, organizations are likely to run out of stock for several reasons.
There could be a sudden surge in demand. Alternatively, the suppliers might not have
delivered the material as per schedule, or a lot could have been rejected because of
defective components. Such events disrupt production and have a cascading effect down
the supply chain. Delivery schedules are missed, leading to customer dissatisfaction and
loss of goodwill. It also introduces additional costs arising out of pushing the order back
and rescheduling the production system to accommodate these changes. Rush
purchases, uneven utilization of available resources, and lower capacity utilization
further escalate the costs in the system. All these form part of the cost of shortage.

The cost of carrying and the cost of ordering are fundamentally two opposing
cost structures in inventory planning.

The cost of shortage per unit is denoted by Cs. Since the effects of shortage are vastly
intangible, it is difficult to accurately estimate Cs. In practice, managers tend to use other
measures to incorporate the cost of shortage if estimation of Cs proves to be futile.

17.4 INVENTORY CONTROL FOR DETERMINISTIC DEMAND ITEMS

Let us consider a situation in which the demand for an item is continuous and is known
with certainty. Since the demand is known, we exclude the possibility of having
shortages. Better inventory control requires that we answer the “how much” and
“when” questions by balancing the total costs of carrying inventory and ordering. For an
order quantity of Q, we can compute the total cost of carrying and ordering from Eqs.
17.2 and 17.3.

Total cost of the plan = Total cost of carrying inventory + Total cost of ordering

When the total cost is minimum, we obtain the most economic order quantity (EOQ).

By taking the first derivative of Eq. 17.4 with respect to Q and equating it to zero, we can
obtain the EOQ. Differentiating Eq. 17.4 with respect to Q we obtain:

Note that the second derivative is positive and hence we obtain the minimum cost by
equating the first derivative to zero. Equating the first derivative to zero and
rearranging the terms, we obtain Eq. 17.5.

Denoting EOQ by Q*, we obtain the expression of Q* as:

Q* answers the “how much” question directly. Every time the inventory depletes to zero,
it is economical to place an order equal to Q*. Similarly, time between orders answers
the “when” question. Since the demand is continuous, the demand rate will determine
“when” to place an order. For instance, if the annual demand for an item is 2,500 units
and if there are 250 working days, the daily demand is 10. If Q* is 300, then it is implied
that an order needs to be placed every 30 days.

2500

EXAMPLE 17.2

A two-wheeler component manufacturing unit uses large quantities of a component

made of steel. Although these are production items, the demand is continuous and
inventory planning could be done independent of the production plan. The annual
demand for the component is 2,500 boxes. The company procures the item from a
supplier at the rate of ₹750 per box. The company estimates the cost of carrying
inventory to be 18 per cent per unit per annum and the cost of ordering as ₹1,080 per
order. The company works for 250 days in a year. How should the company design an
inventory control system for this item? What is the overall cost of the plan?

Solution

Annual demand for the item (D) = 2,500 boxes

Number of working days = 250

The average daily demand =

Unit cost of the item (Cu) = ₹750.00 per box

Inventory-carrying cost = iCu = 0.18 × 750.00 = ₹135.00 per unit per year

Cost of ordering (C0) = ₹1,080.00 per order

The “how much” decision:

Economic order quantity(Q*)

Number of orders to be placed

The “when” decision:

Time between orders

Total cost of the plan

Hence, the manufacturer will place an order for 200 boxes of the component once in
every 20 days and will incur a total cost of ₹27,000 for the plan. Any quantity above or
below will increase the cost of the plan.
 Problems in the EOQ model

We have made several assumptions while deriving Q*. The salient among these include
the following:

1. The demand is known with certainty and is continuous over time.

2. There is an instantaneous replenishment of items.
3. The items are sourced from an external supplier.
4. There are no restrictions on the quantity that we can order.
5. There are no preferred order quantities for the items.
6. No price discount is offered when the order size is large.

In practice, several of these assumptions do not hold. Despite this, the EOQ model can be
applied with suitable modifications because it is robust. Because of the square root in
the formula, changes in model parameters, such as demand and cost, have less impact
on the solution. If demand is not known accurately, one can use representative figures
for D and assess the impact of changes on the total cost of the plan (see Problem 4 at the
end of the chapter). The assumption of instantaneous replacement can be easily taken
care of by placing an order ahead. If the lead time is L, then by placing an order Lperiods
ahead of depletion of inventory, one can ensure availability of material. Similarly, if the
items are manufactured in-house, it is possible to estimate the economic run length by a
simple modification to Eq. 17.5.4

The EOQ model is robust and can be applied in several real-life settings with
some modifications.

Assumptions (d), (e), and (f) indicate the need for examining the suitability of
utilizing order quantities different from Q*. Large order sizes result in price discounts.
There are other reasons for placing a larger order than what the EOQ suggests.
Sometimes, it will be economical to transport a truckload of items and save on
transportation cost. In other cases, the supplier may impose a minimum order quantity.
In all these cases, the relevant cost for analysis includes cost elements other than
carrying and ordering. An analysis of these relevant costs will help the inventory
planner make an appropriate choice in order quantity. See Example 17.3 for an
illustration of this.

EXAMPLE 17.3

Consider Example 17.2. Assume that the carrying cost of the component remains ₹135
per unit per year and that the supplier is willing to offer a discount on the unit price as
per the following structure:

Up to 399 boxes = No discount

400 − 799 boxes = 2 per cent discount

800 − 1,000 boxes = 3 per cent discount

What should the company do in this case?

Solution

The economic order quantity is 200 boxes and the unit price of the item is ₹750.

There are two other order quantities at which the unit price changes on account of
discount.

At Q1 = 400, unit price of the item = 0.98 × 750 = ₹735.00

At Q2 = 800, unit price of the item = 0.97 × 750 = ₹727.50

Since there is a discount on the price as the order quantity is varied, the total cost
comparison between alternatives can be made only after incorporating the purchase
price.

Total cost for Q*

Total cost for Q1

Total cost for Q2

Since TC(Q1) is the lowest among the alternatives, the firm can make use of the discount
offered and reset the order quantity to 400 boxes.

17.5 HANDLING UNCERTAINTY IN DEMAND

With some modifications, the EOQ model can accommodate several practical
considerations. However, when the demand is uncertain, instances of shortages occur
while operating the system with EOQ. There are two ways of handling the issue of
shortages. One is to incorporate shortage cost in the model. The other is to use the
concept of service level. Service level is the desired probability of not running out of
stock between the time an order is placed with a supplier and the order is received. For
example, if an organization wants to operate with a 90 per cent service level, it means
that in the long run, the organization is able to meet the demand on 90 per cent of all
occasions.

Service level is the desired probability of not running out of stock between
the time an order is placed with a supplier and the order is received.

Consider an item with uncertain demand. When the item is available in stock, there is
no risk of shortage. However, when an order is placed, the demand can be met only with
the available stock until the stock is replenished by an order. Hence, if an organization is
protected from the risks of shortage during the supply lead time, then inventory
planning is better. The concept of service levels seeks to achieve this objective. Let us
understand the concept of service level through a simple example.

Consider an item with uncertain demand that has a lead time of one week. Based on
observed consumption patterns one can estimate the weekly demand. Table 17.3 has
illustrative data for the item. The last two columns show the cumulative frequency of
demand exceeding the lower class. For example, the weekly demand exceeded 30 units
during 98.25 per cent of the observed occasions and exceeded 180 units during 18.42
per cent of the occasions. The information in the table can also be plotted as a frequency
ogave (see Figure 17.5).

From the data, one can compute the average demand during lead time to be 143 units.
If the organization stocks 143 units at the time of placing the order with the supplier,
then in the long run, it will be able to meet the demand during lead time only on 50 per
cent of the occasions. In other words, the organization has a 50 per cent service level if
it operates with this inventory level. Clearly, this will be an undesirable situation and
managers would want to offer better service. From the data, we can compute the
number of units to be stocked to offer 90 per cent and 95 per cent service levels to be
203 and 224 units, respectively. By stocking 60 more units (203–143), the organization
can improve the service level from 50 per cent to 90 per cent. Similarly, by investing an
additional 21 units, it can further increase the service level to 95 per cent. This
additional stock is known as “safety stock” because it provides the needed safety to an
organization to handle uncertain demand during lead time.

TABLE 17.3 The Service Level Concept: An Illustration

 The concept of service levels permits managers to sidestep problems related to
estimating shortage cost per unit. Using this concept, it is possible for managers to
relate the amount of additional investment required and the improvement in service
and strike appropriate trade-offs between additional investment and service. In the
example we just discussed, a 5 per cent increase in service level from 90 per cent to 95
per cent entails an additional investment of 21 units. Depending on the unit cost of the
item in question, the cost of carrying and the competitive scenario, managers can strike
a better trade-off in their choice towards the appropriate level of service that needs to
be offered.

The concept of service level permits managers to sidestep problems related to

estimating shortage cost per unit.
FIGURE 17.5 Frequency ogave of weekly demand
 These computations can be generalized by using a few notations and replacing the
empirical distribution for demand by a theoretical distribution such as normal
distribution.

Let the demand during lead time follow a normal distribution with:

μ(L), the mean demand during lead time and

σ(L), the standard deviation of demand during lead time

Let (1 − α) denote the desired service level, where α denotes the probability of a
stockout.

Zα is the standard normal variate corresponding to an area of (1 − α) covered on the

left side of the normal curve.

An expression for safety stock (SS) is given by SS = Zα × σ(L). Figure 17.6 represents the
principle of safety stock and service level.

Due to the introduction of safety stock, the total cost of the plan will change. The total
cost for an order quantity equal to Q* is given by:

Total cost of the plan = Cost of ordering + Cost of carrying cyclic inventory + Cost of
carrying safety stock

FIGURE 17.6 Illustration of service level and the safety stock concept

If the organization places an order when the stock on hand is equal to the sum of mean
demand during lead time and safety stock, then it will be able to provide a service level
of (1 − α) in the long run. Therefore, an expression for reorder point (ROP) for systems
with uncertain demand is given by:
 17.6 INVENTORY CONTROL SYSTEMS

The previous sections provide organizations with the necessary building blocks to put
inventory control systems in place. In practice, organizations employ some methods to
manage and control inventory. Prominent among them include the use of continuous
review of inventory and periodic review of inventory. Let us understand the working of
these two systems, and also how various decision parameters of these systems can be
estimated using the building blocks provided in previous sections.

The Continuous Review (Q) System

Organizations widely use a continuous review system called a two-bin system. In

operation, the available inventory is stocked in two bins, first in a smaller bin and the
balance in a larger bin. As the material is consumed, the larger bin is emptied first. As
soon as the larger bin is empty, an order is placed with a supplier for a predetermined
quantity, Q, and until the material arrives in the stores, the smaller bin is consumed.
During replenishment, the smaller bin is filled in first and the cycle continues. Can you
guess what will be the capacity of the smaller bin? A little thought will help you
appreciate that the capacity of the smaller bin is indeed the reorder point as per the
calculations that we performed in the previous section.

Figure 17.7 shows the general working of a Q system. The inventory position in the
system6 is continuously monitored to check if it has reached the reorder point. Once it
reaches the reorder point, an order is placed for a fixed quantity of Q.

EXAMPLE 17.4

The daily demand for an item is stochastic and follows the normal distribution with a
mean of 100 and a standard deviation of 20. The supplier of the item takes two weeks to
deliver the item from the date the order is placed. What will be the appropriate reorder
point for 90 per cent and 95 per cent service level? The cost of ordering is ₹1,000 per
order and the carrying cost is ₹250 per unit per year. There are 250 working days in a
year. If the organization places orders in fixed quantities of 500, what will be the total
cost of the plan?

Solution

Mean daily demand = 100

Number of working days in a year = 250

Total annual demand = 25,000

Lead time for supply (L) = 2 weeks = 14 days

Therefore, mean demand during LT, μ(L) = 14 × 100 = 1,400

Standard deviation of daily demand = 20

Variance of daily demand = 400

Variance of the demand during LT = 14 × 400 = 5,600

Standard deviation of demand during LT5, σ(L) = 74.83

For 90 per cent service level, α = 10 per cent and (1 − α) = 90 per cent.

From standard normal tables (Zα) = 1.28

Safety stock (SS) = Za × σ(L) = 1.28 × 74.83 = 95.78 ≈ 96

Therefore, ROP = μ(L) + Zα × σ(L) = 1,400 + 96 = 1,496

Total cost of the plan,

For 95 per cent service level, the corresponding values are:

α = 5 per cent, (1 − α) = 95 per cent and Zα = 1.645, SS = 123.09 ≈ 124 and ROP = 1,400 +
124 = 1,524.

Total cost of the plan

FIGURE 17.7 Continuous review (Q) system

Due to this design choice of ordering fixed quantities, Q systems are also known as fixed
order quantity systems. After a lead time of L, the inventory arrives in the system and
the physical inventory increases. In Figure 17.7, the continuous line indicates the on-
hand inventory in the system. When there is a pending order, the physical inventory in
the system is less but the total inventory in the system must take into consideration
scheduled receipts in the future. This is shown by the dotted line of inventory
movement. The two constant dotted lines in the bottom of the figure represent the
safety stock built into the system and the average demand during lead time (LT). The
summation of these two quantities is the reorder point for the system.

The “when” decision in a Q system is answered by reorder point.

The “when” decision is answered by ROP. We can employ the computations in the
previous section to arrive at ROP. The “how much” decision is answered by our choice
of Q. Several alternatives are available to fix Q.

• One is to compute EOQ and fix Q at this value.

• The other is to fix Q to be the minimum order quantity that the supplier insists,
if EOQ value is lesser than this.
• The third option is to have any other preferred quantity arising out of practical
considerations such as full truckload requirement, quantity discounts, savings
in transportation costs, economies of scale, or any other consideration.

The total cost of using a Q system can be computed using Eq. 17.8 for a chosen value of
Q.

The Periodic Review (P) System

An alternative model for inventory control, known as the periodic review system,
operates differently from the Q system. In a periodic review system, the inventory level
in the system is reviewed at fixed intervals of time. Therefore, these systems are also
known as fixed order interval systems. At the time of review, an order is placed to
replenish the inventory to a predetermined level, S. The parameter S, known as the
order up to level, dictates the order quantity. If at any time R, a review is made and if the
inventory position in the system is IR7, then order quantity QR = S − IR. Figure
17.8 illustrates the working of the P system.

The two decisions “when” and “how much” are made in a different fashion compared
to the Q system. The review period R determines when to order. There are several
alternatives available for determining R. One way is to use the EOQ model, derive the
time between orders, and use it for R. Managers tend to review the performance of
departments on a periodic basis. R can be linked to such intervals. Alternatively, the
MRP system used in some organizations has some time buckets and it is possible to
fix R on this basis. In a petrochemical manufacturing unit in western India, the review
period is linked to the value of items under inventory control. In the case of low-value
items, the review is once in 60 days, and in the case of medium-value items, there is a
monthly review. In the case of high-value items, there is a fortnightly review of
inventory and ordering decisions are taken.

In a periodic review system, the inventory level in the system is reviewed at

fixed intervals of time.

FIGURE 17.8 Periodic review (P) system

The order up to level S determines how much to order. Hence, it is important to

derive an appropriate expression for S. Let us consider an instant of time t, when a
review is taken and an order is placed with the supplier. The organization gets the next
opportunity to review the inventory R periods later. An order placed at that point in
time will reach the organization only after L time periods, which is the lead time for
supply. Hence, at every review, the organization needs to protect itself from the risks of
shortages for a period of (R + L) periods. Therefore, an expression for S can be derived
by modifying Eq. 17.9 as follows:

The order-up-to-level S determines how much to order in a P system.

 Order up to level S = Mean demand during (L + R) + Safety stock for the period (L + R).

Where, μ(L + R) = Mean demand during (L + R) and σ(L + R) = Standard deviation of demand
during (L + R)

Issues in the P and Q Systems of Inventory Control

The Q system is based on perpetual monitoring of the inventory level in the system. This
calls for elaborate methods of keeping track of available inventory. To overcome this
problem, organizations use the two-bin system. In recent years, several manufacturing
firms have used a variety of visual control systems to manage the Q system. For
instance, an automobile component manufacturer in South India stocks steel ingots in
its stores with three colour-coded level indicators. When the stock level depletes from
the green zone to yellow zone, an order is placed. When the stock level depletes further
down to the red zone, close follow-up and monitoring of supply is done to avoid
shortage. In other words, the yellow zone corresponds to the reorder point in the Q
system and the red zone to the safety stock.

The Q system is less responsive to changes in demand. When there is a decline in

demand, the ROPs move to the right. Moreover, the system will continue to order Q even
when there is a decline in demand, leading to a situation of keeping the inventory for a
longer period. Therefore, ordering high-value components using the Q system during
periods of falling demand could increase the risk of excessive stocking of inventory for
longer periods and resultant obsolescence. Similarly, if there is an increase in demand,
the ROPs shift to the left, necessitating frequent orders and increasing both the ordering
cost and the risks of shortages. One way of addressing this problem is to order variable
quantities depending on the demand.

The Q system is less responsive to changes in demand and poses greater

difficulty in ordering multiple items from the same supplier.

TABLE 17.4 Comparison of the Q and P Systems of Inventory Control

Criterion Continuous Review (Q) System Periodic Rev

How much to order Fixed order quantity: Q S = μ(L + R) + Z × σ(L

QR = S − IR

When to order ROP = μ (L) + Zα × σ(L) Every R periods

Safety stock SS = Zα × σ(L) SS = Zα × σ(L + R)

Salient aspects Implemented using two-bin system More safety stock

 Criterion Continuous Review (Q) System Periodic Rev

More responsive to d

Suited for medium and low value items Ease of implementati

Another issue in using the Q system is the difficulty of ordering multiple items from
the same supplier. Consider three items—A, B, and C—purchased from a supplier using
the Q system of inventory control. Since demand attributes can vary between the three,
the three items can reach the reorder point on different days. This will call for multiple
orders being placed with the same supplier within a short span of time. In addition to
increasingthe costs of ordering, the administrative mechanisms related to follow-up and
receipt of material against each order is also increased. On the other hand, the
organization could have benefited from placing a single order clubbing the
requirements for Items A, B, and C. This would have resulted in significant reduction in
ordering costs, monitoring and follow-up costs.

The P system is responsive to demand and enables ordering multiple items

from the same supplier at the same time.

However, the P system overcomes several of these limitations of the Q system and
offers many advantages over the Q system. This includes more responsiveness to
demand, the ability to order multiple items from the same supplier at the same time,
ease of planning and control, greater chances for linkages with MRP, and other planning
systems in the organization. Table 17.4 compares the salient features of P and Q
systems of inventory control. The safety stock investment in the P system, however, is
more than that of the Q system because it requires protection from shortage for a longer
period of time.

The safety stock investment in the P system is more than that of the Q system
because it requires protection from shortage for a longer period of time.

EXAMPLE 17.5

A manufacturing organization is using a certain raw material, which is consumed in

large quantities by various products. The raw material is procured from a local supplier.
An extract of the relevant records from the stores indicate the following details about
the component:

Mean of weekly demand: 200

Standard deviation of weekly demand: 40
Unit cost of the raw material: ₹300
Ordering cost: ₹460 per order
Carrying cost percentage: 20 per cent per annum
 The purchase department has indicated that the lead time for procurement of this
raw material is two weeks. Past experience with the supplier suggests that there is no
uncertainty with respect to the lead time. The organization has been using EOQ for the
purpose of scheduling orders. However, there is a general feeling that it is not working
satisfactorily. It is not uncommon for the organization to experience stock-outs. Work
out the parameters of the P and Q systems of inventory control.

Solution

EOQ Model

Weekly demand = 200

Number of weeks per year = 52

Annual demand, D = 200 × 52 = 10,400

Ordering cost, C0 = ₹460 per order

Unit cost of the item = ₹300

Carrying cost, Cc = ₹60 per unit per year

Economic order quantity

Since there is a two-week lead time, an order needs to be placed two weeks ahead of
complete depletion of the inventory, that is, by the time the inventory position in the
system reaches 400 units. The order quantity is 400. There is no safety stock to protect
the system from shortages arising out of uncertain demand. The system can be
improved either by using a Q system or a P system, as shown here.

Q System

Standard deviation of weekly demand = 40

Lead time, L = 2 weeks

Mean demand during L, μ(L) = 2 × 200 = 400

Standard deviation of demand during L, σ(L) = × 40 = 56.57

For a service level of 95 per cent,

SS = Zα × σ(L) = 1.645 × 56.57 = 93.05 ≈ 93

 ROP = μ(L) + Zα × σ(L) = 400 + 93 = 493

Using EOQ as the fixed order quantity, the Q system can be designed such that, as the
inventory position in the system reaches 493, an order is placed for 400 units. In the
long run this will ensure a service level of 95 per cent.

P System

Using the time between orders derived from the EOQ model as the basis for review
period

Review period, R = 2 weeks

Mean demand during (L + R), μ(L + R) = 200 × (2 + 2) = 800 Standard deviation of demand
during (L+ R), σ(L + R) = × 40 = 80

For a service level of 95 per cent,

SS = Zα × σ(L + R) = 1.645 × 80 = 131.6 ≈ 132

Order up to position, S = σ (L + R) + σ(L + R) = 800 + 132 = 932

The P system can be designed such that the inventory position in the system is reviewed
every two weeks and an order is placed to restore the inventory position back to 932
units. This will ensure a service level of 95 per cent.

17.7 SELECTIVE CONTROL OF INVENTORY

Managing inventory invariably amounts to handling a large number and variety of

items. For instance, an automobile manufacturer such as Ashok Leyland may have an
inventory of about 50,000 items in their stores. A vast majority of them will be
consumed (albeit in varying rates) and will require a mechanism for monitoring
inventory on-hand, establishing reorder points, order quantity, and the type of
inventory control system that needs to be adopted. Clearly, establishing the same level
of monitoring and control for all the items may not be practically feasible. Therefore,
organizations devise suitable ways of categorizing the items and adopt mechanisms that
have variable levels of control on the different categories of items.

Consider two items in inventory, a simple fastener that costs less than a rupee and a
specialized electronic sub-assembly that costs several thousands of rupees. Managing
the latter item with close monitoring and tighter control will benefit the organization
more than exercising greater managerial attention and control on fasteners. If there
were errors in judging the demand for the item, or if extra items were ordered, the
impact of these factors will be minimal in the case of fasteners. Also, if there were
shortages, the response time to procure fasteners will be very low. On the other hand, in
the case of the electronics sub-assembly, the impact will be significant. It is therefore
obvious that managers need alternative methods and levels of control while dealing
with a multitude of items in the inventory. Selective control of inventory achieves this
objective.

ABC Classification

It is clear from the arguments outlined earlier that the unit cost or total cost of items
consumed could be one basis on which items could be classified. The ABC classification
of inventories is based on the cost (or value) of items consumed. Very high-value items
are “A-class items” and may require tighter control. Medium-value items are
categorized as “B class” and low-value items as “C class”.

TABLE 17.5 Sample Data for ABC Classification

Let us consider an example of twenty items in inventory, as shown in Table 17.5. For the
twenty items, the unit value and annual consumption are available. Using this, it is
possible to compute the cumulative percentage of items and cumulative value of
consumption (see the last two columns of Table 17.5) and rank them in the descending
order of cumulative value. Figure 17.9 shows a graphical representation of this data.

As shown in Table 17.5, 5–10 per cent of the items typically contributes to 70–80 per
cent of the value and constitutes A-class items.8 These items require greater control and
close monitoring. By virtue of constituting a small percentage of the total in terms of
volume, it will be practically feasible to exercise close monitoring and greater control. At
the other extreme, about 60–70 per cent of items constitute about 5–10 per cent of the
total value. These are the C-class items. These items require simple control mechanisms
such as level-based reordering. The middle portion of about 10–25 per cent by value
and about 20–30 per cent by number of items constitute B-class items. These items
require a moderate level of control.

The periodic review and the continuous review systems of inventory control can be
linked to the category of items. Since A-class items require closer control and better
response to changes in the demand pattern, periodic review systems are more
appropriate. In the case of “B” class items, continuous review systems are appropriate.
“C” class items can have simple level-based rules for inventory control. C-class items are
often available readily off the shelf and it is possible to obtain them by ordering over the
phone. Hence, issuing blanket purchase orders for a year and following up with specific
requests for supply against the purchase order is often practiced in the case of C-class
items.

FIGURE 17.9 ABC classification of inventories

Other Classification Schemes for Selective Control

Using the consumption value as the basis for categorizing inventory is just one method.
In practice, organizations use a wide variety of measures for selective control. Each of
these has relevance in specific contexts. Let us look at a few alternative categorization
schemes:

1. On the basis of unit cost of the item (XYZ classification): (a) high unit cost (X-
class item); (b) medium unit cost (Y-class item); (c) low unit cost (Z-class
item)
This classification is based only on the unit cost, whereas ABC classification,
takes the consumption pattern also into account. A very high-value item often
turns out to be specially made to order, complex, and may call for lengthy
 supply identification procedures. If the item is consumed in small quantities, it
may be classified as a “B-class item” and may be denied adequate managerial
attention.
XYZ classification is based only on the unit cost, whereas ABC
classification takes into account the consumption pattern as well.
2. On the basis of movement of inventory (FSN classification): (a) fast-moving, (b)
slow-moving, (c) non-moving.
This method of classification is ex-post, as opposed to ABC classification,
which is future oriented. Items that have not been moving for sometime incur
carrying costs and may call for managerial attention for disposal decisions. On
the other hand, fast-moving items can be controlled using available inventory
control systems.
VED classification is relevant in the case of maintenance items.
3. On the basis of criticality of items (VED classification): (a) vital, (b) essential, (c)
desirable.
This classification is relevant in the case of maintenance items. In several cases
a vital item for maintenance may not be very expensive. For instance, a wide
variety of oil seals are used in hydraulic systems. If the oil seals are not
available, the entire equipment becomes inoperative and has a ripple effect on
the entire system. However, by virtue of having smaller unit value or lower
consumption value, these items may escape the attention of the management
without this classification scheme in place.
It is often possible to combine more than one classification scheme
and make use of them to further sub-categorize the inventory and
devise appropriate inventory control system for each of them.
4. On the basis of sources of supply: (a) imported, (b) indigenous (national
suppliers), (c) indigenous (local suppliers).

Imported items are usually of high value. Moreover, they have long lead times
owing to several statutory and procedural complexities involved in the buying
process. Therefore, they may require tighter control. On the other hand, items
procured from the local suppliers are available “off the shelf”.

ideas at Work 17.2

The Inventory Control System of a Petrochemical Manufacturer

A few years ago, a well-known petrochemical manufacturer in the country devised a

simple yet effective system of inventory control in one of its manufacturing locations. It
adopted a two-dimensional classification scheme to classify its inventory. Based on the
consumption value, the items were classified as A-, B-, or C-class items using the ABC
classification. Similarly, based on the unit value, items were classified as X, Y, or Z using
XYZ classification.

The management adopted a periodic review control system for the AX items. The
review period was weekly, fortnightly, or monthly. The BY items were controlled using
continuous review (reorder-level based) methods. The system parameters for the BY
items were as follows:

Maximum inventory = Reorder level + Order quantity Reorder level = Safety stock +
Lead time consumption

Safety stock = 1 month consumption for indigenous items and 2 months for imported
items

The CZ items had no specific control mechanism in place. It was customary to have
one blanket purchase order per year and request for 3 or 4 deliveries in a year.

Source: Based on data gathered from the author’s own research.

It is often possible to combine more than one classification scheme and make use of
them to further sub-categorize the inventory and devise an appropriate inventory
control system for each of them. In practice, organizations have utilized a variety of
these combinations to implement appropriate inventory control systems for the items.

17.8 INVENTORY PLANNING FOR SINGLE-PERIOD DEMAND

So far we have considered the problem of inventory planning in the case of recurring
demand that requires continuous replenishment. However, there are a number of
situations that require inventory planning for a single-period demand. In a single-period
demand, the unfulfilled demand cannot be back-ordered to the next period because the
demand ceases to exist after the period for which planning is done. In other cases, even
though demand exists in the future, what is ordered for a period cannot be used for
future periods due to the perishable nature of the item. Examples include the demand
for morning newspapers, tickets for journeys, advertising space for a mega
entertainment event, and expensive maintenance spares. This type of inventory models
are referred to us news vendor model. Often, there is a high degree of uncertainty
involved in estimating the demand for a single period.

In a single-period demand, the unfulfilled demand cannot be back-ordered to

the next period.

Planning for appropriate levels of inventory in such situations requires careful

balancing of two opposing costs. The main driver of costs in this inventory planning is
the fact that uncertain demand manifests only for a period. Therefore, carrying lesser
inventory than demand directly results in lost opportunity to make profit. This
represents the cost of understocking. In the same way, any excessive inventory cannot
 be consumed afterwards. At the most, the unused inventory may fetch some salvage
value and the resulting loss on account of this could be termed as the cost of
overstocking.

Let Cos = Cost of overstocking per unit

Cus = Cost of understocking per unit

Q = Optimal number of units to be stocked

d = Single-period demand

P(d ≤ Q) = The probability of the single-period demand being at most Q units

If d > Q, then we incur costs on account of cost of understocking. On the other hand,
if d < Q, then we incur the cost of overstocking. At a very low value of Q, we tend to
experience costs arising out of understocking and as we increase Q incrementally we
will approach optimal Q. At very high values of Q, we will incur overstocking costs. By
incremental analysis, we find that while taking a decision to stock Q units, we would like
to ensure that:

The expected cost of overstocking ≤ The expected cost of understocking

Therefore, we choose that largest value of Q that satisfies Eq. 17.11 as the optimal
value.9

EXAMPLE 17.6

Navratri is a popular festival in India. In South India, beautifully painted dolls made of
clay are bought by customers during this festival. After the festival, there is no demand
for these dolls. A manufacturer of dolls needs to decide on the optimal stock of dolls that
he needs to carry in his inventory to satisfy the demand during the festival time. The
item fetches a sales value of ₹1,300 per box. The cost of production is ₹1,000 per box.
After the festival is over, the items at best can be salvaged at a value of ₹800 per
box. Table 17.6 presents the distribution of demand for the item during the festival
time. What is the optimal quantity to stock?

TABLE 17.6 Distribution of demand for Example 17.6

 Number of units demanded Probability Cumulative pr

0 0.05 0.05

100 0.15 0.20

200 0.20 0.40

300 0.25 0.65

400 0.20 0.85

500 0.15 1.00

Solution

Since each unfulfilled demand results in a foregone profit, the cost of understocking is
the profit per box. Similarly, by salvaging each unsold box after the festival, the
manufacturer loses an amount equal to the difference between the cost of manufacture
and salvage value, which represents the cost of overstocking.

Selling price per box of the item: ₹1,300.00

Cost of production: ₹1,000.00

Cost of understocking, Cus: ₹300.00

Salvage value: ₹800.00

Cost of overstocking, Cos: ₹200.00

As per Eq. 17.11, the optimal quantity to stock is:

On examination of the cumulative probability values in the last column of the demand
table, we notice that Q lies between 200 and 300. We round up the value of Q to 300.
Therefore, the manufacturer should plan for an inventory of 300 boxes for sale during
the festival.

17.9 OTHER ISSUES IN INVENTORY PLANNING AND CONTROL

In practice, inventory control systems vary from theoretical formulations in many ways.
Moreover, there is a lack of understanding of certain critical issues that influence
inventory management. One serious drawback of inventory control systems in practice
is that they tend to stand aloof from reality. Any inventory control system should have
provisions for linking key parameters such as reorder level and safety stock to actual
changes in consumption pattern, measured in terms of mean and standard deviation of
demand. In the absence of this linkage, the model parameters become outdated and
result in either piling up of inventory or in frequent shortages.

With the installed base of ERP systems and other MIS systems for transactional data
capture, it is possible to upgrade computerized inventory control systems from an
ordinary MIS system generating a host of shortage reports and accurate inventory
status records to one of a decision-support system. On a periodic basis, these
computerized systems could analyse the consumption patterns of items, detect
impending changes, and adjust the model parameters of the inventory control system.

Better management of inventory does not happen only because of good inventory
planning tools. Organizations need to take several other measures to bring down
inventory. A frequently encountered issue is part number proliferation. Over the years,
an organization creates a vast number of part numbers and managing such a large
variety of parts in inventory could be a herculean task. Efforts to reduce part numbers
by variety reduction measures are an important aspect of better inventory
management. Similarly, an organization having several manufacturing/service divisions
must engage in inter-divisional joint planning efforts towards standardization of
classification and coding systems and stock holding of expensive items such as capital
spares. These efforts go a long way in better inventory control.

Opportunities for better inventory control and management often exists outside of
the materials management function in organizations. For example, alternative methods
of launching material onto the shop floor, such as kit launching, helps reduce inventory
mismatch and non-moving inventory. In a kit launching system, items required for
manufacture and assembly are always launched into the system in exact quantities of
ship sets or assembly sets. This reduces the chances of ending up with excess and
unwanted work in progress at the end of the planning period. Another example relates
to performance measurement systems in organizations. Management control systems
that emphasize on utilization-based measures for rewards and incentives tend to
promote inventory build-up in the system. As shown in Chapter 13, better structures
and systems also contribute positively to reducing inventory build up in the system.

Opportunities for better inventory control and management often exist

outside of the materials management function in organizations.

An inventory planning manager should take all these into consideration while
actively pursuing the models suggested in this chapter. Such an approach will ensure
greater chances of reducing inventory in the system.

SUMMARY

• Every organization carries five different types of inventory. This includes cyclic
stock, pipeline inventory, safety stock, decoupling inventory, and seasonal
 inventory. The purpose of carrying these types and the manner to assess the
level of investment required in each of these vary.
• Inventory planning is done in order to minimize the total cost of the plan. The
costs include the unit cost of the item for which planning is done, the cost of
carrying inventory, the cost of ordering, and the cost of shortages.
• The key decisions in any inventory planning scenario is to answer the “how
much” and the “when” questions. These decisions are made by balancing
various costs associated with inventory.
• The EOQ model is useful for inventory planning in the case of multi-period
deterministic demand situations. The EOQ model is robust to model
parameters and could be suitably modified to incorporate some real-life
situations such as quantity discounts and non-zero lead time for supply.
• Service level is a useful concept for modelling inventory planning in the case of
stochastic demand. Safety stocks can be built commensurate to the desired
service level.
• A fixed order quantity (Q system) or continuous review system of inventory
planning and control is useful for B-class and C-class items of inventory. A
popular application of the continuous review system in organizations is the
two-bin system.
• A fixed order interval or a periodic review system (P system) is useful for
planning and control of high-value or A-class items. The P system is more
responsive to changes in demand patterns than the Q system.
• Selective control of inventories is achieved through alternative classification
methodologies. The ABC, VED, and XYZ classifications are often used by
organizations.

FORMULA REVIEW

Total cost associated with carrying inventory

Total ordering cost

Total cost of inventory,

Economic Order Quantity (EOQ),

Optimal number of orders

 Time between orders

For the perpetual review inventory system

Re-order Point (ROP) = μ(L) + Zα × σ(L)

Total cost,

For the periodic review inventory system

Order up to level, S = μ(L + R) + Zα × σ(L + R)

Optimal quantity (Q) to order in a single period inventory system is given

as

REVIEW QUESTIONS
1. Which of the following constitutes independent demand items?

1. Maintenance spares for machine tools in a manufacturing firm

2. Carburettors for a petrol engine manufacturer
3. Fresh linen in a five-star hotel
4. Radiography services in a multi-specialty hospital
5. Number of tyres for an automobile manufacturer
6. Replacement clutch cables for two-wheelers
7. Halogen lamps for automotive headlights
8. Number of operations management text books in a business school
9. Number of bottles of mineral water in a restaurant
10. Number of lunches for the mid-day Chennai–Mumbai flight

2. How is inventory planning for independent demand items different from that for
dependant demand items?
3. Do organizations need to carry inventory? Why?
4. What is the relationship between inventory investment and profitability in an
organization?
5. Consider the inventory planning problem. Write down the relevant total cost equation
in each of the following situations:

1. The organization can fetch a discount on the purchase price if large quantities
are ordered
2. There is a benefit in transportation costs if ordered in full truckloads
3. The supplier is willing to set up elaborate systems for easy ordering,
monitoring, and follow-up of orders if the order quantity is large
 4. There is uncertainty in demand and the organization wishes to carry safety
stock

6. What are the difficulties in using shortage cost measures in inventory planning models?
7. Can you identify four alternatives that organizations use as a basis for fixing the order
quantity?
8. On what basis would you recommend the periodic review system of inventory control?
9. Why should organizations adopt a selective system of inventory control? If you were
asked to recommend a suitable classification scheme, how would you go about the task?
10. What is the relationship between the service level and safety stock?
11. There are N locations at which an organization faces demand for an item. The demand
for the item is uncertain and hence the organization needs to carry safety stock. If it
were to make the choice between centralized storage of the item and localized storage
of the item in each of the location, which alternative will result in lower investment in
inventory? (Hint: Assume that all locations have the same mean and standard deviation
for demand).
12. What is the effect of the cost parameters on the economic order quantity? Perform a
“what if” analysis using a spreadsheet by varying these cost parameters. What did you
deduce from the results?
13. When is it appropriate to use the ABC classification scheme and the FSN classification
scheme?
14. Suppose you develop a classification scheme for selective control of inventories using
ABC and VED classification as two dimensions. Relate the discussions pertaining to
service level to this two-dimensional classification scheme.

PROBLEMS
1. Consider an item that is ordered once per month. The daily requirement is 200 and the
lead time for supply is two days. There are 25 working days in a month. The cost of
ordering is ₹300 per order and the cost of carrying is ₹150 per unit per year.

1. Draw a sketch showing the cyclic and pipeline inventory in the system
2. What is the reorder point for this item?
3. What will the cost of this plan be?

2. An auto-component manufacturer requires a certain steel forging in large quantities.

The annual requirement is 40,000 pieces, each costing ₹450. The ordering cost is ₹600
per order and the carrying cost is ₹100 per unit per year.

1. What is the optimal order quantity?

2. How frequently should the manufacturer place the order with the supplier?
3. Compute the total ordering cost and total carrying cost. Do you notice
anything?

3. Consider Problem 2. Perform a “what if” analysis for the following scenarios and
compute the total cost of the plan for ordering an optimal order quantity:

1. The actual demand is −12 per cent, −8 per cent, −4 per cent, 0 per cent, 4 per
cent, 8 per cent, and 12 per cent of the demand mentioned in the previous problem.
 2. The actual ordering cost has a similar variation as that of the demand
3. The actual carrying cost has a similar variation as that of the demand

Plot the total cost in each of the three scenarios and make your observations.
4. Excel Toys, a manufacturer of plastic toys for children, requires constant supply of high-
density polyethylene (HDPE) in the resin form. HDPE is available in the resin form and
one tonne costs approximately ₹2,000. The manufacturer runs his factory for 250 days a
year and the daily consumption rate for HDPE is four tonnes. The suppliers normally
take a week to replenish an order. The ordering cost is ₹2,000 per order and the
carrying cost is 20 per cent.

1. Estimate the cyclic and pipeline inventory in the system at Excel Toys.
2. What is the total cost of the plan?
3. Suppose if the supplier insists on a minimum order quantity of 75 tonnes,
what is your recommendation to Excel? Will the recommendation change if the
minimum order quantity is 150 tonnes?
4. Suppose Excel launches some improvement initiatives in the company and
brings down the ordering cost by 20 per cent. Recompute the economic order
quantity.
5. If Excel spent a sum of ₹10,000 towards improvements in the system, when
will the improvement efforts bring payback? (Hint: Estimate the savings in costs due
to reduced ordering cost)

5. Consider Example 17.2 in this chapter. If the company continues with the same plan
even when there is an increase in the demand by 10 per cent, what will the impact be?
What do you infer from the result?
6. A manufacturing organization has been consuming a certain item in large quantities and
is currently procuring the item from Supplier A. The price offered by the supplier is
₹400 per piece. The ordering cost is ₹2,800 per order and the carrying cost is ₹350. The
annual demand for the item is 10,000. The supplier is currently not offering any
discount. However, another supplier, Supplier B, is willing to offer the following
discount structure:
Up to an order size of 999 = No discount
For an order size of 1,000–1,999 = 2 per cent discount in price
For an order size of 2,000 and above = 5 per cent discount in price
Switching over to this supplier means incurring an initial cost of ₹15,000. This cost is
primarily to set-up new communication systems with the new supplier. What should
the company do in the light of the new offer?
7. Siemens India Limited manufactures switchgears at their Kalwa plant. One of the key
components, Kombishraube (contacts), is manufactured in-house. If the machine
producing these contacts manufactures at the rate of 800 pieces per hour and the
demand rate is 450 pieces per hour, what is the economic run length for this production
process? How often should they set up the machine if the factory works for 250 days in
a year on a single shift (of 8 hours) basis? The cost of setting up the machine is ₹3,000
per set-up and the cost of carrying the components is ₹400 per unit per year.
8. Consider an item with the following demand attributes:
Mean daily demand = 20; Standard deviation of daily demand = 8.
 Compute the safety stock required for a continuous review system in each of the
situations given in Table 17.7:
What do you infer from these calculations?

TABLE 17.7 Situations for Problem 8

Lead Time Service Level

1 week 90%, 95%, 99%

10 days 90%, 95%, 99%

2 weeks 90%, 95%, 99%

3 weeks 90%, 95%, 99%

9. For Problem 8, compute the order up to levels and safety stock for a periodic review
system with a two-week review period.
10. The weekly requirement of furnace oil in a foundry has a mean of 3,000 litres and a
standard deviation of 900 litres. A litre of furnace oil costs ₹400 and the carrying costs
are estimated at 25 per cent. If the foundry uses a continuous review system of
inventory control with a desired service level of 90 per cent, then

1. What will the reorder point and safety stock for furnace oil be if the lead time
for supply is 1 week?
2. What will the service level be if the reorder point is changed to 3,100 litres?
3. If the reorder point is left unchanged when there is a 5 per cent increase in the
mean demand, how will it affect the service level?
4. If the foundry estimates that the monetary value of the benefit that it may
obtain is ₹3,000 when increasing the service level from 90 per cent to 95 per cent,
what is the appropriate service level for the item?

11. The demand for springs in the coil form for an auto component manufacturer is
continuous and uncertain. The manufacturer places orders for the springs with a local
supplier who takes two weeks to deliver. The cost of the spring is ₹400. The weekly
demand for the springs has a mean of 500 and a standard deviation of 100. The cost of
ordering is ₹2,000 per order and the cost of carrying is 18 per cent. The supplier
specifies a minimum order quantity of 2,000. Assume a service level of 90 per cent.

1. Is it feasible to operate an EOQ based system for this item?

2. Design periodic and continuous review systems of inventory control.
3. What is the total cost of the plan in each of these cases?

12. Oriental Healthcare is a multi-specialty hospital catering to a variety of illnesses

connected to the heart and respiratory system. The demand for a class of medical
consumable is generally random. Initially, Oriental followed a practice of ordering 200
boxes every two weeks. This practice was not found to be satisfactory. After some
review, they resorted to ordering 300 boxes every two weeks. Even this practice was
 not found satisfactory. Recently, an examination of the stores records over a period of
10 weeks revealed the following weekly consumption pattern (Table 17.8):

TABLE 17.8 Weekly Consumption Pattern.

Week no. Consumption (Units)

5 110

6 145

7 144

8 120

9 160

10 110
The supplier of the item takes (on an average) two weeks to deliver once the order is
placed. The item costs ₹450 per box. The ordering cost is ₹2,000 per order and the
carrying cost is 20 per cent. What should Oriental do in the light of this information?
Will they be better off with the new recommendation? Assume a service level of 90 per
cent.
13. A pharmacy needs to decide on monthly procurement quantity of a critical yet a highly
perishable drug that has a shelf-life of just one month. The unit price of drug is ₹ 7,000
and its cost is ₹6,000. As per the historical data, the monthly demand for the drug is
random with a certain distribution. The details are given in Table 17.9. Since the drug is
an emergency drug, the associated hospital offered to reimburse ₹3,000 for each unit of
drug left unsold. At the same time, the store would be penalized ₹2,000 per unit by the
hospital for any unmet demand.

TABLE 17.9 Historical Data on Demand Distribution

What should be the monthly order size the pharmacy must plan for?
14. In problem number 13 consider the following. The hospital is contemplating a change
in the contractual terms with the pharmacy. Suppose the hospital is willing to make an
offer of either withdrawing the reimbursement or penalty. What should the pharmacy
owner do now?
15. A manufacturer of electric ovens has made an estimate (shown in Table 17.10) for
annual consumption and unit cost of the components that are used for manufacture.
Perform an ABC analysis and advise how the manufacturer should plan and control for
inventory.

TABLE 17.10 Annual Consumption and Unit Cost of Components

 MINI PROJECTS
1. Identify a sector of industry of your choice and select three companies operating in that
sector. Analyse their annual report and identify portions of the annual report that have
a direct impact on inventory-related issues.

1. Prepare a report highlighting your understanding of the performance of the

companies with respect to inventory planning and control. Can you identify some
possible explanations for your observations pertaining to the inventory data?
2. Among the three, which one is better in managing their inventory? How do
these firms compare with the industry average?
3. Can you make some comparisons with similar firms elsewhere (outside the
country)?
4. What are your key inferences from this exercise?

2. Study the reports produced by ICICI (Financial Performance of Companies) and the
Centre for Monitoring Indian Economy on performance of corporate sector.

1. Identify the inventory investment across different sectors of our industry. Do

you see any significant trends in these movements?
2. How has the performance been in the last five years? What factors do you
think might have contributed to this?
3. Which sectors have performed better and which have performed the worst?
Can you identify some reasons for these?

3. Analyse the multiplier effect of inventory using the Du Pont equation for return on
investment for a pair of close competitors.10 What are your key inferences from this
exercise?

CASE STUDY

MML Limited
 The Background

MML Limited was incorporated as a private limited company and later converted into a
public limited company in 1988. Though the company started with the manufacture of
soaps and perfumes, it has added a variety of products to diversify its product line.
Today, it is a conglomerate with businesses in soaps, perfumes, plastics, petrochemicals,
paints, industrial electronics, and agro-business. Their unit at Hosur manufactures
electronic components. The inventory position has been deteriorating over the last few
years. The year-end inventory position, as revealed by the annual reports of the
conglomerate, showed an increase from ₹1,230 million as on 30 June 2004 to ₹2,490
million as on 31 March 2007.

The conglomerate has been operating in a highly centralized fashion. All major
planning activities were done at the corporate office. However, many inputs for this
decision making were made available by all the operating units. The headquarters sent
the tentative monthly production plan two months prior to the commencement of
production. The final production plan arrived 5 days prior to start of the production. It
was not unusual for the corporate office to change the production plans while
production was progressing. This was communicated through telephone, telex, fax, or
mail. Once the production plan was made, the requirement of each item was also
computed using the bill of materials. Table 17.11 presents the tentative and final plans,
and the actual production of the Hosur unit for 2005–06 and Table 17.12 presents the
consumption pattern of the “A-class” item.

The Existing Buying Process

The company has been following a centralized ordering system, which was operated
from its headquarters. The advantages of this system according to the organization
were:

1. Better control over inventory-related costs.

2. Since the corporate office compiled the net requirements of all operating units, the
order quantities for the suppliers were large, sometimes inducing them to offer
generous quantity discounts.

TABLE 17.11 Tentative Plan, Final Plan, and Actual Production for Some Products
TABLE 17.12 Consumption Pattern for A-Class Items
 Notes:

*The lead time is an average figure based on six months’ data.

• The consumption details are expressed in units of items. The units of

measurement are different for the items. For example, the unit of
measurement for Item 3 is boxes (each box contains 250 items) whereas the
unit of measurement for Item 8 is kg.
• Item 6 is sold by all the suppliers in integral units of 250 only. This has been
attributed to the fact that once the seal is broken it should be used within
three days.
• Items 7 and 10 are supplied by the same supplier, who is the only available
domestic source.

3. In case of sudden shortages of an item at a location, the corporate office could advise
another location to transfer stocks because it knew the safety stocks at each location.
The corporate office advises the purchase departments at the units on the following:
1. What to order?
2. How much to order?
3. When to order?
4. On whom to place the order?
5. What should be the delivery date?
6. What will be the price?

On receipt of this, the purchase department at the operating units took the
responsibility for the procurement of items on the basis of the advice and subsequently
made the payment to suppliers.

For the corporate office to take decisions on these items, it needed the following:

1. Stock levels of each item under inventory management.

2. The production plan for the following month.
3. The maximum and the minimum stock levels to be maintained for each item.
4. The previous month’s consumption.

The operating unit provided the information pertaining to Item 1. Items 3 and 4 were
policy decisions made at the corporate office based on historical data and future plans
and Item 2 was market-related information that was forecast.

The Hosur Unit

The unit manufactures electronic components that form part of the control devices of a
variety of equipment. Basically, there are minor variations in the basic configuration,
which result in 13 different products as they roll out of the assembly. The variations are
mainly due to the differences in the rating and the number of various electronic
components used to build the product and the variations in the electronic circuit design.

The Purchase Department

A senior manager (purchase) assisted by a manager (purchase) headed the purchase

department of the Hosur unit. There were four buyers attached to the department. The
buyers were given responsibility to procure materials of specific groups of materials.
There was one buyer for semiconductor components, another for raw materials and a
third buyer for imported components. Another buyer was looking after consumables,
office equipment, and capital equipment. Although imported components formed a
small percentage of the total purchase, the procedure and modalities were different,
necessitating an exclusive buyer to handle them. Two clerical staff undertook the
responsibility for all the typing, data preparation and entry into the computer,
preparation of purchase orders, and other such support activities. The purchase
department was provided with a desktop computer, which was connected to a local
area network.

The senior manager was interacting with the corporate office concerning matters
such as source development, supplier rating, and preparation of purchase budgets. In
addition, he was liaising with other departments such as stores, quality control, finance,
production planning, and design. This was an ongoing activity to help take many
decisions on issues such as value engineering, make or buy, new material development,
import substitution, etc.

Recently, there was an exercise carried out by the purchase personnel to collect data
useful for making certain policy decisions. On analysing the past three years’ records it
was found that on an average, 450 purchase orders were sent out per year. An ABC
analysis was carried out and the average lead time taken by the vendors for the supply
of such items were computed. Table 17.12presents the relevant data on the unit price,
lead time, and consumption patterns of “A-class” items. It was also found that the
currently the average investment in inventory is to the tune of ₹35 million.

Inward Goods Stores and Inspection Section

 The Hosur unit had an inward goods stores and inspection section that performed the
task of receiving consignments of supplies, conducting inspections, and initiating the
necessary follow-up action. The section employed two load/unload workers on a
temporary basis each for a monthly wage of ₹1,200. As soon as a consignment arrived, a
goods received note (GRN) was prepared after inspecting the materials for any
damages. If there were damages, the insurance details were verified and the
consignment sent to the claims section. The claims section liaised with either the
supplier or the insurance company for claims.

Those consignments that were free of damage were set aside for marking codes and
placing at the desired location. Simultaneously, the details were filled in the GRN. The
GRN details were used to update the stock position and copies of it were sent to other
departments such as finance and purchase.

The stores employed a clerk, an inspector and an assistant manager. In addition one
forklift truck operator was employed.

TABLE 17.13 Some Cost Details Extracted from the Study Group Report and
Apportionment Details

Notes: * All values are yearly expenditure in rupees; ** All numbers are expressed as
percentages. For limited purposes many departments have been combined with general
administration.
 Recent Developments

Recently, the company took a decision to decentralize most of the decision-making

processes. Under this scheme, each unit was focused on certain areas of the business.
The individual unit heads entered into an agreement with the corporate office regarding
the target for sales turnover, profitability, and a few other broad parameters. The unit
took all operational decisions with the required autonomy.

A study group was constituted at the Hosur unit to analyse the various expenditures
incurred at the plant level. The unit head initiated this as soon as decentralization was
put into effect. Until recently, such statistics was not compiled and analysed at the unit
level. The units would merely send a host of weekly and monthly reports to the
corporate office. The corporate staff performed the task of analysing the data and
informing the various unit heads regarding the variances from budgetary provisions. A
portion of the cost data gathered so far by the study group is given in Table 17.13.
Certain service items such as forklift truck maintenance, insurance premiums freight,
and demurrage were allocated to specific departments using the basis developed for
costing purposes. Table 17.13 also shows the apportionment details for the items.

QUESTIONS FOR DISCUSSION

1. What are the reasons for high levels of inventory at MML Ltd.? Can you offer suggestions
for bringing down the level of inventory?
2. Based on the data provided, compute the cost of carrying inventory at the Hosur unit of
MML Ltd.
3. Design an appropriate inventory control system for the A-class items identified by MML
Ltd.

SUGGESTED READINGS

• R. B. Chase and N. J. Aquilano, Production and Operations Management:

Manufacturing and Services, 9th edition (Boston: Irwin, 1999).
• M. A. Cohen, Y A. Zhang, and Y. Wang, “Identifying Opportunities for Improving
Teradyne’s Service Parts Logistics System,” Interfaces 29, no. 4 (1999): 1–18.
• H. D. Gupta, Inventory Control in Public Sector (New Delhi: Anmol Publications,
1991).
• R. W. Hall, Zero Inventories, (Homewood: Dow Jones, Irwin, 1983).
• A. C. Hax and D. Candea, Production and Inventory Management (Englewood
Cliffs, NJ: Prentice Hall, 1984).
• P. C. Jones, G. Kegler, T. J. Lowe, and R. D. Traub, “Managing the Seed Corn
Supply Chain at Syngenta,” Interfaces 33, no. 1 (2003): 80–90.
• S. Nahmias, Production and Operations Analysis, 3rd edition (Boston: McGraw-
Hill International Editions, 1997).
• N. V. Reinfled, Handbook of Production and Inventory Control (Englewood Cliffs,
NJ: Prentice-Hall, 1987).
 • E. A. Silver, D. F. Pyke, and R. Peterson, Inventory Management and Production
Planning and Scheduling, 3rd edition (New York: John Wiley, 1998).
• M. K. Starr and D. W. Miller, Inventory Control: Theory and Practice (Englewood
Cliffs, NJ: Prentice Hall, 1990).

Find answers on the fly, or master something new. Subscribe today. See pricing options.

back to top

• Recommended

• Playlists

• History

• Topics

• Tutorials

• Settings

• Support

• Get the App

• Sign Out
© 2018 Safari. Terms of Service / Privacy Policy