Inventory Management

Topic

I. General Objectives:

1. Define the term inventory.

2. List the different types of inventory.

3. Describe the main functions of inventories.

4. Discuss the main requirements for effective management.

5. Explain periodic and perpetual review systems.

6. Describe the costs that are relevant for inventory management.

7. Describe the A-B-C approach and explain how it is useful.

8. Describe the basic EOQ model and its assumptions and solve typical

problems.

9. Describe the economic production quantity model and solve typical problems.

10. Describe the quantity discount model and solve typical problems.

II. Summary of Chapter:

Inventory management is a core operations management activity. Good inventory

management is often the mark of a well-run organization. Inventory levels must be

planned carefully in order to balance the cost of holding inventory and the cost of

providing reasonable levels of customer service. Successful inventory management

requires a system to keep track of inventory transactions, accurate information about

demand and lead times, realistic estimates of certain inventory-related costs, and a

priority system for classifying the items in inventory and allocating control efforts.
Four classes of models are described: EOQ, ROP, fixed-order-interval, and single-

period models. The first three are appropriate if unused items can be carried over

into subsequent periods. The single period model is appropriate when items cannot

be carried over. EOQ models address the question of how much to order. The ROP

models address the question of when to order and are particularly helpful in dealing

with situations that include variations in either demand rate or lead time. ROP

models involve service level and safety stock considerations. When the time

between orders is fixed, the FOI model is useful for determining the order quantity.

The single-period model is used for items that have a “shelf life” of one period. The

models presented in this chapter are summarized in Table 13.4 .

Key points:

1. All businesses carry inventories, which are goods held for future use or potential

future use.

2. Inventory represents money that is tied up in goods or materials.

3. Effective inventory decisions depend on having good inventory records, good cost

information, and good estimates of demand.

4. The decision of how much inventory to have on hand reflects a trade-off, for

example, how much money to tie up in inventory versus having it available for

other uses. Factors related to the decision include purchase costs, holding costs,

ordering costs, shortage and backlog costs, available space to store the

inventory, and the return that can be had from other uses of the money.

5. As with other areas of operations, variations are present and must be taken into

account. Uncertainties can be offset to some degree by holding safety stock,

although that adds to the cost of holding inventory.

III. Questions and Answers:

1. Define the term inventory.

Answer:

An inventory is a stock or store of goods. Firms typically stock hundreds or

even thousands of items in inventory, ranging from small things such as

pencils, paper clips, screws, nuts, and bolts to large items such as machines,

trucks, construction equipment, and airplanes. Naturally, many of the items a

firm carries in inventory relate to the kind of business it engages in.

2. What are the different types of inventory?

Answer:

a. The different kinds of inventories include the following:

b. Raw materials and purchased parts.

c. Partially completed goods, called work-in-process (WIP).

d. Finished-goods inventories (manufacturing firms) or merchandise

(retail stores).

e. Tools and supplies.

f. Maintenance and repairs (MRO) inventory.

g. Goods-in-transit to warehouses, distributors, or customers (pipeline

inventory).

3. Describe the main functions of inventories.

Answer:

Inventories serve a number of functions. Among the most important are the

following:

a. To meet anticipated customer demand. A customer can be a person

who walks in off the street to buy a new stereo system, a mechanic

who requests a tool at a tool crib, or a manufacturing operation. These

inventories are referred to as anticipation stocks because they are held

to satisfy expected (i.e., average ) demand.

a. To smooth production requirements. Firms that experience seasonal

patterns in demand often build up inventories during preseason periods

to meet overly high requirements during seasonal periods. These

inventories are aptly named seasonal inventories.

b. Companies that process fresh fruits and vegetables deal with seasonal

inventories. So do stores that sell greeting cards, skis, snowmobiles, or

Christmas trees.

c. To decouple operations. Historically, manufacturing firms have used

inventories as buffers between successive operations to maintain

continuity of production that would otherwise be disrupted by events

such as breakdowns of equipment and accidents that cause a portion

of the operation to shut down temporarily. The buffers permit other

operations to continue temporarily while the problem is resolved.

Similarly, firms have used buffers of raw materials to insulate

production from disruptions in deliveries from suppliers, and finished

goods inventory to buffer sales operations from manufacturing

disruptions. More recently, companies have taken a closer look at

buffer inventories, recognizing the cost and space they require, and

realizing that finding and eliminating sources of disruptions can greatly

decrease the need for decoupling operations. Inventory buffers are

also important in supply chains. Careful analysis can reveal both points

where buffers would be most useful and points where they would

merely increase costs without adding value.

d. To reduce the risk of stock outs. Delayed deliveries and unexpected

increases in demand increase the risk of shortages. Delays can occur

because of weather conditions, supplier stock outs, deliveries of wrong

materials, quality problems, and so on. The risk of shortages can be

reduced by holding safety stocks, which are stocks in excess of

 expected demand to compensate for variability in demand and lead

time.

e. To take advantage of order cycles. To minimize purchasing and

inventory costs, a firm often buys in quantities that exceed immediate

requirements. This necessitates storing some or all of purchased

amount for later use. Similarly, it is usually economical to produce in

large rather than small quantities. Again, the excess output must be

stored for later use. Thus, inventory storage enables a firm to buy and

produce in economic lot sizes without having to try to match purchases

or production with demand requirements in the short run. This results in

periodic orders or order cycles.

f. To hedge against price increases. Occasionally a firm will suspect that

substantial price increase is about to occur and purchase larger-than-

normal amounts to beat the increase.

g. To permit operations. The fact that production operations take a certain

amount of time (i.e., they are not instantaneous) means that there will

generally be some work-in-process inventory. In addition, intermediate

stocking of goods—including raw materials, semi-finished items, and

finished goods at production sites, as well as goods stored in

warehouses—leads to pipeline inventories throughout a production-

distribution system.

h. To take advantage of quantity discounts. Suppliers may give discounts

on large orders.
4. What are the main requirements for effective management?

Answer:

Management has two basic functions concerning inventory. One is to

establish a system to keep track of items in inventory, and the other is to

make decisions about how much and when to order. To be effective,

management must have the following:

4.1. A system to keep track of the inventory on hand and on order.

4.2. A reliable forecast of demand that includes an indication of possible

forecast error.

4.3. Knowledge of lead times and lead time variability.

4.4. Reasonable estimates of inventory holding costs, ordering costs, and

shortage costs.

4.5. A classification system for inventory items.

5. Explain periodic and perpetual review systems.

Answer:

Inventory counting systems can be periodic or perpetual. Under a periodic

system, a physical count of items in inventory is made at periodic, fixed

intervals (e.g., weekly, monthly) in order to decide how much to order of each

item. Many small retailers use this approach: A manager periodically checks

the shelves and stockroom to determine the quantity on hand. Then the

manager estimates how much will be demanded prior to the next delivery

period and bases the order quantity on that information.

A perpetual inventory system (also known as a continuous review system)

keeps track of removals from inventory on a continuous basis, so the system

 can provide information on the current level of inventory for each item. When

the amount on hand reaches a predetermine minimum, a fixed quantity, Q, is

ordered.

6. Describe the costs that are relevant for inventory management.

Answer:

Four basic costs are associated with inventories: purchase, holding, ordering,

and shortage costs.

Purchase cost is the amount paid to a vendor or supplier to buy the

inventory. It is typically the largest of all inventory costs.

Holding, or carrying, costs relate to physically having items in storage.

Costs include interest, insurance, taxes (in some states), depreciation,

obsolescence, deterioration, spoilage, pilferage, breakage, tracking, picking,

and warehousing costs (heat, light, rent, workers, equipment, security ). They

also include opportunity costs associated with having funds that could be

used elsewhere tied up in inventory.

Ordering costs are the costs of ordering and receiving inventory. They are

the costs that occur with the actual placement of an order. They include

determining how much is needed, preparing invoices, inspecting goods upon

arrival for quality and quantity, and moving the goods to temporary storage.

Setup costs are the costs involved in preparing equipment for a job.

Shortage costs are costs resulting when demand exceeds the supply of

inventory; often unrealized profit per unit.

7. Describe the A-B-C approach and explain how it is useful.

Answer:

The A-B-C approach classifies inventory items according to some measure of

importance, usually annual dollar value (i.e., dollar value per unit multiplied by

annual usage rate), and then allocates control efforts accordingly. The actual

number of categories may vary from organization to organization, depending

on the extent to which a firm wants to differentiate control efforts. A-B-C

approach is very useful because it will categorize the items into very

important, moderately important and least important. The manager can decide

which item needs close attention. Managers use the A-B-C concept in many

different settings to improve operations. One key use occurs in customer

service, where a manager can focus attention on the most important aspects

of customer service by categorizing different aspects as very important,

important, or of only minor importance. The point is to not overemphasize

minor aspects of customer service at the expense of major aspects.

8. Describe the basic EOQ model and its assumptions and solve typical

problems.

Answer:

The basic EOQ model is the simplest of the three models. It is used to identify

a fixed order size that will minimize the sum of the annual costs of holding

inventory and ordering inventory. The unit purchase price of items in inventory

is not generally included in the total cost because the unit cost is unaffected

by the order size unless quantity discounts are a factor. If holding costs are

specified as a percentage of unit cost, then unit cost is indirectly included in

the total cost as a part of holding costs.

The basic model involves a number of assumptions.

a. Only one product is involved.

b. Annual demand requirements are known.

c. Demand is spread evenly throughout the year so that the demand rate is

reasonably constant.

d. Lead time is known and constant.

e. Each order is received in a single delivery.

f. There are no quantity discounts.

Example: A local distributor for a national tire company expects to sell

approximately 9,600 steel-belted radial tires of a certain size and tread design

next year. Annual carrying cost is $16 per tire, and ordering cost is $75. The

distributor operates 288 days a year.

a. What is the EOQ?

b. How many times per year does the store reorder?

c. What is the length of an order cycle?

d. What is the total annual cost if the EOQ quantity is ordered?

D = 9,600 tires per year

H = $16 per unit per year

S = $75

Note that the ordering and carrying costs are equal at the EOQ
9. How do you determine the numbers to use in the EOQ formula?

Answer: To determine which numbers to use you must look for the following

items. The number of items per order is the quantity (Q). The number of items

that can be sold is D. D may be the forecast demand for that particular good.

The cost of placing the order is used for S. The final number to find is the

carrying cost (C) which is the cost of the item to be held in inventory.

10. Illustrate the economic production quantity model and solve typical

problems.

Answer:

The batch mode is widely used in production. Even in assembly operations,

portions of the work are done in batches. The reason for this is that in certain

instances, the capacity to produce a part exceeds the part's usage or demand

rate. As long as production continues, inventory will continue to grow. In such

instances, it makes sense to periodically produce such items in batches, or

lots, instead of producing continually.

During the production phase of the cycle, inventory builds up at a rate equal to

the difference between production and usage rates. For example, if the daily

production rate is 20 units and the daily usage rate is 5 units, inventory will

build up at the rate of 20 - 5 = 15 units per day. As long as production occurs,

the inventory level will continue to build; when production ceases, the

inventory level will begin to decrease. Hence, the inventory level will be

maximum at the point where production ceases. Inventory will then decrease

at the constant usage rate. When the amount of inventory on hand is

exhausted, production is resumed, and the cycle repeats itself. Because the

company makes the product itself, there are no ordering costs as such.

Nonetheless, with every production run (batch) there are setup costs—the

costs required to prepare the equipment for the job, such as cleaning,

adjusting, and changing tools and fixtures. Setup costs are analogous to

ordering costs because they are independent of the lot (run) size. They are

treated in the formula in exactly the same way. The larger the run size, the

fewer the number of runs needed and, hence, the lower the annual setup

cost.

The assumptions of the EPQ model are similar to those of the EOQ model,

except that instead of orders received in a single delivery, units are received

incrementally during production.

The assumptions are:

a. Only one product is involved.

b. Annual demand is known.

c. The usage rate is constant.

d. Usage occurs continually, but production occurs periodically.

e. The production rate is constant when production is occurring.

f. Lead time is known and constant.

g. There are no quantity discounts.

Example: A toy manufacturer uses 48,000 rubber wheels per year for its

popular dump truck series. The firm makes its own wheels, which it can

produce at a rate of 800 per day. The toy trucks are assembled uniformly over

the entire year. Carrying cost is $1 per wheel a year. Setup cost for a

production run of wheels is $45. The firm operates 240 days per year.

Determine the

a. Optimal run size.

b. Minimum total annual cost for carrying and setup.

c. Cycle time for the optimal run size.

d. Run time
IV. Reactions:

According to Stevenson (2010), Inventory Management is defined as a framework

employed in firms in controlling its interest in inventory. It includes the recording and

observing of stock level, estimating future request, and settling on when and how to

arrange. On the other hand, Deveshwar and Dhawal (2013) proposed that inventory

management is a method that companies use to organize, store, and replace

inventory, to keep an adequate supply of goods at the same time minimizing cost.

Competitive advantage comprises capabilities that allow an organization to

differentiate itself from its competitors and is an outcome of critical management

decisions (Li, Ragu-Nathan, Ragu-Nathan, & Subba Rao, 2006).

The inventory investment for a small business takes up a big percentage of the total

budget, yet inventory control is one of the most neglected management areas in

small firms. Many small firms have an excessive amount of cash tied up to

accumulation of inventory sitting for a long period because of the slack inventory

management or inability to control the inventory efficiently. Poor inventory

management translates directly into strains on a company’s cash flow.

The challenge in managing inventory is to balance the trade-off between the supplies

of inventory with demand. Ideally a company wants to have enough inventories to

satisfy the demands of its customers no lost sales due to inventory stock-outs. On

the other hand, the company does not want to have too much inventory staying on

hand because of the cost of carrying inventory. Inventory decisions are high risk and

high impact for the supply chain management of an organization. According to

Dimitrios (2008), inventory management practices have come to be recognized as a

vital problem area needing top priority. As a rule of thumb in most manufacturing

organizations, direct materials represent up to 50% of the total product cost, as a

result of the money entrusted on inventory, thereby affecting the profitability and

competitiveness of the organization. According to Sander, Matthias, and Geoff

(2010), historically, however, organizations have ignored the potential savings from

proper inventory management, treating inventory as a necessary evil and not as an

asset requiring management.

As a result, many inventory systems are based on arbitrary rules. Inventory

management according to R.M, Onyango (2013) is a fundamental pillar in an

organization and it should be taken seriously.

The inventory investment for a small business takes up a big percentage of the total

budget, yet inventory control is one of the most neglected management areas in

small firms. Many small firms have an excessive amount of cash tied up to

accumulation of inventory sitting for a long period because of the slack inventory

management or inability to control the inventory efficiently. Poor inventory

management translates directly into strains on a company’s cash flow.

According to Stevenson (2010), Inventory Management is defined as a framework

employed in firms in controlling its interest in inventory. It includes the recording and

observing of stock level, estimating future request, and settling on when and how to

arrange (Adeyemi & Salami, 2010). On the other hand, Deveshwar and Dhawal

(2013) proposed that inventory management is a method that companies use to

organize, store, and replace inventory, to keep an adequate supply of goods at the

same time minimizing cost. Choi (2012) indicates that effective inventory

management is essential in the operation of any business. Thus, keeping stock is

used as an important strategy by companies to meet customers’ needs without

taking the risk of frequent shortages while maintaining high service level. As Axsäter

(2006) describes, inventories make high cost, both in the sense of tied up capital and
also operating and administrating the inventory itself. It is argued that time from

ordering to delivery of replenishing the inventory, referred to as the lead time, is often

long and the demand from customers is almost never completely known (Axsäter,

2006). Therefore, managers should consider how to achieve the balance between

good customer service and reasonable cost, which is the purpose of inventory

management, involving the time and volume of replenishment. To this end, inventory

in many business owners is one of the most visible and tangible aspects of doing

business. Raw materials, goods in process, and finished goods all represent various

forms of inventory. Each type represents money tied up until the inventory leaves the

company as purchased products. Likewise, merchandise stocks in a retail store

contribute to profits only when their sale puts money into the cash register. In a literal

sense, inventory refers to stocks of anything necessary to do business. These stocks

represent a large portion of the business investment and must be well managed in

order to maximize profits. In fact, many small businesses cannot absorb the types of

losses arising from poor inventory management. Unless inventories are controlled,

they are unreliable, inefficient, and costly. Inventory is an idle stock of physical goods

that contain economic value, and are held in various forms by an organization in its

custody awaiting packing, processing, transformation, use or sale in a future point of

time. Ballon (2004) defined inventories as stockpiles of raw materials, supplies,

components, work-in-process, and finished goods that appear at numerous points

throughout a firm’s production and logistics channels. Inventory is the stock of any

item or resource used in an organization. Inventory is generally made up of three

elements such as raw materials, work-in-progress (WIP), and finished goods (Arnold,

2008; Cinnamon, Helweg-Larsen, & Cinnamon, 2010; Gitman, 2009). Raw materials

are concerned with the goods that have been delivered by the supplier to
purchaser’s warehouse but have not yet been taken into the production area for

conversion process (Cinnamon et al., 2010). WIP concerns are when the product

has left the raw material storage area, until it is declared for sale and delivery to

customers. In this process, the working capital must be considered in terms of

reducing the buffer stocks, eliminating the production process, reducing the overall

production cycle time. The raw materials and finished goods must be minimized in

the production area. WIP must be carefully examined to justify how long it takes for

products to be cleared for sale. This stage is normally done by the quality control

procedures (Birt et al., 2011; Cinnamon et al., 2010). Finished goods refer to the

stock sitting in the warehouse waiting for sale and delivery to customers. They could

be sitting in the warehouse or on the shelf for quite some time. The owner/manager

of the business should find what options are available to dispose the slow moving

items. Should the stock be repacked or reprocessed, and sold at lower discount

prices? Sales and operations planning can reduce or eliminate the need for finished

goods. The best example of stock management is car manufacturing. The

manufacturers normally used the Just in Time (JIT) system to deliver finished

products. In this way they minimize or eliminate both raw material stock and work in

progress, as the stock is now in finished goods (Brealey et al., 2006; Cinnamon et

al., 2010; Van Horne & Wachowicz, 2008). There are theories utilized in carrying

clarity to the investigation of the role of stock administration on operational

performance. The major theories include the theory of Constraints and Lean Theory

to build the critical concerns regarding the impacts of inventory management

approaches on the profitability of manufacturing firms.

The Theory of Constraints is an administration reasoning that looks to expand

manufacturing throughput proficiency evaluated on the bases of recognizable proof

of those procedures that are obliging the industrial system. There are various

challenges experienced in the application of the Theory of Constraints. For instance,

there is a long lead time, significant number of unsatisfied requests, irregular state of

meaningless inventories or nonexistence of appropriate inventories, wrong materials

request, expansive number of crisis requests and endeavor levels, absence of

clients engagement, nonattendance of control identified with need orders which

suggests on timetable clashes of the assets. The theory focuses on adequately

dealing with the limit and ability of these limitations to enhance efficiency and this

can be accomplished by manufacturing firms applying fitting inventory control

practices. Theory of constraints is an approach whose proposition is connected to

generation aimed at achieving a reduction of the organizational inventory. Atnafu &

Balda, Cogent Business & Management (2018),

Lean theory Lean theory is an augmentation of thoughts of JIT. The theory disposes

of buffer stock and minimizes waste in production procedure. Inventory leanness

decidedly influences the productivity of a business firm and is the best inventory

control tool. The theory expounds on how manufacturers’ adaptability in their

requesting choices diminish the supplies of stock aimed at eliminating costs

associated with the transportation of inventory. Feedback presented against the

theory insinuates that materials must be available when dealing in long haul

cooperation constituting data and information sharing and the exchange of

accomplices between firms.

Inventory management techniques Inventory management is very vital to an

enterprise since it is custom-made to reducing costs or proliferating profits while

satisfying customer’s demands by guaranteeing that balanced items of stock are

sustained at the right quality, quantity, and that are obtainable at the right time and in

the right place.

Economic order quantity According to Bowersox (2002), the inventory management

needs to be organized in a logical way so that the organization can be able to know

when to order and how much to order. This must be attained through calculating the

Economic Order Quantity (EOQ). Monetary request amount engages correlation to

arrange their stock re-establishment on an ideal premise. For instance, the

arrangement can be scheduled to happen from month to month, quarterly, half

yearly, or yearly. By so doing, it enables firms to have insignificant limit costs or zero

inside their circulation focuses. Along these lines, as associations attempt to

enhance the stock administration, the EOQ and Re-Order Point (ROP) are

necessary instruments that associations can utilize.

Just in time technique: The JIT technique is a Japanese philosophy, rationality

associated with assembling which comprises having the right things in the right

quality and amount in the correct place and at the opportune time. Utilization of JIT

technique brings about the increment in quality, profitability, and effectiveness,

enhanced correspondence, and abatements in expenses and squanders. Hutchins

(1999) characterizes JIT as a process that is prepared for moment response to the

request without the necessity for any overstocking, either in the desire of the

application being approaching or as a concern of improvident characteristics all the

while. Hutchins (1999) additionally concentrated on that the prime objective of JIT

technique is the accomplishment of zero stock, not simply inside the bounds of a

single association at the end of the day all through the whole production network. It

can be connected to the assembling procedure inside any organization as it is

additionally being adjusted inside administration associations. The components of

JIT technique incorporate consistent change, taking out the seven sorts of

squanders among others. The fundamental reason of JIT is to have as of late the

proper measure of stock, whether rough materials or finished stock, open to meet

the solicitations of your creation strategy and the solicitations of the enterprise’s end

customers. The less a firm spends to store and pass on the stock, the less obsolete

quality it has to markdown.