Chavie C.

Noynay
MBA-HRMD
CHAPTER 12: INVENTORY MANAGEMENT

LEARNING OBJECTIVES:

1. Define the term inventory, list the major reasons for holding inventories and list the main requirements
for effective inventory management.
2. Discuss the nature and importance of service inventories
3. Discuss periodic and perpetual review systems.
4. Discuss the objectives of inventory management
5. Describe the A-B-C approach and explain how it is useful.
6. Describe the basic EOQ model and explain how it is useful.
7. Describe the economic production quantity model and solve typical problems
8. Describe the quantity discount model and solve typical problems
9. Describe reorder point models and solve typical problems
10. Describe situations in which the single-period model would be appropriate, and solve typical problems.

INTRODUCTION

Inventory- a stock or store of goods

Two Inventory Models:

a. Independent-demand items – items that are ready to be sold or used
b. Dependent-demand items – items that are components of finished products, rather than the finished
products themselves

THE NATURE AND IMPORTANCE OF INVENTORIES

Kinds of Inventories:
a. Raw materials and purchased parts
b. Partially completed goods, called work-in-process (WIP)
c. Finished-goods inventories (manufacturing firms) or merchandising (retails stores)
d. Replacement parts, tools and supplies
e. Goods-in-transit to warehouse or customers (pipeline inventory)

Functions of Inventory:
1. 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.

2. 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. Companies that process fresh fruits and vegetables
deal with seasonal inventories. So do stores that sell greeting cards, skis, snowmobiles or Christmas
trees.

3. To decouple operations. Historically, manufacturing firms have used inventories as buffers between
successive operations to maintain continuity of production that would otherwise de disrupted by

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 1
 Chavie C. Noynay
MBA-HRMD
events such as breakdowns of equipment and accidents that cause ma 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.

4. To protect against stockouts. Delayed deliveries and unexpected increase in the demand increase the
risk of shortages. Delays can occur because of weather conditions, supplier stockouts, deliveries of
wrong materials, quality problems and so on. The risk of shortages can be reduced by holding safe
stocks, which are stocks in excess of average demand to compensate for variabilities in demand and
lead time.

5. 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 the purchased
amount for later use. Similarly, it is usually economical to produce in large rather than small quantities.
Thus inventory storage enables a firm to buy and produce in economic lot size without having to try to
match purchases or production with demand requirements in the short run. This results in periodic
orders, or order cycles. The resulting stock is known as cycle stock. Order cycles are not always based
in economic lot sizes. In some instances, it is practical or economical to group orders and/or to order at
fixed intervals.

6. To hedge against price increase. Occasionally a firm will suspect that a substantial price increase is
about to occur and purchase larger-than-normal amounts to beat the increase. The ability to store
extra goods also allows a firm to take advantage of price discounts for larger orders.

7. 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.
Little’s Law- The average amount of inventory in a system is equal to the product of the
average demand rate and the average time a unit is in the system.

8. To take advantage of quantity discounts. Suppliers may give discounts on large orders.

Objectives o f Inventory Control:

Two main concerns of inventory management:

a. Level of customer service that is to have the right goods, in sufficient quantities, in the right place, at
the right time
b. Costs of ordering and carrying inventories

Overall objective of inventory management – to achieve satisfactory levels of customer service while keeping
inventory costs within reasonable bounds

REQUIREMENTS FOR EFFECTIVE INVENTORY MANAGEMENT

Inventory System

a. Periodic System – physical count of items in inventory made at periodic intervals (weekly, monthly).

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 2
 Chavie C. Noynay
MBA-HRMD
b. Perpetual Inventory System – keeps track of removals from inventory continuously, thus monitoring
current levels of each item

Demand Forecast and Lead-Time Information

Inventories are used to satisfy demand requirements, so it is essential to have reliable estimates of the
amount and timing of demand. Similarly, it is essential to know how long it will take for orders to be
delivered. In addition, managers need to know the extent to which demand and lead time (the time
between submitting an order and receiving it) might vary; the greater the potential variability, the greater
the need for the additional stock to reduce the risk of the shortage between deliveries. Thus, there is
crucial link between forecasting and inventory management.

Point-of-Sale (POS) system electronically record actual sales. Knowledge of actual sales can greatly
enhance forecasting and inventory management: By relaying information about actual demand in real
time, these systems enable management to make any necessary changes to restocking decisions.

Inventory Costs

a. Holding (carrying) cost – cost to carry an item in inventory for a length of time, usually a year
b. Ordering Costs – costs of ordering and receiving inventory
c. Shortage costs – costs resulting when demand exceeds the supply of inventory; often unrealized profit
per unit

Classification System

A-B-C approach – classifying inventory according to some measure of importance and allocating control
efforts accordingly: A – Very important, B – Moderately important and C – Least important

A-B-C Concept is a guide to cycle counting, which is a physical count of items in inventory. The purpose of
cycle counting is to reduce discrepancies between amounts indicated by inventory records and the actual
quantities of inventory on hand.

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 3
 Chavie C. Noynay
MBA-HRMD

HOW MUCH TO ORDER: ECONOMIC ORDER QUANTITY MODELS

A. Basic Economic Order Quantity (EOQ) Model

- The simplest of the three models
- Used to identify fixed order size that will minimize the sum of the annual costs of holding inventory
and ordering inventory

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 4
 Chavie C. Noynay
MBA-HRMD

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 5
 Chavie C. Noynay
MBA-HRMD

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 6
 Chavie C. Noynay
MBA-HRMD

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 7
 Chavie C. Noynay
MBA-HRMD

B. Economic Production Quantity (EPQ)

The batch mode of production 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

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 8
 Chavie C. Noynay
MBA-HRMD
grow. In such instances, it makes sense to periodically produce such items in batches, or lots instead of
producing continually.

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 9
 Chavie C. Noynay
MBA-HRMD
B. Quantity Discounts
- Price reductions for large orders offered to customers to induce them to buy in large quantities

For Example, an Australian surgical supply company publishes the price list shown in Table 12.2 for
boxes of gauze strips. Note that the price box decreases as order quantity increases.

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 10
 Chavie C. Noynay
MBA-HRMD

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 11
 Chavie C. Noynay
MBA-HRMD

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 12
 Chavie C. Noynay
MBA-HRMD

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 13
 Chavie C. Noynay
MBA-HRMD

Stevenson, William J.: Chuong, Sum See. (2014) Operations Management. Second Edition. Asia Global Edition. McGraw Hill Education
Page 14