Inventory Management

Operations Management

Demand Forecasts 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 additional stock to reduce
the risk of a shortage between deliveries. Thus,
there is a crucial link between forecasting and
inventory management.

Inventory Costs

Four basic costs are associated with

inventories: purchase, holding, transaction
(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 One way to lower inventory holding costs is to
having items in storage. Costs include interest, improve space utilization through narrow aisle
insurance, taxes (in some states), depreciation, handling equipment, mezzanines, layout, or
obsolescence, deterioration, spoilage, pilferage, other appropriate storage modes. Another isan
inventory management system that allows
breakage, tracking, picking, and warehousing
companiesto maintain tight control over
costs (heat, light, rent, security). They also inventory levels. This allows process planners
include opportunity costs associated with to optimize material and maintain accurate
having funds that could be used elsewhere tied quantities.
up in inventory. Note that it is the variable
portion of these costs that is pertinent.
The significance of the various components of holding cost depends on the type of item involved,
although taxes, interest, and insurance are generally based on the dollar value of an inventory. Items
that are easily concealed (e.g., pocket cameras, transistor radios, calculators) or fairly expensive (cars,
TVs) are prone to theft. Fresh seafood, meats and poultry, produce, and baked goods are subject to
rapid deterioration and spoilage. Dairy products, salad dressings, medicines, batteries, and film also
have limited shelf lives

Holding costs are stated in either of two ways: as a percentage of unit price or as a dollar amount per
unit. Typical annual holding costs range from 20 percent to 40 percent or more of the value of an item.
In other words, to hold a $100 item in inventory for one year could cost from $20 to $40.

Ordering costs are the costs of

ordering and receiving inventory.
They are the costs that vary with
the actual placement of an order.
Besides shipping costs, they
include determining how much is
needed, preparing invoices,
inspecting goods upon arrival for
quality and quantity, and moving
the goods to temporary storage.
Ordering costs are generally
expressed as a fixed dollar amount
per order, regardless of order size.

When a firm produces its own inventory instead of ordering it from a supplier, machine setup costs
(e.g., preparing equipment for the job by adjusting the machine, changing cutting tools) are analogous
to ordering costs; that is, they are expressed as a fixed charge per production run, regardless of the size
of the run.

Shortage costs result when

demand exceeds the supply of
inventory on hand. These costs can
include the opportunity cost of not
making a sale, loss of customer
goodwill, late charges, backorder
costs, and similar costs.
Furthermore, if the shortage occurs
in an item carried for internal use
(e.g., to supply an assembly line),
the cost of lost production or
downtime is considered a shortage
cost. Such costs can easily run into
hundreds of dollars a minute or
more. Shortage costs are sometimes
difficult to measure, and they may
be subjectively estimated.

Classification System
An important aspect of inventory management is that items held in inventory are not of equal
importance in terms of dollars invested, profit potential, sales or usage volume, or stockout penalties.
For instance, a producer of electrical equipment might have electric generators, coils of wire, and
miscellaneous nuts and bolts among the items carried in inventory. It would be unrealistic to devote
equal attention to each of these items. Instead, a more reasonable approach would be to allocate control
efforts according to the relative importance of various items in inventory.

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. Typically, three classes of items are used: A (very important), B
(moderately important), and C (least important). However, the actual number of categories may vary
from organization to organization, depending on the extent to which a firm wants to differentiate
control efforts. With three classes of items, A items generally account for about 10 to 20 percent of the
number of items in inventory but about 60 to 70 percent of the annual dollar value. At the other end
of the scale, C items might account for about 50 to 60 percent of the number of items but only about
10 to 15 percent of the dollar value of an inventory. These percentages vary from firm to firm, but in
most instances a relatively small number of items will account for a large share of the value or cost
associated with an inventory, and these items should receive a relatively greater share of control efforts.
For instance, A items should receive close attention through frequent reviews of amounts on hand and
control over withdrawals, where possible, to make sure that customer service levels are attained. The
C items should receive only loose control (two-bin system, bulk orders), and the B items should have
controls that lie between the two extremes.

Note that C items are not necessarily unimportant; incurring a stockout of C items such as the nuts and
bolts used to assemble manufactured goods can result in a costly shutdown of an assembly line.
However, due to the low annual dollar value of C items, there may not be much additional cost incurred
by ordering larger quantities of some items, or ordering them a bit earlier.

FIGURA A

A typical A-B-C breakdown in relative annual dollar value of items and number of items by category

Figure A illustrates the A-B-C concept.

 To solve an A-B-C problem, follow these
steps:

1. For each item, multiply annual volume

by unit price to get the annual dollar
value.
2. Arrange annual dollar values in
descending order.
3. The few (10 to 15 percent) with the
highest annual dollar value are A items.
The most (about 50 percent) with the
lowest annual dollar value are C items.
Those in between (about 35 percent) are
B items.

Operations
Management
eleventh edition

William J. Stevenson
Rochester Institute of Technology
 EXAMPLE

A manager has obtained a list of unit costs and estimated annual demands for 10 inventory items and
now wants to categorize the items on an A-B-C basis. Multiplying each item’s annual demand by its
unit cost yields its annual dollar value:

Arranging the annual dollars values in descending order can facilitate assigning items to categories:

Note that category A has the fewest number of items but the highest percentage of annual dollar value,
while category C has the most items but only a small percentage of the annual dollar value.

Although annual dollar value may be the primary factor in classifying inventory items, a manager may
take other factors into account in making exceptions for certain items (e.g., changing the classification
of a B item to an A item). Factors may include the risk of obsoles- cence, the risk of a stockout, the
distance of a supplier, and so on.

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.

Another application of the A-B-C concept is as a guide to cycle counting, which is a physical count
of items in inventory. The purpose of cycle counting is to reduce discrepancies between the amounts
indicated by inventory records and the actual quantities of inventory on hand. Accuracy is important
because inaccurate records can lead to disruptions in operations, poor customer service, and
unnecessarily high inventory carrying costs. The counts are con- ducted more frequently than once a
year, which reduces the costs of inaccuracies compared to only doing an annual count, by allowing for
investigation and correction of the causes of inaccuracies.

The key questions concerning

cycle counting for management
are

1. How much accuracy is

needed?
2. When should cycle
counting be performed?
3. Who should do it?

APICS recommends the following

guidelines for inventory record
accuracy: 􏰏 .2 percent for A items,
􏰏 1 percent for B items, and 􏰏 5
percent for C items. A items are
counted fre- quently, B items are
counted less frequently, and C
items are counted the least
frequently.

Some companies use certain events to trigger cycle counting, whereas others do it on a periodic
(scheduled) basis. Events that can trigger a physical count of inventory include an out-of-stock report
written on an item indicated by inventory records to be in stock, an inven- tory report that indicates a
low or zero balance of an item, and a specified level of activity (e.g., every 2,000 units sold).

Some companies use regular stockroom personnel to do cycle counting during periods of slow activity
while others contract with outside firms to do it on a periodic basis. Use of an outside firm provides
an independent check on inventory and may reduce the risk of problems created by dishonest
employees. Still other firms maintain full-time personnel to do cycle counting.