Chapter Seven: Inventory Model

1. Introduction
The inventory means a physical stock of good which is kept in hand for smooth and efficient
running of future affairs of an organization at the minimum costs of funds blocked in inventories.
In a manufacturing organization, inventory control plays a significant role because the total
investment in inventories of various kinds is quite substations. Inventory can be defined as the
stock of goods, commodities or other resources that are stored at any given period for future
production. In real, inventory control is a process itself, with the help of which, the demand of
items, scheduling, purchase receiving, inspection, storage and dispatch are arranged in such a
manner that at minimum cost and in minimum time, the goods can be dispatched to production
department. Inventory control makes use of available capital in a most effective way and ensures
adequate supply of goods for production.

2. The main objectives of Inventory Control are as follows:

1. For Effective Cost Accounting System: Cost accounting system is useful only when
there is a tight control over cost and inventory cost is a major part of total production
cost.
2. To Check Waste and Wastage: Inventory control not just only ensures uninterrupted
material supply to production department but also ensures the control from purchasing to
supply of finished goods to customers. So in this way it checks waste and wastage
whether it is about time, money or material.
3. To Check Embezzlement and Theft: Inventory control is to maintain necessary records
for protecting theft and embezzlement.
4. For the Success of Business: Customer’s satisfaction is very much important for the
success of business and customer’s satisfaction is directly related to the goods supplied to
them. If the goods supplied to customers are low in cost with good quality at right time, it
ensures the success of business. Inventory Control helps in achieving this goal.
5. For the Life of the Business: In absence of Inventory Control there are many risks of
losses.
6. To Check National Wastage: Inventory control checks the wastage of nation’s resources
such as raw minerals, ores, etc. classification of inventory

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 3. Inventory cost
The four costs considered in inventory control models are:
1. Purchase costs
2. Inventory carrying or stock holding costs
3. Procurement costs (for bought-out) or setup costs (for made-ins) and
4. Shortage costs (due to disservice to the customers)

1. Purchase Costs
It is the price that is paid for purchasing/producing an item. It may be constant per unit or may
vary with the quantity purchased/ produced. If the cost/unit is constant, it does not affect the
inventory control decision. However, the purchase cost is definitely considered when it varies as
in quantity discount situations.
2. Inventory carrying costs
They arise on account of maintaining the stocks and the interest paid on the capital tied up with
the stocks. They vary directly with the size of the inventory as well as the time for which the
items is held in stock. Various components of the stockholding cost are:
1. Cost of money or capital tied up in inventories. Money borrowed from the banks may
cost interest of about 12%. But usually the problem is viewed in a slightly different way
i.e., how much the organization would have earned had the capital been invested in an
alternative project such as developing a new product, etc. it is generally taken somewhere
around 15% to 20% of the value of the inventories.
2. Cost of storage space. This consists of rent for space, heating, lighting and other
atmospheric control expenses.
3. Depreciation and deterioration costs. They are especially important for fashion items or
items undergoing chemical changes during storage.
4. Pilferage cost. The act of stealing small amounts and it depends upon the nature of the
item.
5. Obsolescence cost. It depends upon the nature of the items in stock. Electronic and
computer components are likely to be fast outdated.

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 6. Handling costs. These include all costs associated with movement of stock, such as cost
of labor, overhead cranes etc.
7. Record-keeping and administrative cost
8. Taxes and Insurance

3. Procurement costs
These include the fixed cost associated with placing of an order or setting up machinery before
starting production. They include costs of purchases, requisition, fellow up, receiving the goods,
quality control, cost of mailing, telephone calls and other follow up actions, salaries of persons
for accounting and auditing etc.
4. Storage costs
These costs are associated with either a delay in meeting demands or the inability to meet it at
all. Therefore, shortage costs are usually interpreted in two ways.
It follows from the above discussion that if the purchase cost is constant and independent of the
quality purchased, it is not considered in formulating the inventory control policy. The total
variable inventory cost in this case is given by
Total variable inventory cost = Carrying cost + Ordering cost + Shortage cost
However, if the unit cost depends up on the quantity purchased i.e., price discounts are available,
the purchases cost is definitely considered in formulating the inventory control policy.
Total Inventory cost = Purchase cost + Carrying cost + Ordering cost + Shortage cost

4. Inventory Control Problem

The inventory control problem consists of determination of three basic factors:
1. When to order (produce or Purchase)?
2. How much to order?
3. How much safety stock should be kept?
When to order. This is related to the lead time (also called delivery lag) of an item. Lead time
may be defined as the time interval between the placement of an order for an item and its receipt
in stock.
How much to order. As already discussed, each order has associated with it the ordering cost or
acquisition cost. To keep it low, the number of orders should be as few as possible i.e., the order
size should be large. But large order size would imply high inventory carry cost.

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How much should be the safety stock. This is important to avoid overstocking while ensuring
that no stock-out take place. The inventory control policy of an organization depends upon the
demand characteristics.

4. Inventory Management Models

The fundamental issues underline all inventory planning are
1. How much to order of each material when orders are placed with either outside suppliers
or production departments within the organization.
2. When to place the order
The determination of order quantities and when to place these orders determine in large measure
the amount of materials in inventory at any given time. The answer to the question how much
should we order depends on the cost of ordering too much and the cost of ordering too little.
Annual stocking cost curve demonstrate an important concept in inventory planning. There exists
for every material held in inventory an optimal order quantity order quantity where total annual
stocking costs are at a minimum.

5. Fixed order quantity inventory management

A fixed, predetermined quantity of an inventoried item is ordered when the stock on hand
reaches a level called reorder point. The order point is determined by estimating how much we
expect to use of a material before we order and receive another batch of that material.

5.1. Model I (Economic order Quantity Model)

Assumptions

1. Annual demand, carrying cost and ordering cost for a material can be estimated.
2. Average inventory level for a material is order quantity divided by 2. This simply
assumes that no safety stock is utilized, orders are received all at once, materials are used
at a uniform rate, and materials are entirely used up when the next order arrives.
3. Stock out, customer responsiveness and other costs are inconsequential
4. Quantity discounts do not exist

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Cost Formulas
Annual Carrying Cost = Average inventory level X Carrying cost
Annual ordering cost = Orders per year x ordering cost per order
Total Annual Stocking cost = Annual Carrying cost + annual ordering cost

Variable definition
D = annual demand for a material (units per year)
Q = quantity of material ordered at each order point (units per order)
C = cost of carrying one unit in inventory for one year (Br/unit/year)
S = average cost of completing an order for a material (Br/order)
TSC = total annual stoking costs for a material (Br/year)
TSC = (Q/2) c + (D/Q) s
Derivation of the economic order quantity (EOQ)
TSC is minimum when annual ordering cost equals annual carrying cost
i.e. (D/Q)s = Q/2(c)
DS/Q = QC/2
Q2C = 2DS
Q2 = 2DS/C
Q = 2DS/C = Economic order quantity.

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Example 1
A firm purchases 10000 parts per year from a manufacture at a per unit cost of Br. 3. The
ordering costs have been estimated to be Br 4 per order. And the annual per unit holding costs
are br1 what EOQ should the firm use?
D = Br 4/older
S = 10000/year
EOQ = 2DS/C = 2(4)10000/1 = 282.8 units/order.

Example 2
A supply Co. stocks thousands of plumbing items sold to regional plumbers, contractors, and
retailers. The firm’s general manager wonders how much money could be saved annually if EOQ
were used instead of the firm’s present rules of thumb. The manager instructs the inventory
analyst to conduct an analysis of one material to see if significant savings might result from
using the EOQ. The analyst develops the following estimates from accounting information.

D = 10,000 valves per year

Q = 400 per order
C = 0.4 Br per valve per year and
S = 5.50 per order
Present Total Stocking Cost;
TSC1 = (Q/2)(c) + (D/Q)s
= 400/2(0.4) + 10000/400(5.5) = 88 + 137.50 = 217.50

2DS / C = 2(10000)(5.5) / 0.4 275000 = 524.4 values

EOQ = =
TSc2 (if EOQ were employed)
TSc2 = (Q/2)c + (Q/D)s = s24.4/2 (0.4) + (10000/524.4)5.5
= 104.88 + 104.88 = 209.76
Estimated annual saving
= TSc1 – TSc2 = 217.50 – 209.78 = 7.74 for one material

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 4.2. ABC Inventory Management Method
An analysis of inventories commonly reveals that a small percentage of items accounts for a
major portion of the inventory investment. With few exceptions, no company maintaining large
number of items in inventory uses EOQ formula to analyze its purchase decisions for every item,
part, or product it buys. From this analysis we can conclude that selective control procedures
rather than equal treatment of all inventory items will yield adequate control at a lower cost.

Under the ABC inventory management method all inventories are classified on the basis of
relative value to the firm’s total inventory investment.

In addition to the assumption that it is uneconomical to manage each item in the inventory, this
approach also assumes that efficient and effective inventory management can be achieved only
by managing groups of items instead of individual items.

There are several reasons for such selective control of inventories

 minimizing investment
 maximizing service
 preventing or mitigating the consequences of stock-outs,
 minimizing transportation costs

In classifying individual items in inventory, all items must be first be listed. The total yearly
usage and production cost is computed for each item (units/year X cost/unit). The items and the
yearly cost are then rearranged in descending order and are separated into class of categories.

The ABC classification method suggests that inventories should be grouped into three categories
A, B and C.

If more than three groups can be justified in a particular case, they should be used.

A typical application of ABC inventory management would classify.

 75 to 80% of the value and 20% of the materials into class A

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  15 to 20% of the value and 30% of the materials into class B
 5 to 10% of the value and 50% of the materials in to class C

Class A items represent the majority of inventory investment but account for only 15 to 20% of
the items. These items justify the employment of inventory models and closer management
controls. While class B and class C can justify less costly inventory control methods.

Inventory control parameters for ABC classification methods

Class Control Lot size Buffer stock Inventory Audit
A Close Small Small Frequent
B Moderate Medium Moderate Occasional
C Loose Large Large infrequent

Although the emphasis of the ABC classification method is on concentrating financial concern
and control in proportion to the investment value of an inventory item, it should be acknowledge
that criteria other than investment may be used to determine inventory classification.

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