Inventory Control

Inventory may be defined as the quantity of goods, commodities or other economic resources that are stored
or reserved at any given point of time for the purpose of smooth and efficient running of business affairs. Inventory
includes raw materials stored for producing goods, semi finished goods, finished goods awaiting shipment from the
factory

Importance of Inventory control

Inventory control is a planned approach of ascertaining when to order, how much to order and how much to
stock so that costs involved in buying and storing are optimally minimum without interrupting production or affecting
sales.. Inventory control basically deals with two problems

1. When should an order be placed ?

2. How much should be ordered ?

Inventory control eliminates the possibility of duplicate ordering. It helps in minimising the loss due to deterioration,
damage etc. It controls and minimises accumulation and build up of surplus stocks.

Objectives of inventory control

1. To minimise the financial investment in inventories

2. To ensure that the value of the materials consumed is minimum
3. To maintain timely records of inventories of all items and to maintain the stock within the desired limits
4. To ensure timely action for replenishment
5. To protect from pilferage, theft, waste, loss, damage etc
6. To meet demand fluctuations
7. To provide a safeguard for variations in delivery time of raw materials by maintaining safety stock
8. To allow flexibility in production scheduling

Causes for maintaining inventory

1. Inventory helps in efficient and smooth running of business affairs.

2. It provides service to the customers immediately or at short notice
3. Maintaining inventory may earn price discounts because of bulk purchasing
4. Inventory acts as a buffer stock when raw materials are received late
5. Inventory reduces production costs
6. It helps in meeting fluctuations in demand

Holding cost ( Inventory carrying cost )

The cost associated with carrying or holding the goods in stock is known as holding cost. Holding cost varies
directly with the size of inventory as well as the time when the item is held in stock. Holding cost includes the
following costs

a. Invested capital costs

b. Administrative costs
c. Handling costs
d. Storage costs
e. Depreciation costs
f. Taxes and insurance costs
g. Salvage costs.
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Set up cost (Order cost or Acquisition cost )

This includes the fixed costs associated with obtaining goods through placing of an order or purchasing or
manufacturing or setting up a machinery before starting production. Set up costs are independent of the quantity
ordered or produced. The administrative costs for purchasing, the costs of requisitioning material, costs for placing an
order, costs for follow up etc are set up costs. The transport costs, cost of checking supplies, cost of advertisements,
consumption of stationary, postage and telephone charges are also included in order costs.

Economic Order Quantity

Economic Order Quantity is that ordering quantity which minimises the total inventory cost. It balances
ordering cost against holding cost.

Formulae

1. Q - stands for ordering quantity

2. Q* - stands for optimal order quantity or EOQ
3. D - stands for annual demand
4. C - stands for cost of one unit of item
5. Co - stands for ordering cost
6. I - stands for inventory carrying charge as percentage of price per year
7. Ch - stands for holding cost per item per year = ( C X I )
8. TIC - stands for Total inventory cost ( annual )
9. TIC* - stands for optimal total inventory cost ( annual )
10. CXD - stands for total annual purchase cost
11. (TIC) + (C D) - stands for total annual cost
12. .t = Q/D - stands for time interval between two orders
13. N = D/Q - stands for number of orders placed during the year
14. D/Q Co - stands for total annual ordering cost
15. Q/2 Ch - stands for total annual holding cost
16. TIC = D/Q Co + Q/2 Ch

Inventory Models

Inventory models may be classified into two categories

a. Deterministic models
b. Probabilistic models

In deterministic models, demand is assumed to be fixed for subsequent periods. In probabilistic models demand is a
random variable, following a probability distribution.

Deterministic models ( Economic lot size models )

In these models demands are known and are constant. The stock levels are deplenished with time. Therefore
new items are ordered for replenishing them. The quantity by which the items ordered is known as EOQ. The
inventory problems in such situations are known as economic lot size problems. The inventory models used in these
problems are known as economic lot size models. Various economic lot size models are with

1. Infinite production rate with no shortages (purchasing model with no shortages)

2. Finite rate of production with no shortages (manufacturing model with no shortages)
3. Infinite rate of production with shortages (purchasing model with shortages)
4. Finite rate of production with shortages.(manufacturing model with shortages)
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Case 1 : EOQ models with uniform demand and infinite production rate, shortages not allowed (Purchase models )

Let D be the annual demand, Q be the quantity ordered, Co be the ordering cost and Ch be the holding costs

Total annual inventory cost ( TIC ) = ( D/Q X Co ) + ( Q/2 X Ch )

This value of Q minimises the total inventory cost and is known as EOQ or Q*

EOQ or Q* = root of 2DCo / Ch

Total annual inventory cost when Q* or EOQ = root of 2 D Co Ch . This is denoted by TIC *

TIC* = root of 2 D Co Ch

N* (optimal no of orders per year ) = D/Q*

.t* (time between two optimal orders) = Q*/D

When Q is the ordering quantity total inventory cost TIC = ( D/Q X Co ) + ( Q/2 X Ch )

When Q* is the ordering quantity total inventory cost TIC* = root of 2 D Co Ch

When Quantity Discount Allowed

Let C be the price of an item and D be the annual demand

Let q be the order quantity when cash discount is allowed

Let C’ be the price of an item when discount is allowed

When ordering quantity is Q, Total cost = (D/Q Co) + (Q/2Ch) + (C’ X D)

When EOQ is followed, total cost = root of 2 D Co Ch + (C X D )

Accept discount if TC (Q) < TC (Q*)

Otherwise Q*

Models with Price Breaks

One price break

When there is only one price break ( one quantity discount ) the situation may be represented as follows

Range of Quantity Purchase cost ( per unit )

0 <= Q < Q1 C1

Q >= Q1 C2

Where Q1 ia a quantity at which the discount applies and C2 < C1

STEP

Compute Q2* = root of 2DCo / Ch2 where Ch2 is C2 x I

If Q2* >= Q1, the optimal purchase quanitity is Q2*

If Q2* < Q1 compute Q1* = root of 2DCo / Ch1 where Ch1 is C1 x I

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Find TC (Q1*) and TC (Q1)

TC (Q1*) = root of 2 D Co Ch1 + (C1 X D )

TC (Q1) = (D/Q1 X Co) +( Q1/2 X Ch) + ( C2 X D )

If TC (Q1*) > TC (Q1), order for the size Q1. Otherwise Q1*

Two price breaks

When there are two price breaks ( two quantity discounts ) the situation can be represented as follows :

Range of quantity Purchase cost / unit

0 <= Q , Q1 C1

Q1 <= Q < Q2 C2

Q>= Q2 C3

Where Q1 and Q2 are the quantities which determine price breaks

Steps

1. Compute Q3*. If Q3* > Q2 optimal purchase quantity is Q3*

2. If Q3* < Q2 compute Q2*. If Q2* > Q1, find TC (Q2* ) and TC (Q2)
If TC (Q*2 ) > TC (Q2), order quantity is Q2 otherwise Q2*
3. If Q2* < Q1 calculate Q1* compare TC (Q1*), TC (Q1) and TC (Q2) to determine the optimal purchase
quantity. Quantity corresponding to the least cost is the order quantity.

Three or more price breaks

EX problems

Lead time

When an order is placed, it may be received immediately or it may take some time for the receipt. The time
between the placement of an order and its accrual arrival in the inventory is known as the lead time. If the lead time
exists and the demand is known, then the order is to be placed in advance by a period of time equal to the lead time.

Re-order level

This is the point fixed between manimum and minimum stock levels at which time it is essential to initiate
purchase requisition ( manufacturing requisition ) for fresh supplies of the material

Re-order level = Average usage of inventory X lead time

Buffer stock ( safety stock )

This is the additional stock needed to allow for delay in delivery or for any higher than expected demand that
may arise during the lead time. The buffer stock must be optimum. If the buffer stock maintained is very low, the
inventory holding cost will be low but shortages will occur very frequently and the cost of shortages may be high. If
the buffer stock is large then shortage will be rare, but the inventory costs would be high. So it is necessary to strike a
balance between the cost of shortages and cost of inventory holding to arrive at an optimum buffer stock
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Case 2 : EOQ models with no shortage, Uniform demand and finite production rate and production > demand rate
( production models)

Let P = production rate and D = demand rate (usage rate )

Q* = root of 2DCo/Ch X root of P/P-D and

TIC* = root of 2DCoCh X root of P-D/P

Case 3 : EOQ models with shortages, demand rate is uniform and production rate is infinite ( purchase models )

Let Cs be the shortage cost, then

1. EOQ = root of 2DCo/Ch X root of Ch + Cs / Cs

2. TIC* = root of 2 D Co Ch X root of Cs / Ch + Cs units
3. Optimal remaining units after the back order is satisfied, say S*
Q* X (Cs / Ch + Cs )
4. No of shortage = Q* - S*

Case 4 : EOQ models with shortages, finite production rate and uniform demand ( Production models ) ( production
rate > demand rate )

EOQ = root of 2 D Co / Ch X root of P / P – D X root of Ch + Cs / Cs

TIC* = root of 2 D Co Ch X root of P – D / P X root of Cs / Ch + Cs

Probabilistic Models

( Stochastic Models) (News paper boy problems ) (Christmas tree problems )

Let C1 be the over supplying cost ( Inventory carrying cost )

C2 be the under supplying cost ( Shortage cost )

Let D be the demand estimated, then

P(D) = Probability for demand ‘r’

Sigma P (D) = Sum of the probabilities upto the demand “ r “

Method : Find the range of sigma P (D) within which C2 / C1 + C2 lies. Then “ D “ corresponding to this range is the
answer.