Jomary C.

Brequillo
MBA 106- Operations Management
INVENTORY MANAGEMENT
NARRATIVE REPORT

I. Importance of Inventory:
Inventory or stock refers to the goods and materials that a business holds for the
ultimate goal of resale, production or utilization.

Inventory consists of the goods that a company creates to sell to customers in

the future or stocks to sell to them today. This includes raw materials used to
manufacture products for customers as well as merchandise stocked to sell to
customers today.
 FUNCTIONS OF INVENTORY:
1. To provide a selection of goods for anticipated customer demand and to
separate the firm from fluctuations in that demand. Such inventories are
typical in retail establishments.
A critical aspect of business operations is inventory management. It involves
purchasing, storing, and utilizing raw materials, work-in-progress, and finished
goods efficiently to meet the demands of customers. Smooth operations,
customer satisfaction, cost control, and profitability contribute to the success of a
business.
2. To decouple various parts of the production process. For example, if a firm’s
supplies fluctuate, extra inventory may be necessary to decouple the production
process from suppliers.
The purpose of inventories in manufacturing has been to maintain continuity of
production when events such as equipment breakdown and accidents cause a
portion of the operation to temporarily shut down. As a buffer between
successive operations, manufacturing firms use inventories to maintain continuity
of production. While the problem is being resolved, other operations can
continue.
3. To take advantage of quantity discounts, because purchases in larger
quantities may reduce the cost of goods or their delivery.
It is possible for suppliers to offer discounts on large orders. To minimize costs,
firms usually purchase more than the forecasted demand. It is most often more
economical to buy in lots and to produce in lots. It is therefore necessary to store
the purchased materials and the finished goods.
4. To hedge against inflation and upward price changes.
 Sometimes a firm will purchase larger-than-normal quantities when it suspects a
substantial price increase is imminent. Larger orders can also be discounted
when a firm has the ability to store extra goods.
 TYPES OF INVENTORY:
The investment in inventories is frequently the largest current asset of
merchandising and manufacturing businesses. Therefore description and
measurement of inventory require careful attention.
A merchandising company ordinarily purchases its merchandise in a form
ready for sale. It reports the cost assigned to unsold units left on hand as
merchandise inventory. Only one inventory account, merchandise inventory,
appears in the financial statements. Example of such a merchandising company
is Wal-Mart.
Manufacturing Companies:
Manufacturing companies produce goods that may be sold to merchandising
companies as well as directly to customers. Manufacturing companies normally
have three inventory accounts, however for in Heizer’s book, there are 4 type of
inventories discussed. These are:
 Raw materials
The cost assigned to goods and materials on hand but not yet placed into
production is reported as raw materials inventory. Examples include the
wood to make a base ball bat and the steel to make a car. These
materials can be traced directly to the end product.
 Work in process
Some units are not completely processed at any point in a continuous
process. The cost of the raw material on which production has been started
but not completed, plus the direct labor cost applied specifically to this
material and a ratable share of manufacturing overhead costs, constitute
the work in process inventory.
 MRO (Maintenance/repair/operating) Inventory
These are inventories devoted to maintenance/repair/operating supplies
necessary to keep machinery and processes productive repair of some
equipment are unknown.
 Finished goods
An end item ready to be sold, but still an asset on the company’s books.
II. Inventory Management Techniques
Operations managers establish systems for managing inventory. In this
section, we briefly examine two ingredients of such systems: (1) how inventory items
can be classified (called ABC analysis ) and (2) how accurate inventory records can be
maintained. We will then look at.
First, we answer how inventory can be classified:
 ABC ANALYSIS:
 Also known as Always Better Control.
ABC analysis divides on-hand inventory into three classifications based on
annual dollar volume. The classification is based on which of the items will
generate more profit, hence will require tighter control or security and
more accurate records.

ABC analysis is a method for managing inventory by evaluating the

importance of each item based on demand, cost, and risk factors.
Inventory managers categorize items into classes, such as A, B, or C,
based on these criteria to help business leaders determine which products
or services are key to the company’s financial success. ABC analysis
helps to optimize inventory levels, reduce costs, and improve customer
satisfaction.

How ABC Analysis Simplifies Work for Inventory Managers?

Inventory managers are always looking for ways to improve pricing and
quality or to achieve greater efficiencies. In light of that goal, they may use
the ABC technique, sometimes called the “always better control” method.
They can use the analysis to focus their time and effort primarily on Class
A inventory and less on B and C class products. For example, inventory
managers will use ABC analysis to check the purchase orders of the
highest value (Class A items) products first, since these generate the most
revenue.

 RECORD ACCURACY
Record accuracy in inventory management is the degree to which your
inventory records match the actual physical inventory in your warehouse
or store. It is important to maintain high inventory accuracy because it can
help you avoid stockouts, overstocking, operational costs, and customer
dissatisfaction.

Accuracy can be maintained by either periodic or perpetual systems.

1. Periodic System:
 Requires regular (periodic) checks of inventory to determine
quantity on hand.
A periodic system in inventory accuracy is a method of accounting for
inventory that involves physically counting the inventory at the end of a
specific period, such as monthly, quarterly, or annually. This system
does not track the inventory changes on a regular basis or after each
sale, unlike the perpetual system. A periodic system can be easier and
cheaper to implement for small businesses with low inventory volumes,
but it also has some drawbacks, such as:

 The possibility of human error during the physical count

 The difficulty of detecting defects, theft, or loss of inventory
 The need to shut down operations or limit sales during the count
  The lack of real-time information on inventory levels and cost of
goods sold

2. Perpetual System:
 Continuously updates inventory records based on electronic
records of purchases and sales
A perpetual system in inventory is a method of accounting for inventory
that records the changes in inventory levels in real-time, using a
computerized point-of-sale (POS) system. This system eliminates the
need for physical inventory counts, as the inventory records are always
updated with every purchase or sale of goods. A perpetual system can
provide more accurate and timely information on inventory levels, cost
of goods sold, and profitability.
After the ABC Analysis, the next techniques will Answer: How accurate the inventory
records can be maintained:

 CYCLE COUNTING
Cycle counting in inventory is a method of verifying the accuracy of
inventory records by counting a small subset of inventory items on a
regular basis. It is a way of ensuring that the physical inventory matches
the inventory records without having to perform a full physical inventory
count. Cycle counting can help to reduce inventory errors, improve
inventory management, and lower operational costs. Some of the steps
involved in cycle counting are:

 Review the existing inventory database and correct any data

entry errors
 Create a cycle count report that includes the items to be
counted, the schedule, and the order of counting
 Perform the count and record the results
 Compare the results with the inventory records and adjust any
discrepancies
 Analyze the causes of inventory errors and implement corrective
actions
There are different methods of selecting the items to be counted, such as:

ABC analysis: This method prioritizes the items based on their value,
frequency, or importance. The most valuable or critical items (A) are
counted more often than the less valuable or less critical items (B and C).
Random sampling: This method selects the items randomly from the entire
inventory. This can help to detect errors across the inventory and avoid
bias.
Control group: This method selects a fixed set of items that are counted
frequently and used as a benchmark for the inventory accuracy. This can
 help to measure the effectiveness of the cycle counting process and
identify any systemic issues.
Because of the volume of inventory, how can you be efficient in cycle counting? The
approach is that the company uses ABC analysis to classify their inventory and then
identify their cycle counting policy.
Number of items to be counted per day= Quantity / cycle counting policy
Advantages of Cycle Counting:
1. Eliminates the shutdown and interruption of production necessary for annual physical
inventories.
2. Eliminates annual inventory adjustments.
3. Trained personnel audit the accuracy of inventory.
4. Allows the cause of the errors to be identified and remedial action to be taken.
5. Maintains accurate inventory records.

 CONTROL OF SERVICE INVENTORIES:

Control of service inventories is the process of managing the resources

and activities involved in providing services to customers. It aims to
ensure that the service delivery is efficient, effective, and meets customer
expectations.
Applicable techniques include the following:
1. Good personnel selection, training, and discipline:
These are never easy but very necessary in food-service, wholesale,
and retail operations, where employees have access to directly
consumable merchandise.
2. Tight control of incoming shipments:
This task is being addressed by many firms through the use of
Universal Product Code (or bar code) and radio frequency ID (RFID)
systems that read every incoming shipment and automatically check
tallies against purchase orders. When properly designed, these
systems—where each stock keeping unit (SKU; pronounced “skew”)
has its own identifier—can be very hard to defeat.
3. Effective control of all goods leaving the facility:
This job is accomplished with bar codes, RFID tags, or magnetic strips
on merchandise, and via direct observation. Direct observation can be
personnel stationed at exits (as at Costco and Sam’s Club wholesale
stores) and in potentially high-loss areas or can take the form of one-
way mirrors and video surveillance.

III. Independent vs. Dependent Demand

 Independent demand is the demand for a finished product or service that is not
influenced by the demand for another product or service.
For example, the demand for a car is independent of the demand for a
bicycle.

Dependent demand is the demand for a component or subassembly that is

derived from the demand for a finished product or service.
For example, the demand for tires is dependent on the demand for cars.

Independent and dependent demand require different inventory management

systems and methods. Independent demand is usually based on forecasts,
estimates, or customer orders, while dependent demand is calculated from the
production plan of the finished product or service.

Holding, Ordering, and Set up Costs

 Holding costs are the costs associated with storing unsold inventory, such
as storage space, labor, and insurance. They are part of total inventory
costs, along with ordering and shortage costs. Holding costs can range
from 15% to 40% of the total inventory value, depending on various
factors.
 Ordering cost is the cost of placing an order for inventory from a supplier.
It includes the expenses related to preparing, processing, inspecting, and
receiving the order. Ordering cost is one of the components of total
inventory cost, along with holding cost and shortage cost. Ordering cost is
inversely related to holding cost, meaning that the lower the holding cost,
the higher the ordering cost, and vice versa. Ordering cost is used to
calculate the economic order quantity (EOQ), which is the optimal order
quantity that minimizes the total inventory cost.
 Set up costs are the costs incurred to prepare a machine, equipment, or
process for a production run. They include the labor, materials, tools, and
time required to change the settings, adjust the parameters, test the
output, and ensure the quality of the product or service. Set up costs are
considered as fixed costs of a batch, and they are spread over the number
of units produced in that batch

There are 3 Inventory Models for Independent Demand:

1. Basic Economic Order Quantity Model
2. Production Order Quantity Model
3. Quantity Discount Model
• Basic Economic Order Quantity Model
The basic economic order quantity model is a simplified version of the economic
order quantity (EOQ) model, which determines the optimal order quantity that
minimizes the total inventory costs. The basic economic order quantity model
assumes that the demand rate, the order cost, and the holding cost are constant
 and known. It also assumes that the orders are placed at fixed intervals and the
inventory level is replenished instantaneously.
This technique is relatively easy to use but is based on several assumptions:
1. Demand for an item is known, reasonably constant, and independent of
decisions for other items.
2. Lead time—that is, the time between placement and receipt of the order—is
known and consistent.
3. Receipt of inventory is instantaneous and complete.
4. Quantity discounts are not possible.
5. The only variable costs are the cost of setting up or placing an order (setup or
ordering cost) and the cost of holding or storing inventory over time (holding or
carrying cost).
6. Stockouts (shortages) can be completely avoided if orders are placed at the
right time.
The formula for the basic economic order quantity model is:

where:

Q is the optimal order quantity

D is the annual demand rate
S is the order cost per order
H is the holding cost per unit per year
The graphical representation of Basic EOQ is a sawtooth shape. From minimum
inventory (0) it rises to its maximum Inventory Lvl because the receipt of your
order is instantaneous.
 Average Inventory on hand = (Q + 0) ÷ 2 OR simply Q ÷ 2

The basic economic order quantity model can help a company to reduce its
inventory costs by finding the best trade-off between ordering more frequently
and holding more inventory. However, it also has some limitations, such as:
 It ignores the uncertainty and variability of demand and supply
 It does not account for the effects of discounts, inflation, or inventory
shortages
 It may not be applicable for perishable or seasonal products

 Minimizing Costs
The objective of most inventory models is to minimize total costs.
With the assumptions just given, significant costs are setup (or
ordering) cost and holding (or carrying) cost. All other costs, such
as the cost of the inventory itself, are constant. Thus, if we minimize
the sum of setup and holding costs, we will also be minimizing total
costs.
 Ordering cost is inversely related to holding cost, meaning that the
lower the holding cost, the higher the ordering cost, and vice versa.

Thus graphs A and B are inversely related. As your order quantity

increases, your set-up costs decrease, while with the holding costs,
as your order quantity increases the holding costs increase as well.

Total Cost = Total Setup Cost + Total Holding Cost

Optimal Order Quantity is represented as Q*, this is the intersection

of Holding and Set up Costs, hence;

Q*= Total Set up Costs = Total Holding Costs

Expected number of Orders placed during the year (N) and
Expected time between orders (T):

If we assume that the annual demand and the price are known values, we need to
include the Price cost. The formula will be:

EOQ is a ROBUST Model

A robust model is a model that maintains its accuracy and performance
even if the underlying assumptions or data are changed or violated.
[SLIDE 30 Example:]
To show how EOQ is a robust model, we will first compute the Annual
Cost using the wrong information and compare it with the Annual Cost using the correct
information. This way we can identify how much percentage is their difference and if it is
considered as material or immaterial.
 Using information that the Annual Demand is understated by 50%, Annual
Demand should be 1,500 and not 1,000. The EOQ calculated using the wrong Annual
Demand was 200 units, Set up is $10 and Holding is $0.50, we can substitute the given
data on the formula:

The Annual Cost is $125, if we look closely, we can notice that there is something
wrong in the solution because Set up Cost should always be equal to Holding Cost and
$75 and $50 are not.

Now, we will solve for the Annual Cost using the correct information, using Annual
Demand as 1,500 and Q= 244.9

EOQ¿
√ 2(1500)($ 10)
0.50
EOQ= 244.9

Using the correct information, the setup and holding cost in this solution should’ve been
equal, the slight difference was due to rounding off.
Last step. Get the percentage of the difference between the two solutions and it will give
2% [(125-122.47) / 122.47] higher than we would have paid. Even so, the slight
difference does so little effect on the answer had we used the correct information, thus,
EOQ is a robust model.
We may conclude that the EOQ is indeed robust and that significant errors do not cost
us very much.
 Re-Order Points
This answers the question: when to order?

ROP = The inventory level (point) at which action is taken to

replenish the stocked item.

Lead Time = In purchasing systems, the time between placing an

order and receiving it; in production systems, the wait, move,
queue, setup, and run times for each component produced.

The reorder point (ROP) is the level of inventory which triggers an

action to replenish that particular inventory . It is a minimum amount
of an item which a firm holds in stock, such that, when stock falls to
this amount, the item must be reordered. It is normally calculated
as the forecast usage during the replenishment lead time plus
safety stock. In the EOQ (Economic Order Quantity) model, it was
assumed that there is no time lag between ordering and procuring
of materials.

ROP=Demand per day x Lead time for a new order in days

ROP=d x L

Demand during lead time and lead time itself are constant.
In the graphical representation, the usage rate is units/day or
represented by d.

d= D ÷ Number of working days in a year

The formula for ROP with Safety Stock (or when the demand
exceeds our ROP):

ROP=Expected demand during lead time +Safety Stock

[SLIDE 32: Example:]

Substitute the given data on ROP=d x L; we will get 96 units when without
SS.
If with Safety stock [ROP=Expected demand during lead time +Safety Stock]
simply add the daily demand on ROP because as per the condition of One day Safety
Stock.
[SLIDE 33:]
We mentioned earlier that the assumption under EOQ is that the receipt of an order is
instantaneous. In other words, they assume (1) that a firm will place an order when the
inventory level for that particular item reaches zero and (2) that it will receive the
ordered items immediately. That is why there is a sudden rise in the graph, the sawtooth
graph.
In this model, we forget the earlier assumptions, the receipt of the order as
instantaneous, so let's forget that., here you receive your inventory over period of time.
• Production Order Quantity Models
This model is applicable under two situations:
(1) when inventory continuously flows or builds up over a period of time after an
order has been placed or
(2) when units are produced and sold simultaneously
This model is especially suitable for the production environment.
 It includes the quantity of a product that should be manufactured in a single
batch so as to minimize the total cost and the inventory holding costs.
 Production order quantity model answers how much to produce in a given
situation and when to order a specific quantity.
 In POQ, we established that per unit cost is same regardless of the order
size.
 In POQ, the demand rate and batch size is determined on the basis of
order
for a product.

[SLIDE 34]
In step 3, your maximum level of inventory formula changed because because your
inventory continuously flows or builds up over a period of time.
In step 4, your Holding Cost will be reduced because the order does not arrive at once.
Thus the formula to get optimal Order under Production Order Quantity Model is:

[SLIDE 35]
Using the formula above, substitute the given data.
[SLIDE 36]
The daily demand rate was 4. We got it by dividing 1,000 by 250.
If we are to compare the Optimal Order Quantity in POQ to EOQ, from 200 it
increased to 283 and this was because of the reduction in holding cost.
If Annual data are available, our Optimal Order under POQ will be:

[SLIDE 37]
• Quantity Discount Models
This model takes into account quantity discounts.
A quantity discount is simply a reduced price ( P ) for an item when it is purchased
in larger quantities.
Price-break Quantity represent the first order amount that would lead to a new
lower price
On table 12.2: We can be offered a $2 discount if order reaches the range 120-
1,499 and be introduced to another price if we reach at least 1,500 units of order.
120 and 1,500 are what we call, Price break Quantity.

[SLIDE 38]
For Quantity Discount Model, the Product Cost is included in the computation of Total
Cost.

Hence, the Optimal Order Quantity under QDM is:

Assume we have the following data:
D= 5,200
S=200
I=28%
P=96
Substituting then in the formula, will give us 278 units.

EOQ¿
√ 2 DS
IP

EOQ¿
√ 2( 5200)(200)
(.28)(96)
EOQ= 278 Units
In order to receive a $4 discount, the order must be at least 1,500, however, the 278<
1,500, thus $96 price is not feasible.
[SLIDE 39]
Using the $98, the Q* is 275, 275 is within 120- 1,499, thus the price is feasible.
Table 12.3: To get the Total Annual Cost, simply add Order Cost, Holding cost, and
Product Cost. For Product Cost, simply multiply the Unit Price and the Annual Demand.
For the graphical representation, you can see that the solid black line in the graph
shows if the Price is feasible. An example is that 275 is in the range of 120-1,499, thus,
it was represented by a solid black line. Once the order reaches that price break
quantity, it will be feasible and will be represented by the black line in the graph.
IV. Probabilistic Model and Safety Stock
A statistical model applicable when product demand or any other variable is not
known but can be specified by means of a probability distribution.

Probabilistic models are a real-world adjustment because demand and lead time
won’t always be known and constant.

Under this model, we forget the assumption that demand for a product is
constant and certain. Because of the uncertain demand, the problem here is that
 there is a possibility of a stock out, to reduce the stock out, you hold extra units
of the stocks, this is what we refer to as safety stock.

Safety stock involves adding several units as a buffer to the reorder.

In inventory management, service level is the expected probability of not hitting
a
stock-out during the next replenishment cycle or the probability of not losing
sales. Service level:The probability that demand will not be greater than supply
during lead time.It is the complement of the probability of a stockout.
When service level is provided; we can use the formula below:

[SLIDE 42]
The formula for ROP is: ROP=d X L , if with Safety stock; ROP=d X L +SS. To get
Annual Stock out Cost : Annual stockout costs = The sum of the units short for each
demand level x The probability of that demand level x The stockout cost/unit x The
number of orders per year.
We can apply these formulas on the example on slide 42. We are looking for the
amount of Safety Stock that will give us lower annual cost or total cost.
To determine how much is the stock out or shortage, we can use the formula:
Shortage= Demand -ROP.
ROP = 50
The Shortage happens when your demand is higher than your ROP, thus for the level
demand of 60; shortage is 10 while for the level demand of 70; shortage is 20.
The probability of that demand level is given in the example.
Annual Cost=(10 frames short) (.2)(40 per stockout) (6 possible stockouts per year)
+ (20 frames short) (.1) (40)(6) = 960.
The table shown as a solution shows the amount of annual cost for the amount of safety
stock that the company has. The Safety Stock of 20 gives 0 total cost, thus the ROP will
be changed to ROP =70. [50+20]
[SLIDE 44]
We were asked to answer:
(a) What is the appropriate value of Z ?
(b) How much safety stock should the hospital maintain?
(c) What reorder point should be used?

A. To get the standard deviation or the Z-value, we can use an excel file.
B. Open Excel file, go to the formulas tab> More Functions > Statistical >
NORM.S.INV.

Then input the percentage of service level, for example if 95%, input .95, and we
will get the Z-value.
 For questions: A, B and C. Substitute all given data on the formulas.

 OTHER PROBABILISTIC MODELS

When data on lead time demand are not available, the preceding formulas
cannot be applied. However, three other models are available.

We need to determine which model to use for three situations:

1. Demand is variable and lead time is constant
2. Lead time is variable and demand is constant
3. Both demand and lead time are variable

[SLIDE46]
1. Demand is variable and lead time is constant

We have the example on Slide 46, all data are given except the Z-value, following the
steps presented previously in Excel file, we can get Z-value. As for Safety stock, simply
subtract ROP from the demand.
[SLIDE 47]
2. Lead time is variable and demand is constant
We use the formula below:

Substitute the given data from the example to the formula above.
[SLIDE 48]
3. Both demand and lead time are variable
Formula under this assumption:
Substitute given data on the formula.
V. Single Period Model [SLIDE 49]
A single-period inventory model describes a situation in which one order is
placed for a product.

In inventory management, the single period model is a method where the order
is placed only once rather than repeating the same order quantity continuously.
This is due to the demand remaining for a short time period. At the end of the
demand, some items may have a salvage value while the value of some items
deteriorates to zero.

In inventory management, the single period model is also known as the

newsboy problem. It occurs when there is a need to make an order size decision
for one period, for the specific case in which the units will have a degree of
obsolescence at the end of the period, and they will have a certain salvage
value at the end of the period (which is typically less than the cost per unit, and
it is usually $0)

Newstand problem:
In other words, even though items at a newsstand are ordered weekly or daily,
they cannot be held over and used as inventory in the next sales period. So our
decision is how much to order at the beginning of the period.

With the given data on the example on Slide 49, simply substitute them on the
formula.

VI. Fixed Period System

A system in which inventory orders are made at regular time intervals. To use
Fixed Period system, inventory must be continuously monitored.

Fixed-period systems have several of the same assumptions as the basic EOQ
fixed- quantity system:

 The only relevant costs are the

ordering and holding costs.
 Lead times are known and constant.
 Items are independent of one another.
It is an inventory control method where orders are periodically placed but the
order quantity is different every time, and is also called Fixed Period Deficit Ordering
System. The downward-sloped lines in the graph, again represent on-hand inventory
 levels, when the time between orders ( P ) passes, we place an order to raise inventory
up to the target quantity ( T ).
The Q represents the period.
The amount ordered during the first period may be Q1, the second period Q2, and so
on. The Qi value is the difference between current on-hand inventory and the target
inventory level.
Because this uses the perpetual system, one advantage of this is that there is no
physical count of inventory items after an item is withdrawn.
The disadvantage of the P system is that because there is no tally of inventory during
the review period, there is the possibility of a stockout during this time. This scenario is
possible if a large order draws the inventory level down to zero right after an order is
placed. Therefore, a higher level of safety stock (as compared to a fixed-quantity
system) needs to be maintained to provide protection against stockout during both the
time between reviews and the lead time.

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