Chapter 8 – Inventory management

Chapter agenda

Objective
Periodic
review
Inventory
mgmt systems
Inventory JIT
Mgmt

Basic EOQ
Calculating
EOQ
Optimising EOQ with
inventory discounts
Calculating re-
order levels

Objective
Reducing inventory level & thereby inventory costs is the main objective of inventory
management.

Issues of inventory
Having too much or too less of inventory can become a major problem for any
manufacturing organisation.

Having too much affects liquidity (Cash is stuck on inventory)

Having too less affects profitability (Possibility of stockouts, disruptions to production etc)

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 Too much Too less
Opportunity cost – Investing too much on Risk of stock outages – Lost
inventory means cash is tied up on revenue/contribution, disruptions to the
inventory which could have earned production process, customer
interest income if cash was deposited in a dissatisfaction
bank
High costs – Inventory holding costs, High re-order & set up costs – Higher time
administration costs and risk of damage & and money spent on administration
theft increase significantly
Loss of quantity discounts – Since inventory
purchases are not in bulk

Optimising inventory
In order to reduce inventory levels and costs, companies need to determine,

1. Optimum re-order level – No of units remaining in the inventory when the NEXT
ORDER is placed

2. Optimum re-order quantity – No of units to be ORDERED

*Note that optimum means the best

When these two are determined, the organisation can strike a balance between
INVENTORY HOLDING COSTS & INVENTORY RE-ORDER COSTS

Key terms used in inventory

Lead time – Time lag between the Date of Delivery & Date of placing the order

Buffer inventory – Extra units of inventory maintained for emergencies

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EOQ (Economic Order Quantity)
EOQ is a model that determines the OPTIMUM ORDER QUANTITY for inventories

It assumes that
o Demand and lead time are constant
o The purchase price of inventory is constant
o No buffer inventory is needed

EOQ attempts to minimise the HOLDING COSTS & ORDERING COSTS of inventory

EOQ is calculated as,

2𝐶! 𝐷
𝐸𝑂𝑄 = &
𝐶"

whereas
CO – Cost per order
D – Annual demand
CH – Cost of holding one unit for one year

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What are the holding costs (CH)?
Typically, these are costs such as obsolescence, damage, warehouse maintenance, stores
labour and administration costs.

Annual holding costs are calculated using

𝑞
𝐴𝑛𝑛𝑢𝑎𝑙 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 𝐶" 𝑥
2

Whereas,

CH – Cost of holding one unit for one year

q – Order Quantity
#
$
– Average inventory

It should be noted that the higher the re-order quantity higher the holding cost. This can be
shown diagrammatically as follows

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What are ordering costs (CO)
These are typically shipping fees, inspection fees, unexpected transportation costs etc
In the EoQ model order cost is assumed to be constant.

Annual ordering costs are calculated using

𝐷
𝐴𝑛𝑛𝑢𝑎𝑙 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 𝐶! 𝑥
𝑞

Whereas
CO – Cost per order
D – Annual sales demand
q – Order quantity

As ordering costs are fixed, the higher the re-order quantity lower the ordering costs. This
can be shown diagrammatically as follows

If the re-order quantity minimises the holding costs & ordering costs, it is known as the EOQ.

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Example – EOQ

A company requires 1,000 units of material A per month. The cost per order is $30
regardless of the size of the order. The holding costs are $2.88 per unit per year.

Required:

a) What is the total cost of buying the material in quantities of 400, 500, or 600 units at
one time?

b) Use EOQ to find the optimal re-order quantity

EOQ with quantity discounts

When purchasing inventory in mass quantities, quantity discounts are offered.

However, the issue is that, if the EOQ Size < Order Size to obtain a quantity discount, then
the EOQ needs to be increased.

Steps

Step 1
Calculate the EOQ, ignoring discounts.
If the EOQ is smaller than the minimum purchase quantity
to obtain a bulk discount then,

Step 2
Calculate the total annual inventory costs arising from using
the EoQ (Refer to the equation below)

Step 3
Calculate the total annual inventory costs that qualifies for
the bulk discount.

Step 4
Compare the totals of step 2 and 3 and select the lowest
cost option

Step 5
If there is a further discount available for an even larger
order size, repeat the same calculations for the higher
discount level.

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Step 2
! #
Total annual cost = (CO X )+ (CH X )
" $

P – Purchasing costs
D – Annual demand

Example – EOQ with discounts

ABC Ltd is a retailer of wine barrels. The company has an annual demand of 30,000 barrels.
The barrels cost $2 each. Fresh supplies can be obtained immediately but ordering costs and
the cost of carriage inwards are $200 per order. The annual cost of holding one barrel in
inventory is estimated to be $1.20. The supplier introduces a quantity discount of 2% on
orders of at least 5,000 barrels and 2.5% on orders of at least 7,500 barrels.

Required:

Calculate the EOQ ignoring the discount

Determine if EOQ changes once the discount is taken into account.

EOQ determines the optimum re-order quantity. (i.e., How much to order) This is simply one
aspect of the optimisation of inventory. The other aspect is determining the optimum re-
order level.

Re-order level (ROL) - under certainty

This solves the issue of ‘When to place the order’

ROL refers to the quantity of inventory held by the company when placing the order

Example - ROL

Using the data for ABC company above, assume that the company adopts the EOQ as its
order quantity and that it now takes two weeks for an order to be delivered.

How frequently will the company place an order? How much inventory will it have on hand
when the order is placed?

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Inventory management systems
There are two main inventory management systems.

Periodic review

Inventory levels are counted (reviewed) at regular intervals (e.g., Monthly)

The existing inventory level is then matched up to a pre-determined level
The predetermined level of inventory is derived after considering demand before the next
count & demand during the lead-time

JIT (Just in time)

Under JIT goods are only manufactured when they are needed, eliminating large stocks of
materials and finished goods.

JIT was developed and perfected in Toyota with the objective meeting customer
requirement with minimum delays.

Key requirements to operate a JIT environment

Computer-aided manufacturing technologies

Flexibility in changing the manufacturing systems and setting to meet different customer
requirements.

The ability of suppliers to supply as needed speedily and accurately. The reliability of the
supplier matters significantly.

Elimination of all non-value-adding activities

Zero tolerance for quality errors

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