Chapter 5

Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 Undergone some change but not completed
 A function of cycle time for a product
 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes
productive
 Finished goods
 Completed product awaiting shipment
© 2006 Prentice Hall, Inc. 12 – 2
 Inventory
Management
and Control

10-3
 Appropriate Level of Inventories
❑ How does a firm determine the appropriate level
of inventories?
➢ Employ a cost-benefit analysis
➢ Compare the benefits of economies of
production, purchasing, and product
marketing against the cost of the additional
investment in inventories.

10-4
 Motives for holding Inventory
1. Transactional motive…. Production
and sales occur at different point in
time
2. Speculative motive …To mitigate the
risk arising from fluctuations in
demand and supply
3. To take advantage of quantity
discounts
4. To hedge against inflation
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 Inventory Management

 How inventory items can be classified

 How accurate inventory records can
be maintained
 What to order, how much and when to
order?

10-6
 Inventory management methods
1. Inventory taking / counting
2. Accurate record keeping
3. ABC system
4. Economic Order Quantity (EOQ)
5. Just in Time (JIT)
6. Material Requirement Planning (MRP)
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 Periodic Counting
 Items are counted and records updated on
a periodic basis
 Often used with ABC analysis to determine
cycle
 Has several advantages
 Eliminates shutdowns and interruptions
 Eliminates annual inventory adjustment
 Trained personnel audit inventory accuracy
 Allows causes of errors to be identified and
corrected
 Maintains accurate inventory records
10-8
 Record Accuracy
 Accurate records are a critical ingredient
in production and inventory systems
 Allows organization to focus on what is
needed
 Necessary to make precise decisions
about ordering, scheduling, and shipping
 Incoming and outgoing record keeping
must be accurate
 Stockrooms should be secure

10-9
 ABC Analysis
 Divides inventory into three classes
based on annual dollar volume
 Class A - high annual dollar volume
 Class B - medium annual dollar volume
 Class C - low annual dollar volume
 Used to establish policies that focus on
the few critical parts and not the many
trivial ones

10-10
 ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% 72% A

#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

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 ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

10-12
 ABC Method of Inventory Control

ABC method of 100

inventory control

Cumulative Percentage
90

of Inventory Value
Method which controls
expensive inventory C
70
items more closely than B
less expensive items.

Review “A” items

most frequently A
Review “B” and “C” 0 15 45 100
items less rigorously Cumulative Percentage
and/or less frequently. of Items in Inventory
10-13
 ABC Analysis
 Policies employed may include
 More emphasis on supplier development
for A items
 Tighter physical inventory control for A
items
 More care in forecasting A items

10-14
 How Much to Order?

The optimal quantity to order depends on:

1. Forecast usage
2. Ordering cost
3. Carrying cost
Ordering can mean either the purchase or
production of the item.

10-15
 Total Inventory Costs
Total inventory costs (T) =
C (Q / 2) + O (S / Q)
Q
Average
INVENTORY
(in units)

Inventory
Q/2

TIME

C: Carrying costs per unit per period

O: Ordering costs per order
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S: Total usage during the period
 Economic Order Quantity
The quantity of an inventory item to order
so that total inventory costs are minimized
over the firm’s planning period.

The EOQ or
optimal 2 (O) (S)
quantity Q* = C
(Q*) is:

10-17
 Example of the
Economic Order Quantity
Basket Wonders is attempting to determine the
economic order quantity for fabric used in the
production of baskets.
10,000 yards of fabric were used at a constant
rate last period.
Each order represents an ordering cost of $200.
Carrying costs are $1 per yard over the 100-day
planning period.

What is the economic order quantity?

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 Economic Order Quantity
We will solve for the economic order quantity
given that ordering costs are $200 per order,
total usage over the period was 10,000 units,
and carrying costs are $1 per yard (unit).

2 ($200) (10,000)
Q* = $1

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Q* = 2,000 Units
 Total Inventory Costs
EOQ (Q*) represents the minimum
point in total inventory costs.

Total Inventory Costs

Costs

Total Carrying Costs

Total Ordering Costs

Q* Order Size (Q)

10-20
 When to Order?
Issues to consider:
Lead Time -- The length of time between the
placement of an order for an inventory item and
when the item is received in inventory.

Order Point -- The quantity to which inventory

must fall in order to signal that an order must
be placed to replenish an item.
Order Point (OP) = Lead time X Daily usage
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 Example of When to Order
Julie Miller of Basket Wonders has determined
that it takes only 2 days to receive the order of
fabric after the placement of the order.
When should Julie order more fabric?
Lead time = 2 days
Daily usage = 10,000 yards / 100 days
= 100 yards per day
Order Point = 2 days x 100 yards per day
= 200 yards
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 Example of When to Order
Economic Order Quantity (Q*)

2000
UNITS

Order
Point

200

0 18 20 38 40
Lead

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Time DAYS
 Safety Stock
Safety Stock -- Inventory stock held in reserve
as a cushion against uncertain demand (or
usage) and replenishment lead time.

Our previous example assumed certain demand

and lead time. When demand and/or lead time are
uncertain, then the order point is:
Order Point =
(Avg. lead time x Avg. daily usage) + Safety stock
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 Order Point
with Safety Stock
2200

2000
UNITS

Order
Point

400
200
Safety Stock
0 18 20 38

10-25
DAYS
 Order Point
with Safety Stock
2200

2000
Actual lead
time is 3 days!
(at day 21)
UNITS

Order The firm “dips”

Point into the safety stock

400

200
Safety Stock
0 18 21

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DAYS
 How Much Safety Stock?
What is the proper amount of
safety stock?
Depends on the:
Amount of uncertainty in inventory demand
Amount of uncertainty in the lead time
Cost of running out of inventory
Cost of carrying inventory
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 Just-in-Time
Just-in-Time -- An approach to inventory
management and control in which inventories
are acquired and inserted in production at the
exact times they are needed.
Requirements of applying this approach:
A very accurate production and
inventory information system
Highly efficient purchasing
Reliable suppliers
Efficient inventory-handling system
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 Importance of JIT

Reduces inventory waste

Decreases warehouse holding cost
Gives the manufacturer more control
Local sourcing
Less working capital is needed for finance
procurement
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 MRP is a computer-based production
planning and inventory control system.
It is concerned with both production
Material scheduling and inventory control.
Requirements It attempts to keep adequate inventory
Planning levels to assure that required materials
(MRP) are available when needed.
MRP is applicable in situations of
multiple items with complex bills of
materials

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 There are three primary objectives that
MRP seeks to provide.
To ensure that raw materials are readily
Material 1.
available for production and products are
Requirements readily available for delivery to
consumers.
Planning 2. To sustain the lowest raw materials and
(MRP) finished product levels in store.
3. To organize manufacturing, delivery
schedules, and purchasing activities.

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 Advantages of MRP
1. Assurance that materials and components will be available
when needed.
2. Minimized inventory levels and costs associated.
3. Optimized inventory management.
4. Reduced customer lead times.
5. Increased manufacturing efficiency.
6. Increased labour productivity.

10-32