CHAPTER OUTLINE

4.1. Introduction
4.2. Functions and Types of Inventory
4.3. Independent vs Dependent Demand
4.4. Inventory Costs
4.5. ABC Classification of Inventory
4.6. Inventory Models
4.6.1. Independent Demand
4.6.1.1. Economic Order Quantity (EOQ) Model
4.6.1.2. Economic Production Quantity (EPQ) Model
4.6.1.3. Quantity Discount Model
4.6.2. Dependent Demand
4.6.2.1. Materials Requirements Planning (MRP)
4.7. Inventory Control Systems
4.8. Just-In-Time (JIT)
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 Chapter Objectives

Upon completion of this chapter, you should be able to:

 Define Inventory and inventory management;
 Describe types and classifications of inventory;
 Identify and compute inventory costs;
 Identify and describe inventory models;
 Calculate economic order quantity;
 Develop material requirement planning;
 Explain the importance of inventory controlling;
 Describe inventory control methods;
 Explain Just-In-Time and its benefits;
 Familiar with different inventory management practices.
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 4.1. Introduction
 All businesses and institutions require inventories to
run their operations smoothly, and thus, it is necessary to
hold inventories of various kinds to act as a buffer
between supply and demand for efficient operation of
the system.
 As inventories are used, their value is converted into
cash, which improves cash flow and return on
investment. There is a cost for carrying inventories,
which increases operating costs and decreases profits.
 On the balance sheet, inventories, current assets,
represent a substantial part of total assets.
Mata M. (PhD) 13-4
 4.1. Introduction…
Definition of Inventory
 Inventory is a physical resource that a firm holds in stock
with the intent of selling it or transforming it into a more
valuable state.
 Inventory is an idle resource with economic value waiting
for future usage, consumption, conversion, or sale.
 Inventory is stock of items kept to meet future demand.
 Inventory represents materials and supplies in stock
that a business or an institution stocked either for sale, or
are in the process of manufacturing, or are to be utilized.
Mata M. (PhD) 13-5
 4.1. Introduction…
 Inventories are one of the most expensive assets of
many companies representing as much as 40-50%
of total invested capital.
 Inventory management is the practice of planning,
overseeing, and controlling inventory from the raw
material stage to the customer, including ordering,
storage, and use of components to be used by a
business or an institution, and maintaining a desired
stock level of specific products or items.
Mata M. (PhD) 13-6
 4.1. Introduction…
 Inventory Management:
 A discipline concerned with the management of
different inventory items for:
• the smooth running of an organization.
• Minimizing inventory cost
• Maintaining expected level of customer service
 Purpose of inventory management
• Monitor and control level of inventory
• Decide how many units to order
• Decide when to order
Mata M. (PhD) 13-7
 4.1. Introduction…
 Inventory is managed not only at the aggregate level but
also at the item level.
 Aggregate inventory management deals with managing
inventories according to their classification (raw material,
work-in-process, and finished goods) and the function they
perform rather than at the individual item level.
 Aggregate inventory management involves: flow and
kinds of inventory needed, supply and demand patterns,
functions that inventories perform, objectives of inventory
management, and costs associated with inventories.

Mata M. (PhD) 13-8

 4.1. Introduction…

 In Item Inventory Management, management

must establish decision rules about inventory
items so the staff responsible for inventory
control can do their job effectively.
 The rules include: which individual inventory
items are most important, how individual items
are to be controlled, how much to order at one
time, and when to place an order.

Mata M. (PhD) 13-9

 4.1. Introduction…
 Every item which is useful in undergoing organization
operations must be available whenever it is required.
 Holding both too much and too less inventory is costly.
 Inventory management has an impact on all business
functions, particularly operations, marketing,
accounting, and finance.
 Materials managers must balance inventory
investment and customer service.
 Customer service is the ability of a company to satisfy
the needs of customers.
Mata M. (PhD) 13-10
 4.1. Introduction…
 In inventory management, the satisfying the needs of
customer describes the availability of items when needed
and is a measure of inventory management effectiveness.
 The problem is to balance inventory investment with the
following:
1) Customer service: The lower the inventory, the higher the
likelihood of a stockout and the lower the level of customer
service. The higher the inventory level, the higher customer
service will be.
2) Costs associated with changing production levels: Excess
equipment capacity, overtime, hiring, training, and layoff costs
will all be higher if production fluctuates with demand.
Mata M. (PhD) 13-11
 4.1. Introduction…

The problem is to balance inventory investment with the

following…
3) Cost of placing orders: Lower inventories can be achieved
by ordering smaller quantities more often, but this practice
results in higher annual ordering costs.
4) Transportation costs: Goods moved in small quantities cost
more to move per unit than those moved in large quantities.
However, moving large lots implies higher inventory.

 If inventory is carried, there has to be a benefit that

exceeds the costs of carrying that inventory.
Mata M. (PhD) 13-12
 4.1. Introduction…
Objectives of Inventory Management
▪ To protect inventories from miss-utilization and
destruction
▪ To satisfy the wants of the customers effectively
▪ To determine compliance with entity`s policy and
procedure
▪ To use store or warehouse properly and efficiently,
and provide sufficient storage space
▪ To purchase material at right time and in right quantity

Mata M. (PhD) 13-13

 4.1. Introduction…

Objectives of Inventory Management…

▪ To ensure effective inventory recording and stock
management system
▪ To enhance efficiency and effectiveness of an
organization
▪ To keep inventory investment minimum
▪ To protect the inventories against deterioration,
obsolescence, and unauthorized use

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 4.1. Introduction…
Objectives of Inventory Management…
▪ To reduce the inventory costs and purchase material
at a minimum cost
▪ To control material stocks and ensure effective
availability of material
▪ To classify material on various parameters
▪ To ensure effective and efficient inventory controlling
system

Mata M. (PhD) 13-15

 4.2. Functions and Types of
Inventory
Reasons for Keeping/Functions of Inventory
 To stabilize production
 To meet anticipated customer demand
 To protect against stockouts/ prevent loss of orders
 To decouple the firm from fluctuations in demand
and provide a stock of goods that will provide a
selection for customers
 To keep pace with changing market conditions

Mata M. (PhD) 13-16

 4.2. Functions and Types of
Inventory…
Reasons for Keeping/Functions of Inventory…
 To decouple or separate various parts of the
production process
 To take advantage of quantity discounts (price
discounts)
 To hedge against uncertainty
 To supply of material whenever required
 To cope up seasonal availability of materials or
sudden increase in prices
Mata M. (PhD) 13-17
 4.2. Functions and Types of
Inventory…
Types of Inventory
A) Direct Inventories
 The inventory of those items, which become an integral
part of finished goods
• Raw materials
• Purchased parts and supplies
• Work-in-process (partially completed) products (WIP)
• Finished Product
B) Indirect Inventories
 The inventory of materials and supplies that do not form an integral
part of finished products is called indirect inventory.  MRO
Mata M. (PhD) 13-18
 4.2. Functions and Types of
Inventory…
Types of Inventory…
Maintenance, Repair, and Operating Supplies
(MROs)
▪ MROs are items used to support general operations
and maintenance but that do not become directly part
of a product.
▪ They include maintenance supplies, spare parts, and
consumables such as cleaning compounds, lubricants,
pencils, erasers, indirect materials, and all other
sundry items required for production/service systems.
Mata M. (PhD) 13-19
 4.2. Functions and Types of
Inventory…
Classification of Inventories
Manufacturing Businesses
1) Raw Material Inventory: Material on which operations
will be performed to convert it into the desired product.
Example: steel, wood, rubber, tubes, plates, and so on.
2) Semi-finished Material Inventory/Work-in-process
material inventory: Material which is processed partially
and waiting for the next process.
3) Finished Material Inventory: These are the final desired
products. They are ready for dispatch to the market.
Mata M. (PhD) 13-20
 4.2. Functions and Types of
Inventory…
Classification of Inventories…
Manufacturing Businesses…
3) Tools Inventory: Tools which are required for
operations in manufacturing. Example: drills, cutters,
turning tools, saws, solder, construction tools and so
on.
4) Machinery Spares Inventory: The spare parts of
machinery are required to be kept in inventory. At
the time of repair, breakdown, replacement of parts
these spares should be available immediately.
Mata M. (PhD) 13-21
 4.2. Functions and Types of
Inventory…
Classification of Inventories…
Manufacturing Businesses…
5) Standard Parts Inventory: The parts which are
bought out from market are called standard parts.
These are directly used in product manufacturing
for assembly or other work. Example: nut, bolt,
washers and so on.
6) Supplies Inventory: These are items which
support the activities but don’t go into the product

Mata M. (PhD) 13-22

 4.2. Functions and Types of
Inventory…
Classification of Inventories…
Merchandising Businesses
7) Merchandise Inventory: These are items which
are purchased, held, and stocked by a company for
sale.
Service Businesses/Gov`t and NFPEs
8) Materials and Supplies: Those items, including
MRO items held by an organization or a
governmental unit for use to support and facilitate
operations.
Mata M. (PhD) 13-23
 4.3. Independent vs Dependent
Demand
Two Forms of Demand for Inventory
1. Independent Demand
2. Dependent (Derived) Demand
▪ It is a difficult task in inventory management to determine
whether demand is independent or dependent.
1. INDEPENDENT DEMAND
▪ The demand for an item is independent of the demand for
any other item in inventory
▪ Demand for finished product or items used by external
customers
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 4.3. Independent vs Dependent
Demand…
INDEPENDENT DEMAND…
 Independent demand is influenced by market
conditions outside the control of operations; it is,
therefore, independent of operations.
 Independent demand item - The demand for the
product is considered independent since orders may not
be necessarily related to others in terms of customer and
quantity.
 Finished goods inventories and spare parts for
replacement usually have independent demand.
Mata M. (PhD) 13-25
 4.3. Independent vs Dependent
Demand…
INDEPENDENT DEMAND…
 For independent demand, a replenishment
philosophy is appropriate. As the stock is used, it
is replenished in order to have materials on hand
for customers.
 As inventory begins to run out, an order is
triggered for more material and the inventory is
replenished.

Mata M. (PhD) 13-26

 4.3. Independent vs Dependent
Demand…
2. DEPENDENT (DERIVED) DEMAND
◼ The demand for an item is derived from the demand
for another inventory item
▪ Tires stored at a Matador plant and waiting for
conversion are an example of a dependent demand
item
▪ Dependent demand is related to the demand for
another item and is not independently determined by
the market.
Mata M. (PhD) 13-27
 4.3. Independent vs Dependent
Demand…
DEPENDENT DEMAND…
 Dependent demand item demand is dependent upon
the demand for their respective higher-level items, and
a reconciliation of this requirement with the production
capacity available.
 The demand of dependent demand products is
related with the demand of next level of product –
there is direct relationship between demand of one
item and demand of its main assembly (e.g. wheel and
bicycle).
Mata M. (PhD) 13-28
 4.3. Independent vs Dependent
Demand…
DEPENDENT DEMAND…
 When products are built up from parts and assemblies,
the demand for these components is dependent on the
demand for the final product.
 For dependent-demand items, a different requirement
philosophy is used. The amount of stock ordered is
based on the requirements for higher-level items.
 As one begins to run out, additional raw material or
work-in-process inventory is not ordered.

Mata M. (PhD) 13-29

 4.3. Independent vs Dependent
Demand…
DEPENDENT DEMAND…
 The order for more material is placed only as
required by the need for other higher-level or
end items.
 MRP is the calculation of the requirements of
the dependent demand items, i.e. items whose
demand is dependent upon the demand for
their respective higher-level items.
Mata M. (PhD) 13-30
 4.3. Independent vs Dependent
Demand…
DEPENDENT DEMAND…
Example
Figure below, Tree Diagram, shows the product
structure of end product P. If 50 units of Pare to be
produced, what are the various lower level items?

Tree
Diagram

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 4.3. Independent vs Dependent
Demand…
DEPENDENT DEMAND…
SOLUTION: It is understood that:
 In order to produce one (unit) of end product P, we
require three of Q, one of R and two of S;
 Each Q requires two of R and two of T;
 Each S requires three of T and four of U.

In the product structure tree, the figures in parentheses

are the number (unit) of the higher-level item.

Mata M. (PhD) 13-32

 4.3. Independent vs Dependent
Demand…
DEPENDENT DEMAND…
 The number of R required to produce of P is:

 The number of T required to produce one of P is:

Mata M. (PhD) 13-33

 4.3. Independent vs Dependent
Demand…
DEPENDENT DEMAND…
▪ Table below indicates a summary of Q, R, S, T and U
required to produce 50 units of assembled product P.
Summary Showing Derivation of Components Requirements

Mata M. (PhD) 13-34

 4.4. Inventory Costs
▪ Inventory procurement, storage and management is
associated with huge costs associated with each of
these functions.
▪ The following costs are used for inventory
management decisions:
1) Purchase (Production) costs - Item costs
2) Carrying costs
3) Ordering costs
4) Stockout costs
5) Capacity-associated costs
Mata M. (PhD) 13-35
 4.4. Inventory Costs…

1) Purchase (Production) cost - Item Cost

▪ Item cost is the price paid for a purchased item, which
consists of the cost of the item and any other direct
costs associated in getting the item into the plant, such
as: transportation, custom duties, and insurance.
▪ The inclusive cost is often called the landed cost. For
an item manufactured in-house, the cost includes direct
material, direct labor, and factory overhead. These
costs can usually be obtained from either purchasing or
accounting.
Mata M. (PhD) 13-36
 4.4. Inventory Costs…
2) Carrying (Holding) costs
 These costs include all expenses incurred by the firm
because of the volume of inventory carried.
 As inventory increases, so do these costs.
 Broken down into:
a) Storage costs
▪ Include cost of space, building rental and facility
maintenance, equipment, depreciation, operational costs,
consumables, communication costs and utilities, human
resources employed in operations as well as management.
Mata M. (PhD) 13-37
 4.4. Inventory Costs…

Carrying costs… Broken into…

b) Cost of capital
• Includes the costs of investments, interest on working
capital, taxes on inventory paid, insurance costs and
other costs associate with legal liabilities.
• Money invested in inventory is not available for other
uses and as such represents a lost opportunity cost.
• Interest lost by not investing the money at the
prevailing interest rate
Mata M. (PhD) 13-38
 4.4. Inventory Costs…
Carrying costs… Broken into…
c) Risk costs
 The risks in carrying inventory are:
i. Obsolescence: Loss of product value resulting from a
model or style change or technological development.
ii. Damage: Inventory damaged while being held or moved.
iii. Pilferage: Goods lost, strayed, or stolen.
iv. Deterioration: Inventory that rots or dissipates in storage
or whose shelf life is limited.
▪ Carrying costs are included in the determination of the
economic order quantity for an inventory item.
Mata M. (PhD) 13-39
 4.4. Inventory Costs…
Carrying costs…
Example
A company carries an average annual inventory of
$2,000,000. If it estimates the cost of capital is 10%,
storage costs are 7%, and risk costs are 6%, what does it
cost per year to carry this inventory?
Answer
Total cost of carrying inventory = 10% + 7% + 6% = 23%
Annual cost of carrying inventory:
= 0.23 * $2,000,000 = $460,000
Mata M. (PhD) 13-40
 4.4. Inventory Costs…

3) Ordering Costs
▪ These costs are associated with placing an order
either with the factory or with a supplier.
▪ The cost of placing an order does not depend upon
the quantity ordered. Whether a lot of 10 or 100 is
ordered, the costs associated with placing the order
are essentially the same.
▪ However, the annual cost of ordering depends upon
the number of orders placed in a year.
Mata M. (PhD) 13-41
 4.4. Inventory Costs…
Ordering Costs…
Include:
a) Production control costs
▪ The annual cost and effort expended in production
control depends on the number of orders placed, not
on the quantity ordered.
▪ The fewer orders per year, the less cost.
▪ The costs incurred are those of issuing and closing
orders, scheduling, loading, dispatching, and
expediting.
Mata M. (PhD) 13-42
 4.4. Inventory Costs…
Ordering Costs…
Include…
b) Setup and teardown costs
▪ Every time an order is issued, work centers
have to set up to run the order and tear down
the setup at the end of the run.
▪ These costs do not depend upon the quantity
ordered but on the number of orders placed per
year.
Mata M. (PhD) 13-43
 4.4. Inventory Costs…
Ordering Costs…
Include…
c) Lost capacity cost
▪ Every time an order is placed at a work center,
the time taken to set up is lost as productive
output time. This represents a loss of capacity
and is directly related to the number of orders
placed. It is particularly important and costly
with bottleneck work centers.
Mata M. (PhD) 13-44
 4.4. Inventory Costs…
Ordering Costs…
Include…
d) Purchase order cost
▪ Every time a purchase order is placed, costs are incurred to
place the order.
▪ These costs include order preparation, follow-up, expediting,
receiving, inspection, authorizing payment, and the
accounting cost of receiving and paying the invoice.
e) Movement or transportation cost
▪ When an order is placed, material for the order has to be
moved from operation to operation, or seller to buyer .
Mata M. (PhD) 13-45
 4.4. Inventory Costs…
Ordering Costs…
 The annual cost of ordering depends upon the
number of orders placed in a year. This can be
reduced by ordering more at one time, resulting in the
placing of fewer orders. However, this drives up the
inventory level and the annual cost of carrying
inventory.
 Ordering costs are the expenses incurred to create
and process an order to a supplier.
 Ordering costs are included in the determination of the
economic order quantity for an inventory item.
Mata M. (PhD) 13-46
 4.4. Inventory Costs…
Ordering Costs…
Examples of Ordering Costs
▪ Cost to prepare a purchase requisition
▪ Cost to prepare a purchase order
▪ Cost of the labor required to inspect goods when they
are received
▪ Cost to put away goods once they have been received
▪ Cost to process the supplier invoice related to an order
▪ Cost to prepare and issue a payment to the supplier
Mata M. (PhD) 13-47
 4.4. Inventory Costs…
Ordering Costs…
Example
Given the following annual costs, calculate the average cost of
placing one order. Production control salaries = $60,000; Supplies
and operating expenses for production control department = $15,000;
Cost of setting up work centers for an order = $120; Orders placed
each year = 2000
Answer:

Mata M. (PhD) 13-48

 4.4. Inventory Costs…
4) Stockout (Shortage) Costs
▪ If demand during the lead time exceeds forecast, a stockout
can be expected.
▪ A stockout can potentially be expensive because of backorder
costs, lost sales, and possibly lost customers.
▪ Stockouts can be reduced by carrying extra inventory to
protect against those times when the demand during lead
time is greater than forecast.
▪ When there is a demand for the product and the item needed
is not in stock, then we incur a shortage cost or cost
associated with stock out.
Mata M. (PhD) 13-49
 4.4. Inventory Costs…

Stockout (Shortage) Costs…

Shortage costs include:
 Backorder costs
 Loss of future sales
 Loss of customer goodwill.
 Extra cost associated with urgent, small quantity
ordering costs.
 Loss of profit contribution by lost sales revenue.
Mata M. (PhD) 13-50
 4.4. Inventory Costs…
5) Capacity-Associated Costs
▪ When output levels must be changed, there
may be costs for overtime, hiring, training, extra
shifts, and layoffs.
▪ These costs can be avoided by leveling
production, that is, by producing items in slack
periods for sale in peak periods.
▪ However, this builds inventory in the slack
periods.
Mata M. (PhD) 13-51
 4.4. Inventory Costs…

Capacity-Associated Costs…
Example
A company makes and sells a seasonal product. Based
on a sales forecast of 2000, 3000, 6000, and 5000 per
quarter, calculate a level production plan, quarterly
ending inventory, and average quarterly inventory. If
inventory carrying costs are $3 per unit per quarter,
what is the annual cost of carrying inventory? Opening
and ending inventories are zero.

Mata M. (PhD) 13-52

 4.4. Inventory Costs…

Capacity-Associated Costs…
Answer
Quarter Quarter Quarter Quarter Total
1 2 3 4
Forecast Demand 2000 3000 6000 5000 16,000
Production 4000 4000 4000 4000 16,000
Ending Inventory 0 2000 3000 1000 0
Average Inventory 1000 2500 2000 500

Inventory Cost (dollars) 3000 7500 6000 1500 18,000

Mata M. (PhD) 13-53

 4.4. Inventory Costs…
Methods of Costing Inventory
▪ There are four methods accounting uses to cost inventory:
first in first out, last in first out, average cost, and standard
cost. Each has implications for the value placed on
inventory.
▪ If there is little change in the price of an item, any of the four
ways will produce about the same results. However, in rising
or falling prices, there can be a pronounced difference.
▪ There is no relationship with the actual physical movement
of actual items in any of the methods. Whatever method is
used is only to account for usage and the accounting value.
Mata M. (PhD) 13-54
 4.4. Inventory Costs…
 Inventory Costing Methods
1. First in first out (FIFO): This method assumes that the
oldest (first) item in stock is used first. In rising prices,
replacement is at a higher price than the assumed cost. This
method does not reflect current prices, and replacement will
be understated. The reverse is true in a falling price market.
2. Last in first out (LIFO): This method assumes the newest
(last) item in stock is the first used. In rising prices,
replacement is at the current price. In a falling price market
existing inventory is overvalued. However, the company is
left with an inventory that may be grossly understated in
value.
Mata M. (PhD) 13-55
 4.4. Inventory Costs…
 Inventory Costing Methods…
3. Average cost: This method assumes an average of
all prices paid for the article. The problem with: this
method in changing prices (rising or falling) is that
the cost used is not related to the actual cost.
4. Standard cost: This method uses a cost
determined before production begins. The cost
includes direct material, direct labor, and overhead.
Any difference between the standard cost and
actual cost is stated as a variance.
Mata M. (PhD) 13-56
 4.5. ABC Classification of
Inventory
 ABC analysis is sometimes called always better
control that classifies items based on the annual
usage value, and identify a small percentage of items
which account for most of the total inventory value.
 The ABC inventory classification system answers
what is the importance of the inventory item? how are
they to be controlled? by determining the importance
of items and thus allowing different levels of control
based on the relative importance of inventory items
Mata M. (PhD) 13-57
 4.5. ABC Classification of
Inventory…
Steps in Making an ABC Analysis
1. Establish the item characteristics that influence the
results of inventory management.
 This is usually annual dollar usage but may be other
criteria, such as scarcity of material, very long replenishment
lead times, short effective shelf life, or quality issues.
2. Classify items into groups based on the established
criteria.
3. Apply a degree of control in proportion to the
importance of the group.

Mata M. (PhD) 13-58

 4.5. ABC Classification of
Inventory…
 The ABC principle is based on the observation that a
small number of items often dominate the results
achieved in any situation.
 This observation was first made by an Italian
economist, Vilfredo Pareto, and is called Pareto’s law.
 As the rule applied to inventories, it is usually found
that the relationship between the percentage of items
and the percentage of annual dollar usage follows a
pattern in which three groups can be defined as
indicated below.
Mata M. (PhD) 13-59
 4.5. ABC Classification of
Inventory…
THREE GROUPS OF INVENTORY ITEMS
BASED ON PARETO RULE
Group A About 20% of the items account for
about 80% of the dollar usage.
Group B About 30% of the items account for about
15% of the dollar usage.
Group C About 50% of the items account for about
5% of the dollar usage.

Mata M. (PhD) 13-60

 4.5. ABC Classification of
Inventory…
ABC Analysis
▪ Applies the Concept of Pareto Rule -
“80% - 20%: the Vital few Trivial
many”
▪ 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
Mata M. (PhD) 13-61
 4.5. ABC Classification of
Inventory…

Class A
• 5 – 15 % of units
• 70 – 80 % of value

Class B
• 30 % of units
• 15 % of value

Class C
• 50 – 60 % of units
• 5 – 10 % of value

Mata M. (PhD) 13-62

 4.5. ABC Classification of
Inventory…
Procedure for ABC Analysis
1. Determine the annual usage for each item.
2. Multiply the annual usage of each item by its cost to
get its total annual dollar usage.
3. List the items according to their annual dollar usage.
4. Calculate the cumulative annual dollar usage and the
cumulative percentage of items.
5. Examine the annual usage distribution and group the
items into A, B, and C groups based on percentage of
annual usage.
Mata M. (PhD) 13-63
 4.5. ABC Classification of
Inventory…
Example 1
Classify Inventory Using 70-20-10% Rule
Item Average Inventory Unit Value (Price)
No Per Week
1 3 $ 2.5
2 2.5 1
3 20 5
4 175 2
5 1 10
6 15 2
Mata M. (PhD) 13-64
 4.5. ABC Classification of
Inventory…
Item Average Unit Average
No. Inventory x Value = usage Value
Per Week (Price) Per Week
1 3 $ 2.5 $7.5
2 2.5 1 2.5
3 20 5 100
4 175 2 350
5 1 10 10
6 15 2 30

Mata M. (PhD) 13-65

 4.5. ABC Classification of
Inventory…
Ranking and ABC Classification of Purchase Items
Item Weekly Total Cumulative Percentage Cumulative ABC
No. Usage Value Usage of Total percentage Classif
Value Ranking Value Usage Value of total ication
usage value
4 $350 1 $ 350 70% 70% A
3 100 2 450 20% 90% B
6 30 3 480 6% 96% C
5 10 4 490 2% 98% C
1 7.5 5 497.5 1.5% 99.5% C
2 2.5 6 500 0.5% 100% C

Mata M. (PhD) 13-66

 4.5. ABC Classification of
Inventory…
Example - Summary of the classification
Class Items Weekly Percent Percent
dollar of dollar of items
volume volume stocked
A #4 $350 70% 16.67%
B #3 $100 20% 16.67%
C #6, #5, $50 10% 66.66%
#1, & #2

Mata M. (PhD) 13-67

 4.5. ABC Classification of
Inventory…
Policies
Factors A B C
1) Control Tight Moderate loose
2) Frequency of Frequent Average infrequent
Checking
3) Inventory Continuous Moderate Periodic/once
Taking in a year
4) Level of Low Average High
Inventory
5) Recording Detailed Overall
Mata M. (PhD) 13-68
 4.5. ABC Classification of
Inventory…
Advantages of ABC Analysis
▪ It ensures a closer and a more strict control over such
items, which are having a sizable investment in there.
▪ It releases working capital, which would otherwise have
been locked up for a more profitable channel of
investment.
▪ It reduces inventory-carrying cost.
▪ It enables the relaxation of control for the ‘C’ items and
thus makes it possible for a sufficient buffer stock to be
created.
▪ It enables the maintenance of high inventory turn over
rate.
Mata M. (PhD) 13-69
 4.5. ABC Classification of
Inventory…
ABC Analysis…Caution
The ABC system of classification should, however, be
used with caution. For example, an item of inventory may
be very inexpensive. Under the ABC system it should be
classified as C category. But it may be very critical to the
production process and may not be easily available. It
deserves the special attention of management. But in
terms of the ABC framework, it would be included in the
category, which requires the least attention. This is a
limitation of the ABC analysis.
Mata M. (PhD) 13-70
 4.5. ABC Classification of
Inventory…
Exercise: Classify the following items into A-B-C class
using 70-20-10% rule

Mata M. (PhD) 13-71

 4.6. Inventory Models
 Inventory models deal with idle resources like
men, machines, money and materials.
 Inventory models used to answer three basic
inventory management questions
1. What to order?
2. How much to order (purchase or
produce)?
3. How and when to order so as to minimize
the total cost?
Mata M. (PhD) 13-72
 4.6. Inventory Models…
❖ Inventory models utilize mathematical optimization to
derive formula for economic order quantity, economic
production quantity or economic batch size under
various situations.
❖ Inventory Models for Independent Demand
1. Economic Order Quantity (EOQ) Model
2. Economic Production Quantity (EPQ) Model
3. Quantity Discount Model
❖ Inventory Model for dependent Demand
1. Materials Requirement Planning (MRP)
Mata M. (PhD) 13-73
 4.6.1 Inventory Models for
Independent Demand
4.6.1.1. Basic Economic Order
Quantity (EOQ) Model
ECONOMIC ORDER OF
QUANTITY(EOQ)
Basic EOQ Model
◼ Determines the order quantity at which
annual ordering cost equals annual
inventory carrying cost PURCHASING CARRYING
COST
COST

◼ Determines an optimal order

quantity which minimizes the sum of
annual inventory ordering and
holding costs
Mata M. (PhD) 13-74
 4.6.1 Inventory Models for
Independent Demand…
Important assumptions for Basic EOQ Model
1. Demand is known, constant, and independent.
2. Lead time is known and constant.
3. Receipt of inventory is instantaneous and complete.
4. Quantity discounts are not possible.
5. Only variable costs are ordering and holding and
known.
6. Stock-outs can be completely avoided.
7. Replacement occurs all at once.
Mata M. (PhD) 13-75
 4.6.1 Inventory Models for
Independent Demand…

Assume
D = Annual demand
Co = ordering cost per order
Cc = Carrying (holding) cost per unit per year
Q = order quantity
P = unit price

Mata M. (PhD) 13-76

 4.6.1 Inventory Models for
Independent Demand…
Inventory cost
i) Annual purchasing cost = (Annual Demand) (unit price)
= (D) (P)
ii) Annual ordering (setup) cost = Number of orders placed per year
x
Setup or order cost per order
Annual demand Setup or order
= D
Number of units in each order cost per order = (Co)
Q
iii) Annual holding cost
= (Average inventory level) (Holding cost per unit per year)
Order quantity Q
= (Holding cost per unit per year) = (Cc)
2 2
Mata M. (PhD) 13-77
 4.6.1 Inventory Models for
Independent Demand…

Mata M. (PhD) 13-78

 4.6.1 Inventory Models for
Independent Demand…
Proving equality of costs at optimal point

CoD CcQ
=
Q 2
2CoD
Q2 =
Cc

EOQ = Qopt =
2CoD
Cc

Mata M. (PhD) 13-79

 4.6.1 Inventory Models for
Independent Demand…
Basic EOQ Model: Example
A retail store stocks different brands of paints in its
warehouse and sells them to individual buyers. The
store’s biggest seller is iron coat paint produced by
Nifas Silk Paints Factory. The store wants to
determine the optimal order quantity for the iron coat
paint given that annual demand of 10,000 tin cans,
annual carrying cost of birr 0.75 per tin can, and
ordering cost of birr 150 per order.
Mata M. (PhD) 13-80
 4.6.1 Inventory Models for
Independent Demand…
Required:
a) Compute the EOQ for the iron coat paint
b) Compute the sum of the minimum annual
carrying and ordering costs
c) Compute the optimum number of orders
per year
d) Compute the time between orders
(optimum order cycle time) given the store
operates for 311 days per year
Mata M. (PhD) 13-81
 4.6.1 Inventory Models for
Independent Demand…
Solution

Mata M. (PhD) 13-82

 4.6.1 Inventory Models for
Independent Demand…
Safety Stock (Buffer Stock/Reserve Stock)
 Held to cover random unpredictable fluctuations in
supply and demand or lead time. If demand or lead
time is greater than forecast, a stockout will occur.
 Describes a level of extra stock that is maintained to
mitigate risk of stockouts or (shortfall in materials)
due to uncertainties in supply and demand.
 Safety stock increases the value of total carrying
cost and it is considered in computing reorder point.
Mata M. (PhD) 13-83
 4.6.1 Inventory Models for
Independent Demand…
Reorder Point
▪ The reorder point is the level of inventory at
which the organization places an order in the
amount of economic order quantity. Re-order
point = (Usage rate) (Lead time + Days of safety)
= (Lead Time x Consumption rate) + Safety
stock.
▪ However, reorder point is the sum of the average
usage during lead-time plus the safety stock.
Mata M. (PhD) 13-84
 4.6.1 Inventory Models for
Independent Demand…
Reorder Point …
▪ In designing reorder point subsystem, three items of
information are needed as inputs to the subsystem.
1. Usage rate -- This is the rate per day at which the
item is consumed in production or sold to customers.
2. Lead time -- This is the amount of time between
placing an order and receiving goods.
3. Safety stock -- The minimum level of inventory may
be expressed in terms of several days’ sales or
usage.
Mata M. (PhD) 13-85
 4.6.1 Inventory Models for
Independent Demand…
Example
An entity is in need of 1000 units of a material for a year. The
ordering cost per order is Birr 8 and the carrying cost per unit is
Birr 1.60. In addition, assume that 10 units are kept as safety
stock, and there are 250 working days and the lead time is 10
days.
Required: Compute total carrying cost and reorder point.
Solution:

Mata M. (PhD) 13-86

 4.6.1 Inventory Models for
Independent Demand…
Safety Stock (Buffer Stock/Reserve Stock)…
 Carried to protect against uncertainty (occurs due to
quantity uncertainty and timing uncertainty) in
supply and demand, and its purpose is to prevent
disruptions in operations or deliveries to customers.
 Quantity uncertainty occurs when the amount of
supply or demand varies; for example, if the demand
is greater or less than expected in a given period
 Timing uncertainty occurs when the time of receipt
of supply or demand differs from that expected.
Mata M. (PhD) 13-87
 4.6.1 Inventory Models for
Independent Demand…
Safety Stock (Buffer Stock/Reserve Stock)…
▪ Ways to protect against uncertainty: (1) carry
extra stock – safety stock, or (2) order early -
safety lead time used to protect against
uncertainty in delivery lead time by planning order
releases and order receipts earlier than required.
▪ Both (safety stock and safety lead time) result
in extra inventory, but the methods of calculation
are different
Mata M. (PhD) 13-88
 4.6.1 Inventory Models for
Independent Demand…
Safety Stock (Buffer Stock/Reserve Stock)…
 The safety stock requirement depends on:
1) Variability of demand during the lead time. The higher the
variability, the greater the need for safety stock.
2) Frequency of reorder. If orders are placed frequently,
changes to the demand or variability of the demand will be
detected earlier.
3) Service level desired. Higher service levels require more
inventory, to accommodate periods of increased demand.
4) Length of the lead time. The longer the lead time, the more
safety stock has to be carried to provide a specified service
level. This is one reason it is important to reduce lead times as
much as possible.
Mata M. (PhD) 13-89
 4.6.1 Inventory Models for
Independent Demand…
Basic EOQ Example 2
A local distributor of Bridgestone tire expects to sell
approximately 9,600 steel belted radial tires of a certain size and
tread design next year. For each tire, the distributor pays $160 to
the manufacturer. Annual carrying cost per tire is estimated to
be10% of the unit price of tire, and ordering cost is $75 per order.
The distributor also operates 288 days a year.
Required:
a) What is the EOQ?
b) How many times per year does the store reorder?
c) What is the total annual cost if the EOQ quantity is
ordered?
Mata M. (PhD) 13-90
 4.6.1 Inventory Models for
Independent Demand…
4.6.1.2. Economic Production Quantity (EPQ)
Model
 Also known as non-instantaneous receipt model, and is an
inventory model in which an order is received gradually, as
inventory is simultaneously being depleted
 In this model, the assumption in the basic EOQ model that
order quantity (Q) is received all at once is relaxed.
 This model is just an extension of EOQ model allowing
shortage.
▪ Economic Production Quantity (EPQ)
represents how much to produce each
time, and given in equation as:
Mata M. (PhD) 13-91
 4.6.1 Inventory Models for
Independent Demand…

Mata M. (PhD) 13-92

 4.6.1 Inventory Models for
Independent Demand…
Assume
Q = Total quantity produced or ordered during
production or order time
p = daily rate at which an order is received or
daily production rate
d = daily rate at which inventory is demanded or
daily consumption rate
t = production time or order time
Mata M. (PhD) 13-93
 4.6.1 Inventory Models for
Independent Demand…

 Total Quantity produced during production time

(Q) = (p) (t) = pt
▪ Solving for t ; thus t = Q/p

Total quantity consumed during production time

= (d) (t) = dt
Maximum Total produced during Total used during
= –
the production run the production
inventory
= pt – dt run
level

Mata M. (PhD) 13-94

 4.6.1 Inventory Models for
Independent Demand…

Maximum Q Q d
=p –d =Q 1–
inventory p p p
level

Average Annual = (Maximum inventory level)/2

inventory level
= Q (1-d/p)
2

Mata M. (PhD) 13-95

 4.6.1 Inventory Models for
Independent Demand…
D = Annual demand
Co = Setup (ordering) cost per order
Cc = Carrying cost per unit per year

i) Ordering (Setup cost) = (D/Q)(Co) CoD CcQ d

TC = + 2 1- p
Q
ii) Holding cost = Q [1 - (d/p)] Cc
2
iii) At EPQ = (D/Q)Co = 1 Q[1 - (d/p)] Cc
2
2DCo
Q2 = 2DCo
Cc [1 - (d/p)] Q = EPQ =
Cc [1 - (d/p)]
Mata M. (PhD) 13-96
 4.6.1 Inventory Models for
Independent Demand…
EPQ Model Example
Assume Nifas Silk Paints Factory started to sell iron coat
paint produced using its own store. Nifas Silk Paints
Factory produces iron coat paint at a daily rate of 150 tin
cans. The store owned by the factory operates for 311
days a year. The factory wants to determine the optimal
production quantity for the iron coat paint given that
annual demand of 10,000 tin cans, annual carrying cost
of birr 0.75 per tin can, and set up cost of birr 150 per
order.
Mata M. (PhD) 13-97
 4.6.1 Inventory Models for
Independent Demand…
Required:
a) Compute the EPQ (economic run size) for the iron coat
paint
b) Compute the sum of the minimum annual carrying and
setup costs
c) Compute the production run time
d) Compute the optimum number of production runs per
year
e) Compute maximum inventory
f) Compute cycle time
g) Compute idle time

Mata M. (PhD) 13-98

 4.6.1 Inventory Models for
Independent Demand…
Cc = birr0.75 per tin can Co = birr150
d = 10,000/311 = 32.2 tin cans per day
p = 150 tin cans per day D = 10,000 tin cans
2CoD 2(150)(10,000)
a) Qopt = = = 2,256.8 tin cans
Cc 1 - d 0.75 1 -
32.2
p 150

CoD CcQ d
b) TC = Q + 2 1 - p = birr 1,329

2,256.8
c) Production run time = Q = = 15.05 days per order
p 150
Mata M. (PhD) 13-99
 4.6.1 Inventory Models for
Independent Demand…

Mata M. (PhD) 13-100

 4.6.1 Inventory Models for
Independent Demand…
f)
Cycle time = Q/d = 2256.8/32.2 = 70.09
days
g)

Idle time = CT- PT = 70.09 - 15.05 = 55.04

days

Mata M. (PhD) 13-101

 4.6.1 Inventory Models for
Independent Demand…
4.6.1.3. Quantity Discount Model
▪ The assumption that no quantity discount in the
basic EOQ model is relaxed here
▪ Reduced prices are often available when larger
quantities are purchased
▪ Price per unit decreases as order quantity
increases
▪ Trade-off is between reduced product (annual
purchase) cost and increased holding cost
Mata M. (PhD) 13-102
 4.6.1 Inventory Models for
Independent Demand…
Total Inventory Cost =
Ordering cost + Holding cost + Annual
Purchasing cost

CoD CcQ
TC = + + PD
Q 2
Where,
P = per unit price of the item
D = annual demand
Cc = annual carrying cost per unit
Co = ordering cost per order
Mata M. (PhD) 13-103
4.6.1 Inventory Models for
Independent Demand…
 4.6.1 Inventory Models for
Independent Demand…
Example: Quantity Discount Model
▪ When annual carrying cost is expressed as a
percentage of unit price
 A manufacturing firm has been offered a particular
component part it uses according to the following
discount pricing schedule from one of its suppliers
Discount Discount Quantity
Number (units) Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4%
3 2,000 and over 5%
Mata M. (PhD) 13-105
 4.6.1 Inventory Models for
Independent Demand…
Additional Information:
◼ Annual inventory holding cost per unit (Cc) =
20% of unit price
◼ Ordering cost per order (Co) = $49
◼ Annual demand for the component = 5,000
units
Required: Which discount rate need to be taken to
minimize annual inventory cost?

Mata M. (PhD) 13-106

 4.6.1 Inventory Models for
Independent Demand…
Step 1: For each discount, calculate EOQ*

2CoD = 2(5000)(49)
d#1 EOQ =
0.2(5)
= 700 units
Cc
2(5000)(49)
d#2 EOQ = 2CoD = = 714 units
Cc 0.2(4.8)

2CoD = 2(5000)(49)
d#3 EOQ = = 718 units
Cc 0.2(4.75)

Mata M. (PhD) 13-107

 4.6.1 Inventory Models for
Independent Demand…
Step 2: If EOQ* for a discount doesn’t qualify,
choose the smallest possible order size to
get the discount
◼ EOQ2* adjusted to 1000
◼ EOQ3* adjusted to 2000

Step 3: Compute the total cost for each EOQ*

or adjusted value from Step 2

Mata M. (PhD) 13-108

 4.6.1 Inventory Models for
Independent Demand…
CoD CcQ
PD + + = TC
Q 2
Unit Order Annual Annual Annual
Discount Price Quantity Purchase Ordering Holding
Number (P) (Q) Cost Cost Cost Total

1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23,750 $122.50 $950 $24,822.50

Mata M. (PhD) 13-109

 4.6.1 Inventory Models for
Independent Demand…

Step 4: Select the EOQ* or adjusted quantity

that gives the lowest total cost

Decision: Take discount number 2, order at

least 1000 units, and the total cost will be
$24,725

Mata M. (PhD) 13-110

 4.6.1 Inventory Models for
Independent Demand…
Steps When annual inventory cost per unit is constant:
▪ Compute the EOQ
▪ Finding which price range it falls in.
▪ If that quantity is valid for the lowest price range, it is the
optimal.
▪ If it falls in a range associated with a higher unit price,
compute the total cost using that price and the total cost
for the minimum quantity needed to qualify for a lower
unit price.
▪ The quantity (valid or price break) that produces the
lowest total cost is the optimum.
Mata M. (PhD) 13-111
 4.6.1 Inventory Models for
Independent Demand…
 A local retail store buys and sells TVs. The annual
carrying cost of the store for a TV is $190, the ordering
cost is $2,500, and annual demand for this particular
model is 200 TVs.
The assembler of the TV has offered the store the following
discount schedule:
QUANTITY PRICE
1 - 49 $1,400
50 - 89 1,100
90+ 900
Required:
a) Which discount schedule should the store take?
Mata M. (PhD) 13-112
 4.6.1 Inventory Models for
Independent Demand…
QUANTITY PRICE Co = $2,500
1 - 49 $1,400 Cc = $190 per TV
50 - 89 1,100 D = 200 TVs per year
90+ 900
2CoD 2(2500)(200)
EOQ = = = 72.5 TVs
Cc 190

For Q = 72.5 CcQ

CoD
TC = Q + + PD
2
2,500(200) 190(72.5)
TC = + + 1,100(200) = $233,784
72.5 2
Mata M. (PhD) 13-113
 4.6.1 Inventory Models for
Independent Demand…

For Q = 90
CoD CcQ
TC = + 2 + PD =
Q

TC = 2,500(200) + 190(90) + 900(200) = $194,105

90 2

Decision: Take the maximum discount price,

order at least 90 TVs, and the total cost will be
$194,105

Mata M. (PhD) 13-114

 4.6.2. Inventory Model for
Dependent Demand Items

 Independent Demand vs Dependent

Demand
1. Independent - EOQ, EPQ, Discount
Model
2. Dependent - MRP

Mata M. (PhD) 13-115

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP
 Computerized inventory control and production planning
system
 Determines the type, quantity, and timing of order for
dependent demand item
• The demand for one item is related to the demand for
another item
 When to use MRP?
• Dependent demand items
• Complex products
• Job shop production
• Assemble-to-order environments
Mata M. (PhD) 13-116
 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…

 MRP system
◼ Begins with the schedule for finished
product that is converted into a schedule
for
• Raw materials
• Components
• Subassembly parts

Mata M. (PhD) 13-117

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…

MRP Inputs and Outputs

Inputs Outputs
1. Master production 1. What to order
schedule (MPS)
2. Product structure file 2. How much to
(Bill of Materials) order
3. Inventory record file 3. When to order

Mata M. (PhD) 13-118

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…

i) Master Production Schedule

◼ Must be in accordance with the aggregate
production plan
◼ Specifies what is to be made, at what quantity, and
when
⚫ Quantities represent production not demand
⚫ Quantities may consist of a combination of customer orders
and demand forecasts
⚫ Quantities represent what needs to be produced, not what
can be produced
⚫ Quantities represent end items that may or may not be
finished products
Mata M. (PhD) 13-119
 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MPS Example

Mata M. (PhD) 13-120

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…

ii) Product Structure File (Bill of

Materials)
◼ List of components, ingredients and
materials, and their quantities needed
to make a unit of product (end item)

Mata M. (PhD) 13-121

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
Product Structure File Example

Top clip (1) Bottom clip (1)

Pivot (1) Spring (1)

Rivets (2)
Finished clipboard Pressboard (1)

Mata M. (PhD) 13-122

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
BOM Presented in Product Structure Tree

Clipboard

Pressboard Clip Ass’y Rivets

(1) (1) (2)

Top Clip Bottom Clip Pivot Spring

(1) (1) (1) (1)

Mata M. (PhD) 13-123

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…

 BOM Provides product structure

• Items above given level are called parents
• Items below given level are called children
 Low-Level Coding
• Item is coded at the lowest level at which it
occurs
• BOMs are processed one level at a time

Mata M. (PhD) 13-124

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
Low-Level Coding

Clipboard Level 0

Pressboar Clip Ass’y Rivets

d (1) (1) (2) Level 1

Top Clip Bottom Clip Pivo Spring

(1) (1) t (1) Level 2
(1)

Mata M. (PhD) 13-125

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…

iii) Inventory Record File

 The inventory record file contains an
extensive amount of information on
every item that is produced, ordered, or
inventoried in the system.

Mata M. (PhD) 13-126

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
Inventory Record File

Mata M. (PhD) 13-127

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing
 Exploding the bill of material
 Netting out inventory
◼ process of subtracting on-hand quantities and scheduled
receipts from gross requirements to produce net requirements
 Lot sizing
◼ determining the quantities in which items are usually made or
purchased
◼ L4L
◼ Lot size
⚫ Minimum order
⚫ Maximum order
⚫ EOQ
 Time-phasing requirements – based on lead times
Mata M. (PhD) 13-128
 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
Basic Terms in MRP processing

Mata M. (PhD) 13-129

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing: Example
School Mates produces and sells Clipboards to encourage
writing outside of the classroom. Rising costs and inventory
levels prompted the company to a computerized planning and
control system called MRP. However, before installing the
system, it wants to know how it works and seeks your advice.
The company has recently accepted two orders for120 and
100 Clipboards which are due at weeks 4 and 6 respectively.
Each unit of Clipboard is assumed to use 4 units of component
P1 and 2 units of component P2. Moreover, while each P1
requires 4 units of RM2 and each P2 uses 1.5 units of RM5.

Mata M. (PhD) 13-130

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing: Example…
 School Mates has also compiled the following inventory record file

Mata M. (PhD) 13-131

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
Based on the given information:
a) Develop MPS
b) Draw Product Structure Tree
c) Process MRP

Mata M. (PhD) 13-132

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…

MRP Processing…
a) Master of Production Schedule for Clipboard
Week 1 2 3 4 5 6 7
Quantity 120 100

Mata M. (PhD) 13-133

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
b) Product Structure Tree

Mata M. (PhD) 13-134

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…

Gross requirement for end item is derived from the MPS

Mata M. (PhD) 13-135
 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…

Gross requirement for a component is derived from the order release of

its parent
Mata M. (PhD) 13-136
 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
Item:P2 LLC: 1 Period
Lot size:Mu50 LT:1 1 2 3 4 5 6 7
Gross Requirement 90 200
Scheduled Receipt 40
Projected On hand 40 80 40 40
(40)
Net requirement 10 160
Planned order receipt 50 200
Planned order release 50 200

Mata M. (PhD) 13-137

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
Item: RM2 LLC: 2 Period
Lot size:L4L LT:1 1 2 3 4 5 6 7
Gross Requirement 400 1320
Scheduled Receipt 320
Projected On hand 100 320
(100)
Net requirement 300 1000
Planned order receipt 300 1000
Planned order release 300 1000

Mata M. (PhD) 13-138

 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
Item: RM5 LLC: 2 Period
Lot size:Mi 200 LT:3 1 2 3 4 5 6 7
Gross Requirement 75 300
Scheduled Receipt 40
Projected On hand 200 165 165 65
(200)
Net requirement - 135
Planned order receipt - 200
Planned order release 200

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 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
MRP Exercise
The production unit of ABC
Item Requires
enterprise has received 1A 2B&5C
orders of 1,000, 200, and
400 units to be fulfilled in B -
APRIL, MAY, and JUNE for
end item A respectively. The 1C 1B&3D
product structure file is
presented as follows D -
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 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
▪ The company also compiled the following inventory file.
The lead times of item A, C, and D are 1 month each
while the lead time for B is 2 months. In addition, the
inventory on hand at the beginning of January is 200
for item C and 500 for item B. There is scheduled
receipt of 100 units for item D in February. Finally,
while Item A is produced on lot-for-lot basis, the lot
sizes of B, C, and D are 300, 150, and 500
respectively.
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 4.6.2. Materials Requirements Planning
(MRP) for Dependent Demand…
MRP Processing…
Required:
a) In which month the order for item C should be released?
b) The net requirement of item C in March is _______
c) Based on lot-for-lot system, how much should order of item
D be released in February?
d) Based on lot size system, how much should order of item
B be released in January?
e) Based on lot size system, how much should item C be
received in March?
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 4.7. Inventory Control Systems

 Inventory control is concerned with the acquisition,

storage, handling and use of inventories so as to
ensure the availability of inventory whenever needed,
providing adequate provision for contingencies, deriving
maximum economy and minimizing wastage and
losses.
 Hence, inventory control refers to a system, which
ensures the supply of required quantity and quality of
inventory at the required time and at the same time
prevent unnecessary investment in inventories.
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 4.7. Inventory Control Systems…

 Inventory control is a planned approach of determining

what to order, when to order and how much to order and how
much to stock so that costs associated with buying and
storing are optimal without interrupting production, sales, or
consumption.
 The aim of a sound inventory control system is to secure
the best balance between “too much and too little.”
 Control of inventory is exercised by introducing various
measures of inventory control, such as ABC analysis fixation
of norms of inventory holdings and reorder point and a close
watch on the movements of inventories.
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 4.7. Inventory Control Systems…

 Inventory control basically deals with two

problems: (i) When should an order be placed?
(Order level), and (ii) How much should be
ordered? (Order quantity).
 Scientific inventory control aims at
maintaining optimum level of stock of goods
required by the company at minimum cost to a
company or an entity.
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 4.7. Inventory Control Systems…

Objectives of Inventory Control

 To ensure adequate supply of products to customer and avoid shortages
as far as possible.
 To make sure that the financial investment in inventories is minimum (i.e.,
to see that the working capital is blocked to the minimum possible extent).
 Efficient purchasing, storing, consumption, and accounting for materials is
an important objective.
 To maintain timely record of inventories of all the items and to maintain the
stock within the desired limits.
 To ensure timely action for replenishment.
 To provide a reserve stock for variations in lead times of delivery of
materials.
 To provide a scientific base for both short-term and long-term planning of
materials.
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 4.7. Inventory Control Systems…

Benefits of Inventory Control

❖ It is an established fact that through the practice of scientific
inventory control, following are the benefits of inventory
control:
1. Improvement in customer’s relationship because of the timely
delivery of goods and service.
2. Smooth and uninterrupted production and, hence, no stock out.
3. Efficient utilization of working capital. Helps in minimizing loss
due to deterioration, obsolescence damage and pilferage.
4. Economy in purchasing.
5. Eliminates the possibility of duplicate ordering.
Mata M. (PhD) 13-147
 4.7. Inventory Control Systems…

Techniques of Inventory Control

 In any organization, depending on the type of
business, inventory is maintained.
 When the number of items in inventory is large
and then large amount of money is needed to
create such inventory, it becomes the concern of
the management to have a proper control over its
ordering, procurement, maintenance and
consumption.
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 4.7. Inventory Control Systems…

Techniques of Inventory Control…

 Selective treatment of inventories is based on the
following basic philosophy of business: “neither one can
control everything nor one should try to do so (even if
one can)”.
 Uniform control is rarely effective. Effectiveness results
when important aspects of a problem are pursued more
rigorously than others. Selective control means variations
in method of control from item to item based on selective
basis. The criterion used for the purpose may be cost of
item, criticality, availability, consumption, and so on.
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 4.7. Inventory Control Systems…

Techniques of Inventory Control…

Different Techniques of Inventory Control
1. ABC analysis – Total inventory is categorized into three sub-
heads (A, B and C  Always – Better - Control) and proper
exercise is exercised for each sub-head. The classification of
existing inventory is based on annual consumption and the
annual value of the items. Hence, to obtain annual usage
cost, the quantity of inventory item consumed during the year
is multiplied by unit cost.
2. HML analysis - In this analysis, the classification of existing
inventory is based on unit price of the items. They are
classified as high price, medium price and low price items.
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 4.7. Inventory Control Systems…

Techniques of Inventory Control…

Different Techniques of Inventory Control…
3. VED analysis - In this analysis, the classification of
existing inventory is based on criticality of the items.
They are classified as vital, essential and desirable
items. This is mainly used in maintenance spare parts
inventory.
4. FSN analysis - In this analysis, the classification of
existing inventory is based on the rate of consumption
of the items. They are classified as fast moving, slow
moving and non-moving items. It should be noted that
high value non-moving items are a liability.
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 4.7. Inventory Control Systems…

Techniques of Inventory Control…

Different Techniques of Inventory Control…
5. SDE analysis - In this analysis, the classification of existing
inventory is based on procurement difficulty or availability of the
items. This analysis classifies items into three groups called
scarce, difficult and easy and focuses on ease of procurement as
the criterion. The information so collected is then used for finalizing
purchasing strategies.
6. SOS analysis - In this analysis, the classification of existing
inventory is based nature of supply of items. They are classified as
seasonal and off-seasonal items. As far as possible, procurement
must be made during harvesting when the price is low.
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 4.7. Inventory Control Systems…

Techniques of Inventory Control…

Different Techniques of Inventory Control…
7. GOLF analysis - In this analysis, the classification of existing
inventory is based sources of the items. This analysis is
based on the nature of the suppliers which determine quality,
delivery, lead time, payment terms, continuity of supply and
administrative work involved. They are classified as
government supply, ordinarily available, local availability
and foreign source of supply items.
 For effective inventory control, combination of the techniques
of ABC with VED or ABC with HML or VED with HML
analysis is practically used.
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 4.8. Just-In-Time (JIT)

 Just-In-Time (JIT) or zero-inventory system is the

concept of inventory management wherein we are able
to supply whatever material is required, wherever
required, and whenever required just in time with 100 %
supply assurances without keeping any inventory on
hand.
 The JIT or Zero Inventory system does not mean
literally nil inventory, small amount of inventories are
maintained, which is required to sustain production
activity between two operation or service in an
organization.
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 4.8. Just-In-Time (JIT) …

 JIT means elimination of all waste and continuous

improvement of productivity.
 JIT is an approach that seeks to eliminate all sources of
waste in production activities by providing the right part at the
right place at the right time.
 Waste means anything other than the minimum amount of
equipment, parts, space, material, and workers’ time
absolutely necessary to add value to the product or service.
This means there should be no surplus, there should be no
safety stocks, and lead times should be minimal: “If you can’t
use it now, don’t make or purchase it now.”
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 4.8. Just-In-Time (JIT) …

 In JIT concept, there are no inventories, no shortages, and no

replenishment orders placed.
 The concept JIT necessitates that the suppliers (vendors) are
local and are 100 % dependable, orders splitting with small
orders without additional transportation costs is feasible, i.e.,
frequent deliveries are economically viable, and the requirements
are firmly known.
 This also calls for a single vendor base and having long-term
relationship with the vendor who has to be a quality vendor.
This also requires that the vendor has sufficient capacity to
supply anytime without passing on the costs of overcapacity to
the buyer.
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 4.8. Just-In-Time (JIT) …

Benefits of JIT System

 Inventory levels are drastically reduced and high
inventory turnovers have been achieved.
 Reduced production cycle time or product throughput
time
 Improved product quality and minimum scrap
 Root-cause elimination approach to solve production
problems.
 Multiskilled and flexible work-force reduces worker idle
time, overheads, fewer lay-offs so on.
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 4.8. Just-In-Time (JIT) …

Benefits of JIT System…

 Elimination of unpleasant suppliers
 Reduced customer related problems
 Lesser work in process and finished goods
inventory
 Shorter procurement lead times
 Improved employee morale due to high employee
involvement and employee empowerment
 Reduced amount of inspection
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