PRODUCTION & OPERATION MANAGEMENT

Unit 3 Demand Forecasting & Capacity

Planning

1 Demand Forecasting
Demand forecasting is the art and science of forecasting customer demand to drive holistic
execution of such demand by corporate supply chain and business management. Demand
forecasting involves techniques including both informal methods, such as educated guesses, and
quantitative methods, such as the use of historical sales data and statistical techniques or current
data from test markets. Demand forecasting may be used in production planning, inventory
management, and at times in assessing future capacity requirements, or in making decisions on
whether to enter a new market.
Demand forecasting is predicting future demand for the product. In other words, it refers to
the prediction of a future demand fora product or a service on the basis of the past events and
prevailing trends in the present.
There are a number of reasons why demand forecasting is an important process
for businesses:

 It allows businesses to more effectively optimize inventory, increasing turnover rates

and reducing holding costs.
 It provides an insight into upcoming cash flow, meaning businesses can more accurately
budget to pay suppliers and other operational costs.
 Anticipating demand means knowing when to increase staff and other resources to keep
operations running smoothly during peak periods.
1.1 Types of demand forecasting
1.1.1 Passive demand forecasting
Passive demand forecasting is the simplest type. In this model, you use sales data from the past
to predict the future. You should use data from the same season to project sales in the future,
so you compare apples to apples. This is particularly true if your business has seasonal
fluctuations.
The passive forecasting model works well if you have solid sales data to build on. In addition,
this is a good model for businesses that aim for stability rather than growth. It’s an approach
that assumes that this year’s sales will be approximately the same as last year’s sales.
Passive demand forecasting is easier than other types because it doesn’t require you to use
statistical methods or study economic trends.
1.1.2 Active demand forecasting
If your business is in a growth phase or if you’re just starting out, active demand forecasting is
a good choice. An active forecasting model takes into consideration your market research,
marketing campaigns, and expansion plans.
Active projections will often factor in externals. Considerations can include the economic
outlook, growth projections for your market sector, and projected cost savings from supply

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chain efficiencies. Startups that have less historical data to draw on will need to base their
assumptions on external data.
1.1.3 Short-term projections
Short-term demand forecasting looks just at the next three to 12 months. This is useful for
managing your just-in-time supply chain. Looking at short-term demand allows you to adjust
your projections based on real-time sales data. It helps you respond quickly to changes in
customer demand.
If you run a product lineup that changes frequently, understanding short-term demand is
important. For most businesses, however, a short-term forecast is just one piece of a larger
puzzle. You’ll probably want to look further out with medium- or long-term demand
forecasting.
1.1.4 Long-term projections
Your long-term forecast will make projections one to four years into the future. This forecasting
model focuses on shaping your business growth trajectory. While your long-term planning will
be based partly on sales data and market research, it is also aspirational.
Think of a long-term demand forecast as a roadmap. Using this forecasting technique, you can
plan out your marketing, capital investments, and supply chain operations. That will help you to
prepare for future demand. Being ready for your business growth is crucial to making that
growth happen.
1.1.5 External macro forecasting
External macro forecasting incorporates trends in the broader economy. This projection looks
at how those trends will affect your goals. An external macro demand forecast can also give
you direction for how to meet those goals.
Your company may be more invested in stability than expansion. However, a consideration of
external market forces is still essential to your sales projections. External macro forecasts can
also touch on the availability of raw materials and other factors that will directly affect your
supply chain.
1.1.6 Internal business forecasting
One of the limiting factors for your business growth is internal capacity. If you project that
customer demand will double, does your enterprise have the capacity to meet that demand?
Internal business demand forecasts review your operations.
The internal business forecasting type will uncover limitations that might slow your growth. It
can also highlight untapped areas of opportunity within the organization. This forecasting model
factors in your business financing, cash on hand, profit margins, supply chain operations, and
personnel.
Internal business demand forecasting is a helpful tool for making realistic projections. It can also
point you toward areas where you need to build capacity in order to meet expansion goals.
1.2 Methods of Demand Forecasting
1.2.1 Survey of Buyer’s Choice
When the demand needs to be forecasted in the short run, say a year, then the most feasible
method is to ask the customers directly that what are they intending to buy in the forthcoming

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time period. Thus, under this method, potential customers are directly interviewed. This survey
can be done in any of the following ways:
a. Complete Enumeration Method: Under this method, nearly all the potential buyers
are asked about their future purchase plans.
b. Sample Survey Method: Under this method, a sample of potential buyers are chosen
scientifically and only those chosen are interviewed.
c. End-use Method: It is especially used for forecasting the demand of the inputs. Under
this method, the final users i.e. the consuming industries and other sectors are identified.
The desirable norms of consumption of the product are fixed, the targeted output levels
are estimated and these norms are applied to forecast the future demand of the inputs.
Hence, it can be said that under this method the burden of demand forecasting is on the buyer.
However, the judgments of the buyers are not completely reliable and so the seller should take
decisions in the light of his judgment also.
The customer may misjudge their demands and may also change their decisions in the future
which in turn may mislead the survey. This method is suitable when goods are supplied in bulk
to industries but not in the case of household customers.
1.2.2 Collective Opinion Method
Under this method, the salesperson of a firm predicts the estimated future sales in their region.
The individual estimates are aggregated to calculate the total estimated future sales. These
estimates are reviewed in the light of factors like future changes in the selling price, product
designs, changes in competition, advertisement campaigns, the purchasing power of the
consumers, employment opportunities, population, etc.
The principle underlying this method is that as the salesmen are closest to the consumers they
are more likely to understand the changes in their needs and demands. They can also easily find
out the reasons behind the change in their tastes.
Therefore, a firm having good sales personnel can utilize their experience to predict the
demands. Hence, this method is also known as Salesforce opinion or Grassroots approach
method. However, this method depends on the personal opinions of the sales personnel and is
not purely scientific.
1.2.3 Barometric Method
This method is based on the past demands of the product and tries to project the past into the
future. The economic indicators are used to predict the future trends of the business. Based
on future trends, the demand for the product is forecasted. An index of economic indicators is
formed. There are three types of economic indicators, viz. leading indicators, lagging indicators,
and coincidental indicators.
The leading indicators are those that move up or down ahead of some other series. The lagging
indicators are those that follow a change after some time lag. The coincidental indicators are
those that move up and down simultaneously with the level of economic activities.
1.2.4 Market Experiment Method
Another one of the methods of demand forecasting is the market experiment method. Under
this method, the demand is forecasted by conducting market studies and experiments on
consumer behavior under actual but controlled, market conditions.

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Certain determinants of demand that can be varied are changed and the experiments are done
keeping other factors constant. However, this method is very expensive and time-consuming.

1.2.5 Expert Opinion Method

Usually, market experts have explicit knowledge about the factors affecting demand. Their
opinion can help in demand forecasting. The Delphi technique, developed by Olaf Helmer is
one such method.
Under this method, experts are given a series of carefully designed questionnaires and are asked
to forecast the demand. They are also required to give the suitable reasons. The opinions are
shared with the experts to arrive at a conclusion. This is a fast and cheap technique.
1.2.6 Statistical Methods
The statistical method is one of the important methods of demand forecasting. Statistical
methods are scientific, reliable and free from biases. The major statistical methods used for
demand forecasting are:
a. Trend Projection Method: This method is useful where the organization has a
sufficient amount of accumulated past data of the sales. This date is arranged
chronologically to obtain a time series. Thus, the time series depicts the past trend and
on the basis of it, the future market trend can be predicted. It is assumed that the past
trend will continue in the future. Thus, on the basis of the predicted future trend, the
demand for a product or service is forecasted.
b. Regression Analysis: This method establishes a relationship between the dependent
variable and the independent variables. In our case, the quantity demanded is the
dependent variable and income, the price of goods, the price of related goods, the price
of substitute goods, etc. are independent variables. The regression equation is derived
assuming the relationship to be linear. Regression Equation: Y = a + bX. Where Y is the
forecasted demand for a product or service.

2 Economies and diseconomies of Scale

When we talk about the scale of production of a firm, we often hear about the fact that large-
scale production, usually, helps in reducing the cost of production. Economies of scale refer to
these reduced costs per unit arising due to an increase in the total output. Diseconomies of
scale, on the other hand, occur when the output increases to such a great extent that the cost
per unit starts increasing. In this article, we will look at the internal and external, diseconomies
and economies of scale.

2.1 Internal and External Economies

When a firm opts for large-scale production, the economies arising out of it are grouped into
two categories:

1. Internal economies – economies of production that the firm accrues when it increases
the output leading to a drop in the cost of production. These arise due to endogenous
factors like entrepreneurial efficiency, talents of the management team, type of
machinery, etc. These economies arise within the firm and help the firm only.

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2. External economies – these are the benefits that each member firm of the industry
accrues due to the expansion of the entire industry.
2.1.1 Internal Diseconomies and Economies of Scale
While studying returns to scale, we observed that they increase during the initial stages, remain
constant for a while, and then start decreasing. The reason is simple – initially, the firm enjoys
internal economies of scale and after a certain limit, it suffers from internal diseconomies of
scale. Let’s look at the types of economies and diseconomies:
2.1.1.1 Technical
Large-scale production is linked to technical economies. When a firm increases its scale of
operations, it needs to use a more specialized and efficient form of capital equipment and
machinery. Such machinery helps to produce larger outputs at a lower unit cost.
Further, as the scale of production increases and the amount of labor and other factors
becomes larger, the firm manages to reduce costs by introducing a degree of division of labor
and specialization.
However, beyond a certain point, the firm experiences diseconomies of scale. This happens
because after reaching a large enough output, the firm utilizes almost all possibilities of the
division of labor and employment of efficient machinery.
Post this, any increase in the size of the plant causes the costs to rise. When the scale of
operations becomes too large, the management finds it more difficult to control and coordinate
the operations.
2.1.1.2 Managerial
As the output increases, the firm can apply the division of labor to the management as well. For
example, the production manager can look after production, the sales manager can look after
sales, etc. When the scale of production increases further, the firm divides each department
into sub-departments like sales is divided into advertising, exports, and service.
Thus helps in increasing the efficiency and productivity of the management team since a
specialist manages each sub-department. Further, the firm has the option to decentralize
decision-making authority enhancing the efficiency further. Therefore, specialized management
allows the firm to reduce managerial costs.
However, as the firm increases its scale of operations beyond a certain limit, the management
finds it difficult to control and coordinate between departments. This leads to managerial
diseconomies.
2.1.1.3 Commercial
As a firm increases its volume of production, it requires large amounts of raw material and
components. Hence, it places a bulk order for such material and components and enjoys
discounted pricing for them.
Economies are also achieved during sales. If the sales staff is working under-capacity, then the
firm can sell additional output at little extra cost.
Further, as the scale of production increases, the advertising cost per unit fall. Hence, the firm
benefits from economies of advertising too. After an optimum level, these economies start
becoming diseconomies though.

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2.1.1.4 Financial
When a firm wants to raise finance, a large-scale firm has many benefits like:

 Better security to bankers

 Well-known
 Can raise finance at lower costs, etc.
However, after the optimum scale of production, the financial costs rise faster due to the
increased dependence on external finances.
2.1.1.5 Risk-bearing
A firm enjoys the economies of risk-bearing if it has a large-scale operation with diverse and
multi-production capabilities. However, if the diversification increases the economic
disturbances rather than covering them, then the risk increases.
2.1.2 External Diseconomies and Economies of Scale
External diseconomies and economies of scale are very important to a firm. These are a result
of the expansion of output of the entire industry and not limited to an individual firm. They are
available to one or more firms in the following forms:
2.1.2.1 Cheaper Raw materials and Capital Equipment
At times, the expansion of an industry results in new and cheaper sources of raw material,
machinery, and other capital equipment. It also results in an increased demand for the various
types of materials and equipment required by the industry.
Hence, such materials/equipment can be purchased from other industries on a large scale. This,
eventually, leads to a lower cost of production and lower price. Therefore, firms using these
materials/equipment get them at lower prices.
2.1.2.2 Technological External Economies
Usually, when an entire industry expands, new technical knowledge is discovered leading to
new and improved machinery for the said industry. This changes the technological coefficient
of production and enhances the productivity of the firms in the industry. Hence, the cost of
production reduces.
2.1.2.3 Development of Skilled Labor
As the industry expands, the labor gets accustomed to managing various production processes
and learns from the experience. This increases the number of skilled workers which in turn has
a favorable effect on the levels of productivity.
2.1.2.4 Growth of Ancillary Industries
When a certain industry expands, many ancillary industries start specializing in the production
of raw materials, tools, machinery, etc. These ancillary industries offer the materials/machinery
at a low price.
Similarly, some ancillary industries also start processing industrial waste and create a useful
product out of it. Overall, it leads to a lower cost of production.
2.1.2.5 Better Transportation and Marketing Facilities
An expanding industry, usually, results in better transportation and marketing networks. These
aspects help reduce the cost of production in the firms from the industry.

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It is important to note that, certain disadvantages can neutralize the advantages of the expansion
of industry and cease the external economies of scale. These are external diseconomies. When
an industry expands, the demand for certain materials and skilled labor increases.
If these factors are in short supply, then their prices can increase. Further, the geographical
concentration of firms from the industry can lead to higher transportation
costs, marketing costs, pollution control costs, etc.

3 CAPACITY PLANNING

Capacity planning is the process of determining the production capacity needed by an

organization to meet changing demands for its products. In the context of capacity planning,
design capacity is the maximum amount of work that an organization is capable of completing
in a given period. Effective capacity is the maximum amount of work that an organization is
capable of completing in a given period due to constraints such as quality problems, delays,
material handling, etc.
Capacity planning is the process used to determine how much capacity is needed (and when)
in order to manufacture greater product or begin production of a new product. A number of
factors can affect capacity-number of workers, ability of workers, number of machines, waste,
scrap, defects, errors, productivity, suppliers, government regulations, and preventive
maintenance. Capacity planning is relevant in both the long term and the short term. However,
there are different issues at stake for each.
3.1.1 Long-term capacity planning
Over the long term, capacity planning relates primarily to strategic issues involving the firm's
major production facilities. In addition, long-term capacity issues are interrelated with location
decisions. Technology and transferability of the process to other products is also intertwined
with long-term capacity planning. Long-term capacity planning may evolve when short-term
changes in capacity are insufficient. For example, if the firm's addition of a third shift to its
current two-shift plan still does not produce enough output, and subcontracting arrangements
cannot be made, one feasible alternative is to add capital equipment and modify the layout of
the plant (long-term actions). It may even be desirable to add additional plant space or to
construct a new facility (long-term alternatives).
3.1.2 Short-term capacity planning
In the short term, capacity planning concerns issues of scheduling, labour shifts, and balancing
resource capacities. The goal of short-term capacity planning is to handle unexpected shifts in
demand in an efficient economic manner. The time frame for short-term planning is frequently
only a few days but may run as long as six months.

4 Capacity Expansion Strategy

Growing an existing business often involves expansion of capacity, in terms of plant, human
resources, technological infrastructure, R&D facilities, etc. Any major capacity expansion is a
strategic decision that involves significant resource commitments and is often difficult to
reverse. So such a decision has to be made carefully.
Capacity expansion strategy is often narrowly applied to manufacturing. But in many
businesses, there is no or little manufacturing. So, capacity needs to be understood in terms of
the investments made in the most critical area of the value chain. Thus, in the pharmaceutical

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industry, capacity has to be defined in terms of scientific manpower and sales force. In a software
development company, capacity has to be understood in terms of the number of programmers
employed. In a Business School, capacity may be defined as the number of professors available
to teach students.
Three different strategies:
1. Lag strategy
Lag strategy is planning to have enough resources to meet true demand (not projected). Lag
strategy is a conservative method of capacity planning that ensures your costs are as low as
possible. The potential downside to this strategy is that it can create a lag in the delivery of
products or services to customers, which is where the name comes from. If you get a sudden
surge in orders or land a large new client who wants fast turnaround times, lag strategy may
prevent you from meeting due dates.
2. Lead strategy
Lead strategy is planning to have enough resources to meet your demand forecasts. Lead
strategy assumes more risk than lag strategy. For example, if you hire new workers and don’t
wind up with the orders you were predicting, you could lose money paying employees to sit
around. The major benefit of this strategy is that if you do have a sudden uptick in orders, you
will most likely be able to keep all of your customers happy and meet due dates.
3. Match strategy
Match strategy is the middle ground between lag and lead strategy. Using match strategy, you
do strategic capacity planning more frequently. You closely monitor true demand, projected
demand, and market shifts/trends. Based on this information, you adjust your capacity
management to meet demand in increments. This strategy offers the most flexibility with less
risk than lead strategy, but it has more ability to scale than lag strategy
According to Michael Porter, the decision to expand capacity has to take into account various
factors. Some of them are:
 Future demand.
 Future input prices.
 Likelihood of technological obsolescence.
 Probable capacity expansion by competitors.
 Future industry capacity and individual market shares.
The main risk in capacity expansion strategy is the creation of excess capacity. When there is
excess capacity, competition intensifies as players try to increase capacity utilization and profits
come down. Excess capacity may result because of various reasons:
 Capacity often has to be added in lumps, not in incremental fashion.
 Economies of scale can prompt indiscriminate capacity expansion.
 Long lead times in adding capacity may motivate firms to add capacity even when future
demand is uncertain.
 Changes in production technology may attract new firms even as older plants continue
to operate due to exit barriers.
 Equipment suppliers, through price cutting and attractive credit schemes, can lure
manufacturers into buying their products.

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 Large buyers, by promising more business in future can tempt the suppliers to add
capacity.
 In some industries, such as airlines, the firm which has the largest capacity may be able
to grab a disproportionately large chunk of the market.
 When there are several players in the market, they may all try to increase market share,
by increasing capacity.
 Firms often build more capacity than is needed in the initial stages when future prospects
look favorable.
 Excess capacity often results when firms overestimate the potential of their competitors
and want to preempt them by adding more capacity.
 Many manufacturing firms do not like to be left behind by competition and embark on a
regular process of capacity expansion.
 Tax incentives sometimes motivate manufacturers to invest in plant and equipment.
Capacity expansion strategy can be used as a pre-emptive strategy to lock up a major share of
the market and to discourage competitors from expanding and potential rivals from entering
the industry. According to Porter, a preemptive strategy is risky. It tends to succeed only under
the following conditions:
 The expansion of capacity is large relative to market size.
 If you are seeing economies advantage in near future.
 The firm’s strategy looks credible in terms of availability of resources, technological
capabilities, past track record, etc.
 The firm announces its plans before competitors develop even a reasonable degree of
commitment to the process.

5 Inventory Management:

5.1 Introduction:
Inventory management is a very important function that determines the health of the supply
chain as well as the impacts the financial health of the balance sheet. Every organization
constantly strives to maintain optimum inventory to be able to meet its requirements and avoid
over or under inventory that can impact the financial figures.
Inventory is always dynamic. Inventory management requires constant and careful evaluation of
external and internal factors and control through planning and review. Most of the organizations
have a separate department or job function called inventory planners who continuously
monitor, control and review inventory and interface with production, procurement and finance
departments.
Inventory management is a very important function that determines the health of the supply
chain as well as the impacts the financial health of the balance sheet. Every organization
constantly strives to maintain optimum inventory to be able to meet its requirements and avoid
over or under inventory that can impact the financial figures.
5.2 DEFINING INVENTORY
Inventory is an idle stock of physical goods that contain economic value, and are held in various
forms by an organization in its custody awaiting packing, processing, transformation, use or sale
in a future point of time.

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Any organization which is into production, trading, sale and service of a product will necessarily
hold stock of various physical resources to aid in future consumption and sale. While inventory
is a necessary evil of any such business, it may be noted that the organizations hold inventories
for various reasons, which include speculative purposes, functional purposes, physical
necessities etc.
The term inventory has been defined by several authors. The popular among them are:-“the
term inventory includes materials-raw, in process, finished packaging, spares and others stocked
in order to meet an unexpected demand or distribution in the future.”
– B.D. Khare, Inventory Control, NPC, p.1.
5.3 DIFFERENT TYPES OF INVENTORY
Inventory of materials occurs at various stages and departments of an organization. A
manufacturing organization holds inventory of raw materials and consumables required for
production. It also holds inventory of semi-finished goods at various stages in the plant with
various departments. Finished goods inventory is held at plant, FG Stores, distribution centers
etc. Further both raw materials and finished goods those that are in transit at various locations
also form a part of inventory depending upon who owns the inventory at the particular juncture.
Finished goods inventory is held by the organization at various stocking points or with dealers
and stockiest until it reaches the market and end customers.
Besides Raw materials and finished goods, organizations also hold inventories of spare parts to
service the products. Defective products, defective parts and scrap also forms a part of
inventory as long as these items are inventoried in the books of the company and have economic
value.
5.3.1 Raw Materials:
Raw materials are the materials a company uses to create and finish products. When the
product is completed, the raw materials are typically unrecognizable from their original form,
such as oil used to create shampoo.
5.3.2 Components:
Components are similar to raw materials in that they are the materials a company uses to
create and finish products, except that they remain recognizable when the product is
completed, such as a screw.
5.3.3 Work In Progress (WIP):
WIP inventory refers to items in production and includes raw materials or components, labor,
overhead and even packing materials.
5.3.4 Finished Goods:
Finished goods are items that are ready to sell.
5.3.5 Maintenance, Repair and Operations (MRO) Goods:
MRO is inventory — often in the form of supplies — that supports making a product or the
maintenance of a business.
5.3.6 Packing and Packaging Materials:
There are three types of packing materials. Primary packing protects the product and makes it
usable. Secondary packing is the packaging of the finished good and can include labels or SKU
information. Tertiary packing is bulk packaging for transport.

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5.3.7 Safety Stock and Anticipation Stock:

Safety stock is the extra inventory a company buys and stores to cover unexpected events.
Safety stock has carrying costs, but it supports customer satisfaction. Similarly, anticipation
stock comprises of raw materials or finished items that a business purchases based on sales and
production trends. If a raw material’s price is rising or peak sales time is approaching, a business
may purchase safety stock.
5.3.8 Decoupling Inventory:
Decoupling inventory is the term used for extra items or WIP kept at each production line
station to prevent work stoppages. Whereas all companies may have safety stock, decoupling
inventory is useful if parts of the line work at different speeds and only applies to companies
that manufacture goods.
5.3.9 Cycle Inventory:
Companies order cycle inventory in lots to get the right amount of stock for the lowest storage
cost.
5.3.10 Service Inventory:
Service inventory is a management accounting concept that refers to how much service a
business can provide in a given period. A hotel with 10 rooms, for example, has a service
inventory of 70 one-night stays in a given week.
5.3.11 Transit Inventory:
Also known as pipeline inventory, transit inventory is stock that’s moving between the
manufacturer, warehouses and distribution centers. Transit inventory may take weeks to move
between facilities.
5.3.12 Excess Inventory:
Also known as obsolete inventory, excess inventory is unsold or unused goods or raw materials
that a company doesn’t expect to use or sell, but must still pay to store.

5.4 Dependent and Independent Demand

Inventory Management deals essentially with balancing the inventory levels. Inventory is
categorized into two types based on the demand pattern, which creates the need for inventory.
The two types of demand are Independent Demand and Dependent Demand for inventories.
5.4.1 Independent Demand
An inventory of an item is said to be falling into the category of independent demand when the
demand for such an item is not dependant upon the demand for another item.
Finished goods Items, which are ordered by External Customers or manufactured for stock and
sale, are called independent demand items.
Independent demands for inventories are based on confirmed Customer orders, forecasts,
estimates and past historical data.
5.4.2 Dependant Demand
If the demand for inventory of an item is dependent upon another item, such demands are
categorized as dependant demand.
Raw materials and component inventories are dependent upon the demand for Finished Goods
and hence can be called as Dependant demand inventories.

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Take the example of a Car. The car as finished goods is an held produced and held in inventory
as independent demand item, while the raw materials and components used in the manufacture
of the Finished Goods - Car derives its demand from the demand for the Car and hence is
characterized as dependant demand inventory.
This differentiation is necessary because the inventory management systems and process are
different for both categories.
While Finished Goods inventories which is characterized by Independent demand, are managed
with sales order process and supply chain management processes and are based on sales
forecasts, the dependant demand for raw materials and components to manufacture the finished
goods is managed through MRP -Material Resources Planning or ERP - Enterprise Resource
Planning using models such as Just In Time, Kanban and other concepts. MRP as well as ERP
planning depends upon the sales forecast released for finished goods as the starting point for
further action.
Managing Raw Material Inventories is far more complicated than managing Finished Goods
Inventory. This involves analyzing and co-coordinating delivery capacity, lead times and delivery
schedules of all raw material suppliers, coupled with the logistical processes and transit timelines
involved in transportation and warehousing of raw materials before they are ready to be
supplied to the production shop floor. Raw material management also involves periodic review
of the inventory holding, inventory counting and audits, followed by detailed analysis of the
reports leading to financial and management decisions.
Inventory planners who are responsible for planning, managing and controlling Raw Material
inventories have to answer two fundamental questions, which can also be termed as two basic
inventory decisions.
a. Inventory planners need to decide how much of Quantity of each Item is to be ordered
from Raw Material Suppliers or from other Production Departments within the
Organization.
b. When should the orders be placed?

5.5 Objectives of Inventory Management

Inventory management objectives are expected to be operational and financial.
Operationally, stocked goods should be available in sufficient amounts and financially, working
capital should be minimized as possible. Here are some main objectives of inventory
management.
5.5.1 Fulfilling the orders
You can’t meet a received order if you don’t exactly know how many of those products
you have in hand. To fulfill the orders, you must have the right products available in times of
need. Otherwise, orders might put you in chaos.
Assume that you are selling toys; you received an order of 100 boxes but when you check out,
there are in fact only 50 boxes available in the warehouse. The sales representative takes the
order of toys without knowing the situation in the warehouse and here comes the mess. To not
experience this, an inventory management system should be used and team members should
be knowing the inventory situation.

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5.5.2 Having sufficient supply

From raw materials to the finished product, inventories should be readily stocked in
advance. You should supply the required material in enough quantity so that products do not
suffer at the time of a customer need.
Tracking supply is a way to make sure that stocks are ready to meet the customers needs. It
also gives the opportunity to shape the demand based on the existing supply. You can set
certain goals directed to customer demand only if you have enough supply to meet such
demand.
5.5.3 Controlling stocks
You need a systematic record of inventory to run things more smoothly. Having this
system makes you control your stocks and prevents you from various confusions such as
duplication in orders or keeping the inventories in the wrong amount. Overstock or understock
situations should always be considered.
We already know that under-stocking might cause scarcity and also ruins the ordering
process, but overstocked products are no less risky than that.
Suppose that you are working with spoilable materials and you overstock them. Maybe you
intend to keep those inventories as a backup in case of greater demand than usual.
However, storing way too much of them may cause you more trouble than which you can’t meet
the demand. They spoil before they get used and it eventually ends up with cost and extra effort.
5.5.4 Minimizing costs
The main point of inventory management is actually minimizing costs. You should
be minimizing the unnecessary capital to be financially alright. Money is a crucial
constraint after all. You should keep your investment at a minimum level and also keep the
material cost under control to reduce the production cost.
When the items do not sell, your assets might suddenly become liabilities. Thus, one of the aims of
inventory management is to ensure that you don’t lose any money by having the inventory.
Items should be used while they have their original value.
Minimize your working capital as possible, since it is also necessary for other activities like
operations and sales. When you effectively manage your inventory, you avert from such
expenses as purchase cost, carrying cost, or storage cost.
5.5.5 Avoiding wastes or losses
Inventory management is highly effective when it comes to dealing with losses. An item being
wasted or lost is quite natural when there is not a proper tracking system.
Besides, theft is always a risk worth considering no matter what type of work you do.
Keeping the record of the items minimizes the odd of loss even if not eliminate. Having a record
in hand prevents any possible waste and also keeps your company away from theft. Especially
for where there are massive amounts of products to be handled, such risks are even greater.
So, an inventory management system is a life-saver tracking everything and avoiding possible
losses.

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5.5.6 Enhancing overall production

Managing your inventory improves production at so many levels. When there is something you
prefer to change in the production, having the inventory system makes you do it faster.
If you want to scale or shrink your production, the first thing to do is looking at your tracking
system and decide how to lead the production.
Besides, in terms of ensuring an effective supply, inventory systems already help production run
steadily. If you keep your records and hold enough supply, production doesn’t have to be
restructured again.
5.5.7 Optimizing product sales
Another thing that you can use inventory management for is analyzing product sales
patterns. Sales is a critical and important phase of the whole process. It helps to understand
the current situation and make future assumptions based on the analysis. You can detect slow-
moving goods for instance, and eliminate them.
Imagine you are selling cosmetic goods. Some of your products are not doing a great job in the
market. Sales are not as predicted and all of them are waiting on the shelves. Keeping those
goods which don’t sell anymore doesn’t seem like a good idea.

5.6 INVENTORY COSTS

Inventory costs are basically categorized into three headings:
1. Ordering Cost
2. Carrying Cost
3. Shortage or stock out Cost & Cost of Replenishment
a. Cost of Loss, pilferage, shrinkage and obsolescence etc.
b. Cost of Logistics
c. Sales Discounts, Volume discounts and other related costs.
1. Ordering Cost: Cost of procurement and inbound logistics costs form a part of Ordering
Cost. Ordering Cost is dependant and varies based on two factors - The cost of ordering
excess and the Cost of ordering too less.
Both these factors move in opposite directions to each other. Ordering excess quantity will
result in carrying cost of inventory. Whereas ordering less will result in increase of
replenishment cost and ordering costs.
How much to order is determined by arriving at the Economic Order Quantity or EOQ.
2. Carrying Cost: Inventory storage and maintenance involves various types of costs namely:
a. Inventory Storage Cost
b. Cost of Capital
Inventory carrying involves Inventory storage and management either using in house
facilities or external warehouses owned and managed by third party vendors. In both cases,
inventory management and process involves extensive use of Building, Material Handling
Equipment, IT Software applications and Hardware Equipment coupled managed by
Operations and Management Staff resources.
a. Inventory Storage Cost: Inventory storage costs typically include Cost of Building
Rental and facility maintenance and related costs. Cost of Material Handling Equipments, IT
Hardware and applications, including cost of purchase, depreciation or rental or lease as
the case may be. Further costs include operational costs, consumables, communication

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costs and utilities, besides the cost of human resources employed in operations as well as
management.
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. The
inventory storage costs as well as cost of capital is dependent upon and varies with the
decision of the management to manage inventory in house or through outsourced vendors
and third party service providers.
Current times, the trend is increasingly in favor of outsourcing the inventory management
to third party service provides. For one thing the organizations find that managing inventory
operations requires certain core competencies, which may not be in line with their business
competencies. They would rather outsource to a supplier who has the required
competency than build them in house.
Secondly in case of large-scale warehouse operations, the scale of investments may be too
huge in terms of cost of building and material handling equipment etc. Besides the project
may span over a longer period of several years, thus blocking capital of the company, which
can be utilized into more important areas such as R & D, Expansion etc. than by staying
invested into the project.

5.7 Inventory Control Systems – EOQ, Continuous, Periodic

5.7.1 EOQ:
Definition: Economic Order Quantity (EOQ) is a production formula used to determines the
most efficient amount of goods that should be purchased based on ordering and carrying costs.
In other words, it represents the optimal quantity of inventory, a company should order each
time in order to minimize the costs associated with ordering and holding inventory.
This model is known as Economic Order Quantity (EOQ) model, because it established the
most economic size of order to place. It is one of the oldest classical production scheduling
models. In 1913, Ford W. Harris developed this formula whereas R. H. Wilson is given credit
for the application and in-depth analysis on this model. By using this model, the companies can
minimize the costs associated with the ordering and inventory holding. It can be a valuable tool
for small business owners who need to make decisions about how much inventory to keep on
hand, how many items to order each time, and how often to reorder to incur the lowest
possible costs. There are two most important categories of inventory costs are ordering costs
and carrying costs.
5.7.1.1 Ordering costs
It is the costs that are incurred on obtaining additional inventories. They include costs incurred
on communicating the order, traveling allowance and daily allowance to purchase officers,
printing and stationary, salary of purchase department, cost of inspection, cost of receiving the
material, transportation cost etc. all above cost, other than transport costs remain unchanged
per order irrespective of the order size. Therefore, it is assumed that ordering cost per order
remain constant. The more frequently orders are placed, and fewer the quantities purchased
on each order, the grater will be ordering cost and vice versa.

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5.7.1.2 Carrying cost:

It is the cost incurred for holding inventory in hand. They include interest on the money locked
up in stocks, storage costs, deterioration spoilage costs, insurance, evaporation, godown rent,
pilferage, shrinkage, obsolescence, other overhead of stores department etc. They are assumed
to be constant per unit of inventory. The large the volume of inventory, the higher will be the
inventory carrying cost and vice versa.

Example:
The material DX is used uniformly throughout the year. The data about annual requirement,
ordering cost and holding cost of this material is given below:
 Annual requirement: 2,400 units
 Ordering cost: $10 per order
 Holding cost: $0.30 per unit

EOQ = √2𝐴𝑂/𝐶

= √2 ∗ 2400 ∗ 10/0.30
= 400 Units
 Number of orders per year
= Annual demand/EOQ
= 2,400 units/400 units
= 6 orders per year
 Ordering cost

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= Number or orders per year × Cost per order

= 6 orders × $10
= $60

 Holding cost
= Average units × Holding cost per unit
= (400/2) × 0.3
= $60
5.7.2 Continuous
When you use a perpetual inventory system, it continually updates inventory records and
accounts for additions and subtractions when inventory items are received, sold from stock,
moved from one location to another, picked from inventory, and scrapped. Some organizations
prefer perpetual inventory systems because they deliver up-to-date inventory information and
better handle minimal physical inventory counts. Perpetual inventory systems also are preferred
for inventory tracking because they deliver accurate results on a continual basis when managed
properly. This type of inventory control system works best when used in conjunction with
warehouse inventory database of inventory quantities and bin locations updated in real time by
warehouse workers using barcode scanners. Inventory management apps are perpetual
inventory systems.
There are some challenges associated with perpetual inventory systems. First, these systems
cannot be maintained manually and require specialized equipment and software that results in
a higher cost of implementation, especially for businesses with multiple locations or
warehouses. Periodic maintenance and upgrades are necessary for perpetual inventory systems,
which also can become costly. Another challenge of using a perpetual inventory system is that
recorded inventory may not reflect actual inventory as time goes by because they do not
conduct periodic physical inventory counts, a necessary activity even when inventory trackers
are used. The result is that errors, stolen items, and improperly scanned items impact the
recorded inventory records and cause them not to match actual inventory counts.
5.7.3 Periodic
Periodic inventory systems do not track inventory on a daily basis; rather, they allow
organizations to know the beginning and ending inventory levels during a certain period of time.
These types of inventory control systems track inventory using physical inventory counts. When
physical inventory is complete, the balance in the purchases account shifts into the inventory
account and is adjusted to match the cost of the ending inventory. Organizations may choose
whether to calculate the cost of ending inventory using LIFO or FIFO inventory accounting
methods or another method; keep in mind that beginning inventory is the previous period’s
ending inventory.
There are a few disadvantages of using a periodic inventory system. First, when physical
inventory counts are being completed, normal business activities nearly become suspended. As
a result, workers may hurry through their physical counts because of time constraints. Periodic
inventory systems typically don’t use inventory trackers, so errors and fraud may be more
prevalent because there is no continuous control over inventory. It also becomes more difficult
to identify where discrepancies in inventory counts occur when using a periodic inventory
control system because so much time passes between counts. The amount of labor that is
required for periodic inventory control systems make them better suited to smaller businesses.

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5.7.4 ABC Inventory Control System

Definition:
The ABC Inventory Control System is applied by those firms that have to maintain several
types of inventories. Ideally, it is not desirable to keep the same degree of control over all the
inventory types, since each vary in terms of its value of annual consumption.
Thus, the ABC Inventory Control System is used to determine the importance of each item of
the stock in terms of its value of annual consumption and are categorized as A, B, and C.

The items of high value are categorized as “A” and generally consists of 15%-25% of inventory
items; that accounts for 60%-75% of annual usage value. The firm keeps strict control over
these inventory items.
The Category “B”, is comprised of those items that are of relatively less value or has moderate
importance and consists of 20%-30% of inventory items, that accounts for 20%-30% of annual
usage value. A reasonable control is kept on the “B” category inventory items.
The least important items of the inventory are categorized as “C”. It consists of 40%-60% of
inventory items; that accounts for 10%-15% of annual usage value. Due to a low value of these
items, a simple or an ordinary control is kept on them.
thus, the ABC Inventory Control System focuses on significant items of the inventory and hence
is also called as “Control by Importance and Exception.” Since the categorization of the
inventory items is done on the basis of their relative value, this approach is often known
as “Proportional Value Analysis.”

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5.8 Inventory Management Techniques

Definition: Inventory management techniques can be seen as a useful tool in the hands of the
management. It ensures the availability of the right type of stock, at the right time, at the right
place and in the desired quantity. It also enables the managers to match the inventory shown in
the books of accounts with that available.
Example: A garment manufacturing industry found that in the financial year 2018-19, it has
increased its sales by 33%. However, the Cash Flow statement depicted a very low balance,
indicating that the company lacks sufficient operating capital.
On analyzing the books of accounts, it was found that the company has blocked its working
capital in the excess inventory.
The stock was maintained in a vast quantity taking up the warehouse space, demanding high
maintenance cost and some of the stock even became obsolete.
All this is the result of substandard and unplanned inventory management.
Different Techniques
1. FIFO
2. LIFO
3. EOQ
4. ABC Analysis
5. VED Classification
6. Drop shipping

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7. Contingency Planning
8. Accurate Forecasting
9. Set PAR Levels
10. Inventory Kitting
11. Just-In-Time
12. MRP
13. Perpetual Inventory Management
14. FSN Inventory
15. Batch Tracking
Different Techniques of Inventory Management
Before starting with the explanation of each of these methods; please note that there is no
perfect way of inventory management. Instead, an organization can go for one or more
techniques to plan, manage and optimize its inventory.
First-In, First-Out (FIFO)
First in, first out is the most prominent inventory valuation method for managing the perishable
goods. These include flowers, fruits, vegetables, fish and meat products, dairy items, chemicals
and pharmaceuticals.
FIFO states that the goods which were received first (old stock) needs to be consumed initially.
Thus, reducing the spoilage of those goods which have a short shelf life.
For this purpose, the store in-charge must ensure proper arrangement of stock. It should be
such that the newest batches should be placed in the last shelves, whereas the oldest ones
should be kept in front.
One of the ways of organizing the goods is through their batch numbers or expiry dates.
In reselling businesses, this method also optimizes the inventory for non-perishable items that
have occupied the store space, since a long time.
When the same product is ready to be launched with new features look, packaging or design;
FIFO is used to avoid antiquity of the left out old stock.
Last-In, Last-Out (LIFO)
Last in last out is an inventory valuation technique used for the goods which are non-perishable
and homogeneous. Some of these are bricks, cement, stones, sand, etc.
Since this type of stock is usually arranged in piles, the newest lot is on the top. Therefore, the
most recent goods have to be used first, followed by the oldest stock, which is at the bottom.
Though, this technique shows a superior income statement; the balance sheet is poorly valued
with old stock.
Also, the International Financing Reporting Standards (IFRS) and the Accounting Standards for
Private Enterprises (ASPE) forbids the use of LIFO in accounting. In the US, Generally Accepted
Accounting Principles (GAAP) has not imposed any such restrictions.
Economic Order Quantity (EOQ)

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EOQ is used as an inventory management method to estimate the optimum quantity of material
to be purchased. It is to fulfil the production requirement such that the inventory maintenance
cost is minimal.
Following are the two main objectives of EOQ:
Reducing the total inventory cost is the primary aim of this method. These costs involve order
cost, holding expense and shortage cost.
Next, is assuring that the right quantity of goods is ordered in each batch. It will not only reduce
the frequency of order placement; but will also keep a check over the surplus inventory.
The formula of EOQ for inventory management is:

EOQ = √2𝐴𝑂/𝐶
A= Annual Consumption
O= Ordering Cost
C= Carrying Cost
ABC Analysis
Another inventory control method is ABC analysis that lists out the goods under three classes
as follows: ABC Analysis

1. A, i.e., Highly Important: These are the goods which cost high and therefore, maintained
in small quantity.
2. B, i.e., Moderately Important: It constitutes the inventory which has an average value
maintained in fair quantity.
3. C, i.e., Less Important: These goods are available in huge quantity due to their low value
or cost.
Thus, category A being quite expensive, requires constant monitoring through EOQ, periodic
check on available quantity, inventory budgeting and ratio analysis.
The goods under category B should be ordered as per the market or production requirements.
Moreover, the ones that belong to category C does not require much control. Instead, only
the cost monitoring approach is enough for such goods.
Vital, Essential and Desirable (VED) Classification
The VED classification is mostly used in industries where machines are used for production. It
distinguishes the stock according to the significance of its usage into the following three
categories:

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Vital: Items signifying the lifeline of the production process are termed as vital items. In the
absence of these, the whole process would halt.
Essential: The stock out cost of the essential items is quite high. Thus, their absence leads to a
significant loss.
Desirable: The desirable items does not immediately hamper the production and also have a
minimal stock out the cost.
In the above classification, we can see that the essential items hold the highest significance since
its non-availability would pause the production process. These items usually comprise of
machinery which requires excessive control.
Drop shipping
Drop shipping is that form of business which ensures inventory control for resellers. The
organization does not maintain any inventory.
On receiving the order from a customer, the company forwards it to manufacturer, supplier or
wholesaler. Then, the vendor directly ships the product to the customer.
Thus, cross-docking has the following advantages:

 Minimal inventory cost;

 Meagre startup investment;
 Scalability with low risk;
 Minimal order fulfilment expense.
Contingency Planning
Contingency strategy can be seen as a backup plan. Thus, this type of inventory management
technique helps to deal with any of the following adverse business circumstances:
 Shortage of space in warehouses;
 False inventory valuation or calculation;
 Vendor runs out of stock and cannot meet the order deadlines;
 A sudden increase in demand leads to stock over-valuation;
 The manufacturer or vendor stops dealing in particular goods without any prior
information;
 The company runs out of sufficient working capital to acquire essential products.

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In this method, the organization should foresee the inventory-related risk and its impact.
Accordingly, it should plan what actions are to be taken, if any of the above problems arise.
Along with this, a constant effort should be made to build strong public relations for long-term
existence.
Therefore, contingency planning is essential for effective inventory management.
Accurate Forecasting
In inventory management, market demand analysis and estimation of sales, play a significant role.
If the organization lacks proper information about a precise number of future sales units, there
are high chances of stock wastage or shortage.
While accurate demand forecasting the organization must look into the following factors:

 Economic conditions;
 Market trends;
 Planned advertisements and promotion;
 Marketing cost;
 Consumers’ growth rate;
 Seasonal impact on demand;
 Previous year’s sales record.
Set PAR Levels
Minimum safety stock or Periodic Automatic Replenishment (PAR) level refers to establishing
minimum stock criteria for each type of goods. If the inventory goes down the set limit, it is an
indication that the new minimum order needs to be placed.
For such decision making, the store manager needs to analyze the frequency of sales or
production and procurement period. With the changing market demand, production capacity,
warehousing capacity, maintenance cost and various other factors; the PAR levels can be
altered.

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Therefore, the organization must review the PAR levels considering these factors, from time
to time. In the absence of the manager, safety stock levels also aid the employees to take prompt
inventory procurement decisions.
Inventory Kitting
Product bundling as we call it is a method of creating a bundle by grouping different products,
packaging and merchandising them together as a single unit.
In the inventory management, on selling a bundle, the system automatically associates the pack’s
sale to the sale of items included in it, separately.
Some of the benefits of this method are as follows:
 Spontaneous selling of different products helps to minimize inventory obsoletion; along
with clearance of the old stock.
 It reduces the overall warehousing, maintenance and shipping costs.
 It initiates inventory tracking and its minimum level maintenance.
 It improves the average order values and enhances sales revenue.
Just-In-Time (JIT) Inventory Management
Just-in-time is one of the Japanese inventory management techniques, that emphasizes keeping
a ‘zero inventory ‘.
As the name suggests, it refers to maintaining only that much stock which is required at present,
for carrying out the production or merchandising process.
Some organizations first receive the order from the clients, and then they proceed with the
inventory procurement and manufacturing activities.
Following are the various advantages of JIT:

 JIT benefits through ordering the new stock only when the old one is about to finish.
Thus, it reduces obsoletion or expiry of the existing stock.
 It ensures a positive cash flow, with less working capital engaged in inventory.
 It also provides for optimizing the inventory cost by reducing the warehousing and
insurance expenses.
However, one of the most significant drawbacks of this technique is it may result in stock-out.
Since there is a possibility that the procurement team fails to order the goods on time or the
delivery of stock is delayed.
Material Requirement Planning (MRP)
Commonly known as MRP method, it is an analytical approach. The manager places the order
with the vendors, for new stock only after finding out the market demand and sales forecast,
acquired from the different business areas.
For the manufacturers, merchandisers, wholesalers and stockists; it is a beneficial technique
since it provides for price risk optimization and also reduces the overstock uncertainties.
Perpetual Inventory Management

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It is a continuous inventory system that helps in regular tracking of the real-time stock
movements.
In this method, the inventory is promptly updated in the books of accounts, as soon as the
purchase or sale of goods is made.
Thus, this is a superior technique to the periodic inventory system which initiates only an
occasional or random check of inventory through physical counting of goods.
Given below are the various plus points of perpetual inventory system:

 Efficient inventory forecasting;

 Immediate recording of the stock information;
 Competent in terms of time and cost;
 Error-free due to validated data.
Fast, Slow and Non-Moving (FSN) Inventory
The critical function of the FSN inventory technique is understanding the frequency with which
a specific product is consumed for production or merchandising. Let us now go through its
following three elements:

1. Fast-Moving Inventory: The goods which are readily saleable or consumed in bulk, are
termed as fast-moving inventory. The inventory turnover ratios of such stock are quite
high.
2. Slow-Moving Inventory: The stock which is not consumed that frequently resulting in
low turnover ratio, is categorized under slow-moving inventory.
3. Non-Moving Inventory: Some goods in the warehouse, goes out of demand and
therefore, becomes obsolete. Many times, such non-moving inventory leads to dead
stock.
The manager should take steps to use or eradicate the non-moving inventory for creating space
in the warehouse. Also, the slow-moving goods should be stored in a limited quantity to avoid
the chances of obsoletion.
On the other hand, the fast-moving stock should be maintained in a sufficient quantity for
uninterrupted production or supply of goods.
Batch Tracking
Throughout the supply chain management, goods are recorded and traced as per their batch
numbers, to facilitate lot tracking.

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 It is widely used to figure out where the inventory is, right from its receiving and
warehousing to production or sales. It even keeps track of the products’ expiration date
(if available).
 Given below are the benefits of batch tracking to the organizations:
 Batch tracking is a more efficient method of inventory management when compared to
the manual process.
 It improves vendor relationship through the identification and selection of prominent
suppliers.
 It helps to make out defective products in a batch, and thus, reduces the chances of loss.
 A robust quality control system can be established through a lot tracking system. Since
the expiry date of each product or batch is known, the chances of quality degradation
reduce.
Conclusion
We have seen that managing inventory is a vital task for any business organization. In large scale
companies, this process becomes even more complicated. Thus, automated ways of inventory
management came into action for simplifying the entire process.
We have discussed the most common methods above. Other than these, there are multiple
small techniques which also facilitate the inventory management process. Some of these include
inventory turnover ratio, regular inventory audit, periodic inventory system, cycle counting,
backordering, consignment, etc.

ENDS HERE

Compiled by: Prof. Mohammadali GUNI VMPCM