CHAPTER FOUR

INVENTORY MANAGEMENT
4.1. Introduction

It is very known that the task of inventory control is a part of a management function, which is
concerned with acquisition, distribution, storage, and disposal of materials and parts. For most
companies, the expense associated with financing and maintaining inventories is the substantial
part of doing business. Mathematical models are used to gain an appreciation of how inventory
costs arise and what managers do to control them. Moreover, these tools are useful to determine
the best inventory level to maintain and the best time to reorder merchandise proper inventory
management may be one of the most important functions of management. Excessive inventories
are costly to store but insufficient inventories may result in loss of market share or idle
employees.

Inventories are stocks of goods held for expected/potential future use. Inventory is, hence any
stock on hand that is tangible. It is a material held in its idle state for future use. Inventories of
business organizations might include raw materials, purchased parts, work – in process, finished
goods, supplies and spare parts. Since inventories are vital to the successful functioning of
manufacturing and retailing organizations, they need efficient management as a substantial share
of its funds is invested on them. Control and maintenance of inventories is a common problem to
all organization. But, inventory problem has increased with the need to produce goods in greater
quantities, faster and in multiple variations. Poor control of inventories can create negative cash
flows, tie up large sum of money, limits an expansion of the organization and also reduce the
return on investment.
4.2. Functions and Types of Inventories
4.2.1. Fundamental functions of inventories
 To protect against uncertainties regarding demand, supply, lead-time, delivery in all aspects
of inventories namely raw materials, work-in-process and finished goods. Maintaining
inventories is a must because it is impractical or impossible to forecast demand with
certainty. The primary role of inventories is to uncouple operations. Raw materials
inventories are to uncouple supplies and produces. Work- in-process inventories are to

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 uncouple stages of production and finally finished goods inventories are to uncouple
customer and manufacture.
 To achieve economies of scale: in purchasing to get discount, in transportation full
utilization of equipment and in production large-scale production and the like.
 To hedge against contingencies: labor strike, fire, flood, earth quick and any other natural
and social factors from the supplier side can create production interruption.
 To meet anticipated changes when the change is certain: inventories here are hence used to
meet forecasted changes in demand with more inventories, from price increase, from
expansion of market, constant labor turn over.
 To improve customer service: this function specifically focuses on customer satisfaction by
not being out of stock
4.2.2. Types of inventories
A. Anticipation Inventory

Anticipation inventories are built up in anticipation of future demand. For example, they are
created ahead of a peak selling season, a promotion program, vacation shutdown, or possibly the
threat of a strike. They are built up to help level production and to reduce the costs of changing
production rates.

B. Fluctuation Inventory (Safety Stock)

Fluctuation inventory is held to cover random unpredictable fluctuations in supply and demand
or lead time. If demand or lead time is greater than forecast, a stock out will occur. Safety stock
is carried to protect against this possibility. Its purpose is to prevent disruptions in manufacturing
or deliveries to customers. Safety stock is also called buffer stock or reserve stock.

C. Lot-Size Inventory

Items purchased or manufactured in quantities greater than needed immediately create lot-size
inventories. This is to take advantage of quantity discounts; to reduce shipping, clerical, and
setup costs; and in cases where it is impossible to make or purchase items at the same rate that
they will be used or sold. Lot-size inventory is sometimes called cycle stock. It is the portion of

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inventory that depletes gradually as customers’ orders come in and is replenished cyclically
when suppliers’ orders are received.

D. Transportation Inventory

Transportation inventories exist because of the time needed to move goods from one location
to another such as from a plant to a distribution center or a customer. They are sometimes called
pipeline or movement inventories. The average amount of inventory in transit is:
I= tA
365

Where I is the average annual inventory in transit, t is transit time in days, and A is annual
demand. Notice that the transit inventory does not depend upon the shipment size but on the
transit time and the annual demand. The only way to reduce the inventory in transit, and its cost,
is to reduce the transit time.

EXAMPLE PROBLEM

Delivery of goods from a supplier is in transit for 10 days. If the annual demand is 5200 units,
what is the average annual inventory in transit?

Answer
I= 10 X 5200 = 142.5 unit
365

The problem can be solved in the same way using dollars instead of units.

E. Hedge Inventory

Some products such as minerals and commodities—for example, grains or animal products—are
traded on a worldwide market. The price for these products fluctuates according to world supply
and demand. If buyers expect prices to rise, they can purchase hedge inventory when prices are
low.

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 F. 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, and erasers.

4.3. INVENTORY COSTS

The following costs are used for inventory management decisions:

Item cost.
Carrying costs.
Ordering costs.
Stock out costs.
Capacity-associated costs.
A. 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. These could include such things as
transportation, custom duties, and insurance. The inclusive cost is often called the landed price.
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.

B. Carrying Costs

Carrying costs include all expenses incurred by the firm because of the volume of inventory
carried. As inventory increases, so do these costs. They can be broken down into three
categories:

i. Capital costs. Money invested in inventory is not available for other uses and as such
represents a lost opportunity cost. The minimum cost would be the interest lost by not
investing the money at the prevailing interest rate, and it may be much higher depending
on investment opportunities for the firm.
ii. Storage costs. Storing inventory requires space, workers, and equipment. As inventory
increases, so do these costs.

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 iii. Risk costs. The risks in carrying inventory are:
 Obsolescence; loss of product value resulting from a model or style change or
technological development.
 Damage; inventory damaged while being held or moved.
 Pilferage; goods lost, strayed, or stolen.
 Deterioration; inventory that rots or dissipates in storage or whose shelf life is
limited.

What does it cost to carry inventory? Actual figures vary from industry to industry and company
to company. Capital costs may vary depending upon interest rates, the credit rating of the firm,
and the opportunities the firm may have for investment.

Storage costs vary with location and type of storage needed. Risk costs can be very low or can be
close to 100% of the value of the item for perishable goods. The carrying cost is usually defined
as a percentage of the dollar value of inventory per unit of time (usually one year). Textbooks
tend to use a figure of 20–30% in manufacturing industries. This is realistic in many cases but
not with all products. For example, the possibility of obsolescence with fad or fashion items is
high, and the cost of carrying such items is greater.

EXAMPLE PROBLEM

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 = 0.23x2, 000,000 = 460,000
C. Ordering Costs

Ordering costs are those costs associated with placing an order either with the factory or a
supplier. The cost of placing an order does not depend upon the quantity ordered. Whether a lot
of 10 or 100 are 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.

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Ordering costs in a factory include the following:

 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.
 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.
 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.
 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,
authorizing payment, and the accounting cost of receiving and paying the invoice.

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.
EXAMPLE PROBLEM
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
Average cost= Fixed costs + variable cost
Number of orders
= $60,000+$15,000 + $120 = $157.50

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 2000

D. Stock out Costs

If demand during the lead time exceeds forecast, we can expect a stock out. A stock out can
potentially be expensive because of back-order costs, lost sales, and possibly lost customers.
Stock outs can be reduced by carrying extra inventory to protect against those times when the
demand during lead time is greater than forecast.
E. Capacity-Associated Costs
When output levels must be changed, there may be costs for overtime, hiring, training, extra
shifts, and layoffs. These capacity-associated 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.

4.4. Economic Order Quantities

The objectives of inventory management are to provide the required level of customer service
and to reduce the sum of all costs involved. To achieve these objectives, two basic questions
must be answered:

1. How much should be ordered at one time?

2. When should an order be placed?

Management must establish decision rules to answer these questions so inventory management
personnel know when to order and how much. Lacking any better knowledge, decision rules are
often made based on what seems reasonable. Unfortunately, such rules do not always produce
the best results.

In this section we will discuss the above questions. First, we must decide what we are ordering
and controlling.

Stock-Keeping Unit (SKU)

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Control is exercised through individual items in a particular inventory. These are called stock-
keeping units (SKUs). Two white shirts in the same inventory but of different sizes or styles
would be two different SKUs. The same shirt in two different inventories would be two different
SKUs.

Lot-Size Decision Rules

A lot, or batch, as “a quantity produced together and sharing the same production costs and
specifications.” Following are some common decision rules for determining what lot size to
order at one time.

 Lot-for-lot. The lot-for-lot rule says to order exactly what is needed—no more— no
less. The order quantity changes whenever requirements change. This technique requires
time-phased information such as provided by a material requirements plan or a master
production schedule. Since items are ordered only when needed, this system creates no
unused lot-size inventory. Because of this, it is the best method for planning items and is
also used in a just-in-time environment.
 Fixed-order quantity. Fixed-order quantity rules specify the number of units to be
ordered each time an order is placed for an individual item or SKU. The quantity is
usually arbitrary, such as 200 units at a time. The advantage to this type of rule is that it is
easily understood. The disadvantage is that it does not minimize the costs involved.

A variation on the fixed-order quantity system is the min-max system. In this system, an
order is placed when the quantity available falls below the order point. The quantity
ordered is the difference between the actual quantity available at the time of order and the
maximum. For example, if the order point is 100 units, the maximum is 300 units, and the
quantity actually available when the order is placed is 75, the order quantity is 225 units.
If the quantity actually available is 80 units, an order for 220 units is placed. One
commonly used method of calculating the quantity to order is the economic order
quantity, which is discussed in the next section.

Order n periods supply. Rather than ordering a fixed quantity, inventory management can order
enough to satisfy future demand for a given period of time. The question is how many periods

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should be covered? The answer is given later in this section in the discussion on the period-order
quantity system.

Costs

The cost of ordering and the cost of carrying inventory both depend on the quantity ordered.
Ideally, the ordering decision rules used will minimize the sum of these two costs. The best-
known system is the economic-order quantity.

ECONOMIC-ORDER QUANTITY (EOQ)

Assumptions
The assumptions on which the EOQ is based are as follows:
1. Demand is relatively constant and is known.
2. The item is produced or purchased in lots or batches and not continuously.
3. Order preparation costs and inventory-carrying costs are constant and known.
4. Replacement occurs all at once.

These assumptions are usually valid for finished goods whose demand is independent and fairly
uniform. However, there are many situations where the assumptions are not valid and the EOQ
concept is of no use. For instance, there is no reason to calculate the EOQ for made-to-order
items in which the customer specifies the order quantity, the shelf life of the product is short, or
the length of the run is limited by tool life or raw material batch size. In material requirements
planning, the lot-for lot decision rule is often used, but there are also several rules used that are
variations of the economic-order quantity.

Development of the EOQ Formula

Under the assumptions given, the quantity of an item in inventory decreases at a uniform rate.
Suppose for a particular item that the order quantity is 200 units and the usage rate is 100 units a
week. Figure 10.1 shows how inventory would behave. The vertical lines represent stock arriving
all at once as the stock on hand reaches zero. The quantity of units in inventory then increases
instantaneously by Q, the quantity ordered. This is an accurate representation of the arrival of
purchased parts or manufactured parts where all parts are received at once.

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 4.5. ABC Classification of Inventory System
A few materials in a firm often account for the most of inventory value consumption unit price.
These items have to be separated so that detailed and precise control could be made over these
inventories. It is often uneconomical to apply equal degree of control and maintain equal level of
inventories. It is however, economical to purchase large supply of low value items and maintain
relatively little control over them. Conversely, small quantities of high value items are purchased
and tight and detailed control is exercised. Therefore, we have to apply selective inventory
control system i.e. material inventories should be given the attention they deserve.

One of the methods to apply selective inventory control is ABC Classification of inventories. A
constitutes for 75-80% of the total value; however, in terms of total quantity it constitutes only
15-20%. B constitutes for 10-15% of the total value but 20-25% of the total quantity. And finally
C constitutes for 5-10% of the total value but 60-65% of the total quantity.
Generally speaking, the classification of inventory into ABC is arbitrary. The exact percentage of
items may vary from one organization to another. What is most important is that there are always
few items, which are significant, and a large number of items, which are relatively insignificant.
Therefore, the same degree of control for all inventories is not economically justifiable.
Item % of total % of total Degree of Type of Lot size Frequency of Size of
inventory value inventory control record review safety stock
quantity

A 80% 20% Tight Accurate Low Continuous Low

B 15% 25% Moderate Good Medium Occasional Medium
C 5% 55% Loose Simply Large Infrequent Large

4.6. Just – In Time (JIT)

Just- in- time Philosophy (JIT) was introduced by the Ford motor company but publicized by
Total Motor Corporation of Japan as part of its Toyota Production Systems (TPS). Toyota’s
effort to continually improve their production system over years, along with diffusion of their
improved production system to other Japanese companies and a dedicated effort to pursue

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perfection has resulted in the effective, efficient, integrated materials management system known
as Just- In- Time manufacturing technique. Just in Time (JIT) manufacturing is described as a
system that helps in making appropriate order of materials available to each operating unit at the
right time in the right quantity. JIT is a systematic concept consisting of JIT purchasing, JIT
transportation and JIT production. These three elements combine to create a material handling
system that avoids waste and minimizes inventory investment. The technique has changed
employees’ belief, attitude, work habits and awareness of quality assurance.

JIT technique’s main focus is identification and elimination of all material handling related
activities that do not add value to product or service, a commitment to a high level of quality
from purchasing, transporting to production, a commitment to continuous improvement in the
efficiency of materials management activities and quality product. Product quality is one of the
central managerial focuses of any competitive organizations. It requires planning and organizing
and controlling manufacturing resource and tailored towards high quality and performance. Just
in time is a method based on initiation of a “pull” system of manufacturing (matching production
to predetermined demand) and the advantages include significant reductions of raw materials,
semi-finished goods, components and parts, and finished goods inventories. Also, some benefits
include meaningful reduction in throughput time and reduction of production process space.
Hence, this helps management to reduce production costs, achieve their target and offer quality
product to customers.

The JIT philosophy begins with purchasing the raw materials by receiving frequent receipts of
material from supplier to meet immediate requirements. This is achieved if there are close and
collaborative buyer-seller relationships, extensive sharing of information between parties, a
commitment to zero defects and processing data electronically. JIT purchasing method does not
tolerate high inventory levels, less materials quality, waste between buyer and seller and related
inefficiency. JIT transportation is the next another important philosophy which addresses the
efficient movement of materials between the buyer and seller. This entails frequent deliveries of
materials directly to the right pace as required by the buyer. JIT transportation relies on efficient
private or public carriers that move materials between buyer and seller on a regular and repetitive
basis. Closed-loop system of transportation refers to a situation where materials are moved from
seller to buyer and then from buyer back to seller with return material where necessary. Adopting

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efficient JIT transportation scheme involves the following; organization must adjust its structure
to support JIT deliveries, reduce the number of carrier, have long-term agreements with carriers
to foster commitment and dedication, process supply chain related activities electronically, a
closed-loop system of delivery should be adopted and materials flow should be handled by
modern equipment and technology.

The third aspect of JIT philosophy is JIT production which involves transforming raw and semi
finished materials to finished products to satisfy the needs and wants of customers. JIT
production addresses the following activities among others: machine setup time reduction,
adjusting facility layout, focused factory, group technology layout, pull production system, total
quality management, product and process improvement, teamwork management, sound
performance evaluation, flexible workforce arrangement, harmless material handling and
packages, preventive maintenance and safe work environment, etc.

Objectives of Just in Time Technique

The objectives of JIT are to reduce processing time, elimination of waste, have respect for people
and cost minimization. This can be achieved if firms hold zero inventory; a system known as
lean supply chain. The summary of the objectives of lean supply chain oriented organizations is
to improve productivity by minimizing the cost of the quality product. The following factors can
be considered for the required improvements:
1. Process and Product design.
2. Using state-of-the art equipment and technology.
4. Holding zero inventory
5. Reducing lead-time of supply of materials.
5. Reducing batch size.
6. Using pull production system.
7. Simplifying factory layout
8. Reducing machine set up.
9. Improving on waste reduction
In order for organizations to achieve these objectives, JIT practices must be linked with other
activities that provide supporting infrastructure. Supporting infrastructure refers to those

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concepts that give synergy advantages to JIT practices in items of above mentioned factors. Few
amongst the JIT supporting infrastructures that are considered important are; visionary
leadership, total organization commitment, customer empowerment, strict adherence to product
quality standard, qualified personnel, employee’s education and training, systematic performance
appraisal, good salaries and other benefits and employees’ empowerment.

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