COURSE LEARNING MODULE

OMGT 1013 (Operations Management and Total Quality Management)

AY 2024-2025

Lesson 13 and 14: Inventory Management

Learning Outcomes: After reading this module, you are expected to:

 Define the term of inventory;

 Describe the functions of inventory;
 Discuss the main requirements for effective inventory management.

THE NATURE AND IMPORTANCE OF INVENTORIES

Inventories are a vital part of business. Not only are they necessary for operations, but they also
contribute to customer satisfaction. To get a sense of the significance of inventories, consider the following:
Some very large firms have tremendous amounts of inventory. For example, General Motors was at one point
reported to have as much as $40 billion worth of materials, parts, cars, and trucks in its supply chain! Although
the amounts and dollar values of inventories carried by different types of firms vary widely, a typical firm
probably has about 30 percent of its current assets and perhaps as much as 90 percent of its working capital
invested in inventory. One widely used measure of managerial performance relates to return on investment
(ROI), which is profit after taxes divided by total assets. Because inventories may represent a significant
portion of total assets, a reduction of inventories can result in a significant increase in ROI, although that
benefit has to be weighed against a possible risk of a decrease in customer service. It is interesting to note that
the ratio of inventories to sales in the manufacturing, wholesale, and retail sectors is one measure that is used
to gauge the health of the U. S. economy.

Inventory decisions in service organizations can be especially critical. Hospitals, for example, carry an array of
drugs and blood supplies that might be needed on short notice. Being out of stock on some of these could
imperil the well-being of a patient. However, many of these items have a limited shelf life, so carrying large
quantities would mean having to dispose of unused, costly supplies. On-site repair services for computers,
printers, copiers, and fax machines also have to carefully consider which parts to bring to the site to avoid
having to make an extra trip to obtain parts. The same goes for home repair services such as electricians,
appliance repairers, and plumbers.

The major source of revenues for retail and wholesale businesses is the sale of merchandise (i.e., inventory).
In fact in terms of dollars, the inventory of goods held for sale is one of the largest assets of a merchandising
business. Retail stores that sell clothing wrestle with decisions about which styles to carry, and how much of
each to carry, knowing full well that fast' Selling items will mean greater profits than having to heavily discount
goods that didn’t sell:

The different kinds of inventories include the following:

- Raw materials and purchased parts.

- Partially completed goods, called work-in-process (WIP)
- Finished-goods inventories (manufacturing firms) or merchandise (retail stores).
- Tools and supplies.
- Maintenance and repairs (MRO) inventory.
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 - Goods-in-transit to warehouses, distributors, or customers (pipeline inventory).

Both manufacturing and service organizations have to take into consideration the space requirements of
inventory. In some cases, space limitations may pose restrictions on inventory storage capability, thereby
adding another dimension to inventory decisions.

To understand why firms have inventories at all, you need to be aware of the various functions of inventory.

Functions of Inventory
Inventories serve a number of functions. Among the most important are the following.

1. To meet anticipated customer demand. A customer can be a person who walks in off the street to buy a
new stereo system, a mechanic who requests a tool at a tool crib, or a manufacturing operation. These
inventories are referred to as anticipation stocks because they are held to satisfy expected (i.e.,
average) demand.
2. To smooth production requirements. Firms that experience seasonal patterns in demand often build up
inventories during preseason periods to meet overly high requirements during seasonal periods. These
inventories are aptly named seasonal inventories; Companies that process fresh fruits and vegetables
deal with seasonal inventories. So do stores that sell greeting cards, skis, snowmobiles, or Christmas
trees.
3. To decouple operations. Historically, manufacturing firms have used inventories as buffers between
successive operations to maintain continuity of production that would otherwise be disrupted by events
such as breakdowns of equipment and accidents that cause a portion of the operation to shut down
temporarily. The buffers permit other operations to continue temporarily while the problem is resolved.
Similarly, firms have used buffers of raw materials to insulate production from disruptions in deliveries
from suppliers, and finished goods inventory to buffer sales operations from manufacturing disruptions.
More recently, companies have taken a closer look at buffer inventories recognizing the cost and space
they require, and realizing that finding and eliminating sources of disruptions can greatly decrease the
need for decoupling operations. Inventory buffers are also important in supply chains. Careful analysis
can reveal both points where buffers would be most useful and points where they would merely
increase costs without adding value.
4. To reduce the risk of stock outs. Delayed deliveries and unexpected increases in demand increase the
risk of shortages. Delays can occur because of weather conditions, supplier stock outs, deliveries of
wrong materials, quality problems, and so on. The risk of shortages can be reduced by holding safety
stocks, which are stocks in excess of expected demand to compensate for variability in demand and
lead time.
5. To take advantage of order cycles. To minimize purchasing and inventory costs, a firm often buys in
quantities that exceed immediate requirements. This necessitates storing some or all of the purchased
amount for later use. Similarly, it is usually economical to produce in large rather than small quantities.
Again the excess output must be stored for later use. Thus, inventory storage enables a firm to buy and
produce in economic lot sizes without having to try to match purchases or production with demand
requirements in the short run. This results in periodic orders or order cycles.
6. To hedge against price increases. Occasionally a firm will suspect that a substantial price increase is
about to occur and purchase larger-than-normal amounts to beat the increase.
7. To permit operations. The fact that production operations take a certain amount of time (i.e., they are
not instantaneous) means that there will generally be some work-in-process inventory. In addition,
intermediate stocking of goods-including raw materials, semi-finished items, and finished goods at

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 production sites, as well as goods stored in warehouses-leads to pipeline inventories throughout a
production-distribution system. Little’s Law can be useful in quantifying pipeline inventory. It states that
the average amount of inventory in a system is equal to the product of the average rate at which
inventory units leave the system (i.e., the average demand rate) and the average time a unit is in the
system. Thus, if units are in the system for an average of 10 days, and the demand rate is 5 units per
day, the average inventory is 50 units: 5 units/day x 10 days = 50 units.
8. To take advantage of quantity discounts. Suppliers may give discounts on large orders.

Objective of Inventory Management

Inadequate control of inventories can result in both understand overstocking of items. Understocking
results in missed deliveries, lost sales, dissatisfied customers, and production bottlenecks; overstocking
unnecessarily takes up space and ties up funds that might be more productive elsewhere. Although
overstocking may appear to be the lesser of the two evils the price tag for excessive overstocking can be
staggering when inventory holding costs are high.

The overall objective of inventory management is to achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds. The two basic issues (decisions) for inventory management
are when to order and how much to order. The greater part of this chapter is devoted to models that can be
applied to assist in making those decisions.

Managers have a number of performance measures they can use to judge the effectiveness of inventory
management. The most obvious, of course, are costs and customer satisfaction which they might measure by
the number and quantity of backorders and/or customer complaints. A widely used measure is inventory
turnover, which is the ratio of annual cost of goods sold to average inventory investment. The turnover ratio
indicates how many times a year the inventory is sold. Generally, the higher the ratio, the better, because that
implies more efficient use of inventories. However, the desirable number of turns depends on the industry and
what the profit margins are. The higher the profit margins, the lower the acceptable number of inventory turns,
and vice versa. Also, a product that takes a long time to manufacture, or a long time to sell, will have a low
turnover rate. This is often the case with high-end retailers (high profit margins). Conversely, supermarkets
(low profit margins) have a fairly high turnover rate. Note, though, that there should be a balance between
inventory investment and maintaining good customer service. Managers often use inventory turnover to
evaluate inventory management performance; monitoring this metric over time can yield insights into changes
in performance. Another useful measure is days of inventory on hand, a number that indicates the expected
number of days of sales that can be supplied from existing inventory. Here, a balance is desirable; a high
number of days might imply excess inventory, while a low number might imply a risk of running out of stock.

Requirements for Effective Inventory Management

Management has two basic functions concerning inventory. One is to establish a system to keep track of
items in inventory, and the other is to make decisions about how much and when to order. To be effective,
management must have the following:

1. A system to keep track of the inventory on hand and on order.

2. A reliable forecast of demand that includes an indication of possible forecast error.
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
5. A classification system for inventory items.

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 INVENTORY CONCEPTS
 INVENTORY is created when the receipt of materials, parts, or finished goods exceeds their
disbursement; it is depleted when their disbursement exceeds their receipt.

 Pressures for Low Inventories

 INVENTORY HOLDING (OR CARRYING) COST is the variable cost of keeping items on
hand, including interest, storage and handling, taxes, insurance, and shrinkage.
• Interest or Opportunity Cost whichever is greater, usually is the largest component of
holding cost.
• Storage and Handling Costs may be incurred when a firm rents space on either a
long-term or short-term basis.
• Taxes, Insurance, and Shrinkage.
 More taxes are paid if end-of-year inventories are high.
 Insurance on assets increases when there is more to insure.
 Shrinkage takes three forms:

o PILFERAGE - theft of inventory by customers or employees.

o OBSOLESCENCE – occurs when inventory cannot be used or
sold at full value, owing to model changes, engineering
modifications, or unexpectedly low demand.
o DETERIORATION – physical spoilage or damage

 Pressures for High Inventories

Why are inventories necessary?

 CUSTOMER SERVICE
 Creating inventory can speed delivery and improve on-time-delivery.
 STOCKOUT – occurs when an item that is typically stocked isn’t available to satisfy a
demand the moment it occurs, resulting in loss of the sale.
 BACKORDER – is a customer order that can’t be filled when promised or demanded
but is filled later.
 ORDERING COST
 For the same item, the ordering cost is the same regardless of the order size.
 ORDERING COST - Cost of preparing a purchase order for a supplier or a production
order for the shop
 SETUP COST
 It is also independent of the order size.
 It is the cost involved in changing in changing over a machine to produce a different
component or item
 LABOR AND EQUIPMENT UTILIZATION
 By creating more inventory, management can increase work-force productivity and
facility utilization.
 TRANSPORTATION COSTS
 Outbound and inbound transportation cost can be reduced by increasing inventory
levels.
 PAYMENT TO SUPPLIERS
 A firm often can reduce total payment to suppliers if it can tolerate higher inventory
levels.
 QUANTITY DISCOUNT – price per unit drops when the order is sufficiently large. It is an
incentive to order larger quantities.

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TYPES OF INVENTORY

A. CYCLE INVENTORY – the portion of total inventory that varies directly with lot size
 LOT SIZING – determining how frequent to order, and in what quantity

2 Principles of Lot Sizing

1. The lot size, Q, varies directly with the elapsed time (or cycle) between orders.
2. The longer the time between orders for a given time, the greater the cycle inventory
must be.

Average Cycle Inventory (ACI) is the average of the maximum and minimum cycle inventory level at the
beginning and end of the interval respectively. At the beginning of the interval, the cycle inventory is at its
maximum or Q. At the end of the interval, just before a new lot arrives, cycle inventory drops to its minimum
or 0.

B. SAFETY STOCK INVENTORY – protects against uncertainties in demand, lead time, and supply

C. ANTICIPATION INVENTORY – used to absorb uneven rates of demand or supply, which businesses
often face

D. PIPELINE INVENTORY – inventory moving from point to point in the materials flow system. It consists
of orders that have been placed but not yet received.

ESTIMATING INVENTORY LEVELS

Example:

A plant makes monthly shipments of electric drills to a wholesaler in average lot sizes of 280 drills.
The wholesaler’s average demand is 70 drills per week, and the lead time from the plant is three
weeks. On average, how much cycle inventory and pipeline inventory does the wholesaler carry?

ANSWER:
The wholesaler’s cycle inventory is 140 drills, whereas the pipeline inventory (inventory in transit)
averages 210 drills.

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Inventory Models for Independent Demand
1. Basic Economic Order Quantity (EOQ)

ECONOMIC ORDER QUANTITY (EOQ) is the lot size that minimizes total annual inventory holding
and ordering costs.

 The approach to determining the EOQ is based on the following assumptions:

1) The demand rate for the item is constant and known with certainty.
2) There are no constraints on the size of each lot.
3) The only two relevant costs are the inventory holding cost and fixed cost per lot for
ordering or setup.
4) Decisions for one item can be made independently of decisions for other items.
5) There is no uncertainty in lead time or supply

CALCULATING THE EOQ

Where: D = annual demand

S = Annual Ordering/Set-up cost
H = Annual Holding Cost

 Annual Holding Cost

= (Average cycle inventory)(Unit holding cost)
 Annual Ordering Cost
= (Number of orders/year)(Ordering or setup cost)
 Average Number of Orders Per Year
= Annual demand
Lot size

 Total Cost
= Annual holding cost + Annual ordering or set up cost
or C = Q (H) + D (S)
2 Q

Where C = total cost per year

Q = lot size, in units
H = cost of holding one unit in inventory for a year, often calculated as the proportion of
the item’s value
D = annual demand, in units per year
S = cost of ordering or setting up one lot, in dollars per lot

 TIME BETWEEN ORDERS (TBO) for a particular lot size is the average elapsed time between
receiving (or placing) replenishment orders of Q units
 When we use EOQ the TBO can be expressed in various ways for the same time period:

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 Formula for determining TBO in years:
TBO = EOQ/D

Formula in determining TBO in months, weeks and days:

TBO = EOQ/D x 12 months

TBO = EOQ/D x 52 weeks

TBO = EOQ/D x 365 days

Example:

A museum of natural history opened a gift shop two years ago. Managing inventories has
become a problem. Low inventory turnover is squeezing profit margins and causing cash-flow
problems.
One of the top selling items in the container group at the museum’s gift shop is a birdfeeder.
Sales are 18 units per week, and the supplier charges $60 per unit. The cost of placing an order
with the supplier is $45. Annual holding cost is 25% of a feeder’s value, and the museum operates
52 weeks per year. Management chose 390-unit lot size so that new orders could be placed less
frequently. What is the annual cost of the current policy of using 390-unit lot size?

SOLUTION:

For the birdfeeder in the previous example, calculate the EOQ and its total cost. How frequently will
orders be placed if the EOQ is used?

First, compute the EOQ......then the Annual cost as follows:

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 Now, to compute how frequent orders will be made, we first determine the time between orders:

So, given those TBOs in year, month, weeks and days, how frequent will the museum order
birdfeeders? Answer : Approximately 12 times a year.

2. Production order quantity

3. Quantity discount model

UNDERSTANDING THE EFECT OF CHANGES

 A change in the Demand Rate. Because D is in the numerator, the EOQ increases in proportion to the
square root of the annual demand.
 A change in the Setup Costs. Because S is in the numerator, increasing S increases the EOQ and,
consequently, the average cycle inventory. Conversely, reducing S reduces the EOQ, allowing smaller
lot sizes to be produced economically.
 A Change in the Holding Costs. Because H is in the denominator, the EOQ declines when H
increases. Conversely, when H declines, the EOQ increases.
 Errors in Estimating D, H, and S. Total cost is fairly insensitive to errors even when estimates are
wrong by a large margin.

Inventory Control Systems

 Continuous Review (Q) System

- sometimes called a reorder point (ROP) system or fixed order quantity system
- tracks the remaining inventory of an item each time a withdrawal is made to determine
whether it is time to reorder.
- reviews are done frequently or continuously

INVENTORY POSITION (IP) - measures the item’s ability to satisfy future demand. It includes
scheduled receipts (SR), which are orders that have been placed but not yet received (also
called open orders), plus on-hand inventory (OH) minus backorders (BO).
Inventory Position = On-hand inventory + Scheduled receipts – Backorders
IP = OH + SR - BO

A. Selecting the Reorder Point When Demand is Certain

 Reorder point , R
-predetermined minimum level
- R equals demand during lead time, with no added allowance for safety stock

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 R = Average demand during lead time

Example:

Demand for chicken soup at a supermarket is 25 cases a day and the lead time is four days.
The shelves were just restocked with chicken soup, leaving an on-hand inventory of only 10 cases.
There are no backorders, but there is one open order for 200 cases. Should a new order be placed?

B. Selecting the Reorder Point When the Demand is Uncertain

 This approach will create a safety stock, or stock held in excess of expected
demand to buffer against uncertain demand

R = Average demand during lead time + Safety stock

 Finding the Safety Stock
 We compute the safety stock by multiplying the number of standard deviations from the
mean needed to implement the cycle-service level, z, by the standard deviation of demand
during lead time probability distribution, σL

Example:

Records show that the demand for dishwasher detergent during the lead time is normally
distributed, with an average of 250 boxes and σL = 22. What safety stock should be carried for a
99 percent cycle-service level? What is R?

Solution:

 Periodic Review (P) System

- sometimes called a fixed interval reorder system or periodic reorder system in
which an item’s inventory position is reviewed periodically rather than continuously.

 Hybrid System
a. Optional Replenishment System
- Sometimes called the optional review, min-max, or (s, S) system
- Much like the P system

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 - It is used to review the inventory position at fixed time intervals and, if the position has
dropped to (or below) a predetermined level, to place a variable-sized order to cover
expected needs.

b. Base-Stock System
- Issues a replenishment order, Q, each time a withdrawal is made, for the same amount
as the withdrawal

*** END of LESSON***

REFERENCES

Textbooks

Chase, Richard,et.al. Production and Operations management: Manufacturing and Services 8th ed.
Irwin/McGrwa-Hill. Boston

Stevenson, William J. (2018). Operations management thirteenth edition. McGraw Hill Education, 2 Penn
Plaza, New York, NY 10121.

WARNING: No part of this E-module/LMS Content can be reproduced, or transported or shared to others without
permission from the University. Unauthorized use of the materials, other than personal learning use, will be penalized.
Please be guided accordingly.

Prepared by:

GLADYS T. TUMBALI, DBM

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