INVENTORY
MANAGEMENT
INVENTORY
• Idle goods or materials (i.e. raw materials,
purchased parts, components, sub-assemblies,
work-in-process, finished goods, and supplies) held
by the business for future use.
• Inventories are “added to” and “depleted from”; if
the addition and depletion process are stopped,
what remains is inventory.
2 REASONS WHY ORGANIZATIONS STOCK INVENTORY:
1. Take advantage of economies-of-scale that exists due
to the fixed cost of ordering items, and;
2. Buffer against uncertainty in customer demand or
disruptions in supply.
The expense associated with financing and
maintaining inventories is part of the cost of doing
business. In large organizations, inventories can run into
billions of pesos.
INVENTORY MANAGERS
MANAGEMENT
MUST ANSWER
TWO
QUESTIONS:
How much to order?
The proper quantity of
inventory to order at
any given time.
When to order?
The proper time to
order the quantity.
INVENTORY To show how quantitative models
MANAGEMENT can assist in making the “how
much to order” and “when to
PURPOSE: order” inventory decisions.
TWO CONSIDERATIONS FOR
INVENTORY MANAGEMENT:
• Deterministic inventory models –
assumption is that the rate of
demand for the item is constant
or nearly constant;
• Probabilistic inventory models –
for which the demand for the item
fluctuates and can be described
only in probabilistic terms.
INVENTORY MODELS
1. Deterministic inventory models – assumption is that the
rate of demand for the item is constant or nearly constant.
Total cost models:
a) Ordering costs
b)Holding costs
c) Order quantity (Q) - minimum cost formulas
d)Reorder point
e) Cycle time
INVENTORY MODELS
2. Probabilistic inventory models – is obtaining a
probability distribution that most realistically
approximates the demand distribution.
Single-period model where only one order is placed for the product
and, at the end of the period, either the product has sold out or a
surplus remains of unsold products that will be sold for a salvage value.
Solution procedures for multi period models based on order quantity,
reorder point, continuous review system or replenishment-level,
periodic review system.
1. PURCHASE COST
2.HOLDING OR CARRYING COST
3. ORDERING COSTS
4.SHORTAGE COSTS
FOUR BASIC
COSTS
ASSOCIATED • Annual cost of inventory is the
WITH sum of the annual ordering cost
INVENTORIES and annual carrying cost.
FOUR BASIC COSTS ASSOCIATED
WITH INVENTORIES
1. HOLDING OR CARRYING COST (Ch)
Cost associated with maintaining or carrying a given level of inventory,
depending on the size of the inventory.
Relates to physical holding items in storage.
This cost is proportional to the amount of inventory and the time over which
it is held.
It include interest, insurance, taxes, depreciation, obsolescence,
deterioration, spoilage, pilferage, breakage and warehousing cost (heat,
light, rent, security).
It also includes opportunity costs associated with having funds tied up in
inventory that could be used elsewhere.
FOUR BASIC COSTS ASSOCIATED
WITH INVENTORIES
1. HOLDING OR CARRYING COST
It is the explicit and implicit cost of maintaining and owning the inventory.
Holding cost is stated in two ways:
Cost is specified as a percentage of unit price,
Cost is specified as a peso amount per unit.
Explicit cost - Are money paid by a firm to purchase the services of productive resources.
Implicit cost - Opportunity costs associated with a firm’s use of resources that it owns.
The cost do not involve a direct money payment. Examples: wage income & interest
forgone by the owner of a firm who also provided labor services & equity capital to the
firm.
FOUR BASIC COSTS ASSOCIATED
WITH INVENTORIES
2. ORDERING COST (Co)
Cost associated with ordering and receiving inventory.
Cost considered fixed regardless of the order quantity.
Cost is incurred whenever an inventory is replenished.
Generally expressed as peso amount per order, regardless of order size.
Ordering costs is the term used for purchase or vendor models. These
costs include determining how much is needed, typing up invoices,
inspecting goods upon arrival for quality and quantity, moving the
goods to temporary storage.
FOUR BASIC COSTS ASSOCIATED
WITH INVENTORIES
3. PURCHASE OR DIRECT PRODUCTION COST
It is for vendor supply environments or direct production cost
in case items produced by user.
The unit cost can either be constant for all replenishment
quantities, or it may vary with the quantity purchased or
produced.
Businessmen often offer discounts or price breaks if the user
purchases quantities that exceed some specified quantity.
Unit cost may decrease as larger production runs are made
due to economies of scale.
FOUR BASIC COSTS ASSOCIATED
WITH INVENTORIES
4. SHORTAGE COST
Results when demands exceed the supply of inventory on hand.
The cost can include the opportunity cost of not making a sale,
loss of customer goodwill, lateness charges, and similar costs.
If the shortage occurs for an item carried for internal us (e.g. to
supply an assembly line), the cost of lost production or
downtime is considered a shortage cost.
FOUR BASIC COSTS ASSOCIATED
WITH INVENTORIES
4. SHORTAGE COST
Shortage costs are computed differently depending or whether
or not, back ordering is possible.
Explicit cost are incurred for overtime when back ordering is
permitted.
Implicit cost reflecting goodwill when the unavailable item is a
finished good
Shortage cost is a difficult cost to measure, since it supposedly
accounts for lost future sales.
HOW MUCH TO ORDER:
THE ECONOMIC ORDER QUANTITY
MODELS
EOQ model identifies the optimal order, quantity in terms of
minimizing the sum of certain annual costs which vary with order size.
EOQ model is the best known and most fundamental inventory
model.
This model is applicable when the demand for an item has a
constant or nearly constant rate and when the entire quantity
ordered arrived in the inventory at one point in time.
The constant demand rate condition means simply that the same
number of units is taken from the inventory each period of time.
HOW MUCH TO ORDER:
THE ECONOMIC ORDER QUANTIY
MODELS
The how much to order decision involves selecting an order
quantity that draws a compromise between:
1. Keeping small inventories and ordering frequently,
2. Keeping large inventories and ordering frequently.
The first alternative would result in undesirably high ordering
costs, while
The second alternative would result in undesirably high
inventory hold cost.
The Economic Order Quantity (EOQ)
2 (Annual inventory) (Cost per code)
--------------------------------------------------------
(percentage of carrying cost) (Cost per unit)
The Economic Order Quantity (EOQ)
Smaller order quantities (Q) - lowers inventory – using smaller
order quantities
The annual inventory holding or carrying costs can be calculated
using the average inventory. We can calculate the annual inventory
carrying costs by multiplying the average inventory by the cost of
carrying one unit in the inventory for a year.
Annual Inventory Carrying Costs (Ch) =
Average Annual holding or
Inventory cost per unit
Annual Carrying Costs = (1/2) Average inventory cost times
percentage of carrying cost
Annual Ordering Costs
Can be reduced by using large order quantities.
The annual ordering costs can be calculated by multiplying
the number of order per year and the cost per order.
Annual Ordering Cost (Co):
Number of orders Cost
per year per order
Total Cost = Annual Inventory Carrying Cost PLUS Annual
Ordering Cost
EOQ MODEL ASSUMPTIONS
1. Demand D is deterministic and occur at a constant rate.
2. The order quantity Q is the same order: The inventory level increases by Q units each
time an order is received.
3. The cost per order, Co, is constant and does not depend on the quantity ordered.
4. The purchase cost per unit, C, is constant and does not depend on the quantity
ordered.
5. The inventory holding cost per unit per time period, Ch, is constant. The total
inventory holding cost depends on both Ch and the size of the inventory.
6. Shortages such as stock-outs or backorders are not permitted.
7. The lead time for an order is constant.
8. The inventory position is reviewed continuously. As a result, an order is placed as
soon as the inventory position reaches the reorder point.
Figure: Physical relation of the annual carrying cost, annual ordering cost, total
annual cost, and the economic order quantity
WHEN TO ORDER
DECISIONS?
Inventory Position
Amount of inventory on hand plus the amount of inventory on order.
Same as inventory on hand.
With long lead times, inventory position maybe larger than inventory on
hand.
Re-order Point (r) – the inventory position at which new order should be placed.
r = dm
where: d = demand per day
m = lead time for a new order in days
WHEN TO ORDER DECISIONS?
Cycle Time (T) – period between orders.
T = Working days per year
D
EOQ
where D = annual demand for the product
Suppose that Coca-Cola Philippines Inc., has a beverage product that has a
constant annual inventory of 7,200 cases. A case of soft drink cost Coca-Cola
288 PhP. Ordering cost is 200 PhP per order and inventory carrying cost is
charged at 25% of the cost per unit. Identify the following aspects of the
inventory policy:
a. Economic Order Quantity
b. Annual Carrying Cost
c. Annual Ordering Cost
d. Total Annual Cost
e. Reorder point
f. Cycle Time
EXAMPLE:
EXAMPLE
Solution:
Given:
Annual Inventory = 7,200 cases
Cost per case of soft drinks = 288 PhP
Cost per order = 200 PhP
Percentage of Carrying Cost = 25%
a. EOQ = 2(7,200)(200)
(0.25)(288)
= 2,880,000
72
= 40,000
EOQ = 200 cases
EXAMPLE
b. Annual Carrying Cost = (Average inventory cost) (Percentage of Carrying Cost)
Average Inventory = ½ Economic Order Quantity
Annual Carrying Cost = ½ (200) x 0.25 (288)
= 100 x 72
= 7,200 PhP
c. Annual Ordering Cost = No. of orders x Cost per order
Number of orders = Annual Inventory
EOQ
= 7,200
200
= 36
Total Annual Ordering Cost = 36 x 200 PhP
= 7,200 PhP
d. Total Annual Cost = Annual Ordering Cost + Annual Carrying Cost
Total Annual Cost = 7,200 PhP + 7,200 PhP
= 14,400 PhP
