Operations Management

Inventory Management
Jan 2022
 Learning Objectives

You must be able to

• Define the term “inventory”

• Identify items that need to be managed

Next week:
• Economic Order Quantity
• Inventory costs

Text:

Shenoy & Rosas, Problems & Solutions in Inventory Management, 2018, Springer

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 Definition
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 Inventory
Raw Materials, Work-in-
Process

The stock of items used in production, supporting activities and customer service

Maintenance Operations (sales,

operations, Spare Parts marketing, product testing)

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 Tequila Production – A Case to Identify inventory
items

The Agave Plant The Agave root-ball

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 Production Process

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 Questions

Prepare a list of inventory items

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 Identify Raw materials, WIP & Finished
Product
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 Inventory Management – What does it mean?
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 Question

Every month Sudhir Shetty buys 3000 kgs. of rice from the market. Each kilo of rice costs Rs. 50. It costs
Sudhir Rs. 500 every time he sends a person to the market to buy rice.

How many kilos of rice should Sudhir buy each time he places an order for rice?

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 Inventory Management

Answering the following concerns:

• How much to order?

• When to order?

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 Economic Order Quantity

Based on two types of costs:

• Carrying Cost – The cost of holding a unit of item in inventory

• Ordering Cost – The cost of placing an order

These two are opposing costs.

• If you order small amounts, you will have to order more frequently – thereby increasing
ordering costs. However, since you are ordering less, the holding cost (carrying cost) would be
lower.
• If you order large quantity, you place fewer orders, thereby reducing ordering costs. But you will
have to hold those until exhausted thereby increasing carrying costs.

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 Inventory Costs
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 Inventory costs

• Carrying costs

• Ordering costs

• Shortage costs

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 Carrying rate & carrying cost

Cost associated with temporary storage of items

Components of carrying rate (annual):

• Cost of capital: What if I invest this money in other schemes rather than in this inventory?
• Cost of storage: Rent for physical space and maintenance, cold storage etc.
• Cost of inventory risk: damage during loading, unloading, obsolescence
• Cost of servicing: insurance, taxes

Carrying cost is where is the carrying rate and is the item cost.

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 Problem : Calculate carrying rate

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 Problem: Calculate carrying cost for a $20
item
Carrying rate (calculated earlier) is 19.75%
Item cost is $20

Carrying cost is

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 Ordering costs

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 Ordering cost computation for a company

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 Practice Problem 1

Table shows data collated for a single item in an

inventory system. Compute the following: Type of cost Values (per year)
Cost of capital 9.25%
a. Inventory holding rate Cost due to breakage 6.25%
b. the annual carrying cost of an item that costs $25 Cost of physical handling 0.50%
Rent paid towards physical
c. the total annual carrying cost for 15 items that space for storage 3.50%
cost $25 per unit
Premium paid to insure
d. the total carrying cost for 15 items that cost $25 inventory 0.50%
per unit and are held in inventory for a period of 5 Tax 1.00%
years.

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 Practice Problem 2
Expense head Total Annual Weightage Apportioned to
Expenditure ($) ordering cost
Table shows costs incurred by an organization computation
during one financial year. Fill up the last column in Cost of Administration
the table. Also, if the organization has placed 5000 Stationery (e.g. Order forms) 1,000 5%
orders in the financial compute the average cost Communication (Telephone, Courier etc.) 5,500 25%
per order. Salary – Manager (Purchase Department) 65,000 85%
Salary – Record-keeping Assistant (Purchase 48,000 100%
Department)
Cost of Inspection
Travel to suppliers workplace (for inspection) 3,500 100%
Salary - Incoming Goods Inspector 50,000 100%
Cost of Transportation
Transportation costs (Fuel expenses) 15,000 100%
Unskilled labour (loading/unloading) – 2 18,000 100%
persons @ $10 per hour for 2 hours per day
Total Expenses
Number of orders placed during the year
Order cost per order

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 How much to order?
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 Assumptions

• Annual demand is known and constant

• ONLY one item
• Costs are known
• No discounts are offered by suppliers
• No constraints
• Item is not perishable

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 • The total Inventory cost in a system is the sum of the ordering costs , holding costs and investing costs over
ONE YEAR
• Let us assume the annual demand for an item is . We need to find the order quantity for which the total
inventory cost is minimum.
• If is the economic order quantity, then ordering cost can be computed as follows:
• Number of orders to be placed to meet is

EOQ – Derivationwhere is the order cost per order. If is the order quantity, then the average units held is
of Wilsons
Formula
where is the holding rate per year and C is the item cost per unit. The total money invested in
inventory is

• The total cost is therefore Wilsons Formula, also referred to as

just EOQ

• Differentiating w.r.t Q, and equating it to 0 (to find minima) we get

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 Application of Wilsons Formula
𝐷 𝑄
𝑇𝐼𝐶= 𝐶 𝑜 + 𝑖𝐶+𝐷𝐶
𝑄 2

𝑄=
𝑖𝐶 √
2 𝐷 𝐶𝑜

Key point:
• All units must be consistent. For eg., if D is in years, then holding rate must also be in years.

• In some cases, we would need to reverse –engineer the price (or rate) is the Q is given.

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 Numerical Example

Compute the economic order quantity of an item that has an annual demand of 5000 units. Assume the
following:
• Holding rate of 20% per year
• Item cost is $10 per unit
• Ordering cost per order is $25.2

Solutions steps:
• Check if all data is expressed in consistent units
• Apply Wilsons Formula
• Round-off answer

Ans: 355 units

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 EOQ – Basic Concept

Cost
Total Cost
Minimum
Cost Point

Ordering Cost
Carrying Cost

Q, The economic Quantity

order quantity

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 Graphical Method

People residing at FLAME University consume 36000 kgs of rice every year. The rate of storing rice is their
campus godown is 8% per annum, and the cost of rice per kg is Rs 30. If the store manager has to spend
Rs 150 each time he goes to the market to procure rice, what is the EOQ ?

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 A Tricky Problem

Sun Corporation is a retailer of school notebooks. They buy notebooks from a wholesaler at $0.50 per
notebooks and sell it to retailers at $0.85 per notebook. If the demand for notebooks is 9000 per quarter,
determine the EOQ if =15% per year and ordering cost per order is $4.

Ans: 1960 notebooks per order

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 Find the holding rate

The EOQ for a $20 item is 150 units. Annual demand is 2400 units. If ordering cost per order is $20,
compute the implied carrying (holding) rate i.

Ans: 21.3% per year

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