INVENTO

RY
CONTROL
OFIANA, ALTHEA
REGACHO, SEANN AUBREY
BALLESTEROS, LAURENCE
DEFINITION OF INVENTORY
 Inventory is the stock of any item or resource used in an
organization. An Inventory system is the set of policies and
controls that monitor levels of inventory and determine what
levels should be maintained, when stock should be replenished,
and how large orders should be.
 By convention, manufacturing inventory generally refers to
items that contribute to or become part of a firm's product
output.
 In services, inventory generally refers to the tangible goods to
be sold and the supplies necessary to administer the service.
1. To maintain independence of
operations.
2. To meet variation in product
demand.
3. To allow flexibility in production
scheduling.
4. To provide a safeguard for variation
in raw material delivery time.
5. To provide a safeguard for variation
in raw material delivery time.
INVENTORY COSTS
1. Holding (or carrying) costs. This broad category includes the costs for storage
facilities, handling, insurance, pilferage, breakage, obsolescence, depreciation,
taxes, and the opportunity cost of capital.
2. Setup (or production change) costs. To make each different product involves
obtaining the necessary materials, arranging specific equipment setups, filling
out the required papers, appropriately charging time and materials, and moving
out the previous stock of material.
3. Ordering costs. These costs refer to the managerial and clerical costs to prepare
the purchase or production order.
4. Shortage costs. When the stock of an item is depleted, an order for that item
must either wait until the stock is replenished or be canceled.
 INDEPENDENT VERSUS
DEPENDENT
In independent DEMAND
demand, the demands for various items
are unrelated to each other.

In dependent demand, the need for any one item is a

direct result of the need for some other item, usually a
higher-level item of which it is part. In concept,
dependent demand is a relatively straightforward
computational problem.
 INVENTORY
An
SYSTEMS
inventory system provides the
organizational structure and the operating
policies for maintaining and controlling
goods to be stocked. The system is
responsible for ordering and receipt of
goods: timing the order placement and
keeping track of what has been ordered, how
much, and from whom. This section divides
systems into single-period systems and
multiple-period systems.
 A SINGLE-PERIOD INVENTORY
Single-period inventory models are MODEL
useful for a wide variety of service and manufacturing
applications. Consider the following:

1. Overbooking of airline 3. Any type of one-time order.

2. Ordering of fashion items. A For example, ordering T-shirts
flights. It is common for
problem for a retailer selling for a sporting event or printing
customers to cancel flight
fashion items is that often only maps that become obsolete
reservations for a variety of
a single order can be placed for after a certain period of time.
reasons. Here the cost of
the entire season. This is often
underestimating the number caused by long lead times and
of cancellations is the revenue limited life of the merchandise.
lost due to an empty seat on a The cost of underestimating
flight. The cost of demand is the lost profit due to
overestimating cancellations sales not made. The cost of
is the awards, such as free overestimating demand is the
flights or cash payments, that cost that results when it is
are given to customers unable discounted.
to board the flight.
 MULTIPERIOD INVENTORY
SYSTEMS
There are two general types of multiperiod inventory systems: fixed-order
quantity models (also called the economic order quantity, EOQ, and Q-model) and
fixed-time period models (also referred to variously as the periodic system,
periodic review system, fixed-order interval system, and P-model).

Multiperiod inventory systems are designed to ensure that an item will be available
on an ongoing basis throughout the year. Usually the item will be ordered multiple
times throughout the year where the logic in the system dictates the actual quantity
ordered and the timing of the order.
 Some additional differences tend to influence the choice of systems:

• The fixed-time period model has a larger average inventory because it must also protect against
stockout during the review period, T; the fixed-order quantity model has no review period.

• The fixed-order quantity model favors more expensive items because average inventory is
lower.

• The fixed-order quantity model is more appropriate for important items such as critical repair
parts because there is closer monitoring and therefore quicker response to potential stockout.

• The fixed-order quantity model requires more time to maintain because every addition or
withdrawal is logged.
 Fixed-Order Quantity and Fixed-Time Period Differences

FEATURE Q-MODEL P-MODEL

FIXED-ORDER QUANTITY MODEL FIXED-TIME PERIOD
MODEL

Order quantity Q-constant (the same amount q-variable (varies each time
ordered each time) order is placed)
When to place order R-when inventory position drops to T-when the review period
the reorder level arrives
Recordkeeping Each time a withdrawal or addition is Counted only at review period
made
Size of inventory Less than fixed-time period model Larger than fixed-order
quantity model
Time to maintain Higher due to perpetual
recordkeeping
Type of items Higher-priced, critical, or important.
Items
Comparison of Fixed-Order Quantity and Fixed-Time Period Reordering
Inventory Systems
FIXED-ORDER QUANTITY MODELS
Fixed-order quantity models attempt to determine the specific point, R. at which an
order will be placed and the size of that order. Q. The order point. R. is always a specified
number of units. An order of size Q is placed when the inventory available (currently in stock.
and on order) reaches the point R. Inventory position is defined as the on-hand plus on-order
minus backordered quantities. The solution to a fixed-order quantity model may stipulate
something like this: When the inventory position drops to 36, place an order for 57 more units.

The simplest models in this category occur when all aspects of the situation are
known with certainty. If the annual demand for a product is 1,000 units, it is precisely 1.000 not
1,000 plus or minus 10 percent. The same is true for setup costs and holding costs. Although the
assumption of complete certainty is rarely valid, it provides a good basis for our coverage of
Inventory position
 These assumptions are unrealistic, but they represent a starting point and
allow us to use a simple example.

• Demand for the product is constant and uniform throughout the period.
• Lead time (time from ordering to receipt) is constant.
• Price per unit of product is constant.
• Inventory holding cost is based on average inventory.
• Ordering or setup costs are constant.
• All demands for the product will be satisfied. (No backorders are allowed.)
In constructing any inventory model, the first step is to develop a functional relationship between
the variables of interest and the measure of effectiveness. In this case, because we are concerned
with cost, the following equation pertains:
 ANNUAL PRODUCT COST,
BASED ON SIZE OF THE
ORDER

Where: R = Reorder point

TC = total annual cost L = Lead time
D = Demand (annual) H = Annual holding and storage cost per unit of
c = Cost per unit average inventory (often holding cost is taken as
Q = Quantity to be ordered (the optimal amount is a percentage of the cost of the item, such as H
termed the economic order quantity – EOQ or Qopt =iC, where i is the percent carrying cost)
S = Setup cost or cost of placing an order
 Safety stock must therefore be maintained
to provide some level of protection against
stockouts. Safety stock can be defined as
the amount of inventory carried in addition
to the expected demand.
 A fixed-order quantity system perpetually
monitors the inventory level and places a
new order when stock reaches some level,
R. The danger of stockout in this model
occurs only during the lead time, between
the time an order is placed and the time it is
received.
 FIXED-TIME PERIOD MODELS
In a fixed-time period system, inventory is counted only at particular times, such as
every week or every month. Counting inventory and placing orders periodically is desirable in
situations such as when vendors make routine visits to customers and take orders for their
complete line of products, or when buyers want to combine orders to save transportation costs.
Other firms operate on a fixed time period to facilitate planning their inventory count; for
example, Distributor X calls every two weeks and employees know that all Distributor X's
product must be counted.
Fixed-time period models generate order quantities that vary from period to period,
depending on the usage rates. These generally require a higher level of safety stock than a fixed-
order quantity system. The fixed-order quantity system assumes continual tracking of inventory
on hand, with an order immediately placed when the reorder point is reached. In contrast, the
standard fixed-time period models assume that inventory is counted only at the time specified
for review. It is possible that some large demand will draw the stock down to zero right after an
order is placed. This condition could go unnoticed until the next review peri-od. Then the new
order, when placed, still takes time to arrive. Thus, it is possible to be out of stock throughout
the entire review period, T, and order lead time, L. Safety stock, therefore, must protect against
stockouts during the review period itself as well as during the lead time from order placement to
order receipt.
FIXED-TIME PERIOD INVENTORY
MODELS
 FIXED-TIME PERIOD MODELS WITH SAFETY
STOCKS
In a fixed-time period system, reorders are placed at the time of review (T), and the
safety stock must be reordered is
Safety stock = zσT +L

Last photo shows a fixed-time period system with a review cycle of 7 and a
constant lead time of L. In this case, demand is randomly distributed about a mean d. The
quantity to order. q. is

Where: z = Number of standard deviations for a

specified service probability
q = Quantity to be ordered zσT + L= Standard deviation of demand over
T = The number of days between reviews the review and lead time
L = Lead time in days (time between placing I = Current inventory level (includes items on
an order and receiving it) order)
d = Forecast average daily demand
 INVENTORY CONTROL AND SUPPLY CHAIN
MANAGEMENT
It is important for managers to realize that how they run items using inventory
control logic relates directly to the financial performance of the firm. A key measure that relates
to company performance is inventory turn. Recall that inventory turn is calculated as follows:
 PRICE-BREAK MODELS
Price-break models deal with the fact that, generally, the selling price of an item
varies with the order size. This is a discrete or step change rather than a per-unit change.

Curves for Three Separate Order Quantity Models in a Three-Price-Break Situation

(orange line depicts feasible range of purchases)
 MISCELLANEOUS SYSTEMS AND
ISSUES
Obtaining actual order, setup, carrying, and shortage costs is difficult-sometimes
impossible. Even the assumptions are sometimes unrealistic. For example, Exhibit 15.9 com-
pares ordering costs that are assumed linear to the real case where every addition of a staff per-
son causes a step increase in cost.
All inventory systems are plagued by two major problems: maintaining adequate
control over each inventory item and ensuring that accurate records of stock on hand are kept.
In this section we present three simple systems often used in practice (an optional replenishment
system, a one-bin system, and a two-bin system), ABC analysis (a method for analyzing
inventory based on value), and cycle counting (a technique for improving inventory record
accuracy).
THREE SIMPLE INVENTORY SYSTEMS
1. Optional Replenishment System An optional replenishment system forces
reviewing the inventory level at a fixed frequency (such as weekly) and ordering a
replenishment supply if the level has dropped below some amount. In Exhibit 15.1, this is a P-
model. For example, the maximum inventory level (which we will call M) can be computed
based on demand, ordering costs, and shortage costs. Because it takes time and costs money to
place an order, a minimum order of size Q can be established. Then, whenever this item is
reviewed, the inventory position (we will call it I) is subtracted from the replenishment level
(M). If that number (call it q) is equal to or greater than Q, order q. Otherwise, forget it until the
next review period. Stated formally,

Otherwise, do not order any.

 In a two-bin system, items are used from one bin, and the second bin provides an
amount large enough to ensure that the stock can be replenished. In Exhibit 15.1, this is a Q-
model. Ideally, the second bin would contain an amount equal to the reorder point (R)
calculated earlier. As soon as the second bin supply is brought to the first bin, an order is placed
to replenish the second bin. Actually, these bins can be located together. In fact, there could be
just one bin with a divider between. The key to a two-bin operation is to separate the inventory
so that part of it is held in reserve until the rest is used first.

3. One-Bin System
One-Bin System A one-bin inventory system involves periodic replenishment no matter how
few are needed. At fixed periods (such as weekly), the inventory is brought up to its
predetermined maximum level. The one bin is always replenished, and it therefore differs from
the optional replenishment system, which reorders only when the inventory used is greater than
some minimum amount.
 ABC INVENTORY PLANNING
Maintaining inventory through counting, placing orders, receiving stock, and so on
takes personnel time and costs money. When there are limits on these resources, the logical
move is to try to use the available resources to control inventory in the best way. In other words,
focus on the most important items in inventory.
In the nineteenth century Villefredo Pareto, in a study of the distribution of wealth
in Milan, found that 20 percent of the people controlled 80 percent of the wealth. This logic of
the few having the greatest importance and the many having little importance has been
broadened to include many situations and is termed the Pareto principle. This is true in our
everyday lives (most of our decisions are relatively unimportant, but a few shape our future)
and is certainly true in inventory systems (where a few items account for the bulk of our
investment).
Any inventory system must specify when an order is to be placed for an item and
how many units to order. Most inventory control situations involve so many items that it is not
practical to model and give thorough treatment to each item. To get around this problem, the
ABC classification scheme divides inventory items into three groupings: high dollar volume
(A), moderate dollar volume (B), and low dollar volume (C). Dollar volume (B), and low dollar
volume (C). Dollar volume is a measure of importance; an item low in cost but high in volume
can be more important than a high-cost item with low volume.
 ABC CLASSIFICATION
ABC Classification If the annual usage of items in inventory is listed according to
dollar volume, generally, the list shows that a small number of items account for a large dol- lar
volume and that a large number of items account for a small dollar volume.

Annual Usage of Inventory by Value

 The ABC approach divides this list into three groupings by value: A items
constitute roughly the top 15 percent of the items, B items the next 35 percent, and C items the
last 50 percent. From observation, it appears that the list in last slide may be meaningfully
grouped with A including 20 percent (2 of the 10), B including 30 percent, and C including 50
percent. These points show clear delineations between sections.

ABC Group of Inventory Items

ABC Inventory Classification (inventory value for each group versus the group's
portion of the total list)
Inventory records usually differ from the
actual physical count; inventory accuracy
refers to how well the two agree.
Companies such as Wal-Mart (see the
Breakthrough box titled "Inventory on a
Grand Scale") understand the importance
of inventory accuracy and expend
considerable effort ensuring it.
 Inventory at Wal-Mart is precision on a
gargantuan scale, like a maneuver of the
Atlantic Fleet or a dam project in the
Yangtze River.
In his ruling on Wal-Mart's tax court case,
Judge David Laro provided a behind-the-
scenes look at the operation. Its
effectiveness, he says, has led "many other
companies, both domes tic and foreign" to
seek Wal-Mart's advice on inventory
taking.
Virtually all inventory systems these days are computerized. The computer can be
programmed to produce a cycle count notice in the following cases:
1. When the record shows a low or zero balance on hand. (It is easier to count fewer items.)
2. When the record shows a positive balance but a backorder was written (indicating a
discrepancy).
3. After some specified level of activity.
4. To signal a review based on the importance of the item (as in the ABC system) such as in
the following table:
 To demonstrate how inventory control is
conducted in service organizations, we
have selected two areas to describe: a
department store and an automobile service
agency
 The common term used to identify an
Service inventory item is the stockkeeping
unit (SKU). The SKU identifies each item,
its manufacturer, and its cost. The number
of SKUs becomes large even for small
departments.