Inventory Management

1. Inventory ManagementAnkush Singla
Assistant Professor
TIMT

2. Inventory
Inventory may be defined as the stock of goods, commodities or other economic resources that are stored or
reserved in order to ensure smooth and efficient running of business affairs.
Such resources may be classified into three categories:-
(i) Physical Resources- Such as raw material, semi finished goods, spare parts, lubricants etc
(ii) Human Resources- Such as unused labour (Manpower)
(iii) Financial Resources- Such as working capital

3. Definition
“The Term Inventory includes materials-raw in process, finished packaging, spares and other stocked in order to
meet an unexpected demand or distribution in the future.”
-B. D. Khare
“Inventory refers to the stock on hand at particular time of raw materials, goods in progress of manufacture,
finished products and the like, tangible assets which can be seen, measured and controlled.”
- C. Paul Jennis

4. Example
Organisation Types of Inventory held
Manufacturer Raw Material, Semi Finished Goods, Finished Goods, Spare Parts, etc.
Hospital Number of beds, Stock of drugs, Specialized Personnel
Bank Cash Reserves, Tellers
Airline Company Seating Capacity, Specialized Maintenance Crew

5. Inventory Decision
(a) What items should be stocked
(b) When should an order be placed replenish inventory
(c) How much should be ordered in each replenishment

6. Type of Inventory
1. Lot Size (or Cycle Inventory)
2. Pipeline Inventory or Transit Inventory
3. Safety (or Buffer) Inventory
4. Seasonal Inventory
5. Decoupling Inventory

7. Lot Size (Or Cycle Inventory)
It is the inventory necessary to meet the average demand during the successive replenishment. The amount of such
inventory depends upon the production lot size, economical shipment quantities, warehouse space availability,
lead time, price quantity, discount schedule, etc.

8. Pipeline Inventory (Or Transit Inventory)
Since the movement of item cannot be instantaneous. Optimum inventory level is required for shipment of
inventory item to distribution centres and customer from production centres. Such an inventory is called a pipeline
inventory or Transit inventory. For satisfying demand without delay, it is essential to keep extra stock of inventory
item at various workplaces to meet the demand while the supply is in transit.

9. Safety (Or Buffer Inventory)
It is a specific level of extra stock of inventory that is maintained for protection against uncertainties of demand
and the lead time necessary for delivery of goods. Such additional stock is known as buffer stock as it provide
buffer or a safety margin against future uncertainty.

10. Seasonal Inventory
Inventory is also needed for items whose sales depend on seasonal pattern of demand and whose production is not
uniform. This includes fashion items, agriculture products, calendar, etc. In these cases, manufacturer faces peak
demand where the production facility is unable to meet the demand on period by period basis. Thus seasonal or
anticipated inventory are built up in advance or are procured during the period of low demand to be used during
the peak demand period.

11. Decoupling Inventory
Various manufacturing processes (stages) corporate successively, then in the case of breakdown of one or due to
any disturbance at some stage, the entire system could be affected. This kind of interdependence is not only costly
but disruptive for the entire system. Thus stocking point of inventory are created between adjacent stage of
production to achieve a certain degree of independence among stages of production.

12. Costs involved in Inventory
The costs that are affected by the firm's decision to maintain a particular level of inventory are called inventory
cost. These are classified as follows:
a) Purchase cost
b) Carrying or holding cost
c) Ordering or (Set up) cost
d) Shortage (or stock out)

13. Purchase Cost
This Cost consists of the actual price paid for the procurement of items. The unit price “C" of an item is
independent of the size of the quantity ordered or purchased.
Purchase cost = (Price per unit) X (Demand per unit time) = C.D.
When price break or quantity discounts are available for bulk purchase above a specified quantity level. In such
cases, the purchase cost become variable and depends on a size of order.
Purchase cost = Price per unit when order size is Q X Demand per unit time

14. Carrying or Holding Cost
It is the expenses incurred for carrying inventory item in the warehouse. They include-
a) Storage cost for providing warehouse space to store the products.
b) Inventory holding cost for payment of salaries to employees.
c) Insurance cost against possible loss from fire or other form of the damage.
d) Opportunity cost of money invested in inventory.
e) Obsolescence cost
f) Depreciation
Carrying Cost = Cost of carrying one unit of an item in inventory for a given time period usually one year X Average
number of items carried in inventory for that period

15. Ordering or Set Up Cost
It includes all costs that do not vary with the size of the order but are included each time an order is placed for
procuring item from outside supplier. It includes:
a) Requisition cost of handling of invoice, stationery, payment, etc.
b) Cost of service like cost of mailing, telephone calls, transportation.
c) Material handling cost incurred in receiving, sorting, inspection and storing the items included in order.
d) Accounting and auditing is done when an item is produced in house, ordering cost is referred as setup cost
which include both paperwork cost and the physical preparation cost.
Ordering cost = cost per order X Number of orders in the planning period

16. Shortage (Or Stock Out) or Customer Service Cost
The shortage of items occurs when item cannot be supplied on demand. The shortage can be viewed in two
different ways-
a) The supply of items is awaited by the customer i.e. the item are back ordered.
b) Customer are not ready to wait and this lead to loss of customer goodwill and therefore cause loss of sale.
Shortage cost= (Cost of being short one unit of an item) X (Average number of units shorts)
Total inventory cost = Purchase cost + Ordering cost + Carrying cost + Shortage Cost

17. Tools & Techniques of
Inventory Management

18. ABC Analysis (Always Better Control)
The materials are divided into a number of categories for adopting a selective approach for material control. It is
generally seen that in manufacturing concern, a small percentage of items contribute a large percentage of value of
consumption and a large percentage of items contribute a small percentage of value. In between these two limits
there are some items which have almost equal percentage of value of materials.
Under A-B-C Analysis, the materials are divided into three categories: A, B and C. Past Experience has shown that
almost 10% of items contribute to 70% of value of consumption and this category is called “A” category. About
20% of items contribute about 20% of value of consumption and this is known as category “B” material. Category
C cover about 70% of items of materials which contribute only 10% of value of consumption. There may be some
variation in different organizations and an adjustment can be made in this percentage.

19. ABC Analysis
A-B-C Analysis helps to concentrate more on Category “A” Since greater monetary advantage will come up by
controlling these items. An attention should be paid in estimating requirement, purchasing, maintaining safety
stock and properly storing of “A” category material. These items are kept under constant review so that substantial
material cost may be controlled. The control of “C” items may be relaxed and these stocks may be purchased for
the year. A little more attention should be given towards “B” category item and their purchase should be
undertaken at quarterly or half yearly interval.
Class No. of Items (%) Value of Items (%)
A 10 70
B 20 20
C 70 10

21. VED Analysis (Vital Essential Desirable)
The VED Analysis is used generally for spare parts. The requirement and urgency of spare parts is different from
that of materials. A-B-C Analysis may not be properly used for spare parts. The demand of spare parts depends
upon the performance of the plant and machinery. Spare parts are classified as Vital, Essential and Desirable.
1. The Vital spares are a must for running the Concern smoothly and these must be stored adequately. The non
availability of vital spares will cause havoc in the concern.
2. The E-type of spares are also necessary but their stocks may be kept at low figures.
3. The stocking of D type of spares may be avoided at times. If the lead time of these spares is less then stocking
of these spares can be avoided.

23. FNSD Analysis (Fast Moving, Normal Moving,
Slow Moving, Dead Items)
FNSD analysis seeks to categorize the inventories into four groups in descending order of their usage. A portion of
the inventory items is fast moving ‘F’ which is consumed in a short span of time. Some parts of the inventory
items move normally (N) and are used for over a period of a year or so. Some items are slow moving (S) stock of
which would last for more than one year. Some materials may be dead stock (D) in the sense that no further
demand of such materials is foreseen.

24. FNSD Analysis (Fast Moving, Normal Moving,
Slow Moving, Dead Items)
According to this technique, fast moving items of stock need to be constantly monitored and replenishment orders
are placed in time to avoid stock-out situations. In case of slow moving items, careful review is required before
any order is placed for their replenishment. The reorder levels and quantities for such items should be on the basis
of a new estimate of future demand to minimize the risks of a surplus stock being left when a slow moving item
become obsolescent or dead. Dead stock represents that portion of inventory which is of no value to the enterprise
but occupies useful space. Hence, once such items are identified, efforts should be made to find an alternative used
for it. Otherwise, it must be disposed off.

25. Stock Levels
Carrying of too much and too little of inventories is detrimental to the firm. If the inventory level is too little, the
firm will face frequent stock-outs involving heavy ordering cost and if the inventory level is too high it will
unnecessary tie-up of capital.
Therefore, an efficient inventory management requires that a firm should maintain an optimum level of inventory
where inventory costs are minimum and at the same time there is no stock out which may result in loss of sale or
stoppage of production.

26. Stock Levels
Various stock levels are discussed as such:
1. Minimum Level
2. Re-ordering Level
3. Maximum Level
4. Danger Level

27. Determination of Safety Stocks
Safety stock is buffer to meet some anticipated increase in usage. The usage of inventory cannot be perfectly
forecasted. It fluctuates over a period of time. The demand for materials may fluctuate and delivery of inventory
may also be delayed and in such a situation the firm can face a problem of stock out. The stock out can prove
costly by affecting the smooth working of the concern.
In order to protect against the stock out arising out of usage fluctuations, firm usually maintain some margin of
safety and safety stocks.

28. Determination of Safety Stocks
Two cost are involved in the determination of safety stock:
1. Opportunity Cost:
The stock out of raw material cause production disruption resulting into higher cost of production. Similarly, the
stock outs of finished goods result into failure of the firm in competition as the firm cannot provide proper
customer service. If a firm maintain low level of safety stock, frequent stock out will occur resulting into the larger
opportunity cost.

29. Determination of Safety Stocks
2. Carrying Cost:
The larger quantity of safety stocks involves higher carrying costs. Thus, the optimum level of safety stock
involves a trade off between the costs of stock-out and the carrying costs of safety stock. The safety stock will be
minimum when carrying costs and stock-out costs will be low.

30. Economic Order Quantity (EOQ)
Economic order quantity (EOQ) refers to the optimum amount of items that should be ordered at any given point
of time, such that total annual cost of carrying and ordering that item is minimized.
Economic order quantity is the point at which inventory carrying cost is equal to the ordering cost.

31. Economic Order Quantity (EOQ)
Assumptions
1. The inventory system involves one type of item on product.
2. The demand is known as constant.
3. Lead time is known as constant.
4. Shortages are not allowed
5. Purchase price and reorder cost do not vary with quantity ordered.
6. Carrying cost per year and ordering cost per order are known and constant.

32. Economic Order Quantity (EOQ)

33. Economic Order Quantity (EOQ)
At the beginning of inventory cycle time, we start with maximum amount of inventory equal to the
ordered quantity Q. As this item is consumed, the level of inventory drop at a constant rate equal to
demand rate D. When it reaches a specific level called reorder level (ROL), enough inventory is
available to cover expected demand during the lead time LT. At this, an order is placed equal to Q,
which arrives at the end of lead time, when the inventory level reaches zero. This amount is placed in
stock all at once and the inventory level goes up to its maximum value.

34. Economic Order Quantity (EOQ)

35. Economic Order Quantity (EOQ)
1. Annual Ordering Cost
= No. of orders placed X Ordering cost per order
= (D/Q) X C0
2. Annual Carrying Cost
= Average inventory X Carrying cost/ unit/ year
= (Q/2) X Ch
Total variable annual cost = Annual carrying cost + Annual ordering cost
TVC = (Q/2)Ch + (D/Q)C0

36. Economic Order Quantity (EOQ)
The total variable inventory cost is minimum at a value of Q, which appears to be at the point where
inventory carrying cost and order cost are equal.
(D/Q)C0 = (Q/2)Ch
Q2 = 2DC0/Ch
Q = √(2DC0/Ch)
EOQ= √{(2 X Annual demand X Ordering cost)/ Carrying cost}
This formula is also known as Wilson or Harish lot size formula.

37. Just in Time Inventory
Just-in-time purchasing is the purchase of material or goods so that they are delivered just as needed for
production or sales. A company in this case has either long-term agreement with supplier for the major component
of their products or inventory should be easily available in the market as and when necessary. Nowadays there is a
trend towards just-in-time inventory because of high carrying cost of the products. In fact in the past, it has been
realised by many concerns that carrying cost have actually been much greater than estimated because cost of
warehousing, handling, shrinkage and capital have not been properly identified.

38. Just in Time Inventory
Advantages
1. No investment in inventory because more frequent purchase orders of small quantities are made.
2. Reduction in carrying cost.
3. Time, energy and money is saved because in JIT purchasing, only proven suppliers who can give quick
delivery of quantity goods are given purchase orders.
4. Quality cost such as inspection cost of incoming goods are reduced because JIT purchasing assure quick and
frequent delivery of small order size. This leads to low level of inventory causing minimum possible wastage.