This document discusses inventory management. It defines inventory and explains that good inventory management is important for business success. It outlines various inventory classification systems like ABC analysis, which sorts inventory into A, B, and C categories based on value. Additional classification systems covered include VED, HML, SDE, FSN, and XYZ analysis, which categorize inventory based on factors like criticality, value, procurement lead time, and movement frequency. The document also discusses inventory counting systems and key effectiveness measures for evaluating inventory management.

1. Inventory Management
Dr. T Kachwala

2. Brief Outline
1. Meaning of the term Inventory, Inventory Control
2. Functions of Inventory
3. Effectiveness Measures of Inventory Management
4. Inventory Counting Systems
5. Inventory Classifications: ABC, VED, FSN, HML, SDE, XYZ
Analysis etc.
6. Economic Order Quantity: Basic Economic Order Quantity,
EOQ for Production Lots, EOQ with Quantity Discounts

3. Meaning of the term Inventory
 An inventory is a stock or store of goods. Firms stock hundreds of items ranging
from small items such as nuts & bolts to large items such as machines and trucks.
 Inventory for a manufacturing plant means all the materials, parts, supplies,
expense tools & in-process or finished products recorded in the books of account of
an organization and kept aside in its stock either in the factory or at the warehouse
for a defined period of time.
 Service firms carry inventories of supplies & equipment:
 Inventory for Department Stores includes clothing, furniture, stationery, appliances, toys,
gifts, cards etc.
 Inventory for Hospitals includes drugs, surgical supplies, life monitoring equipment,
sheets & pillow cases etc.
 Inventory for Supermarkets includes fresh foods, canned foods, frozen foods, household
supplies, baked goods, dairy products, groceries etc.

4. Meaning of the term Inventory
Good inventory management is important for the successful operation of most
businesses & their supply chains. Operation, Marketing & Finance have interests in
Good Inventory Management. Poor inventory management hampers operations,
diminishes customer satisfaction & increases operating costs.
One widely used measure of Managerial performance relates to ROI which is PAT
divided by Total assets. Reduction of Inventories reduces total assets & therefore
indirectly increases ROI.
Inadequate control of inventories can result in both under & overstocking of items.
Under-stocking results in missed deliveries, lost sales, dissatisfied customers and
production bottlenecks. Over-stocking unnecessarily ties up funds that might be
productive else where.

5. Meaning of the term Inventory
Inventory control process consists of four steps:
1. Setting objectives (defining inventory levels)
2. Measuring actual levels of inventory
3. Comparing actual levels with set standards
4. If there is a deviation, taking appropriate corrective actions
Inventory management has two main concerns: level of customer service (right
goods, in the right quantity, in the right place, at the right time) & cost of
ordering & carrying inventories.
Inventory manager tries to achieve a balance in stocking with two fundamental
decisions: when to order & how much to order.

6. Functions of Inventory
1. To meet anticipated customer demand (anticipation stock).
2. To smooth production requirements (seasonal inventories).
3. To decouple operations {buffers between successive operations to
maintain continuity of production, buffers of raw materials to insulate
production from disruptions in deliveries from suppliers (to protect against
stock outs due to delayed deliveries), and finished goods inventory to
buffer sales operations from manufacturing disruptions (to protect against
stock outs due to unexpected increases in demand)}.
4. To hedge against price increases.
5. To take advantage of quantity discounts.

7. Effectiveness Measures of Inventory Management
 Managers can use a number of measures to judge the effectiveness of inventory
management.
1. Customer satisfaction; which is measured by the number and quantity of
backorders and / or customer complaints.
2. 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.
3. Days of inventory on hand; a number that indicates the expected number of days of
sales that can be supplied from existing inventory.

8. Inventory Counting Systems
Inventory counting systems can be:
(i)Perpetual (Fixed Order Quantity Models also called EOQ or “Q” System)
(ii)Periodic (Fixed time Period Model also referred as Periodic system or “P”
system)
1.Under a periodic system, (‘P’ system) a physical count of items in inventory is made at
periodic intervals (e.g. weekly, monthly) in order to decide how much to order of each item.
2.A perpetual inventory system (also known as a continual system) keeps track of removals
from inventory on a continuous basis, so the system can provide information on the current
level of inventory for each item. When the amount on hand reaches a predetermined
minimum, a fixed quantity Q (optimal order quantity) is ordered (‘Q’ System)

9. Classification of Inventory
 Large number of Material are used in production. All items held in
inventory are not of equal importance in terms of dollars invested,
criticality to production, lead time of procurement etc. It is therefore
desirable to classify materials according to the amount of analysis that
can be justified. Control efforts can be allocated according to the
relative importance of various items in inventory. Some of the
schemes for classification of the material are:
1. ABC based on value of item
2. VED based on criticality to production
3. HML based on value
4. SDE based on lead time of procurement
5. FSN based on requisition of material
6. XYZ based on general classification

10. Classification of Inventory – A-B-C Approach
 A-B-C Approach is a classification of inventory into three classes: A, B and C, based on their
value. This analysis is based on the popular Pareto Principle, which states that 80% of the
value of the material or items is on account of 20% of the items.
 The analysis is done by rearranging the item in the order of value and identifying the three
categories as given in the table below (Approximate percentages):
a. Rigid control for A-Class items.
b. Moderate control for B-Class items
c. Loose control is adequate for C-Class items.
Value of
consumption of items
No. of items Class
70% of value 10% of no. of items A (very Important)
20% of value 20% of no. of items B (moderately Imp)
10% of value 70% of no. of items C (least Important)

11. Classification of Inventory - VED Analysis
 VED analysis is a classification of inventory into three classes: Vital,
Essential and Desirable based on their importance. The analysis is done
by rearranging the items in the order of importance and identifying the
three categories as explained in the example below :
 Example: Inventory classification of spare parts in Maintenance
1. V – Vital items are those items the absence of which will result in total
stoppage of the production line. Rigid control is required for these items.
2. E – Essential items are those items the absence of which results in partial
stoppage of the production line. Moderate control is required for these items.
3. D – Desirable items are those items the absence of which does not affect the
production line. Loose control is adequate for these items.

12. Classification of Inventory - HML Analysis
 HML analysis is a classification of inventory into three classes: High value
items, Medium value items, and Low value items based on their value
(similar to ABC Analysis). The analysis is done by rearranging the items in
the order of value and identifying the three categories as explained in the
example of Inventory classification of Purchase Order (contractual
document and hence very critical for an organization) below:
 The purchase orders can be classified according to their value, so that
only the high value purchase order are monitored by the manager. The
other smaller value purchase orders can be delegated to the lower
authorities.

13. Classification of Inventory - SDE Analysis
SDE analysis is a classification of inventory into three classes: Scarce, Difficult & Easy based
on the lead time of procurement. The analysis is done by rearranging the items in the order of
the lead time of procurement and identifying the three categories as explained in the example
of regular purchased items below:
1.S – Scarce items, which are the items that are in short (limited) supply & very difficult to
procure. e.g. Imported items, where the lead time is very high. Rigid control is required.
2.D – Difficult items, which are available but difficult to procure because there are limited
suppliers, where the lead time is moderate. Moderate control is required
3.E – Easy items, which are items that are easily available. E.g. standard items available off
the shelf. There is no lead time of procurement for these items. Loose control is adequate

14. Classification of Inventory - FSN Analysis
FSN analysis is a classification of inventory into three classes: Fast moving, Slow moving &
Non moving based on the frequency of issue of items from Stores. The analysis is done by
rearranging the items in the order of the frequency of issue of items and identifying the three
categories as explained in the example of items issued by stores below:
1.F – Fast moving items, which are the items that are required frequently; for example all
direct items. Rigid control is required.
2.S – Slow moving items are issued limited number of times in a given period; for example
indirect items like machine oil. Moderate control is required
3.N – Non moving items are not issued for the period of time under consideration. These
items may have become obsolete due to product or process changes

15. Classification of Inventory - XYZ Analysis
The XYZ category is a general category of classification for the three classes:
Example1: Categorization of the items in terms of size.
1. ‘X’ items are those items that are heavy & bulky.
2. ‘Y’ items are those items that are moderate bulky.
3. ‘Z’ items are those items that are not bulky.
Example2: Categorization of the items in terms of shelf-life.
1. ‘X’ items are those items that have very short shelf-life
2. ‘Y’ items are those items that have moderate shelf-life.
3. ‘Z’ items are those items that do not have a shelf-life
Rigid control is required on X-Category items,
Moderate control is required on Y-Category items
Loose control is adequate on Z-Category items

16. Categories of Inventory Cost
 Ordering Cost – is incurred for processing the purchase order, expediting,
record keeping, and receiving the order into the warehouse.
 Stock out costs - In raw-materials inventory, stock out costs can include
the cost of disruptions to production. In finished-goods inventory, stock out
costs can include lost sales and dissatisfied customers.
 Acquisition costs – is the unit cost of the item. For purchased materials,
ordering larger batches may lower unit costs because of quantity discounts
and lower freight and materials-handling costs.
 Carrying costs - Interest on debt, interest income foregone, warehouse
rent, cooling, heating, lighting, cleaning, repairing, protecting, shipping,
receiving, materials handling, taxes, insurance, and management are
some of the costs incurred to insure, finance, store, handle, and manage
larger inventories.

17. Categories of Inventory Cost
 Cost of production problems - Higher in-process inventories
camouflage underlying production problems. Problems like
machine breakdowns, poor product quality, and material shortages
never get solved.
 Cost of coordinating production - Because large inventories clog
the production process, more people are needed to unsnarl traffic
jams, solve congestion-related production problems, and
coordinate schedules.
 Cost of Obsolescence - Large inventories of items that are
obsolete due to design and / or process changes

18. Opposing Views on Inventory
 If the order quantity is small (i.e. If the inventory is too little) then the
following cost are high:
1. Ordering Costs
2. Stock out Costs
3. Acquisition Costs
 If the order quantity is large (i.e. If the Inventory is too much) then the
following cost are high:
1. Carrying Costs
2. Cost of Production Problem
3. Cost of Coordinating Production
4. Cost of Obsolescence

19. Concept of Economic Order Quantity (EOQ)
 Materials are ordered so that the cost of ordering too little is
balanced against the cost of ordering too much on each order.
Two classes of cost are graphed. Carrying cost represents all the
annual costs associated with ordering too much. Ordering cost
represents all the annual costs associated with ordering too little.
 When annual carrying cost curve is added to the annual ordering
costs curve, an annual total stocking cost curve results. The order
quantity where total stocking cost is minimum is traditionally called
Economic Order Quantity (EOQ)

20. Determining Order Quantities (EOQ Models)
Three Order size Models being used are :
1. Model I – Basic Economic Order Quantity (EOQ).
2. Model II-EOQ for Production Lots.
3. Model III-EOQ with Quantity Discounts.
Model I – Basic Economic Order Quantity (EOQ)
Assumptions:
1. Annual demand, carrying cost, and ordering cost for a material can be estimated.
2. Average inventory level for a material is order quantity divided by 2. This implicitly
assumes that no safety stock is utilized, orders are received all at once (instantaneous
replenishment), materials are used at a uniform rate, and materials are entirely used up
when the next order arrives.
3. Stock out, customer responsiveness, and other costs are inconsequential.
4. Quantity discounts do not exist.

21. Time
Quantity
Replenishment Cycle
Material Received all at once (Instantaneous Replenishment)
Consumption of
material at a
constant rate
The same cycle
repeats
Q
Instantaneous Replenishment
Average inventory when the material is received all at once is
Q
2
Q
2
Slide 21

22. Slide 22

23. Model II-EOQ for Production Lots
Assumptions:
1. Annual demand, carrying cost, and ordering cost for a material can be estimated.
2. No safety stock is utilized, materials are supplied at a uniform rate (p) and used at a
uniform rate (d), and materials are entirely used up when the next order begins to
arrive.
3. Stock out, customer responsiveness, and other costs are inconsequential.
4. Quantity discounts do not exist.
5. Supply rate (p) is greater than usage rate (d)
Variable Definitions
1. All the definitions in Model I apply also to Model II. Additionally
2. d = rate at which units are used out of inventory (units per time period)
3. p = rate at which units are supplied to inventory (same units as d)

24. Quantity
Time
Replenishment Cycle
Material received uniformly at a constant rate
The rate at which the inventory is increasing is the difference between
production rate and demand rate (p-d)
The rate at which the inventory is decreasing is the
function of the demand rate (d)
The same cycle
repeatsQ
Average inventory when the material is gradually received at a constant rate is
- 1-
d
p
Q
2
1-
d
p
Q
2
Slide 24

25. Model II-EOQ for Production Lots
Cost Formulas -
Annualcarryingcost  AverageinventorylevelxCarryingcost  C
Q
2
1
d
p

Annualorderingcost  OrdersperyearxOrderingcost  S
D
Q

Totalannualstockingcost TSC Annualcarrying cost  Annual orderingcost  C
Q
2

1
d
p
 S
D
Q

Equatingannualcarrying cost & annualorderingcost: EOQ 
2SD
C1 d
p

Slide 25Slide 25

26. Model III – EOQ with Quantity Discounts
Assumptions:
1. Annual demand, carrying cost, and ordering cost for a material can be
estimated.
2. Average inventory levels can be estimated at either:
a. Q/2 – if the assumption of Model I prevail : no safety stock, orders are received
all at once, materials are used a uniform rate, and materials are entirely used
up when the next order arrives.
b. Q/2 [(p – d)/p] – if the assumption of Model II prevail : no safety stock, materials
are supplied at a uniform rate (p) and used at a uniform rate (d), and materials
are entirely used up when the next order arrives.
3. Stock out, customer responsiveness, and other costs are inconsequential.
4. Quantity discounts do exist. As larger quantities are ordered, price breaks
apply to all units ordered.

27. Concept of Quantity Discount
Quantity discount signifies the discount that the manufacturer can avail if he
places a large order on the vendor. This is because a large order offers economy of
scale for the vendor which can be explained on the break even chart drawn below
Sales
Variable Cost
Total Cost
Fixed Cost
Profit
Quantity
Sales/Cost
It can be observed in the above break-even chart, that as the output (quantity)
increases, the profit increases.
Slide 27

28. Model III-EOQ with Quantity Discounts
Variable Definitions :
1. All the definitions in previous models apply to Model III. Additionally,
2. TMC = Total annual material costs (rupees per year)
3. ac = Acquisition cost of either purchasing or producing one unit of a material
(rupees per unit)
Formulas
1. The EOQ and TSC formulae from either Model I or Model II are applied to Model III,
depending on which assumption best fit the inventory situation.
2. Annual acquisition costs = Annual demand x Acquisition cost = (D) * ac
3. Total annual material costs (TMC) = Total annual stocking costs + Annual acquisition cost
= TSC + (D) * ac

29. Model III – EOQ with Quantity Discounts
Model I Model II
Order Delivered Gradual Deliveries
All at One Time
EOQ  2SD
C
EOQ  2SD
C 1 – d
p
TMC  C Q
2
 S D
Q
 Dac TMC  C Q
2
1 –
d
p
 SD
Q
 Dac
Procedures
1. Compute the EOQ using each of the sales prices.
2. Determine which EOQ from Step I above is feasible. In other words, is the computed EOQ
in the quantity range for its price ?
3The total annual material cost TMCis computed for the feasible EOQ and the quantity at any
price break with lower sales prices.
4. The order quantity with the lowest total annual material cost TMCis the economic order
quantity for the material.
Slide 29