CHAPTER FOUR

INVENTORY MANAGEMENT
4.1. INTRODUCTION
Inventory management is really applicable in every walk of life. Every family went flour mill
or market to buy one quintal of teff/wheat or others depending on their interests. Farmers
produce at the rainy season and have their own inventory of different crops to be used on the
other coming seasons and to sell the extra to the market. People of rural Christians used to
fetch water on every Friday to be used on Saturday and Sunday. The oil mill around your
locality buys more oil seeds at the harvest season and used it according to their utilization
rate. This shows that inventory is applicable in every walk of life.
On one hand, a firm can try to reduce costs by reducing on hand inventory levels. On the
other hand customers become dissatisfied when an item is frequently out of stock. For
example, assumes that there is a restaurant that always brings bread from a bakery. Now the
bakery is unable to deliver the required quantity at the required time to the restaurant. This
leads to the loss of revenue for both businesses as customers shouldn’t satisfied and join other
competitors to get their demands. Thus companies must strike a balance between inventory
investment and customers service levels. As you would expect, cost minimization is a major
factors in obtaining delicate balance.
Organizations have some types of inventory planning and control system. A bank has method
to control its inventory of cash. A hospital has methods used to control blood supplies and
pharmaceuticals. Government agencies, schools, and of course virtually every manufacturing
and production organizations are concerned with inventory planning and control.
4.2. MEANING OF INVENTORY
Inventory can be defined as:
 An idle resource (physical stock of goods) possessing economic value which is
waiting or kept for future use or sale.
 A stock of materials that are used to facilitate production or to satisfy customers’
demand
Inventories are usually in the form of raw materials, semi - finished goods used in the
production process, or finished products ready for delivery to consumers.

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4.3. FUNCTIONS AND TYPES OF INVENTORY
4.3.1. Functions of inventory
Within most organizations inventory exists in a variety of places, and in a variety of
forms, and for a variety of reasons. Although these inventories represent a substantial cost
investment (in some cases as much as 40% of total capital invested), they are necessary to
provide a desired level of service to customers. The major reasons for holding tangible
inventors include:
I. Decoupling production Process
After each production and distribution stage, inventories serve to increase the rationality
of the production distribution system by decoupling its parts. This is achieved by
providing inventories between the various steps from the procurement of raw materials
through the various production operations in to finished product inventories and moving
from the point of manufacture through whole sale distribution to retail outlets. By
providing inventories at selected steps in the manufacturing - distribution system, a firm
obtains a certain degree of independence for the steps following or '' downstream'' from
these inventories. If for example one production operation becomes inoperative because
of break down, the succeeding operation can continue as long as the in-process
inventory ahead of it exists. Even though the firm that makes the product is closed,
retail customer service can be maintained if there are inventories at the retail level.
II. Stabilizing employment
Inventories can effectively serve to mitigate the problem of minimizing major changes
in the size of the work force under conditions of fluctuating demand. If for example it is
believed that demand for a firm's product or products will decrease in the near future,
the additional costs involved in inventorying excess production may be entirely or in
part off set by avoiding layoffs which could adversely affect the firm's state of
unemployment, compensation costs and results in a loss of employee skills and
experience that will be needed when product demand picks up.
III. Taking advantage of quantity Discounts
The willingness of a firm to held larger inventories of supplies and purchased parts may
gain the firm the advantage of lower prices. The fixed costs of ordering will also be
shared by a larger number of units if price increases are considered imminent. Since
lead times are judged as being erratic, increasing inventories of key or critical items
may represent a sound and prudent managerial philosophy.

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IV. Buffer inventories
The purpose of inventory is to protect against the uncertainties of supply and demand.
Buffer inventories sometimes called, safety stock, serve to cushion the effect of
unpredictable events. The amount of inventory over and above the average demand
requirements is considered to be buffer stock held to meet any demand in excess of the
average. The higher the level of inventory, the better the customer service—that is, the
fewer the stock outs and backorders. It should be recognized that while protection
against stock outs may be available when demand suddenly increases, an increased
expense stemming from this inventory must be borne when demand is stack. A stock
out exists when a customer’s order for an item cannot be filled because the inventory of
the item has run out. If there is a stock out, the firm will usually backorders the
materials immediately, rather than wait until the next regular ordering period.
V. To meet anticipated customer demand
An anticipated future demand is the reason for holding anticipation inventory. Rather
than operating with excessive overtime in one period and then allowing the productive
system to be idle or shut down because of insufficient demand in another period,
inventories can be allowed to build up before an event and consumed during or after the
event. Manufacturers, wholesalers, and retailers build anticipation inventories prior to
occasions or holidays when demand for specialized products will be high. It is only
when inventories get out of hand that they become an unnecessary burden: If they are
managed properly, they permit quick and economic customer service.
VI. To smooth production requirements
Firms that experience seasonal patterns in demand often build up inventories during off
-Season periods in order to meet overly high requirements that exist during certain
seasonal periods. Therefore inventories are used to smooth out seasonal demands by
leveling out production. This helps to minimize overtime, manning up & training costs,
etc for seasonal peaks.
VII. To stabilize production
The demand for an item fluctuates because of the number of factors, e.g., seasonality,
production schedule etc. The inventories (raw materials and components) should be
made available to the production as per the demand failing which results in stock out
and the production stoppage takes place for want of materials. Hence, the inventory is
kept to take care of this fluctuation so that the production is smooth.

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 VIII. To meet the demand during the replenishment period
The lead time for procurement of materials depends upon many factors like location of
the source, demand supply condition, etc. So inventory is maintained to meet the
demand during the procurement (replenishment) period.
IX. To prevent loss of orders (sales)
In this competitive scenario, one has to meet the delivery schedules at 100 percent
service level, means they cannot afford to miss the delivery schedule which may result
in loss of sales. To avoid the organizations have to maintain inventory.

4.3.2. TYPES OF INVENTORIES

Inventories are usually classified in different forms, some of which corresponds directly
with the inventory function but some of which do not. For this discussion inventories are
classified into two categories, namely; Direct and Indirect Inventories
A. Direct inventories
The inventory of those items, which become a component of finished goods, is termed
as direct inventory. Direct inventories are categorized as follows;
 Inventory of raw materials: Raw material inventory has been purchased but not
processed, i.e. it requires further processing before they are used in any assembly
or as a finished product. They are a major input and their shortages can be holding
up the production. They are also useful for seasonal fluctuations, changes in
production rate and act as buffer between procurement and manufacture. These
items can be used to decouple (i.e. separate) supplier variability in quality, quantity
or delivery time so that separation is not needed.
 Work in process (progress (WIP) Inventories: These types of inventories consist
of materials actually worked on and inventories lying between machines or
operations. Work-in-process inventories are waiting to be processed within the
operations systems. Decoupling inventories are an example of work-in-process.
That is, they are all the items that have left the raw materials inventory but have not
yet been converted or assembled into a final product. They minimize the
production loss, which may occur due to different production rates at different
centers and braked down at any center. They also help in replacing wastage and
maintaining uniform production, even though sales may vary. WIP exists because
of the time it takes for a product to be made (called cycle time)

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  Finished products inventory: Stock of finished goods between production and
marketing is known as finished product inventory, i.e. completed product awaiting
shipment. This type of inventory is essential to assure a free flow of supply to the
consumer, to allow stabilization of the level of production, and for sales promotion.
Finished goods may be inventoried because future consumer demands are
unknown.
B. Indirect inventories
Inventory of raw materials that do not form an integral part of finished products is
called indirect inventory. This may include item such as lubricants, grease, oil, petrol,
maintenance materials etc. These are also termed as maintenances, repair, and
operating supplies (MRO) they are consumed in the production process but which do
not become parts of the finished products. Their primary purpose is to keep machinery
& process productive. They exist because the need and timing for maintenance and
repair of some equipment are unknown. Although the demand for MRO inventories is
often a function of maintenance sc+-hedules, other unscheduled MRO demands must
be anticipated. So we can define two additional types as: Spare parts, for machinery,
equipment, etc., Consumables, such as oil, paper, cleaners, etc. These are needed to
support operations, but they do not form a part of the final product
Functional classification
Another less widely used classification of stock describes its overall purpose:
 Cycle stock is the normal stock used during operations.
 Safety stock is a reserve of materials that is held for emergencies.
 Seasonal stock is used to maintain stable operations through seasonal variations in
demand.
 Pipeline stock is currently being moved from one location to another.
 Other stock consists of all the stocks that are held for some other reason

4.4. DEPENDENT AND INDEPENDENT DEMAND

The demand for inventory may be dependent or independent.
 Dependent Demand of Items: are those items where their demand is related to the
demand for another item. This demand is also known as Derived Demand.
 Independent Demand of Items: are those items that are not influenced by
production/operation but by the market forces.

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 For example, if an automobile company plans on producing 500 automobiles per day, then
obviously it will need 2,000 wheels and tires (plus spares). The number of wheels and tires
needed is dependent on the production level for automobiles and not derived separately. The
demand for automobiles, on the other hand, is independent-it comes from many sources
external to the automobile firm and is not a part of other products and so is unrelated to the
demand for other products.

4.5. INVENTORY COSTS

If we need to keep a stock of inventory, we have to pay its costs. The 3 categories of
inventory costs are
1. Acquisition (set up) costs
2. Purchase cost
3. Carrying (holding) costs
1. Acquisition (set up) costs
Acquisition cost also called ordering cost is incurred each time an order is placed for
procuring items from outside suppliers. The cost per order generally includes:
 A certain portion of wages and operating expenses of such departments as purchasing
and supply, production control, receiving, inspection, stores and accounts payable.
Those departments whose personnel devote time to the generation and handling of
purchase orders.

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  The cost of supplies such as engineering drawings, envelops, stationery and forms for
purchasing, production control, receiving, accounting and etc
 The cost of services such as computer time. Telephone, fax machines, telegraph and
postage expended in procuring the material. When an item is produced internally
(rather than purchased from outside) ordering cost is referred as set up cost, which
includes both paperwork costs and physical preparation costs.
2. Purchase cost
This cost consists of the actual price paid for the procurement of items. Its unit of
measurement is birr/dollar per unit. The purchase cost is given by
Purchase cost = (price per unit) x (demand per unit time)
3. Carrying (holding) costs
The carrying cost is associated with holding inventories. Carrying materials in inventory is
expensive. Carrying costs include:
A. Storage costs: The cost of warehouse space is a given number of dollars/birr per
cubic foot per year and this cost conceptually can be charged against inventory
occupying the space.
B. Obsolescence and deterioration: In most inventory operations, a certain percentage
of the stock is spoiled, damaged, pilfered and eventually becomes obsolete. With new
products being introduced at an increasing rate, the probability of obsolescence is
increased accordingly, consequently, the larger the inventory, typically the greater the
absolute loss from this source.
C. Opportunity costs of invested funds: When a firm purchases 20,000 birr worth of
production materials and keeps it in inventory, it simply has this much less cash to
spend for other purposes. It is logical for the firm to charge all money invested in
inventory an amount equal to that it could earn if invested elsewhere in the company.
This is the “opportunity cost” associated with inventory investment.
D. Insurance costs: Most firms insure their assets against any possible loss for fire and
other forms of damage. The above 20000 birr worth of inventory, for example,
represents an additional asset on which proportional insurance premiums must be
paid.
E. Property taxes: As with insurance, property taxes are levied on the assessed value of
a firm’s assets. The greater the inventory value, the greater the asset value, and
consequently the higher the firm’s tax bill.

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4.6. INVENTORY CONTROL
Inventory control is concerned with the acquisition, storage, handling and use of inventories
so as to ensure the availability of inventory whenever needed, providing adequate provision
for contingencies, deriving maximum economy and minimizing wastage and losses. Hence
Inventory control refers to a system, which ensures the supply of required quantity and
quality of inventory at the required time and at the same time prevent unnecessary investment
in inventories. Inventory control is the process of maintaining sufficient stock of items to
meet customer needs, weighed against the cost of carrying inventory to determine the
appropriate inventory levels. It involves process, procedures, and infrastructure to maintain
the inventory at the desired level. A lot of money is tied up in inventories and inventory
control is now well recognized in most companies as being so vital. Therefore inventory
control helps in maintaining optimal stock levels by identifying how much to order, when to
order to avoid over investment or under investment in inventories
Selective inventory control
Selective Inventory Control is defined as a process of classifying items into different
categories, thereby directing appropriate attention to the materials in the context of
company’s viability.
Inventories can be classified in to various groups on the basis of the selective inventory
management approach as follows.
1. ABC Inventory Analysis (Always, Better, Control) Analysis.
2. VED Inventory Analysis (Vital, Essential, Desirable) Analysis.
3. FSN Inventory Analysis (Fast moving, slow moving, Non-moving) Analysis.
4. SDE Inventory Analysis (Scarce, Difficulty, Easy) Analysis.
5. XYZ Inventory Analysis (High, Moderate & Low closing inventory items) Analysis.

1. ABC classification
ABC analysis is a basic analytical management tool which enables top management to
place the effort where the results will be greatest. ABC classification underlines a very
important principle of “Vital Few and Trivial Many”. ABC analysis therefore segregates
the items into 3 categories on the basis of their annual usage, value or expenditure. Such
categorization enables one to give the necessary attention as merited by each item. In
general, the extent of expenditure and the number of items in each category looks as
follows.

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 Class of items Expenditure Number of items
A 70% 10%
B 20% 20%
C 10% 70%
Steps in ABC classification
1. List the items that quantify annual usage and their unit price
2. Multiply the number of units by the unit price
3. Rank the items on the basis of their annual expenditure
4. Re-write or list the items and their annual expenditure in their ranking order
5. Complete the cumulative annual expenditure at each item level
6. Compute the cumulative percentage expenditure at each item level
7. Classify the items on given percentage
Example:
Classify the following items under ABC with A item taking 70% of the total Expenditure, B
item 25% and C items 5% of the total expenditure. Show your result by using diagram and
summary.
Items Annual number of usage Unit price Items Annual number of usage Unit price
F 11 40, 000 0.07 L 16 240,000 0.07
F 20 195,000 0.11 L 17 16,000 0.08
F 31 4,000 0.10 N8 80,000 0.06
L 45 100,000 0.05 N 91 10,000 0.07
L 51 2,000 0.14 N 100 5,000 0.09

Solution:
Step 1 Step 2 Step 3
Items Annual number of usage Unit price
F 11 40, 000 0.07 2800 5
F 20 195,000 0.11 21450 1
F 31 4,000 0.10 400 9
L 45 100,000 0.05 5000 3
L 51 2,000 0.14 280 10
L 16 240,000 0.07 16800 2
L 17 16,000 0.08 1280 6
N8 80,000 0.06 4800 4
N 91 10,000 0.07 700 7
N 100 5,000 0.09 450 8

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Solution continued
Step 4 Step 5 Step 6 Step 7
Annual expenditure Cumulative Cumulative Percent Inventory
expenditure Expenditure classification
F 20 21450 21450 21450/53960 x 100 = 39.80
L 16 16800 38250 38250/53960 x 100 = 71.0 A items
L 45 5000 43250 43250/53960 x 100 = 80.2
N8 4800 48050 48050/53960 x 100 = 89.3 B items
F 11 2800 50850 50850/53960 x 100 = 94.4
L 17 1280 52130 52130/53960 x 100 = 96.7
N 91 700 52830 52830/53960 x 100 = 97.9
N 100 450 53280 53280/53960 x 100 = 98.9 C items
F 31 400 53680 53680/53960 x 100 = 99.6
L 51 280 53960 53960/ 53960 x 100 = 100

2. VED Analysis
This analysis attempts to classify items into three categories depending upon criticality /
the Consequences of material stock out when demanded. As stated earlier, the cost of
shortage may vary depending upon the seriousness of such a situation. Accordingly the
items are classified into V(Vital), E(Essential) and D(Desirable) categories. Vital items
are the most critical having extremely high opportunity cost of shortage and must be
available in stock when demanded. Essential items are quite critical with substantial cost
associated with shortage and should be available in stock by and large. Desirable group of
items do not have very serious consequences if not available when demanded but can be
stocked items.
Since even a C-class item may be vital or an A-class item may be `Desirable' we should
carry out a two-way classification of items grouping them in 9 distinct groups as A-V, A-
E, A-D, B-V, B-E, B-D, C-V, C-E and C-D. Then we are able to argue on the aimed at
service-level for each of these nine categories and plan for inventories accordingly.
3. FSN Analysis
Not all items are required with the same frequency. Some materials are quite regularly
required, yet some others are required very occasionally and some materials may have
become obsolete and might not have been demanded for years together. FSN analysis
groups them into three categories as Fast-moving, Slow-moving and Non-moving (dead

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 stock) respectively. Inventory policies and models for the three categories have to be
different. Most inventory models in literature are valid for the fast-moving items
exhibiting a regular movement (consumption) pattern. Many spare parts come under the
slow moving category which has to be managed on a different basis. For non-moving
dead stock, we have to determine optimal stock disposal rules rather than inventory
provisioning rules. Categorization of materials into these three types on value, criticality
and usage enables us to adopt the right type of inventory policy to suit a particular
situation. In this unit, we shall mainly be developing some decision models more
appropriate for A-class and fast-moving items. Later on a brief discussion on the
inventory management of slow-moving items will be given.
4. SDE analysis
This type of analysis is useful in the study of those items, which are scarce in availability.
The 'S' class items are scarce items, e.g. imported items, which are generally in short
supply. The 'D' class stand for difficult items, which are available in the market but not
always traceable or immediately supplied, and 'E' class items are easily available in the
market.
5. XYZ Analysis
The analysis is based on the value of closing inventory.
 X-items – Items with high closing inventory.
 Y-items – Items with moderate closing inventory.
 Z-items – Items with low closing inventory.

Summary of selective Inventory management

Classification
Basis of classification Main use
Technique
ABC Annual Consumption value Controlling raw material & work in progress
inventories
VED Criticality Controlling the inventory level of spare parts
SDE Scarcity/Purchasing problems Controlling the inventory of scarce items
in regard to availability
F-S-N Issue from stores Controlling obsolescence
XYZ Closing inventory value Controlling over stocking and under stocking of
items

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4.7. Inventory Cost Control Techniques For Independent Demand Items

4.7.1. Economic Order Quantity (EOQ)

The EOQ (Economic Order Quantity) model is one method of determining the adequate
(optimum) inventory level for independent demand of materials. It is used to identify a fixed
order size that will minimize the sum of the annual costs of ordering and hold inventory.
Assumptions of this model are;
- Only one product is involved. - Lead time does not vary.
- Annual demand requirement are known. - Demand is constant.
- Each order is received in a single delivery. - There are no quantity discounts
As long as the demand is constant and delivery time is either constant or zero, the assumption
will hold. Otherwise, a safety stock should be added or a modified model with a shortage can
be used.
With these assumptions, the graph of inventory usage over time has a saw tooth Shape; no
shortages are allowed; each new order arrives just as the inventory level reach 0.

Inventory cycle

The cycle begins with receipt of an order of Q units. These are withdrawn at a constant rate
over time. When the quantity on hand is just sufficient to satisfy demand during lead time
(the time between submitting an order and receiving that order), an order for Q units is
submitted to the supplier.
Because it is assumed that both the usage rate and the lead time do not vary, the order will be
received at the precise instant that the inventory on hand falls zero.

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Thus, orders are timed to avoid having excess stock on hand and to avoid stock-outs.Because
demand is constant overtime, inventory drops at uniform rate overtime (refer to the above
figure). When the inventory level reaches 0 each item, the new order is placed and received,
and the inventory level again jumps to Q units (represented by the vertical lines). This
process continues indigently over time. Thus, orders are timed to avoid having excess stock
on hand and to avoid stock outs.

Minimizing Basic EOQ Model Costs

Only ordering and carrying costs need to be minimized (all other costs are assumed constant).
As Q (order quantity) increases: - Carry cost increases but ordering cost decreases (since the
number of orders per year decreases).
The objective of most inventory modes is to minimize total cost. With the assumptions just
given significant cost are set up (or ordering) costs and holding (or carrying) cost. All other
costs, such as the cost of the inventory itself, are constant. Thus if we minimize the sum of
ordering and holding costs, we will also minimize total costs.

Basic EOQ Model Total Cost

At optimal order quantity (Q*): Carrying cost = Ordering cost

As we can see form the figure, a reduction in either holding or setup cost will reduce the total
cost curve.

A reduction in the total cost curve also reduces the optimal order quantity (lot size). In
addition, smaller lot sizes have a positive impact on quantity and production flexibility.

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 In the above the figure, the optimal order quantity occurs at the point where the ordering cost
curve and the carrying cost curve intersect. This was not by chance, with the basic EOQ
model, the optimal order quantity will occur at a point where the total setup cost is equal to
the total holding cost. We use this fact to develop equations that solve directly for Q*. The
necessary steps are:

1. Develop an expression for ordering/set up cost

2. Develop an expression for holding cost
3. Set carrying cost equal to holding cost
4. Solve the equation for the optimal order quantity.
Using the following variables, we can determine ordering and holding cost and solve for Q

Q= Order quantity in units

P= Purchase price and Total purchase cost = P x D

D= Annual demand in units for the inventory item

S or Cs= Setup or ordering, cost for each order

H or Ch= Holding or carrying cost per unit per year

(Q/2) = the average inventory level

Q* = optimal quantity order:

TC= Total annual cost.

Let us now consider each of this cost.

1. Annual ordering /set up cost = (D/Q) S = D/Q S

Annual demand
Number of units in each order
(Set up or order cost per order)

2. Annual holding cost = (Average inventory level) X (Holding cost per unit per year)
 order quantity 
=  holding cos t per unit per year  = (Q/2) H = Q/2H
 2 
3. Optimal order quantity is found when annual setup cost equals annual holding cost,
namely;(D/Q) S = Q/
2H

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4. To solve for Q* simply cross-multiply terms and isolate Q* on the left of the equal sign.
D
/Q S = Q/2 H
2D S = Q2H
2 DS
Q2 =
H

2 DS
Q*=
H

Average Inventory Value: After Q* is found we can calculate the average value of
inventory on hand. Average inventory value = P x (Q*/2)
Calculating Ordering and Carrying Costs for a Given Q
• We can use the EOQ formula to calculate the value of S or H that would make a given
Q* optimal:
Ordering cost(S) = Q2 x H/ (2D)
Carrying cost (H) = 2DS/Q2
Example: A small clinic that uses disposable needles, would like to reduce its inventory cost
by determining the optimal number of needles to obtain per order. The annual demand is
1,000 units; ordering cost is birr 10 per order; and the holding cost per unit per year is birr
0.50. Using these figures, we can calculate the optimal number of units per order.

2 DS 2(1000)(10)
Q*= Q*= = 4000 = 200 UNITS
H 0.50
Therefore at one time 200 units of disposable needles is ordered and received.
We can also determine the expected number of orders placed during the year (N) and the
expected time between orders (T) as follow.
demand D
Expected number of orders (N) = =
ordered Q Q
Expected time between orders = T = Number of working days per year
N
The following example illustrates this concept. Using the data from the clinic and
assuming a 250-day working year, we find the number of orders (N) and the expected
demand 1000
time between orders (T) as: N = = =5
Q 200

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 Hence, orders have to be placed 5 times to get the annual demand of 1000 units of
disposable needles. At each order the clinic pays an ordering cost of $10. Then the total
annual ordering cost is 5 x 10 = $ 50
The expected time between the orders is calculated as;
T = Number of working days per year
Expected number of orders
= 250 working days per year = 50 days between order
5 orders
As mentioned earlier in this section, the total annual variable inventory cost is the sum of
ordering and holding costs:
Total annual cost = ordering cost +Holding cost,
DS Q
TC = + H
Q 2
Again, using the clinic data from the above examples, we determine that the total annual
inventory costs as :
DS Q
TC = + H
Q 2

TC =
1000 10  + 200
0.50
200 2
= (5) ($10) + (100) ($.50)
= $50 + $50 = $100
Note that at EOQ, the holding cost and the ordering costs are equal. The total inventory
cost expression may also be written to include the actual cost of the material purchased. If
we assume that the annual demand and the price per disposable needle are known values
(for example, 1,000 deposable needles per year at P=birr 10) and total annual cost should
include purchase cost, then the above equation becomes;
DS Q
TC= + H + PD
Q 2
Because material cost does not depend on the particular order policy, we still incur and
annual material cost of DXP= (1000) (10) = $10, 000

Reorder Point: Determining when to order. Now that we have decided how much to
order, we will look at the second inventory question, when to order. The ROP provides for
replenishing stocks when they reach some low level. Thus, when to order decision is usually

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expressed in terms of a reorder point (ROP) - the inventory level at which an order should be
placed.
• After Q* is determined, the second decision is when to order
• Orders must usually be placed before inventory reaches 0 due to order lead time
• Lead time is the time from placing the order until it is received
The reorder point (ROP) depends on the lead time (L)

Reorder Point (ROP)

The amount generally includes expected demand during lead-time and perhaps an extra
cushion of stock, which serves to reduce the probability of experiencing a stock out during
lead-time.
There are four determents of based and forecast quantity.
1. The rate of demand (usually based on a forecast)
2. The length of lead time
3. The extent of demand and lead time variability
4. The degree of stock-out risk acceptable to management.

The models generally assume that any variability in either demand rate or lead-time can be
adequately described by a normal distribution. However, this is not a strike requirement the
models provide approximate reorder points even in cases where actual distribution depart
substantially from normal.
The discussion begins with the simplest case (demand and lead time both constant) and
proceed to models that can be used when either demand or head time or both, is variable
The order point (ROP) is given as:
ROP = (Demand per day) (Lead time for a new order in days) = d X L

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The equation for ROP assumes that demand during head time and lead time it self are
constant. When this is not the case, extra stock, often called safety stock should be added.
Lead time: Denote by L the lead time in days between the time an order is placed and the
time the units arrive. The order for units needs to be place, not at T, but at L days before T if
the order is to arrive when the inventory runs out at a time. Rather than express the reorder
point in days, we express it in units. During the lead time, the daily demand rate is d.
The demand per day, d, is found by dividing the annual demand, D, by the number of
working days in a year:
d= Annual Demand
Number of working days in a year.
Example: The MIS department of XX store uses Flash disk at a rate of 4,000 per year (250
working days). The annual holding cost is $2 per Flash disk and the cost of placing an order
is $10. It takes the vendor 5 days from the time the order is placed to deliver the Flash disk.
What is the complete inventory policy (amount to order and time to order?)
To compute policy is given by Q and ROP. The order quantity is

2DS 2(2400)(10)
Q=  = 200
H 2
The reorder point is given by lead time, where d is the daily demand rate. In this example, the
4000
daily demand rate is given by d=  16 flash disks per day.
250
Therefore, ROP= d X L = 5 x 16 = 80

4.7.2. Economic Production Quantity (EPQ): Determining How Much to Produce

In the basic EOQ model, it is assumed that orders are delivered as whole units at a single
point in time (instantaneous replenishment). This is more suitable for purchased quantity in
which the whole lot is usually delivered at one time. However, in some instances such as
when a firm is both a producer and user, or when deliveries are spread over time, inventories
tend to build up gradually instead of instantaneously.
The assumptions of EPQ model are similar to those of the basic EOQ model, except that
instead of orders received in a single delivery, units are received incrementally during
production. The assumptions are:
 Only one item is involved
 Annual demand is known
 The usage rate is constant
 Usage occurs continually, but production occurs periodically

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  The production rate is constant
 Lead times does not vary
 There are no quantity discounts
If usage and production (or delivery) rates are equal, there will not be an inventory build up
since all output will be used immediately, and the question of lot size doesn’t come up. This
model is designed for production situations in which once an order is placed, production
begins and a constant number of units are added to inventory each day until the production
run has been completed. To satisfy demand and avoid back orders, the production rate must
be greater than the demand rate. This ensures a gradual buildup of inventory during the
production period. When the production run is completed, the inventory shows a gradual
decline until a new production run is started. The inventory pattern for this system is shown
in the following figure.
During the production phase of the cycle, inventory builds up at a rate equal to the difference
between production and usage rate.
For example, if the daily production rate is 20 units and the daily usage rate is 5 units,
inventory will build up at the rate of 20 – 5 = 15 units per day.
As long as production occurs, the inventory level will continue to build; when production
ceases, the inventory level will begin to decrease. Hence, the inventory level will be
maximum at the point where production ceases. When the amount of inventory on hand
exhausted, production is resumed, and the cycle repeats itself.
Because the finite replenishment rate usually implies a production rate, this model usually is
referred to as an economic production quantity model (EPQ) or economic lot size model
(ELS). Within the context of this discussion, however, the EPQ model is merely an extension
of the EOQ model.
This model is applicable under two situations.
1. When inventory continuously flows or builds up over a period of time after an order
has been placed or
2. When units are produced and sold simultaneously
Under these circumstances, we take into account daily production (or inventory-flow) rate
and daily demand rate.As it is stated above, this model is especially suitable for the
production environment; it is commonly called the production order quantity model. It is
useful when inventory continuously builds up over time and traditional economic order
quantity assumptions are valid.

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If we have a production system that produces 50 units per day, and we decide to schedule 10
days of production each time we want additional units, we have a 50(10)= 500- unit
production run size. Alternative terminology may refer to the 500 units as the production lot
size or the lot quantity. We denote the production lot size by Q and build a model that
minimizes total annual cost. As in the EOQ model, we are now dealing with two costs, the
inventory holding cost and the ordering cost. The total cost analysis for the EPQ model is
exactly the same as for the EOQ model, the inventory-holding and the ordering cost. While
the inventory holding cost is identical to our definition in the EOQ model, the ordering cost
may be more correctly referred as production-set up costs. This cost, which includes labor
hours, materials, and lost production costs incurred while preparing the production system for
operation, is fixed cost that occurs for every production run, regardless of the production
quantity. Let us begin building our model attempting to write the inventory holding cost in
terms of our production quantity model, Q.
Again, our approach is to develop an expression for average inventory and then establish the
holding cost associated with the average inventory level.
We saw in the EOQ model that the average inventory was simply one-half the maximum
Q
inventory, or . The previous page shows a constant inventory buildup rate during the
2
production run and a constant inventory depletion rate during the non-production period, the
average inventory for the production lot size model will be half of the maximum inventory
level. However, in this inventory system the production quantity, Q, does not go into
inventory at one time, and thus the inventory level reaches a level of Q units.
Let us see if we can compute the maximum inventory level.
First we define the following symbols:
Q = number of production quantity,
H = holding cost per unit
d = daily demand rate for the product
p = daily production rate for the product and
t = number of days for a production run.
Since we are assuming p is larger than d, the excess production each day is p – d, which is the
daily rate of inventory buildup. If we run production for t days and place p – d units in
inventory each day, the inventory level at the end of the production run will be (p – d) t. from
the figure of the previous page, we can see that the inventory level at the end of the
production run is also the maximum inventory level. Thus we can write

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Maximum inventory = (p – d)t
If we know we are producing a production quantity of Q units at a daily production rate of p
units, then Q = pt, and we can compute the length of the production run t to be

t=
Q
days Thus, Maximum inventory =  p  d t  ( p  d )  Q  = 1  d Q
p  p  p
The average inventory, which is half of the maximum inventory, is given by
1 d 
Average inventory = 1  Q
2  p

With an annual inventory holding cost of H per unit, the general equation for annual
inventory-holding cost is
 average  annual holding  1  d 
Annual inventory holding cost =    = 1   QH
 inventroy  cos t per uunit  2  p 
If D is the annual demand for the product and S is the set up cost for a production run, then
the total annual setup cost, which takes place of the total annual ordering costs of the EOQ
model.
D
Annual setup cost = number of production runs per year setup cos t per run =   S
Q
1 D D
Thus total annual cost (TC) model = 1   QH +   S
2  p Q
d
In this total cost model, we use the ratio of daily demand to daily production, . Actually
p
this ratio of demand relative to production is the same, regardless of the period of time
considered. In terms of an annual demand, D, and an annual production capacity, P, the ratio
D d D d
 . Substituting for provides this total cost formula.
P p P p

1 D D
TC = 1  QH   S
2 P  Q
Using the expression for holding cost above and the expression for setup cost developed in
the basic EOQ model, we solve for the optimal number of pieced per order by equating set up

cost and holding cost. Set up cost =

D  S
Q 
1 d 
Holding cost = 1   QH
2  p 

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Set ordering cost equal to holding cost to obtain Q:
D  S  H  Q 1  d 
=  
Q  2  P 
2 DS p
EPQ = x
H pd

Example: A toy Manufacturer uses 48,000 rubber wheels per year for its popular truck
series. The firm makes its own wheels, which it can produce at a rate of 800 per day. The
toy trucks are assembled uniformly over the entire year. Carrying cost is $1 per wheel per
year. Set up cost for a production run of wheels is $45. The firm operates 240 days per
year. Determine the following
a) The optimal run size
b) The minimum total annual cost for carrying and set up.
c) The cycle time for the optimal run size
d) The run time
Solution: D= 48,000 wheels per yearS = $45H = $1 per wheel per year p=
48,000
800 wheels per dayd = = 200 wheels per day
240

2 DS p 2(48000)45 800
a) Q = x Q= = 2400 wheels
H pd 1 800  200
( Maximum inventory) D
b) TC = carrying cost + set up cost = H S
2 Q
Thus, we must first compute maximum inventory;
 pd   800  200 
Maximum inventory = Q   = 2400   = 1800 wheels
 p   800 
1,800 48,000
TC = x $1  x $45 = 900 + 900 = $1800
2 2,400
Note again that set up cost is equal to carrying cost at EOQ.
Q 2400 wheels
c) Cycle time =  12 days
d 200 wheels per day
Thus, a run of wheels will be made every 12 days.
Q 2400 wheels
d) Run time:   3 days
p 800 wheels per day
Thus, each run will require three days to complete.

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4.9. Inventory Cost Control Techniques for Dependent Demand Items

4.9.1. Materials Requirement Planning (MRP)

MRP is a technique used to determine the quantity and timing requirements of dependent
demand materials used in manufacturing operations. MRP begins with a schedule for
finished goods that is converted into a schedule of requirements for the subassemblies,
component parts, and raw materials needed to produce the finished items in the specified time
frame. Thus, MRP is designed to answer three questions:
 What is needed?
 How much is needed? and
 When is it needed for dependent demand items?
MRP INPUTS AND OUT PUTS
The three major inputs are
 The master production schedule: tells what a finished product is composed of
 The bill of materials: tells how much finished product is desired and when
 The inventory record file: tells how much inventory is on hand or on order
Master production schedule: The master schedule states which end items are to be
produced, when these items are needed, and what quantities are needed. The master
production schedule is the controlling mechanism of the MRP system. In it, the needs for
each end item are spelled out by scheduling period (daily, weekly, and so forth). The manager
using an MRP system specifies the needs, and the system generates all of the production and
purchasing schedules for each component and subcomponent of each end item.
MPS for end item P
Item: p 1 2 3 4 5 6 7 8 9
Quantity 200 100

The figure illustrates how a master schedule for end item P might appear. It shows that 200
units of P will be needed at the start of week 6 and that another 100 units of p will be needed
at the start of week 8. The quantities in a master schedule can come from a number of
different sources, including customer orders, forecasts, order from wholesalers and external
demand.

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The Bill of Materials (BOM):
A bill of materials (BOM) contains a listing of all of the assemblies, sub-assemblies, parts,
and raw materials that are needed to produce one unit of a finished product. Thus, each
finished product has its own bill of materials. As such, it also is the means by which the
master schedule acts as the controller for each system. For each end item, the bill of
materials lists all of the materials required to produce the end item. This list includes all
components, of course, but it also includes items required for productions that do not become
part of the end item, such as solder for welding, grease for lubricants, and dying for forming
processes. The bill of materials used in the MRP system also provides additional information
to link the items, including the specific place in the process where each item is needed and
lead times for obtaining each item. This type of bill of materials is referred to as a
''structured'' bill of materials.
Inventory Record File or Inventory Master File
The inventory master file contains an extensive amount of information on every item that is
produced, ordered, or inventoried in the system. It includes such data as on hand quantities,
on order quantities, lot sizes safety stock, lead time and past usage figures.
An accurate inventory count is essential to a successful MRP system. Access to stockroom is
limited so that the withdrawal of inventory can be carefully monitored. Cycle counting in
which inventory is counted continuously during the year.
Product Structure File
Once the MPS is set, the MRP system accesses the product structure file to determine which
component items need to be scheduled. The product structure file contains a bill of materials
(BOM) for every item produced. The bill of material lists the item when and in what quantity
each item is needed in the assembly process.
When each item is needed can best be described in the form of a product structure diagram,
as shown in figure below. An assembled item is sometimes referred to as a parent, and a
component as a child. The number in parentheses beside each item is the quantity of a given
component needed to make one parent. The listing in the bill of materials life is hierarchical;
its shows the quantity of each item (in parentheses) needed to complete one unit of the
following level of assembly.
MRP Processing
The essence of material requirements planning is determined the quantity and timing
necessary for each component in order to achieve the quantity and timing of end items in
master schedule. The process then begins with the master schedule. Then, each end item is
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"exploded" into its component parts using the bill of materials file, indicating the assemblies,
subassemblies, parts, and raw materials that will be needed. Conceptually, this is the same as
identifying an end items product tree.
 Gross requirements: the gross requirements are the total expected demand for an item
or raw material during each time period/production plan. They also include demand not
otherwise accounted for, such as demand for replacement parts for units already sold. For
end items, these quantities equal the planned-order releases of their immediate “parents.”
 Schedule receipts: The schedule receipts are orders that have been placed but not yet
completed or scheduled to arrive from vendors or elsewhere in the pipeline. For a purchased
item, the schedule receipt could be in one of several stages: being ordered by a buyer, being
processed by a supplier, being transported to the purchaser, or being inspected by the
purchaser’s receiving department. If a production is making the item in-house, the order
could be on the shop floor being processed, waiting for components, waiting to be moved to
its next operations.
 Project on hand: the expected amount of inventory that will be on hand at the beginning
of each time period: scheduled receipt + available from last period.
 Net requirements: the actual amount needed in each time period.
Planned order receipt: A planned receipt is a new order not yet released to the shop or the
supplier. It the quantity expected to be received by the beginning of the period in which it is
shown. Planning for receipt of these new orders will keep the projected on-hand balance from
dropping below the desired safety stock level.
 Planned-order-releases: A planned order release indicates when an order for a
specified quantity of an item is to be issued. It shows a planned amount to order in each
time period; equals planned-order receipts offset by lead time. This amount generates gross
requirements at the next level in the assembly or production chain. When an order is
executed, it is removed from the “planned-order receipts” and “planned-order release” rows
and entered in the “scheduled receipts” row.
Given the product structure tree for “A” and the lead time and demand
information below, provide a materials requirements plan that defines the
number of units of each component and when they will be needed suppose at day
10 50 units of A needed

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First, the number of units of “A” are scheduled backwards to allow for their lead time. So, in
the materials requirement plan below, we have to place an order for 50 units of “A” on the 9 th
day to receive them on day 10

Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
Order Placement 50
Next, we need to start scheduling the components that make up “A”. In the case
of component “B” we need 4 B’s for each A. Since we need 50 A’s, that means
200 B’s. And again, we back the schedule up for the nec essary 2 days of lead
time.

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Finally, repeating the process for all componen ts, we have the final materials
requirements plan:

Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
LT=1 Order Placement 50
B Required 200
LT=2 Order Placement 200
C Required 100
LT=1 Order Placement 100
D Required 400 300
LT=3 Order Placement 400 300
E Required 200
LT=4 Order Placement 200
F Required 200
LT=1 Order Placement 200

Example 2: Requirements include 95 units (80 firm orders and 15 forecasts) of X in

week 10

Item On-Hand Lead Time (Weeks)

X 50 2
A 75 3
B 25 1
C 10 2
D 20 2

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 Day: 1 2 3 4 5 6 7 8 9 10
X Gross requirements 95
LT=2 Scheduled receipts
Proj. avail. balance 50 50 50 50 50 50 50 50 50 50
On- Net requirements 45
Hand Planned order receipt 45
50 Planner order release 45
A Gross requirements 90
LT=3 Scheduled receipts
Proj. avail. balance 75 75 75 75 75 75 75 75
On- Net requirements 15
Hand Planned order receipt 15
75 Planner order release 15
B Gross requirements 45
LT=1 Scheduled receipts
Proj. avail. balance 25 25 25 25 25 25 25 25
On- Net requirements 20
Hand Planned order receipt 20
25 Planner order release 20
C Gross requirements 45 40
LT=2 Scheduled receipts
Proj. avail. balance 10 10 10 10 10
On- Net requirements 35 40
Hand Planned order receipt 35 40
10 Planner order release 35 40
D Gross requirements 100
LT=2 Scheduled receipts
Proj. avail. balance 20 20 20 20 20 20 20
On- Net requirements 80
Hand Planned order receipt 80
20 Planner order release 80

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5.JUST-IN-TIME (JIT) APPROACH
Just in time (JIT) systems, which are designed to produce or deliver goods or services as
needed and minimize inventories, require major changes in traditional operating practices

Just -in-time (JIT) is a philosophy of continuous and forced problem solving that drives out
waste. The term JIT is used to refer to a repetitive production system in which both the
movement of goods during production , and deliveries from suppliers, are carefully timed so
that at each step of the process the next (usually small) batch arrives for processing just as the
preceding batch is completed. The result is a system in which there are neither idle item
waiting to be processed, nor idle workers and equipment waiting for items to process.

It refers to a production system in which operations such as processing, movement of

material and goods, etc. occur as they are needed or demanded. The result is very little
inventory (i.e. idle resources); production is very much a hand-to-mouth type of operations.

JIT pertains to the timing, to the flow of parts and material through the system, and the timing
of services. Companies that employ the JIT/Lean production approach typically enjoy a
competitive advantage over companies that used more traditional approach to repetitive
processing. They have lower processing costs, fewer defectives, greater flexibility, and are
able to bring new or improved products to the market more quickly.

Just in time (J.I.T) Inventory system: This is an inventory control method whose goal is to
maintain just enough material in just the right place at just the right time to make first the
right amount of the product. Just in time inventory control system helps in reducing inventory
costs by avoiding carriages of excess inventories, mishandling raw materials like printing ink
and just in time purchasing recognizes high costs associated with holding high inventory
level and as such it has become important in most organizations to order inventory just in
time of production so as to cut costs of holding inventory like storage lighting, heating,
security, insurance and staffing.
Hence, in an effective JIT application the operating policy is to minimize production
inventories and work-in-process inventories by providing each work center with just the
quantity of materials needed. JIT inventory system is used, most, if not all, for dependent
demand items. The buying firm’s production schedule drives the entire process.

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