MODULE V: INVENTORY MANAGEMENT

Inventory management refers to the development and administration of

inventory policies, systems, and procedures necessary to efficiently and
satisfactorily meet inventory requirements at the minimum cost possible. It
requires the coordination of both purchasing and financing functions to effectively
manage inventory. Turnover formulas can be used not only to test the efficiency
of inventory utilization but also to measure the efficiency in purchasing, stock
management and selling activities.

Objective of Inventory Management

Inventory is the stockpile of the product the firm is offering for sale and the
components that make up the product. It is the responsibility of the financial officer
to maintain a sufficient amount of inventory to insure the smooth operation of the
firm's production and marketing functions and at the same time avoid tying up
funds in excessive and slow-moving inventory. The following are the objectives of
inventory management:
1. To reduce inventories while maintaining customer service level and quality.
The firm can free needed cash to finance both internal and external growth.
This involves a delicate balance between ordering costs, carrying or holding
costs and shortage costs.
2. To establish production and inventory control. Proper control system must
be set up such as stock cards and other records to monitor physical
movements of inventories.
3. To ensure that proper communication on the information of inventory levels
are not only in place but also must be on time to avoid stock out.
4. To ensure the proper valuation of inventories on hand.

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Functions of Inventories
1. Pipeline or transit inventories
These are inventories which are being moved or transported from one
location to another and they fill the supply pipelines between stages of the
entire production-distribution system.
2. Organizational or decoupling inventories
These are inventories that are maintained to provide each link in the
production-distribution chain a certain degree of independence from the
others. These will also take care of random fluctuations in demand and/or
supply.
3. Seasonal or anticipation stock
These are built in anticipation of the heavy selling season or in anticipation
of price increase or as part of promotional sales campaign.
4. Batch of lot-size inventories
These are inventories that are maintained whenever the user makes or buys
materials in larger lots than are needed for immediate purposes.
5. Safety or buffer stock
These inventories are maintained to protect the company from uncertainties
such as unexpected customer demand, delays in delivery of goods ordered,
etc.

Inventory Management Techniques

Inventory Planning
Inventory Planning involves the determination of what inventory quality,
quantity, timing, and location should be in order to meet future business
requirements. The approach and mathematical techniques that may be used in
determining inventory order size, timing, etc. includes the economic order quantity
(EOQ) Model and Reorder point.

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 Economic Order Quantity is the order size or the appropriate number of
units that must be ordered at the least cost. It can also be defined as the
optimal number of units to be ordered to maintain the minimum cost or the
quantity of stock where the total ordering or carrying cost are at its minimum.
The basic assumptions of using EOQ in inventory planning are:
1. prices are stable.
2. supply of goods is stable.
3. demand or use in a given period is uniform.
EOQ is computed as follows:

2(𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑 )(𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠)

𝐸𝑂𝑄 = √
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠

Annual Demand (AD) refers to the total estimated demand for the given
product.
Ordering Costs (OC) refers to cost incurred in placing an order for a
certain product. It includes:
• Cost of preparing purchases or production orders;
• Transportation and receiving cost (i.e. unloading, unpacking and
inspecting);
• Costs of processing related documents of the order; and
• Cost of mailing, stationeries, telephone bills/ cell phone loads, clerical
and other costs that may be involved in placing an order.
Carrying Costs (CC) refers to costs incurred in holding or carrying an
inventory. It includes:
• Storage space costs (i.e. warehouse rental or depreciation and
security costs);
• Property taxes and insurance costs on carrying such inventory;
• Risk of obsolescence, spoilage, theft and deterioration; and
• Desired rate of return on inventory investment (foregone interest on
working capital tied up in inventory)

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 Total Inventory Costs is the sum of total ordering costs and total
carrying costs of an inventory. It is computed as:

𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑠𝑡𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 + 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡

Where:
Total Ordering Costs refer to the total cost incurred in placing an
order. It is equal to the number of orders placed per year multiplied by
the fixed cost of placing an order. It is computed as:

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 = 𝑥 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟
𝐸𝑂𝑄

Total Carrying Costs refer to the total costs of carrying or holding

inventory. It is the average inventory multiplied by the cost of carrying
inventory. It is computed as:

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑥 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝐸𝑂𝑄
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
2

Another use of the EOQ model is to help the management in deciding

how much is to order at one time and when to order and this is known as
the re-order point.

Re-order Point represents the level of inventory where the order must be
placed for the quantity size as predetermined in the EOQ. It is computed
as:

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 𝑅𝑒 − 𝑜𝑟𝑑𝑒𝑟 𝑃𝑜𝑖𝑛𝑡 = 𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒 𝑈𝑠𝑎𝑔𝑒 + 𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘

Where:
Lead Time Usage refers to the interval of use of inventory between
placing an order and receiving delivery.

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑
𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒 𝑈𝑠𝑎𝑔𝑒 = 𝑥 𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒
𝐸𝑠𝑡. 𝑛𝑜. 𝑜𝑓 𝑤𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

Illustrative Case I:
Assume that a local gift shop is attempting to determine how many sets of wine
glass to order. The store feels it will sell approximately 800 sets in the next year at
a price of P18 per set. The wholesale price that the store pays per set is P12. Costs
of carrying one set of wine glasses are estimated at P1 per year while ordering
costs are estimated at P25.

a. Determine the economic order quantity for the sets of wine glasses.
Answer:

2(𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑 )(𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟 )

EOQ =√
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

2(800)(25)
EOQ =√
1

= 200 units per order

b. Determine the annual inventory costs for the firm if it orders in this quantity.
Answer:
Total inventory costs=𝑇𝑜𝑡𝑎𝑙 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 + 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠
𝐴𝐷 𝐸𝑂𝑄
=[ 𝑥 𝑂𝐶] + [ 𝑥 𝐶𝐶]
𝐸𝑂𝑄 2

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 800 𝑢𝑛𝑖𝑡𝑠 200 𝑢𝑛𝑖𝑡𝑠
= [200 𝑢𝑛𝑖𝑡𝑠 𝑥 𝑃25.00] + [ 𝑥 𝑃1]
2

= [𝑃100] + [𝑃100]
= P200

Illustrative Case II:

Given the following inventory information and relationships for the Baguio
Corporation:
• Orders can be placed only in multiples of 100 units.
• Annual unit usage is 300,000. (Assume a 50-week year in your calculations.)
• The carrying cost is 30 percent of the purchase price of the goods.
• The purchase price is P10 per unit.
• The ordering cost is P50 per order.
• The desired safety stock is 1,000 units. (This does not include delivery-time
stock.)
• Delivery time is two weeks.

Given this information:

a. What is the optimal EOQ level?
b. How many orders will be placed annually?
c. At what inventory level should a reorder be made?

Solution:

2(𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑 )(𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟 )

a. EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

= 3,162 units
but since orders must be placed in multiples of 100 units , the effective EOQ
becomes 3,200.

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 𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑
b. Number of Orders =
𝐸𝑂𝑄

= 94.87 orders per year

c. Reorder Point = Lead Time Usage + Safety Stock

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑
= [ 𝑥 𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒] +
𝐸𝑠𝑡.𝑛𝑜.𝑜𝑓 𝑤𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘

300,000 𝑢𝑛𝑖𝑡𝑠
= [ 𝑥 2] + 1,000 𝑢𝑛𝑖𝑡𝑠
50 𝑤𝑒𝑒𝑘𝑠

= 13,000 units

Inventory Control Systems

Inventory control is the regulation of inventory within predetermined limits.
Effective inventory management should provide adequate stocks to meet the
requirements of the business, while at the same time keeping the required
investment to a minimum. Various systems and techniques have been
developed to provide effective control over inventories.
1. Fixed Order Quantity System
This is a system wherein each time the inventory goes down to a
predetermined level known as the reorder point, an order for a fixed quantity
is placed. This system requires the use of perpetual inventory records or the
continuous monitoring of the inventory level. Example of the application of this
type of control is the two-bin system under which reorder is placed when the
contents of the first bin are used up.
2. Fixed Reorder Cycle System
This is also known as the periodic review or the replacement system where
orders are made after a review of inventory levels has been done at regular
intervals. An order is placed if at the time of the review the inventory level had

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gone down since the preceding review. The quantity ordered under this system
is variable depending on usage or demand during the review period.
Replenishment level is computed by the following formula:
M = B+D(R+L)
Where:
M = Replenishment level in units
B = Buffer stock in units
D = Average demand per day
R = Time interval in days, between reviews
L = Lead time in days
3. Optional Replenishment System
This system represents a combination of the important control mechanisms
of the other systems described above. Replenishment level is computed by the
use of the following equation:
P = B + D ( L + R/2 )
Where:
P = Reorder point in units
B = Buffer stock in units
D = Average daily demand in units
L = Lead time in days
R = Time between review in days
4. ABC Classification System
Under this system, segregation of materials for selective control is made.
Inventories are classified into “A” or high-value items, “B” or medium cost items
and “C” or low cost items. Control may be exercised on these items as follows:
1. A Items
Highest possible controls, including most complete, accurate records,
regular review by top supervisor, blanket orders with frequent deliveries
from vendor, close follow-up through the factory deliveries from vendor,
close follow-up through the factory to reduce lead time, careful and

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accurate on determination of order quantities and order point with frequent
review to reduce, if possible.
2. B Items
Normal controls involving good records and regular attention; good
analysis for EOQ and order point but reviewed quarterly only or when
major changes occur.
3. C Items
Simplest possible controls such as periodic review of physical inventory
with no records or only the simplest notations that replenishment stocks
have been ordered; no EOQ or order point calculations.

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