Unit 5: Inventory Control

The word ‘inventory’ means simply a stock of idle resources of any kind having an economic
value. In other words, inventory means a physical stock of goods, which is kept in hand for
smooth and efficient running of future affairs of an organization. It may consist of raw materials,
work-in-progress, spare parts/consumables, finished goods, human resources such as unutilized
labor, financial resources such as working capital, etc. It is not necessary that an organization has
all these inventory classes but whatever may be the inventory items, they need efficient
management as generally a substantial amount of money is invested in them.
The basic inventory decisions include:
1) How much to order?
2) When to order?
3) How much safety stock should be kept?
The problems faced by different organizations have necessitated the use of scientific techniques
in the management of inventories known as inventory control. Inventory control is concerned
with the acquisition, storage, and handling of inventories so that the inventory is available
whenever needed and the associated total cost is minimized.

Basic Terminologies
The followings are some basic terminologies which are used in inventory theory:
1. Demand
It is an effective desire which is related to particular time, price, and quantity. The demand
pattern of a commodity may be either deterministic or probabilistic. In case of deterministic
demand, the quantities needed in future are known with certainty. This can be fixed (static) or
can vary (dynamic) from time to time. On the contrary, probabilistic demand is uncertain over a
certain period of time but its pattern can be described by a known probability distribution.
2. Ordering cycle
An ordering cycle is defined as the time period between two successive replenishments. The
order may be placed on the basis of the following two types of inventory review systems:
• Continuous review: In this case, the inventory level is monitored continuously until a specified
point (known as reorder point) is reached. At this point, a new order is placed.
• Periodic review: In this case, the orders are placed at equally spaced intervals of time. The
quantity ordered each time depends on the available inventory level at the time of review.
3. Planning period
This is also known as time horizon over which the inventory level is to be controlled. This can be
finite or infinite depending on the nature of demand.
4. Lead time or delivery lag
The time gap between the moment of placing an order and actually receiving it is referred to as
lead time. Lead time can be deterministic (constant or variable) or probabilistic.
5. Buffer (or safety) stock
Normally, demand and lead time are uncertain and cannot be predetermined completely. So, to
absorb the variation in demand and supply, some extra stock is kept. This extra stock is known as
buffer stock.
6. Re-order level
The level between maximum and minimum stocks at which purchasing activity must start for
replenishment is known as re-order level.

Reasons for Carrying Inventory

Inventories are carried by organizations because of the following major reasons:
1. Improve customer service- An inventory policy is designed to respond to individual customer’s
or organization’s request for products and services.
2. Reduce costs- Inventory holding or carrying costs are the expenses that are incurred for
storage of items. However, holding inventory items in the warehouse can indirectly reduce
operating costs such as loss of goodwill and/or loss of potential sale due to shortage of items. It
may also encourage economies of production by allowing larger, longer and more production
runs.
3. Maintenance of operational capability- Inventories of raw materials and work in-progress
items act as buffer between successive production stages so that downtime in one stage does
not affect the entire production process.
4. Irregular supply and demand- Inventories provide protection against irregular supply and
demand; an unexpected change in production and delivery schedule of a product or a service can
adversely affect operating costs and customer service level.
5. Quantity discount- Large size orders help to take advantage of price-quantity discount.
However, such an advantage must keep a balance between the storage cost and costs due to
obsolescence, damage, theft, insurance, etc.
6. Avoiding stock outs (shortages)- Under situations like, labor strikes, natural disasters,
variations in demand and delays in supplies, etc., inventories act as buffer against stock out as
well as loss of goodwill.

Costs Associated with Inventories

Various costs associated with inventory control are often classified as follows:
1. Purchase (or production) cost: It is the cost at which an item is purchased, or if an item is
produced.
2. Carrying (or holding) cost: The cost associated with maintaining inventory is known as holding
cost. It is directly proportional to the quantity kept in stock and the time for which an item is held
in stock. It includes handling cost, maintenance cost, depreciation, insurance, warehouse rent,
taxes, etc.
3. Shortage (or stock out) cost: It is the cost which arises due to running out of stock. It includes
the cost of production stoppage, loss of goodwill, loss of profitability, special orders at higher
price, overtime/idle time payments, loss of opportunity to sell, etc.
4. Ordering (or set up) cost: The cost incurred in replenishing the inventory is known as ordering
cost. It includes all the costs relating to administration (such as salaries of the persons working
for purchasing, telephone calls, computer costs, postage, etc.), transportation, receiving and
inspection of goods, processing payments, etc. If a firm produces its own goods instead of
purchasing the same from an outside source, then it is the cost of resetting the equipment for
production.

Classification of Inventory

Inventory

Manufacturing
Service Aspect Control Aspect
Aspect

Raw Materials /
A-Items
Production Lot size stocks
Inventory
Inventory

Work-in-Process Anticipation B-Items

Inventory Stocks Inventory

Fluctuation C-Items
M.R.O Inventory
Stocks Inventory

Finished Goods
Risk Stocks
Inventory

Miscellaneous
Inventory
Manufacturing Inventory
There are five types of Manufacturing Inventory, they are
Raw Materials / Production Inventory
Items going to final product such a raw material, sub-assemblies purchased from outside are called
production inventory.

Work-in-Process Inventory
The items in the form of semi-finished or products at different stage of production process are known as
work-in-process inventory.

M.R.O. Inventory
Maintenance, Repair and Operating supplies such as spare parts and consumable stores, which do not go
into final product but are consumed during the production process.

Finished Goods Inventory

Finished Goods Inventory includes the products ready for dispatch to the consumers or
distributors/retailers.

Miscellaneous Inventory
Items excluding those mentioned above, such as waste, scrap, obsolete, and un-saleable items arising
from the main production process, stationery used in the office and other items required by office, factory
and other departments, etc. are called miscellaneous inventory.

Service Inventory
The service inventory can be classified into four types, they are:
Lot Size Stocks
Lot size means purchasing in lots. The reasons for this is to
 Obtain quantity discounts
 Minimize receiving and handling costs
 Reduce purchase and transport costs
For example: It would be uneconomical for a textile factory to buy cotton everyday rather than in bulk
during the cotton season.

Anticipation Stocks
Anticipation stocks are kept to meet predictable changes in demand or in availability of raw materials.
For example: The purchase of potatoes in the potato season for sale of roots preservation products
throughout the year.

Fluctuation Stocks
Fluctuation stocks are carried to ensure ready supplies to consumers in the face of irregular fluctuations
in their demands.

Risk Stocks
Risk stocks are the items required to ensure that there is no risk of complete production breakdown. Risk
stocks are critical and important for production.

Control Inventory
ABC Analysis
A good way of examining an inventory control is: to make ABC classification, which is also known as ABC
analysis. ABC analysis means the “control” will be “Always Better” if we start with the ABC classification
of inventory.
The ABC concepts classifies inventories into three groups in terms of percentage of total value and
percentage of number of inventory items, this is illustrated in the figure 3.5 and 3.6 as given below.

The three groups of inventory items are called A-items group, B-items group, C-items group, which are
explained as follows:
A-items Group: This constitutes 10% of the total number of inventory items and 70% of total money value
for all the items.
B-items Group: This constitutes 20% of the total number of inventory items and 20 % of total money value
for all the items.
C-items Group: This constitutes 70% of the total number of inventory items and 10 % of total money value
for all the items. This is just opposite of A-items group.

The ABC classification provides us clear indication for setting properties of control to the items, and A-
class item receive the importance first in every respect such as tight control, more security, and high
operating doctrine of the inventory control.

The coupling of ABC classification with VED classification enhances the inventory control efficiency. VED
classification means Vital, Essential and Desirable Classification. From the above description, it may be
noted that ABC classification is based on the logic of proportionate value while VED classification based
on experience, judgment, etc. The ABC /VED classification is presented in the following table.
 This is an example of a particular case
 The values are expressed in percentage

Note that the total number of categories becomes nine

Uses of ABC Analysis

The ABC analysis is widely used in supply chain management and stock checking and inventory system
and is implemented as a cycle counting system. It is most important for companies that seek to bring
down their working capital and carrying costs. This done by analyzing the inventory that is in excess stock
and those that are obsolete by making way for items that are readily sold. This helps avoid keeping the
working capital available for use rather than keeping it tied up in unhealthy inventory.

When a company is better able to check its stock and maintain control over the high-value goods it helps
them to keep track of the value of the assets that are being held at a time. It also brings order to the
reordering process and ensures that those items are in stock to meet the demands.

The items that fall under the C category are those that slow-moving and need not be re-ordered with the
same frequency as item A or item B. When you put the goods into these three categories, it is helpful for
both the wholesalers and the distributors to identify the items that need to be stocked and those that can
be replaced.

For Example- ‘H&M’ manufactures 80% of its retail inventory in advance and introduces the remaining
20% based on the most current market trends.

Similarly, ‘Amazon’ does not keep stock of every single item offered on its website. The stocks of only the
popular items that are frequently purchased are maintained. If there is an order for an unpopular item,
then Amazon would request it from its distributor, who would then ship it to the company.

Advantages of Implementing the ABC Method of Inventory Control

 This method helps businesses to maintain control over the costly items which have large amounts
of capital invested in them.
 It provides a method to the madness of keeping track of all the inventory. Not only does it reduce
unnecessary staff expenses but more importantly it ensures optimum levels of stock is maintained
at all times.
 The ABC method makes sure that the stock turnover ratio is maintained at a comparatively higher
level through a systematic control of inventories.
  The storage expenses are cut down considerably with this tool.
 There is provision to have enough C category stocks to be maintained without compromising on
the more important items.

Disadvantages of using the ABC Analysis

 For this method to work and render successful results, there must be proper standardization in
place for materials in the store.
 It requires a good system of coding of materials already in operation for this analysis to work.
 Since this analysis takes into consideration the monetary value of the items, it ignores other
factors that may be more important for your business. Hence, this distinction is vital.
The ABC model works in a manner as to get prime attention to the important items or the critical few and
not have unnecessary attention be spent on the not so important items or the trivial many. Each category
has a differing management control in place. This prioritization of attention and focus is vital to keep the
costs in check and under control in the supply chain system. To get the best results it is important that
items that involve a lot of costs are given the due management attention.

How to Reduce Inventory

1) Fixing up maximum limit of inventory in terms of value.
2) Fixing up responsibility of controlling the inventories with one person preferably at Senior level
reporting to top Management.
3) Meticulous materials planning and forecast.
4) A well designed and defined Inventory Control system.
5) Fixing up realistic Inventory levels i.e. maximum, minimum, reorder levels and safety stock Inventory
levels should be fixed item wise Allocation wise.
6) By reducing lead-time.
7) Adjustment in Inventory levels. Wherever called for Inventory levels should be adjusted as per changes
in requirement/consumption, changes in market conditions etc.
8) Strict control on obsolete, slow moving and non-moving items.
9) Reducing the number of stock points.
10) Standardization and variety reduction.
11) Maintaining close co-ordination with other user Depts., Store, Quality Assurance, etc. and creating an
awareness and positive attitude at all levels in all the Depts. to reduce the Inventories. Push the idea that
Inventories are cash.
12) Computerized the Inventory control system.
13) By improving the buyer seller relationship, selecting the right source of supply in terms
of location, quantity/quality etc.

Economic order quantity

The concept of economic ordering quantity (EOQ) was first developed by F. Harris in 1916. The concept is
as follows: Management of inventory is confronted with a set of opposing costs. As the lot size increases,
the carrying cost increases while the ordering cost decreases. On the other hand, as the lot size decreases,
the carrying cost decreases but the ordering cost increases. The two opposite costs can be shown
graphically by plotting them against the order size as shown in Fig below:
Economic ordering quantity(EOQ) is that size of order which minimizes the average total cost of carrying
inventory and ordering under the assumed conditions of certainty and the total demand during a given
period of time is known.

The formula for Economic Order Quantity is:

2 × 𝑆 ×𝐷
𝐸𝑂𝑄 = √
𝐻
where:
S = Setup costs (per order, generally including shipping and handling)
D = Demand rate (quantity sold per year)
H = Holding costs (per year, per unit)

Example of Economic Order Quantity

EOQ considers the timing of reordering, the cost incurred to place an order, and the costs to store
merchandise. If a company is constantly placing small orders to maintain a specific inventory level, the
ordering costs are higher, along with the need for additional storage space.

For example, consider a retail clothing shop that carries a line of men’s shirts. The shop sells 1,000 shirts
each year. It costs the company $5 per year to hold a single shirt in inventory, and the fixed cost to place
an order is $2.
Solution:
Setup Cost (S) = $2
Demand Rate (D) = 1000 shirts
Holding Cost (H) = $5
Then,
2 × 2 × 1000
𝐸𝑂𝑄 = √
5

EOQ = 28.28 ≈ 28

The ideal order size to minimize costs and meet customer demand is slightly more than 28 shirts.
Inventory models with deterministic demands
Model I(a): EOQ model without shortage
The basic assumptions of the model are as follows:
• Demand rate R is known and uniform.
• Lead time is zero or a known constant.
• Replenishment rate is infinite, i.e., replenishments are instantaneous.
• Shortages are not permitted.
• Inventory holding cost is c1 per unit per unit time.
• Ordering cost is c3 per order.
Our objective is to determine the economic order quantity q∗ which minimizes the average total cost of
the inventory system. An inventory-time diagram with inventory level on the vertical axis and time on the
horizontal axis is shown in Fig. 1.2. Since the actual consumption of inventory varies constantly, the
concept of average inventory is applicable here.
Average Inventory = 1/2[maximum level + minimum level] = (q + 0)/2 = q/2.

1
Thus, the average inventory carrying cost is = average inventory × holding cost = 𝑞𝑐1
2

The average ordering cost is (R/q)c3. Therefore, the average total cost of the inventory system is given by
1 𝑐3 𝑅
𝐶(𝑞) = 𝑐1 𝑞 +
2 𝑞
Since the minimum average total cost occurs at a point when average ordering cost and average inventory
1 𝑐3 𝑅
carrying cost are equal, therefore, we have 𝑐1 𝑞 + which gives the optimal order quantity
2 𝑞

2𝑐3 𝑅
𝑞∗ = √
𝑐1
This result was derived independently by F.W. Harris and R.H. Wilson in the year 1915. That's why the
model is called Harris-Wilson model.
Model I(b): EOQ Model with Different Rates of Demand
This inventory system operates on the assumptions of Model I(a) except that the demand rates are
different in different cycles but order quantity is fixed in each cycle. The objective is to determine the
order size in each reorder cycle that will minimize the total inventory cost. Suppose that the total demand
D is specified over the planning period T . If t1 , t2 ,..., tn denote the lengths of successive n inventory
cycles and D1 ,D2 ,...,Dn are the demand rates in these cycles, respectively, then the total period T is given
by T = t1+t2+...+tn. Fig. 1.3 depicts the inventory system under consideration.

Suppose that each time a fixed quantity q is ordered. Then the number of orders in the time period T is
n = D/q. Thus, the inventory carrying for the time period T is

Here we observe from the optimal results that the fixed demand rate R in Model I (a) is replaced by the
average demand rate (D/T) in this model.