Chapter 5

Inventory Control
Meaning & definition of Inventory
 Dictionary meaning of inventory is “Stock of
Goods” or “a list of goods”
 The term inventory can be used to mean several
things.
In this way inventory can mean:
I. The stock in hand of materials at a given time.
II. A list of all physical assets (item wise)
III. To determine the quality of items on hand.
IV. For financial and accounting records, the value
of stock of goods owned by an organization at
a particular time.
Definition
 Inventory can be defined as the stock of
goods, commodities or other resources
that are stored at any given period for
future production.
Meaning & definition of inventory
control

 Inventory control is the process by which

material of the correct quality and
correct quantity are made available as and
when required with due regard to
economy in storage and ordering costs,
purchase prices and working capitals.
Inventory control includes the
following aspects
(i) Size of inventory : Determining maximum
& minimum levels establishing time
schedules, procedures and lots of sizes for
new orders ascertaining minimum safety
levels, according sales, production and
inventory policies.
(ii) Providing proper storage facilities,
arranging the receipts, disbursement and
procurement of materials, developing the
form of recording these transactions.
(iii)Assigning responsibilities for carrying
out inventory control functions.
(iv) Providing for the reports necessary for
supervising overall activity.
Need for Inventory
 From the discussion in previous article it is clear that
inventory involves costs. So a natural question which arises is
that why we do want to hold an inventory?
There are four main purposes of holding an inventory:

1. Transaction motive
(i) Economies of scales
(ii) Specialization
(iii) Permits purchase and Transportation Economies
2. Precautionary motive
(i) Inventory as a Buffer
(ii) Hedges against Price changes
(iii) Protects against Demand and Lead-time uncertainties
3. Speculative motive
4. To maintain customer's goodwill and improve
customer Service
Classification of inventories
Direct Material Inventories
 These materials undergo transformation
in the manufacturing operation and
thereafter sent to distributors or final
customers.
 i) Production inventories: Raw materials,
parts and components which are
consumed in the production process of
goods. Purpose of holding theses
materials is to ensure uninterrupted
production process.
In process inventories
 These are partially completed/finished
goods that are still in the production
operation. i.e., Semi finished products at
various stage in the production process.
Finished Good Inventories
 These inventory items are final products
available for sale and distribution.
 They help to reduced the risk associated
with stoppage of output on account of
strike, breakdown or shortage of
materials.
Indirect Materials Inventories
 These materials in the inventory are
required for manufacturing process but
do not undergo transformation in the
process.
MRO Inventories
 Maintenance, Repair and operating
supplies which are used in the production
process but do not become part of
products.
 Examples are lubricating oils, old clothes
and machine parts.
Consumables
Consumables are products that are
required recurrently i.e., items which get
used up or discarded.
 papers, pens, files, folders
Uses of Materials
 Transaction inventory:
 Items are basically needed for transaction.
 Also called movement inventories or
pipeline inventory.
 Their existence is due to the fact that
transportation time is involved in
transferring substantial amount of
resources, such as coal.
Speculative Inventory
 Stocking of materials as a measure of
speculation so as a measure of
speculation so as to get more price of
goods in future.
Anticipation Inventories
 Anticipation inventories are held for the
reason that a future demand for the
product are anticipated.
 Production of umbrellas before rainy
season.
Buffer or precautionary Inventories
 Are held to protect against the
uncertainties of demand and supply.
 Organization generally knows the average
demand for various items that it needs.
 Always maintain the stock above average
level.
 They are also known by the terms of
safety stocks.
Minimum Inventory Level
 The minimum stock level represent the
lowest quantitative balance of materials in
hand which must be maintained in hand at
all time so that the assembly line may not
be stopped on account of non- availability
of materials.
Minimum Inventory Level
 The minimum stock level is given by
 Minimum stock level=
Re-ordered level –(Average rate of
consumption x Lead Time)
Factors Affecting Minimum levels
 Lead Time: Time required to obtain
delivery of fresh supplies.
 Administrative lead time: is the time taken
from initiating the procurement action
until the placing of order.
 Delivery lead time: is the time taken from
placing the order until the delivery of the
ordered materials.
Importable Inventory
 If the material is to be imported then the
lead time will be more implying min
inventory level is to be kept high.
Availability of inventory
 If the material is not easily available then
the min. stock level is to be kept high.
Interruption in production
 If the production process is not smooth
due to some reason such as frequent
strike, power cuts etc. then it is not easy
to find out exact level of min. stocks.
Nature of the Material
 Materials that are regularly required must
be maintained at a min. level.
Rate of consumption:
Minimum rate, maximum rate and normal
rate of consumption are to be taken into
consideration while fixing the min. stock
levels.
Maximum Inventory Level
 Maximum quantity of inventory which can
be kept in store at any time.
 This quantity is fixed keeping in view of
disadvantage of over-stocking.
Maximum Inventory Level
Factors Affecting Max. levels
 Rate of consumption of material
 Lead time
 Max. requirement of material at any point
of time
 Materials which deteriorate quickly are
stored as minimum as possible.
 Seasonal material are cheap during the
harvesting season, so maximum purchase
is made during season.
Factors Affecting Max. levels
 Cost of storage and insurance
 When the material is costly the maximum
level is likely to be relatively low
 In case of slow moving materials the
maximum level is low and in case of quick
moving materials it is high.
 If supply is uncertain, maximum level
should be as high as possible.
Re-ordering Inventory Level
 This is the fixed point between the
maximum stock levels and minimum stock
levels at which time the order for next
supply of material from the vendor is to
be done.
 Depends on rate of maximum usage and
maximum re-order or delivery time.
Assumptions for Re-order levels are
 The time of delivery remains fixed
 The average rate of consumption of
materials does not change.
Average Inventory Level
 Average quantity which must be available
for a given period of time
Danger inventory levels
 This level is below the minimum level and
when actual stock reaches this inventory
level immediate measure is to be taken to
replenish stock.
Inventory turnover
 Inventory turnover is the ratio of
average cost of goods sold to
average inventory investment.
ABC Classification System

Classifying inventory according to some

measure of importance and allocating control
efforts accordingly.
A - very important
B - mod. important High
A
C - least important Annual
$ value B
of items

Low C
Low High
Percentage of Items
ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

ABC Analysis
A Items
80 –
Percent of annual dollar usage

70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items Figure 12.2
Inventory Control System
 Order Quantity: how much to order each
material, also called lot size or economic
order quantity. (EOQ)
 Order point: the issue here is when to
order, also called re-order point.
Inventory Control System
1) Q System
2) P System
Fixed order quantity system (Q)
 The fixed order quantity system assumes
that the demand for inventories over
period of time is constant and the lead
time for replenishment of inventories is
zero.
Fixed Order Period System (P)
The order period is fixed but the order
quantity varies with the requirement.
 The quantity ordered each time depends
upon the current inventory level.
Independent Versus
Dependent Demand
 Independent demand - the
demand for item is independent of
the demand for any other item in
inventory
 Dependent demand - the demand
for item is dependent upon the
demand for some other item in the
inventory
Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
 Inventory Usage Over Time

Usage rate Average

Order quantity inventory on
= Q (maximum hand
inventory level)
Inventory level

Q
2

Minimum
inventory

0
Time
 Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order Order quantity
Table 11.5 quantity (Q*)
The EOQ Model Annual setup cost = S
D
Q

Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order

= D (S)
Q
The EOQ Model Annual setup cost = S
D
Q
Q
Annual holding cost = H
Q = Number of pieces per order 2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

= Q (H)
2
The EOQ Model Annual setup cost = S
D
Q
Q
Annual holding cost = H
Q = Number of pieces per order 2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Optimal order quantity is found when annual setup cost

equals annual holding cost

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H 2DS
Q* =
H
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected number Demand D

of orders =N= =
Order quantity Q*

1,000
N= 200 = 5 orders per year
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected time days per year
between orders =T = N

250
T= 5 = 50 days between orders
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days
Total annual cost = Setup cost + Holding cost

D Q
TC = SQ + H 2

1,000 200
TC = ($10) +
200 ($.50)2

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Robust Model

 The EOQ model is robust

 It works even if all parameters and
assumptions are not met
 The total cost curve is relatively flat
in the area of the EOQ
An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = SQ + H 2

1,500 200
TC = ($10) +
200 ($.50)2 = $75 + $50 = $125

Total annual cost increases by only 25%

An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2 Only 2% less than the
1,500 244.9 total cost of $125
TC = ($10) +
244.9 ($.50) when the order
2
quantity was 200

TC = $61.24 + $61.24 = $122.48

Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to
order
Demand Lead time for a new
ROP = per day order in days
=dxL
D
d= Number of working days in a year
Reorder Point Curve
Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Figure 12.5 Lead time = L
Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days
D
d= Number of working days in a year

= 8,000/250 = 32 units

ROP = d x L

= 32 units per day x 3 days = 96 units