INVENTORY

Sivaram kotha
 Definition & Types of Inventory
Inventory Definition:
• The goods or commodities that are stored in an organization to
ensure smooth and efficient running of business are called
inventories. Goods or commodities refer to finished products,
raw materials in process, packaging spares… etc.
• It is the list of movable goods in stock which helps directly or
indirectly in the production of goods for sale.
Types of Inventory:
• Direct inventories:-
• It is the integral part of the end product.
• Ex: raw materials
work in progress(WIP) or in process inventory
Purchased parts
Finished goods
 Types of Inventory
Direct inventories:
Raw materials:
• basic materials from which components, parts and products are
manufactured by the company.
• Ex:steel items(tubes, plates, shafts, flats, angles, channels etc.),
copper, tin, rubber, forgings, wood, casting, leather etc.
Inprocess inventory(Work in Progress-WIP):
• These are the semi-finished goods at various stages of manufacture.
• Raw material become WIP at the end of the first operation and
remain in this classification until they become finished goods.
• WIP can be found on the conveyors, pallets, in and around the
machines and in temporary storage awaiting for the next operation.
 Types of Inventory
Direct inventories:
Purchased parts:
• These are some purchased items(components, sub assemblies,
finished parts etc.) from outside supplier instead of
manufacturing in the factory itself.
• Ex: ball bearings, screw, nuts, bolts, tyres required in
automobile industries.
Finished Goods:
• These are the inventories contain the output of the production
process and are waiting for the inspection.
• Finished parts ready for dispatching to the customer.
• Products usually leave work in process classification and enter
in the classification of finished goods.
 Types of Inventory Contd.
Indirect inventories:-
• It do not become the integral part of the final product.
• It helps the raw material to get converted Into finished product
• Ex: Tools, supplies etc.
• Standard tools:-lathe tools, milling cutter, drills, reamers, taps, hobs,
broaches, form tools etc.
• Hand tools:- spanners, wrenches, hand saws, chisels, hammers, mallets,
punches etc.
• Supplies:
(i) Miscellaneous consumable stores like brooms, cotton waste, toilet
paper, vim power, jute etc.
(ii) Welding, soldering and tinning materials like electrodes, welding rods
etc
(iii) Abrasive materials like emery cloth, emery belts, sand paper emery,
graphite etc.
 Types of Inventory Contd.
Indirect inventories:-
• Supplies:
(iv)Brushes, maps and bobs etc.
(v) Empties such as bags, glass bottles, cardboard boxes, drums, jars, tins
etc.
(vi)Oils and grease like kerosene, transformer oil, petrol, diesel,
lubricating and cutting oil.
(vii)General office supplies like candles, sealing wax, ink and ink pads,
nibs, pencils and refills, files, pins, clips, carbon paper, erasers etc.
(viii)Envelops, letter heads, enquiry forms, order acceptance forms, tender
forms, requisition forms, goods receipt report, vouchers, debit and
credit note etc.
(ix)Electric supplies like cables, clips, cut-outs, fuses, lamps, holders,
plugs, hoses, switches etc.
 Functions of Inventory management
• Effective running of the store including problems
• Technological responsibility.
• Stock control systems
 Reasons for holding Inventory
• To create a buffer between input and output so
that the outgoing flow can be as little dependent
in the input characteristics as possible.
• To ensure against delays in deliveries.
• To allow for a possible increase in output if so
required.
• To take advantage of quantity discounts
• To ensure against scarcity of materials in the
market
• To utilize the advantage of price fluctuations
 Advantages of inventory
• Improves customer service
• Reduces costs
• Meets irregular supply & demand
• Quantity discounts
• Avoids stockouts/shortages
• Maintenance of operational capability
• Increase in produdction
 Disadvantages of inventory
• Additional funds
• Storage and handling cost
• Decrease in price
• Obsolescence
• Deterioration
• losses
 Relevant Inventory Costs

• Cost of item/purchase cost.

• Ordering cost/procurement cost
• Inventory holding or carrying cost
• Shortage cost
 Relevant Inventory Costs
Cost of item:
• It is a purchase cost associated with a particular item
• Actual cost of the item per year = R. Cu
where, R- Annual demand
Cu- unit cost
• Cost of the item does not change during planning period.
Ordering cost :
• It is independent of the quantity being ordered.
• Co is incurred every time an order is placed for an item.
 Relevant Inventory Costs
Ordering cost :
• “Co” can have several components as follows:
• People or payroll cost: cost associated for the money given to the
people who work in the purchasing area
• Transportation cost: to bring the the items from supplier to the
organization,
• Inspection: Items that are purchased or come into the organization have
to be inspected. Inspection can be either 100% or sampling.
• Rejection: It is an undesirable cost, which occurs when the items
received are rejected at the end of the inspection. It include return
transport, replace, time consuming and cost.
• Follow-up cost: If an item has to come to the organization, it require
lot of follow-up activities carried out by the senior people of the
organization or over phone.
• Delay cost
 Relevant Inventory Costs
Inventory holding or carrying cost:
• Cost associated with saving, storing, holding and controlling the
ordered quantity(Q).
• Cost of paying rent to the storage facilities.
• Safety and security cost to guard the items
• Cost of power
• Special requirements like specific temperature conditions and
dust proof environment need to be maintained for some items.
• Obsolescence cost: due to change in technology, some times the
old stock become obsolete(unusable).
• Pilferage cost: occurred when the items get stolen.
 Relevant Inventory Costs
Inventory holding or carrying cost:
• Capital cost:
“It is the total interest on the borrowed money”.
• Capital cost dominates all other carrying costs. So the cost
of carrying can be written as:
Cc = i. Cu
where,
‘i’ is the interest percent per year
‘Cu’ is the unit cost of the item
 Relevant Inventory Costs
Shortage cost :
• It is cost that occurs when there is a shortage of inventory which
may cause delay in meeting the delivery dates.
• This situation can be handled in two ways which will increase the
total inventory cost.
“Back order & lost sale”
• Back order: it is possible to carry the demand to the next period.
• Lost sale: it is not possible to carry the demand to the next period
• This shortage cost has got several components as follows.
• Loss of profit: in case of lost sale situation, the loss of profit may
occur because the incompletion of sales.
• Loss of opportunity: Company is going to loose its business due
to lack of meeting delivery dates.
 Relevant Inventory Costs
Shortage cost(CS) :
• Cost of additional capacity: If it is a back ordering situation, it
requires more capacity to meet the delivery dates.
• Re-scheduling cost: Organization has to reschedule to use
additional capacity in order to meet delivery dates.
• Under utilization of resources/Cost of idleness of Resources:
Period at which there is a scarcity of inventory, it is not possible
to continue production i.e resources are ideal at that period.
• Increased freight: in certain situations it is customary to air lift
the finished goods to the customer instead of sending them by
road. Here the transportation is cost effective.
• Loss of customer good will: If the customer is unhappy with the
performance of the organization for several times, it causes the
loss of customer good will.
 Inventory control systems
• The main features of stock control system are
defined by the ordering procedure which is
designed to answer to two simple questions.
1. How much to order?
2. When to order?
The most common stock control systems are:
1. two bin system or minimax system
2. ordering cycle system
3. combination of two bin and ordering cycle system
 ABC analysis
• (ABC = Always Better Control) This is based on
cost criteria.
• It helps to exercise selective control when
confronted with large number of items it
rationalizes the number of orders, number of
items & reduce the inventory
 Category A Items
• The most Important Items of the Company
• Accounts for only 10 to 25 % of the total
Inventory Items
• Accounts for 70 to 80 % of the Annual
consumption value of the Company.(which is
the Highest Value)
• Have very Tight Inventory Control
• Managed by Top level Management
 Category B Items
• Less Important Items than ‘A’ Items but more
Important than ‘C’ Items of the Company
• Accounts for 25 to 30 % of the total Inventory
Items
• Accounts for 15 to 25 % of the Annual
consumption value of the Company
• Have Intermediate Inventory Control
• Managed by Middle level Management
 Category C Items
• Marginally Important Items of the Company
• Accounts for 45 to 50 % of the total Inventory
Items
• Accounts for 5 to 10 % of the Annual
consumption value of the Company
• Have Low Inventory Control
• Managed by Middle & lower level
Management
ABC analysis
 ABC classification of inventory items
• A items : 70% of the annual consumption of
inventory is covered by only 10% of the items
in the inventory, deserve highest attention.
• B items : 20% of the items covering 20% of the
inventory investment (less stringent control).
• C items : rest 70% of the inventory items (very
little control)
 Steps for implementation of
ABC analysis
1. Classify the items of inventories determining the expected
use in units and the price per unit for each item.
2. Determine the total value for each item by multiplying the
expected units by its unit price.
i.e. (Annual demand) x (item cost per unit)
3. Rank the items in accordance with the total value, giving
first rank to the items with highest total value and so on.
4. Compute the ratio (percentages) of number of units of
each item to total units of all items and the ratio of total
value of each item to total value of all items.
5. Combine items on the basis of their relative value to form
three categories A, B and C.
 Advantages of ABC analysis
1. It ensures a closer and a more strict control over
such items, which are having a sizable
investment in there.
2. It releases working capital, which would
otherwise have been locked up for a more
profitable channel of investment.
3. It reduces inventory-carrying cost.
4. It enables the relaxation of control for the ‘C’
items and thus makes it possible for a sufficient
buffer stock to be created.
5. It enables the maintenance of high inventory
turn over rate.
 Disadvantages of ABC analysis
1. Proper standardization & codification of
inventory items needed.
2. Considers only money value of items & neglects
the importance of items for the production
process or assembly or functioning.
3. Periodic review becomes difficult if only ABC
analysis is recalled.
4. When other important factors make it obligatory
to concentrate on “C” items more, the purpose
of ABC analysis is defeated.
 VED analysis
• It attempts to classify the items used into 3
broad categories namely
• V – Vital
• E – Essential
• D – Desirable
• The analysis classifies item on the basis of
their criticality for the industry or company
• It is adjustable for the organization to use the
combination of ABC & VED analysis and such
control systems found more effective.
MRP - I
MRP - II
 Problems on inventory
• Inventory costs
1. Carrying or holding cost (c1)
2. Shortage or stockout cost (c2)
3. Ordering or setup or procurement cost (c3)
4. Unit or item cost or production cost (c)
 Economic order quantity (EOQ)
• It is the size of the order representing standard
quantity of material and it is the one for which
aggregating the cost of procuring the inventory
and the cost of holding the inventory is minimum
• EOQ is the size of the order that yields the
optimum total incremental or variable inventory
cost during the given period of time under the
assumption that the demand rate is constant and
is known.
EOQ Graph
 Economic order quantity (EOQ)
2𝑅𝐶3
• EOQ(q*) =
𝐶1
Where R is demand rate or annual demand
c3 is ordering cost
c1 is carrying cost
c1 = I * c
where I is % of inventory carrying cost per unit item
c is purchase cost of an item
 Optimal lot size or economic lot size
• Optimum no of orders per unit time or
optimum no of setups per unit
𝑅
𝑛=
𝑞
where R is demand rate
q is EOQ
• Optimum length of time between orders or
Optimum cycle time
𝑞 1
𝑡 = ൗ𝑅 𝑖. 𝑒.,
𝑛
• Total minimum inventory cost
𝑐 = 2𝑅𝐶3 ⋅ 𝐶1
1. A company uses annually 12000 units of raw
material costing Rs. 1.25 per unit, placing each
order cost 45 paise and carrying cost is 15% per
year per unit of avg inventory.
2. The demand of an item is uniform at a rate of
25 units/month. The fixed cost is Rs.15 each
time the production run is meet. The
production per unit is Rs.1 the inventory cost
per item is Rs.0.3, determine size & frequency
of production run.
3. An aircraft company uses rivets at an appropriate customer
rate of 2500 kg/year. Each unit cost is Rs.30/kg and company
personel estimate that it costs Rs.130 to place an order and
that the carry cost of inventory is 10% of year. How frequently
should order for rivets be placed also find optimum size of
each order.
4. The following info is available from the records of
manufacturing company. Setup cost 80 annual demand 20,000
units. Lot size 5000 units. Carrying cost 20%. Unit price of
product Rs.20. study the present policy under economic
aspect. Can we study some more economical alternative plan
to company. If yes? Explain it.
5. A drawing office requires 2400 rolls of tracing paper per year,
holding costs are estimated to be Rs.36 per roll per year. It costs
Rs. 300 to place an order for those rolls. Present practice is to
place an order for 200 rolls each time would there be any
advantage in changing the ordering policies. If so obtain the
ordering policy.
 Inventory model with price breaks or
quantity discounts
• One price break :
Purchase cost p/item in Rs Range of quantity
p1 1 < q1 < b
p2 q2 ≥ b

where b is the quantity at and beyond

which quantity discount applies.
Decision rule or working procedure for
EOQ model with one price break
Step-1 : compute 𝑞2∗ by using formula.
2𝑅𝑐3 2𝑅𝑐3 2𝑅𝑐3
𝑞2∗ = = =
𝑐1 𝐼⋅𝑐 𝑝2 ⋅ 𝐼
(a)If 𝑞2∗ ≥ b then optimum lot size to be purchased
or ordered will be 𝑞2∗ .
(b)If 𝑞2∗ ≤ b then quantity discount no longer applies
to the purchase quantity 𝑞2∗ .
Hence to determine optimal purchase quantity we
go to step-2
Step-2 : compare the total expected inventory
∗
cost for lot size q = 𝑞1 with that for lot size q = b.
their cost equations are
1 ∗ ∗ 𝑅
𝐶𝑞1 = 𝑞1 𝑃1 ⋅ 𝐼 + ∗ 𝐶3 + 𝑅𝑃1∗
∗
2 𝑞1
1 𝑅
𝐶𝑏 = 𝑏 𝑃2 ⋅ 𝐼 + 𝐶3 + 𝑅𝑃2
2 𝑏
 Two price breaks

Purchase cost range

p1 1 ≤ q1 < b1
p2 b1 ≤ q2 < b2
p3 b2 ≤ q3

Where b1 , b2 are the quantities which determine price break.

2𝑅𝑐3
Step – 1 : compute 𝑞3∗ = and compare with b2
𝑝3 𝐼

(a) if 𝑞3∗ ≥ b2 then optimum purchase quantity is 𝑞3∗ .

(b) if 𝑞3∗ < b2 then go to step 2.
 2𝑅𝑐3
Step – 2 : compute 𝑞2∗ =
𝑝2 𝐼

where 𝑞3∗ < b2. 𝑞2∗ is also < 𝑞3∗

(𝑞1∗ < 𝑞2∗ < 𝑞3∗ …………. < 𝑞𝑛∗ )
(a) If 𝑞2∗ < b2 but ≥ b1 then proceeding in the case of one price
break i.e., compare c𝑞2∗ & cb2 to obtain the optimum purchase
quantity. The quantities with lower cost naturally be optimum.
(b) If 𝑞2∗ < b2 and b1 then compute 𝑞1∗ which will satisfy the
equation 𝑞1∗ < b1 . In this case, compare the cost c𝑞1∗ , cb1, cb2.
and determine the optimum purchase quantity.
6. Find the optimum order size/ quantity for a production for
which price breaks are as follows. The monthly demand for a
product is 200 units. The cost of storage is 2% of unit cost and
cost of ordering is Rs.350.
Purchase cost (p) in Rs Quantity range
10 1 ≤ q1 < 500
9.25 500 ≤ q2 < 750
8.75 750 ≤ q3
7. With the same data of previous question with the change of
ordering cost of Rs.100. Find the optimal order size or
quantity.
 Problems on ABC analysis
Step-1 : Calculate the annual consumption value
Step-2 : Arrange the items in descending order of
annual consumption value and calculate
cumulative value of ACV.
Step-3 : Classify the ABC as given in the problem,
if not specified assume general percentages
Step-4 : Categorize the items in to ABC.
 1. The following information is about a group of items. Classify
the items as A,B and C.
Item No. 501 502 503 504 505 506 507 508 509 510
Annual usage 30000 280000 3000 110000 4000 220000 15000 80000 60000 8000
price 10 15 10 5 5 10 5 5 15 10
2. The store of oil engine repair shop has 10 items whose details
are shown in the following table. Apply ABC analysis to the store,

Component code Description Price/unit Unit/year

C01 Packing thread 100 100
C02 Tower bolt 200 300
C03 Hexagonal nut 50 700
C04 bush 300 400
C05 coupling 500 1000
C06 Bearing(big) 3000 30
C07 Bearing(small) 1000 100
C08 Fuel pump 7000 500
C09 fixture 5000 105
C10 Drill bit 60 1000
Deterministic model with shortage
• Total cycle time T = ts + ti
where ts is shortage time (or) back order time (or) stock out
time.
ti time b/w receiving the order and when the inventory level
reaches zero.
• Total quantity q = qs + qi
Where qs is no. of units that are back order (or) shortage
quantity
qi maximum elementary quantity when reveived
𝒒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑
• Annual demand R = =
𝒕 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
𝑞
𝑡=
𝑅
𝑞𝑖
𝑡𝑖 =
𝑅
𝑞𝑠 𝑞 − 𝑞𝑖
𝑡𝑠 = =
𝑅 𝑅
 𝑞𝑖2 𝑡
• Average carrying inventory =
2𝑞
𝑞𝑖2 𝑡
• Carrying cost per cycle = .c1
2𝑞
1
• Average shortage inventory = 𝑞𝑠 ⋅ 𝑡𝑠 ⋅
2
• Total variable cost (tvc) = 2annual order cost + ACC +
𝑐3 𝑅 𝑞𝑖 𝑐1 𝑞−𝑞𝑖
ASC 𝑇𝑉𝐶 = + +
𝑞 2𝑞 2𝑞

∗ 2𝑅𝑐3 𝑐1 +𝑐2
• Economic order quantity (EOQ) 𝑞 =
𝑐1 𝑐2
2𝑅𝑐3 𝑐2
• Optimal 𝑞𝑖∗
stock level =
𝑐1 𝑐1 +𝑐2
• Optimal shortage level 𝑞𝑠∗ = 𝑞 ∗ − 𝑞𝑖∗
• Total cost = TVC + R × P
1. A manufacturer has to supply his customer 30,000 units
of products per year. Demand is known and fixed. There
is no shortage space the penalty for failure to supply is
Rs.0.20 per unit per month. The inventory holding cost
Rs.0.1 per month and setup cost is Rs. 350 /production
run. Find optimum lot size for the manufacturer.
2. A commodity is to be supplied at constant rate of 200/day
supplies of any amount can be added at any required time but
each ordering cost is Rs.50 cost of holding the commodity
inventory is Rs.2 per unit per day while the delay in the supply
in the item induces a penalty of Rs.10 per unit. Find the
optimal policy q, t. where t is the reorder cycle period and q is
the inventory level after reorder. Also find the optimal
inventory level and shortage units. What would be the best
policy if the penalty cost becomes infinity.