Lesson 13: Inventory Management Part I

An inventory is a stock or store of would depend on how many of each item is

goods. Firms typically stock hundreds or needed for a computer, as well as how many
even thousands of items in inventory, computers are going to be made.
ranging from small things such as pencils,
Inventories are a vital part of business.
paper clips, screws, nuts, and bolts to large
Not only are they necessary for operations,
items such as machines, trucks, construction
but they also contribute to customer
equipment, and airplanes. Naturally, many
satisfaction.
of the items a firm carries in inventory relate
to the kind of business it engages in. Thus, Inventory decisions in service
manufacturing firms carry supplies of raw organizations can be especially critical.
materials, purchased parts, partially finished Hospitals, for example, carry an array of
items, and finished goods, as well as spare drugs and blood supplies that might be
parts for machines, tools, and other supplies. needed on short notice. Being out of stock
on some of these could imperil the well-
Examples:
being of a patient. However, many of these
✓ Department stores carry clothing, items have a limited shelf life, so carrying
furniture, carpeting, stationery, large quantities would mean having to
cosmetics, gifts, cards, and toys. dispose of unused, costly supplies. On-site
Some also stock sporting goods, repair services for computers, printers,
paints and tools. Hospitals stock copiers, and fax machines also must carefully
drugs, surgical supplies, life- consider which parts to bring to the site to
monitoring equipment, sheets and avoid having to make an extra trip to obtain
pillowcases, and more. parts. The same goes for home repair
✓ Supermarket’s stock fresh and services such as electricians, appliance
canned foods packaged and frozen repairers, and plumbers.
foods, household supplies,
The major source of revenues for retail
magazines, baked goods dairy
and wholesale businesses is the sale of
products, produce, and other items.
merchandise (i.e., inventory). In fact, in
The inventory models described in this terms of dollars, the inventory of goods held
chapter relate primarily to what are referred for sale is one of the largest assets of a
to as independent demand items, that is, merchandising business. Retail stores that
items that are ready to be sold or used. sell clothing wrestle with decisions about
Dependent-demand items are components which styles to carry, and how much of each
of finished products. Thus, a computer to carry, knowing full well that fast' Selling
would be an independent-demand item, items will mean greater profits than having
while the components that are used to to heavily discount goods that didn’t sell:
assemble a computer would be dependent-
demand items: The demand for those items
 The different kinds of inventories 2. To smooth production requirements.
include the following: Firms that experience seasonal
patterns in demand often build up
- Raw materials and purchased parts.
inventories during preseason periods
- Partially completed goods, called to meet overly high requirements
work-in-process (WIP) during seasonal periods. These
inventories are aptly named seasonal
- Finished-goods inventories
inventories; Companies that process
(manufacturing firms) or merchandise
fresh fruits and vegetables deal with
(retail stores).
seasonal inventories. So do stores
- Tools and supplies. that sell greeting cards, skis,
snowmobiles, or Christmas trees.
- Maintenance and repairs (MRO)
inventory.
3. To decouple operations. Historically,
- Goods-in-transit to warehouses, manufacturing firms have used
distributors, or customers (pipeline inventories as buffers between
inventory). successive operations to maintain
Both manufacturing and service continuity of production that would
organizations must take into consideration otherwise be disrupted by events
the space requirements of inventory. In such as breakdowns of equipment
some cases, space limitations may pose and accidents that cause a portion of
restrictions on inventory storage capability, the operation to shut down
temporarily. The buffers permit
thereby adding another dimension to
other operations to continue
inventory decisions. To understand why
temporarily while the problem is
firms, have inventories at all, you need to be
resolved.
aware of the various functions of inventory.

4. To reduce the risk of stock outs.

Functions of Inventory Delayed deliveries and unexpected
increases in demand increase the risk
1. To meet anticipated customer of shortages. Delays can occur
demand. A customer can be a person because of weather conditions,
who walks in off the street to buy a supplier stock outs, deliveries of
new stereo system, a mechanic who wrong materials, quality problems,
requests a tool at a tool crib, or a and so on. The risk of shortages can
manufacturing operation. These be reduced by holding safety stocks,
inventories are referred to as which are stocks more than expected
anticipation stocks because they are demand to compensate for
held to satisfy expected (i.e., variability in demand and lead time.
average) demand.
5. To take advantage of order cycles. 8. To take advantage of quantity
To minimize purchasing and discounts. Suppliers may give
inventory costs, a firm often buys in discounts on large orders.
quantities that exceed immediate
requirements. This necessitates
storing some or all the purchased
amount for later use. Similarly, it is Objective of Inventory
usually economical to produce in Management
large rather than small quantities.
Again, the excess output must be
stored for later use. Thus, inventory ✓ Inadequate control of
storage enables a firm to buy and inventories can result in both
produce in economic lot sizes understand overstocking of
without having to try to match items.
purchases or production with ✓ Understocking results in
demand requirements in the short missed deliveries, lost sales,
run. This results in periodic orders or dissatisfied customers, and
order cycles. production bottlenecks.
✓ Overstocking unnecessarily
takes up space and ties up
6. To hedge against price increases. funds that might be more
Occasionally a firm will suspect that a productive elsewhere.
substantial price increase is about to
occur and purchase larger-than- The overall objective of inventory
normal amounts to beat the management is to achieve satisfactory
increase. levels of customer service while keeping
inventory costs within reasonable bounds.
The two basic issues (decisions) for
7. To permit operations. The fact that
inventory management are when to order
production operations take a certain
and how much to order.
amount of time (i.e., they are not
instantaneous) means that there will Managers have several performance
generally be some work-in-process measures they can use to judge the
inventory. In addition, intermediate effectiveness of inventory management. The
stocking of goods-including raw most obvious, of course, are costs and
materials, semi-finished items, and customer satisfaction which they might
finished goods at production sites, as measure by the number and quantity of
well as goods stored in warehouses- backorders and/or customer complaints. A
leads to pipeline inventories widely used measure is inventory turnover,
throughout a production-distribution which is the ratio of annual cost of goods
system. sold to average inventory investment. The
turnover ratio indicates how many times a 2. A reliable forecast of demand that
year the inventory is sold. includes an indication of possible forecast
error.
Generally, the higher the ratio, the
better, because that implies more efficient 3. Knowledge of lead times and lead
use of inventories. However, the desirable time variability.
number of turns depends on the industry
4. Reasonable estimates of inventory
and what the profit margins are. The higher
holding costs, ordering costs, and shortage
the profit margins, the lower the acceptable
costs.
number of inventories turns, and vice versa.
Also, a product that takes a long time to 5. A classification system for
manufacture, or a long time to sell, will have inventory items.
a low turnover rate. This is often the case
with high-end retailers (high profit margins).
Conversely, supermarkets (low profit Inventory Counting Systems
margins) have a high turnover rate. Note, ✓ Inventory counting systems can be
though, that there should be a balance periodic or perpetual.
between inventory investment and
maintaining good customer service.
Managers often use inventory turnover to ✓ Periodic system, a physical count of
evaluate inventory management items in inventory is made at
performance; monitoring this metric over periodic, fixed intervals (e.g., weekly,
time can yield insights into changes in monthly) in order to decide how
performance. much to order of each item.

Requirements for Effective Inventory ✓ Perpetual inventory system (also

Management known as a continuous review
system) keeps track 0f removals from
Management has two basic functions inventory on a continuous basis, so
concerning inventory. One is to establish a the system can provide information
system to keep track of items in inventory, on the current level of inventory for
and the other is to make decisions about each item. Perpetual systems range
how much and when to order. To be from very simple to very
effective, management must have the sophisticated.
following:
1. A system to keep track of the
inventory on hand and on order.
Today, most have switched to computerized Demand Forecasts and Lead Time
checkout systems using a laser scanning information
device that reads a universal product code
(UPC), or bar code, printed on an item tag or Inventories are used to satisfy
on packaging. A typical grocery product code demand requirements, so it is essential to
is illustrated here: have reliable estimates of the amount and
timing of demand.
In addition, managers need to know
the extent to which demand and lead time
(the time between submitting an order and
receiving it) might vary; the greater the
potential variability, the greater the need
for additional stock to reduce the risk of a
shortage between deliveries. Thus, there is
a crucial link between forecasting and
inventory management.

The zero on the left of the bar code

identifies this as a grocery item, the first six Inventory Costs
numbers (712345) indicate the Four basic costs are associated with
manufacturer (Mott’s), and the last six inventories:
numbers (678911) indicate the specific item
(natural-style applesauce). Items in small ➢ Purchase
packages, such as candy and gum, use a six- ➢ Holding
digit number. ➢ Ordering
➢ Shortage costs.
✓ Point-of-sale (POS) systems
electronically record actual sales. - Purchase cost is the amount paid to a
✓ UPC scanners represent major vendor or supplier to buy the inventory. It is
benefits to supermarkets. typically the largest of all inventory costs.
✓ Bar coding is important for other - Holding, or carrying, costs relate to
sectors of business besides retailing. physically having items in storage. Costs
✓ Radio frequency identification include interest, insurance, taxes (in some
(RFID) tags are also used to keep states), depreciation, obsolescence,
track of inventory in certain deterioration, spoilage, pilferage, breakage,
applications. tracking, picking, and warehousing costs
(heat, light, rent, workers, equipment,
security). They also include opportunity
costs associated with having funds that
could be used elsewhere tied up in
inventory. Note that it is the variable portion fixed dollar amount per order, regardless of
of these costs that is pertinent. order size.
- Ordering costs are the costs of ordering - Shortage costs result when demand
and receiving inventory. They are the costs exceeds the supply of inventory on hand.
that occur with the actual placement of an These costs can include the opportunity cost
order. They include determining how much of not making a sale, loss of customer
is needed, preparing invoices, inspecting goodwill, late charges, backorder costs, and
goods upon arrival for quality and quantity, similar costs.
and moving the goods to temporary storage.
Ordering costs are generally expressed as a
 Lesson 14: Inventory Management Part II
After knowing the nature and Shrinkage takes three forms:
importance of Inventory Management, it is
o PILFERAGE - theft of inventory by
also important to know the reasons why
customers or employees.
inventories should be properly maintained
for the smooth flow of operations of the o OBSOLESCENCE – occurs when inventory
business. This is to keep a balance between cannot be used or sold at full value, owing to
inventory investment and customer service. model changes, engineering modifications,
or unexpectedly low demand.
o DETERIORATION – physical spoilage or
INVENTORY CONCEPTS
damage.
 INVENTORY is created when the receipt
of materials, parts, or finished goods
exceeds their disbursement; it is depleted  Pressures for High Inventories
when their disbursement exceeds their
Why are inventories necessary?
receipt.
✓ CUSTOMER SERVICE
 Pressures for Low Inventories
▪ Creating inventory can speed
 INVENTORY HOLDING (OR CARRYING) delivery and improve on-
COST is the variable cost of keeping items on time-delivery.
hand, including interest, storage and ▪ STOCKOUT – occurs when an
handling, taxes, insurance, and shrinkage. item that is typically stocked
is not available to satisfy a
• Interest or Opportunity Cost
demand the moment it
whichever is greater, usually is the largest
occurs, resulting in loss of the
component of holding cost.
sale.
• Storage and Handling Costs may be ▪ BACKORDER – is a customer
incurred when a firm rents space on either a order that cannot be filled
long-term or short-term basis. when promised or demanded
but is filled later.
• Taxes, Insurance, and Shrinkage.
o More taxes are paid if ✓ ORDERING COST
end-of-year ▪ For the same item, the
inventories are high. ordering cost is the same
o Insurance on assets regardless of the order size.
increases when there ▪ ORDERING COST – Cost of
is more to insure. preparing a purchase order
for a supplier or a production
order for the shop.
 LOT SIZING – determining how
frequent to order, and in what quantity.
✓ SET UP COST
▪ It is also independent of the
order size.
▪ ORDERING COST – It is the 2 Principles of Lot Sizing
cost involved in changing in 1. The lot size, Q, varies directly with the
changing over a machine to elapsed time (or cycle) between orders.
produce a different
component or item. 2. The longer the time between orders for a
given time, the greater the cycle inventory
✓ LABOR AND EQUIPMENT must be.
UTILIZATION
▪ By creating more inventory,
management can increase
work-force productivity and
facility utilization.

✓ TRANSPORTATION COSTS
▪ Outbound and inbound
transportation cost can be Average Cycle Inventory (ACI) is the
reduced by increasing average of the maximum and minimum cycle
inventory levels. inventory level at the beginning and end of
the interval, respectively. At the beginning of
✓ PAYMENT TO SUPPLIERS the interval, the cycle inventory is at its
▪ A firm often can reduce total maximum or Q. At the end of the interval,
payment to suppliers if it can just before a new lot arrives, cycle inventory
tolerate higher inventory drops to its minimum or 0.
levels.
▪ QUANTITY DISCOUNT – price
per unit drops when the order is ESTIMATING INVENTORY LEVELS
sufficiently large. It is an
Example: A plant makes monthly shipments
incentive to order larger
quantities.
of electric drills to a wholesaler in average lot
sizes of 280 drills. The wholesaler’s average
demand is 70 drills per week, and the lead
time from the plant is three weeks. On
TYPES OF INVENTORIES average, how much cycle inventory and
A. CYCLE INVENTORY – the portion of pipeline inventory does the wholesaler
total inventory that varies directly carry?
with lot size
ANSWER: The wholesaler’s cycle inventory is 2. Tight control on incoming shipments
140 drills, whereas the pipeline inventory
3. Effective control on all goods leaving
(inventory in transit) averages 210 drills.
facility

INVENTORY REDUCTION TACTICS

Independent versus Dependent
LEVERS – basic tactics for reducing inventory Demand
 PRIMARY LEVER is one that must  Independent demand - the demand for
be activated if inventory is reduced. item is independent of the demand for any
other item in inventory
 SECONDARY LEVER reduces the
penalty cost of applying the primary lever  Dependent demand - the demand for item
and the need for having inventory in the first is dependent upon the demand for some
place. other item in the inventory
ABC ANALYSIS – It is the process of dividing
items into three classes according to their
dollar usage so that the manager can focus Inventory Models for Independent
on the items that have the highest dollar Demand
value.
1. Basic Economic Order Quantity
(EOQ)
ECONOMIC ORDER QUANTITY (EOQ) is the
lot size that minimizes total annual
inventory holding and ordering costs.

 The approach to determining the EOQ is

based on the following assumptions:
1) The demand rate for the item is
constant and known with certainty.
2) There are no constraints on the
size of each lot.
3) The only two relevant costs are
Control of Service Inventories can be a the inventory holding cost and fixed cost
critical component of profitability. Losses per lot for ordering or setup.
may come from shrinkage or pilferage.
Applicable techniques include: 4) Decisions for one item can be
made independently of decisions for other
1. Good personnel selection, training, and items.
discipline
 5) There is no uncertainty in lead
time or supply.

Example: A museum of natural

history opened a gift shop two years ago.
Managing inventories has become a
problem.
Low inventory turnover is squeezing
profit margins and causing cash-flow
problems. One of the top selling items in the
container group at the museum’s gift shop is
a birdfeeder. Sales are 18 units per week,
and the supplier charges $60 per unit. The
cost of placing an order with the supplier is
$45. Annual holding cost is 25% of a feeder’s
value, and the museum operates 52 weeks
 TIME BETWEEN ORDERS (TBO) for a per year. Management chose 390-unit lot
particular lot size is the average elapsed size so that new orders could be placed less
time between receiving (or placing) frequently. What is the annual cost of the
replenishment orders of Q units. current policy of using 390-unit lot size?

 When we use EOQ the TBO can be

expressed in various ways for the same Solution:
period:
For the birdfeeder in the previous example, EOQ and, consequently, the average cycle
calculate the EOQ and its total cost. How inventory. Conversely, reducing S reduces
frequently will orders be placed if the EOQ is the EOQ, allowing smaller lot sizes to be
used? produced economically.

 A Change in the Holding Costs. Because H

is in the denominator, the EOQ declines
when H increases. Conversely, when H
declines, the EOQ increases.

 Errors in Estimating D, H, and S. Total cost

is insensitive to errors even when estimates
Now, to compute how frequent orders will
are wrong by a large margin.
be made, we first determine the time
between orders which is as follows:

Inventory Control Systems

 Continuous Review (Q) System
- sometimes called a reorder point
(ROP) system or fixed order quantity
system.

So, given those TBOs in year, month, weeks - tracks the remaining inventory of
and days, how frequent will the museum an item each time a withdrawal is made to
order birdfeeders? determine whether it is time to reorder.

Answer: Approximately 12 times a year. - reviews are done frequently or

continuously.
INVENTORY POSITION (IP) - measures the
2. Production order quantity
item’s ability to satisfy future demand. It
3. Quantity discount model
includes scheduled receipts (SR), which are
orders that have been placed but not yet
received (also called open orders), plus on-
hand inventory (OH) minus backorders
UNDERSTANDING THE EFECT OF CHANGES
(BO).
 A change in the Demand Rate. Because D
Inventory Position = On-hand inventory +
is in the numerator, the EOQ increases in
Scheduled receipts – Backorders IP = OH +
proportion to the square root of the annual
SR - BO
demand.

 A change in the Setup Costs. Because S is

in the numerator, increasing S increases the
A. Selecting the Reorder Point When standard deviation of demand during lead time
Demand is Certain probability distribution, σL.

 Reorder point, R
- predetermined minimum level
- - R equals demand during lead time,
with no added allowance for safety
stock.
R = Average demand during lead time

Example: Demand for chicken soup Example: Records show that the
at a supermarket is 25 cases a day and the demand for dishwasher detergent during the
lead time is four days. The shelves were just lead time is normally distributed, with an
restocked with chicken soup, leaving an on- average of 250 boxes and σL = 22. What
hand inventory of only 10 cases. There are safety stock should be carried for a 99
no backorders, but there is one open order percent cycle-service level? What is R?
for 200 cases. Should a new order be placed? Solution:

B. Selecting the Reorder Point When  Periodic Review (P) System

the Demand is Uncertain
- sometimes called a fixed interval reorder
 This approach will create a safety stock, or system or periodic reorder system in which
stock held more than expected demand to an item’s inventory position is reviewed
buffer against uncertain demand. periodically rather than continuously.
R = Average demand during lead time +
Safety stock
 Hybrid System
 Finding the Safety Stock
a. Optional Replenishment System
 We compute the safety stock by
multiplying the number of standard - Sometimes called the optional review, min-
deviations from the mean needed to max, or (s, S) system
implement the cycle-service level, z, by the
- Much like the P system
- It is used to review the inventory position
at fixed time intervals and, if the position has
dropped to (or below) a predetermined
level, to place a variable-sized order to cover
expected needs.

b. Base-Stock System
- Issues a replenishment order, Q, each time
a withdrawal is made, for the same amount
as the withdrawal.