Chapter Four

Inventory
Management
Inventory
Refers to current assets, which
will be used in production or sold
in the future in the normal
course of business operations.
Is a necessary current asset that
permits the production–sale process
to operate with minimum of
disturbance.
Represents a significant monetary
investment on the part of most firms.
Inventory management
Process of ordering,
storing, using, and selling
a company's inventory.
This includes the
management of raw
materials, components,
and finished products, as
well as warehousing and
Inventory Management
…
Is concerned with
keeping enough
inventory on hand to
avoid running out of stock
At the same time
maintaining a small
enough inventory balance
to allow for a reasonable
Types of Inventory
The three basic types of
inventories are:
◦raw materials inventory,
◦Work-in process
inventory and
◦finished goods
inventory.
1. Raw Materials
Inventory-
Consists of Inventory Management
by the firm for use in the manufacture
of a finished product.
If a firm manufactures complex
products with numerous parts;
◦ Its raw materials inventory may consist of
 Manufactured items that have been
purchased from another company or
 From another division of the same
firm.
2. Work-In-Process
Inventory
Consists of all items that are
currently in production process.
Are partially finished goods at some
intermediate stage of completion.
Inventory of partially completed units
allows the separation of different phases
of the production process.
The amount of work-in-process inventory
is in part a function of the type of
product, the measurement period, and
the nature of the production process.
3. Finished Goods
Inventory
Consists of items that have been
produced completely but not yet sold.
An inventory of finished goods allows
separation of production from selling.
With a stock of finished merchandise
on hand, a firm can fill orders as they
are received rather than depend upon
the completion of production to satisfy
customer demands.
Inventory Management
Costs
The twin goals of inventory
management are
i. To ensure that the inventories
needed to sustain operations
are available, but
ii. To hold the costs of ordering
and carrying inventories to
the lowest level possible.
Inventory Management
Costs …
Relevant inventory
management costs are
usually grouped into three
categories:
◦Ordering costs
◦Carrying costs
◦ Stock out costs
1. Ordering Costs
Every time an order is placed for stock
replenishment, certain costs are involved.
OC may vary, dependent upon the type of
item.
However, an estimated OC can be obtained
for a given range of items.
Ocs are normally stated as Birr per order.
Costs of ordering include:
◦ Paper work costs of typing and dispatching an
order.
◦ Follow-up costs-includes the travel cost for
purchase follow-up, telephone, telex and postal
bills.
◦ Costs involved in receiving the order, inspection,
checking, and handling to the stores.
 2. Carrying Costs
Constitute all the costs of holding items
in inventory for a given period of time.
Expressed either in Birr per unit per
period or as a percentage of the
inventory value per period.
Components of this cost include the
following:
◦ Storage and handling costs.
◦ Obsolescence and deterioration costs.
◦ Insurance.
◦ Taxes.
◦ The cost of the funds invested in
inventories.
3. Stock out Costs:
Incurred whenever a business is unable
to fill orders because the demand for
an item is greater than the amount
currently available in inventory.
Stock out in raw materials occurs,
for example, stock out costs include the
expenses of placing special orders
(backordering) and
Expediting incoming orders, in addition
to the costs of any resulting production
delays.
Stock out…
A stock out in work-in-
progress inventory results in
◦additional costs of
rescheduling and speeding
production within the plant,
and
◦Lost production costs if work
stoppages occur.
Stock out…
Stock out in finished
goods inventory may result
in the immediate loss of
profits
◦if customers decide to purchase
the product from a competitor
and
◦in potential long-term losses if
customers decide to order from
other companies in the future.
Inventory Management
Techniques
The ultimate goal of an
inventory management
program is to provide
maximum customer service at
a minimum cost.
Effective inventory
management requires
effective techniques of
inventory control.
… Techniques…
Proper inventory control
◦Not only helps in solving the
acute problem of liquidity
but also
◦Increases profits and causes
substantial reduction in
working capital requirement
of a firm.
… Techniques…
Techniques that are
commonly used in managing
inventory are:
◦ Materials Requirement Planning
(MRP) System
◦ABC system
◦Economic Order Quantity (EOQ)
Model
◦Just-In-Time (JIT) system
Materials Requirement
Planning (MRP) System
In most Manufacturing
organizations - production
requirements - based directly on
the sales forecast.
For each of its products, it
prepares a bill of materials- a list
of the parts (and their quantities)
needed for various products in
the production process.
… MRP …
To determine overall material
requirements, each sub-assembly
or part on the bill of materials is
extended or multiplied by the
planned number of finished
products.
This yields the total materials
requirement for each product.
This is called materials requirement
planning (MRP) system.
…MRP…
Many companies use a
materials requirement
planning (MRP) system to
determine
◦what to order,
◦when to order, and
◦in what quantity to order
materials.
… MRP … Advantage
It forces the firm to more
thoroughly consider its
inventory needs and plan
accordingly.
The objective is to lower
the firm’s inventory
investment without
impairing production.
2. ABC Inventory Control
System
One of the most widely recognized
concepts of inventory management
Maintains appropriate control according
to the potential savings associated with
each category of inventory.
For example an item having an
inventory cost of Br. 10,000 has a much
greater potential for saving of expenses
related to maintaining inventories than
an item with a cost of Br. 200.
ABC …
A firm divides its
inventory into three
classes—A, B, and C—
based on annual volume
in monetary terms
(estimated as annual
demand multiplied by
unit cost).
 ABC …
A means of categorizing inventory items into
three classes “A," "B" and "C" according to the
potential amount of investment to be
controlled.
The "A" group inventory includes those items
that require the largest birr investment.
The "B” group inventory consists of the items
accounting for the next largest investment.
The "C" group typically consists of a large
number of items accounting for relatively small
birr investment.
ABC…
Dividing inventory into "A," "B" and
"C" items allows the firm to determine
the level and types of inventory
control procedures needed.
Control of the "A" items should be
most intensive because of the high
birr investment involved; the
perpetual inventory record keeping
that allows daily monitoring of these
inventory levels is appropriate.
ABC…
"B" items are frequently controlled
through periodic checking, possibly
weekly, of their levels.
"C" items could be controlled by
using simple procedures.
In general, the ABC inventory
control system is an inventory
technique, which controls expensive
inventory items more closely than
less expensive inventory items.
3. Just-In- Time (JIT)
Inventory System
Part of a manufacturing approach
that seeks to reduce the
company's operating cycle and
associated costs by eliminating
wasteful procedures.
All inventories are acquired and
used in production at the exact
time and at the right quantity
they are needed.
JIT…
While raw materials inventory and work-
in-process inventory can never be
reduced to zero, the notion of JIT is one
of extremely tight control so as to
minimize inventory size as low as
possible.
However, it requires close coordination
between a company and its suppliers as
any interruption in the flow of parts and
raw materials from the supplier can
result in costly production delays and lost
sales.
JIT….
Itrequires extensive
cooperation among all parties
involved in the process -
suppliers, shipping
companies, and the firm’s
employees.
Because its objective is to
minimize inventory
investment, a JIT system uses
4. The Economic Order
Quantity (EOQ) Model
 Although there are benefits and
costs associated with holding
inventories, it is important for the firm
to efficiently control the level of
inventory investments.
A number of inventory management
or control models are available that
can help in determining the optimal
inventory level of each item.
One of these models is economic order
quantity (EOQ) model.
EOQ
The model assumes the annual
demand or usage for a particular
inventory item is known with
certainty.
It also assumes that this demand
is stationary or uniform throughout
the year.
In other words, seasonal
fluctuations in the rate of demand
are ruled out.
EOQ…
Finally, the model assumes that
orders to replenish the inventory
item are filled instantaneously.
That means the lead-time is zero.
Lead-time is the time taken from
ordering inventory to the supplier
until the ordered inventory is
received from the supplier.
EOQ…
Given a known and constant demand
and a zero lead-time for replenishing
inventories, there is no need for a
company to maintain additional
inventories, or safety stocks to
protect itself against stock outs.
Thus, this model eliminates the need
to consider stock out costs since one
can determine exactly when to order
the required inventory to avoid stock
outs.
EOQ
This model assumes that the costs of
placing and receiving an order are the
same for each order and independent
of the number of units ordered.
It also assumes that the annual cost
of carrying 1 unit of the item in
inventory is constant regardless of the
inventory level.
Total annual inventory costs, then, are
the sum of ordering costs and
carrying costs.
Chapter Four and
Five:
Storage
Management and
Materials Handling