Bangladesh Open University

Lesson-7: Inventory Management: Elements and

Techniques
After attentively studying the lesson 7, you should be able -

 To know about the elements of inventory management;

 To learn about the techniques of inventory management and

 To analyze the investments made in inventories.

Elements of Inventory Management

Inventory management consists of two important elements namely
inventory planning and inventory control.
Inventory Planning
It is important for financial management to determine the correct amount
Inventory
of working capital to invest in inventory at any one time. But the management
question is : what is the appropriate size of inventory ? No standard set consists of two
of rules can be formulated and offered as a ready solution for all important elements
enterprises and in all circumstances. The nature of the business activity, namely inventory
planning and
location of the sources of materials and services, as also of the sales
inventory control.
outlets, reliability on the sources of supply, speed and efficiency of
transport and communication facilities etc. influence the inventory levels.
Here lies the necessity of inventory planning. Inventory planning not
only includes investments of working capital in inventories of all types at
one point of time; but it also includes the amount and types of
inventories to be maintained for the smooth production of a
manufacturing enterprise. Therefore, inventory planning covers the
fixation of the following policies :
(i) Inventory turnover policy
(ii) Finished goods policy
(iii) Purchase and procurement policy
(iv) Inventory accounting policy.
Each of these policies is discussed below :
(i) Inventory Turnover Policy Inventory turnover
is a test of efficient
Inventory turnover is a test of efficient inventory management which inventory
signifies the number of times inventory is sold during a particular period. management which
signifies the number
A high inventory turnover is a sign of good inventory management; of times inventory is
while a low inventory turnover is a symptom of bad inventory sold during a
management. Investment of working capital in inventory will be less for particular period.
sales volume if inventory turnover is higher. On the other hand,
investment of working capital in inventory will be higher for sales

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volume. Therefore, fixation of proper inventory policy is a great concern

of inventory planning.
(ii) Finished Goods Policy
While fixing finished goods policy, the inventory management should
The question of
fixation of finished take into consideration the costs involved in storing inventories like rent
goods policy arises of the ware house, insurance premium, inventory handling and
because of sales of distribution costs, maintenance etc. The question of fixation of finished
inventory and costs goods policy arises because of sales of inventory and costs of
of inventories.
inventories. Therefore, fixation of proper finished goods policy is a must
for effective inventory planning.

(iii) Purchase and Procurement Policy

The main objective of purchasing and procuring raw materials, supplies,
spares etc. is to ensure continuity of their supplies and at the same time
to reduce the ultimate costs of finished goods. For ensuring this, there are
a number of parameters viz., right price, right quantity, right quality,
right time, right source, right terms and conditions etc. Therefore, fixing
proper purchase and procurement policy is a sine-qua-non for efficient
inventory planning.
(iv) Inventory Accounting Policy
Proper inventory accounting i.e. store keeping and recording of
inventories and also for right pricing of them is a precondition of
efficient inventory management. Material costing is very significant in
terms of valuation of the cost of materials consumed by the production
department. Therefore, fixing proper inventory accounting policy is a
must for efficient inventory management.

Inventory Control and Its Approaches

Inventory control refers to the physical control of inventory as well as
Inventory control
refers to the
control of over-investment in the inventory. Inventory is significant for
physical control of the efficient inventory management. To control over-investment in
inventory as well as inventories, preparing proper inventory budget, production budget,
control of over- purchase budget and sales budget is very significant. To control physical
investment in the
inventory, ABC analysis, stores level control, determination economic
inventory.
order quantity, reorder level etc. are the vital ones

Techniques of Inventory Management

To manage inventories efficiently, answers should be sought to the
following two questions :

 How much should be ordered ?

 When should it be ordered ?

The first question, how much to order, relates to the problem of
determining economic order quantity EOQ), and is answered with an
analysis of costs of maintaining certain level of inventories,. The second

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question, when to order, arises because of uncertainty and is a problem

of determining the re-order point.
Determination of Economic Order Quantity (EOQ)
Economic Order Quantity is that order quantity of inventories that will Economic Order
minimize inventory costs. The EOQ is a model which can be expressed Quantity is that
as follows : order quantity of
inventories that will
minimize inventory
2(0)(T )
EOQ = Where 0 = Fixed order cost per order costs.
(C )( PP )

T = Annual sales in units

C = % cost of carrying
PP = Purchase price per unit
The above formula indicates two types of costs viz., ordering costs and
carrying costs. Such costs are explained below:
a) Ordering Costs
The term ordering costs is used in case of raw materials or supplies and
The term ordering
includes the whole costs of acquiring raw materials. They include costs cost is used in case
incurred in the following activities: requisitioning, purchase ordering, of raw materials or
transporting, receiving, inspecting and storing. Ordering costs increased supplies and
in proportion to the number of orders placed. Hence, the more frequently includes the whole
costs of acquiring
inventory is acquired, the higher the firm’s ordering costs on the other raw materials.
hand, if the firm maintains larger inventory levels, there will be few
orders placed and as such ordering costs will be relatively small. Thus,
ordering costs decrease with increasing size of inventory.
b) Carrying Costs
Costs incurred for maintaining a given level of inventory are called
Costs incurred for
carrying costs. They include storage, insurance, taxes, handling, maintaining a given
deterioration and obsolescence. The storage costs consist of ware level of inventory
housing costs, store handling costs and clerical and staff services costs. are called carrying
Such costs vary with the size of inventory. The behavior of such costs is costs.
contrary to that of ordering costs, which decline with increase in
inventory size. The economic size of inventory would therefore, depend
on trade-off between carrying costs and ordering costs.
It is that order size
Ordering and Carrying Costs Trade-off at which annual
total costs of
The optimum inventory size is commonly referred to as EOQ. It is that ordering and
handling are the
order size at which annual total costs of ordering and handling are the minimum.
minimum.

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Besides, ordering and carrying costs there are stock out costs which are
In general, carrying
costs increase as the
also included in inventory costs. In general, carrying costs increase as the
level of inventory level of inventory rises; but ordering costs and stock out costs decline
rises; but ordering with larger inventory holdings.
costs and stock out
costs decline with Determination of various Inventory Costs
larger inventory
holdings. Total Inventory Cost (TIC) =
Total Carrying Costs + Total ordering costs
= (Carrying cost per unit) (Average units in inventory) + (Cost per order)
(Number of orders)
=(C×PP) × (Q/2) + (O) (T/Q)
The variables in the equation are defined as follows:
C = Carrying costs as a percent of the purchase price of each inventory item.
PP = Purchase price, or cost, per unit.
Q = Number of units purchased with each order.
T = Total demand, or number of units sold, per period.
O = Fixed costs per order.
Re-order Point
The problem, how much to order, is solved by determining the economic
The re-order point
is that inventory
order quantity, yet the answer should be sought to the second problem,
level at which an when to order. This is a problem of determining the re-order-point. The
order should be re-order point is that inventory level at which an order should be placed
placed to replenish to replenish the inventory. To determine the re-order under certainty, we
the inventory. should know : (a) lead time, (b) average usage, and (c) economic order
quantity. Lead time is the time normally taken in replenishing inventory
after the order has been placed. By certainty we mean that usage and lead
time do not fluctuate. Under such a situation, re-order point is simply that
inventory level which will be maintained for consumption during the
lead time. That is :
Re-order point = Lead time x Average usage
Safety Stock
The re-order point is determined under the assumption of certainty. But it
In order guard
against the stock is difficult to predict usage and lead time accurately. The demand for
out, the firm may materials may fluctuate from day to day, week to week or month to
maintain a safety month. Similarly, the actual delivery time may be different from the
stock – some normal lead time. If the actual usage increases or the delivery of
minimum or buffer
inventory as cushion
inventory is delayed, the firm can face a problem of stock out which can
against expected prove to be costly for the firm. Therefore, in order guard against the
increased usage stock out, the firm may maintain a safety stock – some minimum or
and/or delay in buffer inventory as cushion against expected increased usage and/or
delivery time.
delay in delivery time.
Safety stocks are held to avoid shortages arisen from: (i) demand
increases and (ii) shipping delays are caused. Such safety stocks also
involves costs. The cost of carrying safety stocks is equal to the
percentage cost of carrying inventories times the purchase price per unit
times the number of units held as the safety stock. Thus :

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Cost of Safety Stock (SS) = (C) (PP) (SS)

Selective Inventory Control: ABC Analysis

Usually a firm has to maintain several types of inventories. It is not
The firm should be
desirable to keep the same degree of control on all the items. The firm selective in its
should pay maximum attention to those items whose value is the highest. approach to control
The firm should, therefore, classify inventories to identify which items investment in
should receive the most effort in controlling. The firm should be various types of
selective in its approach to control investment in various types of inventories.
inventories. This analytical approach is called the ABC analysis and
tends to measure the significance of each item of inventories in terms of
its value. The high-value items are classified as ‘A items’ and would be
under the tightest control. ‘C items’ represent relatively least value and
would be under simple control. ‘B items’ fall in between these two
categories and require reasonable attention of management.
The following steps are involved in implementing the ABC analysis :
 Classify the items of inventories, determining the expected use in
units and the price per unit for each item.
 Determine the total value of each item by multiplying the expected
units by its units price.
 Rank the items in accordance with the total value, giving first rank
to the item with highest total value and so on.
 Compute the ratios (percentage) 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.
 Combine items on the basis of their relative value to form three
categories – A, B and C.
Investment in Inventories and Analysis thereof
It is the major responsibility of the financial manager to over-see the The inventory policy
will maximize the
management of inventory since inventories represent investment of the
firm’s value at a
firms’ large funds in practice. A decision to determine or change the point at which
level of inventory is an investment decision. The analysis should marginal
therefore involve an evaluation of the profitability of investment in (incremental) return
inventory. The goal of the inventory policy should be maximization of from the investment
in inventory equals
the firm’s value. The inventory policy will maximize the firm’s value at the marginal
a point at which marginal (incremental) return from the investment in (incremental) cost
inventory equals the marginal (incremental) cost of funds used to finance of funds used to
the investment in inventory. As stated in the earlier Lesson, the cost of finance the
investment in
funds is the required rate of return to the suppliers of funds, and it
inventory.
depends on the risk of the investment opportunity.

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Incremental Analysis
The investment in inventory should be analyzed involving the following
The incremental
analysis should be four steps :
used to compute the  Estimation of operating profit
values of operating
 Estimation in investment in inventory
profit, investment in
inventory, rate of  Estimation of the rate of return on investment in inventory
return and cost of  Comparison of the rate of return on investment with the cost of
funds. funds.
The incremental analysis should be used to compute the values of
operating profit, investment in inventory, rate of return and cost of funds.
A change in the inventory policy is desirable if the incremental rate of
return exceeds the required rate of return.
Choice of Policy The choice of the inventory policy by the management
If a firm increases of a corporate firm will depend on the required rate of return, k, on
its investment in
inventories, its risk incremental (or marginal) investment in inventories. The concept of the
increases. required rate of return, k, has been discussed in earlier Lesson. At this
stage, we shall emphasize that the required rate of return is not the
borrowing rate. It depends on the risk of investment. Higher the risk,
higher the rate of return. If a firm increases its investment in inventories,
its risk increases. For example, the company may not be able to realize
receivables, or inventory may become obsolete if it cannot sell goods
because of recession or other unfavorable market conditions.
Thus, the choice of inventory policy will depend on a comparison of the
The firm should
invest in higher
expected rate of return and the required rate of return. The firm should
level of inventory if invest in higher level of inventory if r ≥ k.
r ≥ k.
Problems and Solutions
Problem - 1
The Homemade Bread Company buys and then sells (as bread) 2.6
million bushels of wheat annually. The wheat must be purchased in
multiples of 2,000 bushels. Ordering costs are $5,000 per order. Annual
carrying costs are two percent of the purchase price of $5 per bushel. The
delivery time is six weeks.
a. What is the EOQ ?
b. At what inventory level should an order be placed ?
c. What are the total inventory costs ?

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Solution

20T
a. EOQ =
C  PP

(2)($5,000)(2,600,000)
=
(0.02)($5.00)

= 509,902 bushels
Because the firm must order in multiples of 2,000 bushels, it should
order in quantities of $10,000 bushels.
b. Average weekly sales = 2,600,000/52
= 50,000 bushels.
Reorder point = 6 weeks’ sales
= 6 (50,000)
= 300,000 bushels

c. Total inventory costs :

Q T 
TIC = (C)PP    O 
2 Q

 510,000   2,600,000 
= (0.02)($5)    $5,000 
 2   510,000 
= $25,500 + $25,490.20
= $50,990.20

Problem - 2
Vostick Filter Company is a distributor of air filters to retail stores. Its
buys its filters from several manufacturers. Filters are ordered in lot sizes
of 1,000 and each order costs $40 to place. Demand from retail stores is
20,000 filters per month, and carrying cost is $.10 a filter per month.
a. What is the optimal order quantity with respect to so many lot
sizes?
b. What would be the order quantity if the carrying cost were $.50 per
month ?
c. What would be the optimal order quantity if ordering costs were $
10 ?
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Solution

2(20)(40)
a. Q* = 4
100
Carrying costs = $.10 x 1,000 = $100. The optimal order size would be
4,000 filters, which five orders a month.

2(20)(40)
b. Q*   5.66
50
Since the lot size is 1,000 filters, the company would order 6,000 filters
each time. The lower the carrying cost, the more important ordering costs
become relatively, and the larger the optimal order size.

2(20)(10)
c. Q* = 2
100
The lower the order cost, the more important carrying costs become
relatively and the smaller the optimal order size.

Problem - 3
The following inventory data have been established for the Thompson
Company :
(1) Orders must be placed in multiples of 100 units.
(2) Annual sales are 338,000 units.
(3) The purchase price per unit is $6.
(4) Carrying cost is 20 percent of the price of goods.
(5) Fixed order cost is $48.
(6) Three days are required for delivery.
a. What is the EOQ ?
b. How many orders should an Thompson place each year ?
c. At what inventory level should an order be made ?
d. Calculate the total cost of ordering and carrying inventories if
the order quantity is (1) 4,000 units, (2) 4,800 units, or (3)
6,000 units. (4) What are the total costs if the order quantity is
the EOQ ?
Solution
2(0)(T )
(a) EOQ =
(C )( PP )
Where :
O = Fixed cost per Order
T = Annual Sales in Units
C = % Cost of Carrying Inventory
PP = Purchase price per unit

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2(48)(3,38,000)
 EOQ=
(.20)(6)
= 2,70,40,000
= 5,200 units
AnnualSales 3,38,000
(b) No. of order to be placed =   65
EOQ 5,200
(c) Reorder Point = Safety Stock + (Lead Time x Usage Rate) – Goods
in Transit
 3,38,000 
= 12,000 +  2x  -10,400
 52 
= 12,000 + 13,000 – 10,400
= 14,600 Units
Goods in Transit = EOQ x Lead Time
= 5,200 x 2 = 10,400 Units

(d) (i) Total Inventory Cost (TIC) = Total Carrying Cost (TCC) + Total
Ordering Cost (TOC)
T 
= (C)(PP)(A) + (O)  
Q
 4,000  3,38,000
= (.20)(6)    (48)
 2  4,000
= $2,400 + $4,056
= $6,456

(ii)TIC = TTC + TOC

 4,800   3,38,000 
= (.20)(6)    (48) 
 2   4,800 
= $2,880 + $3,380
= $6,260

(iii) TIC = TCC + TOC

 6,000   3,38,000 
= (.20)(6)    (48) 
 2   6,000 
= $3,600 + $2,704
= $6,304

(iv) TIC = TCC + TOC

 5,200   3,38,000 
= (.20)(6)    (48) 
 2   5,200 
= $3,120 + $3,120
= $6,240

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Review Questions
Short Questions
1. What is EOQ ? How it is determined ?
2. What are ordering costs ? Give examples.
3. What are carrying costs ? Give examples.
4. What do you mean by inventory planning ? Explain.
5. What is inventory control ? Explain.
6. What is re-order point ? Discuss. How it is computed.
7. What is safety stock ? Explain. How it is determined ?
8. How would you analyze investment in inventory ?
9. What is ABC control of inventory ? Explain.
10. What is lead time ? How it is calculated ?
Broad Questions
11. Discuss briefly the techniques involved in inventory management.
12. Explain the steps involved in analyzing investment in inventories.
Illustrate with an example.
Review Problems
Problem - 1
Two components, A and B are, used as follows :
Normal usage : 50 units each per week
Minimum usage : 25 units each per week
Maximum usage : 75 units each per week
Re-order quantity : A : 300 units; B : 500 units
Re-order period : A : 4 to 6 weeks; B : 2 to 4
weeks
Calculate for each component :
(a) Reorder level
(b) Minimum level
(c) Maximum level
(d) Average stock level
Problem - 2
Green Thumb Garden Centers sells 240,000 bags of lawn fertilizer
annually. The optimal safety stock (which is on hand initially) is 1,200
bags. Each bag costs (Green Thumb $4, inventory carrying costs are 20
percent, and the cost of placing an order with its supplier is $25.
(a) What is the Economic Ordering Quantity ?
(b) What is the maximum inventory of fertilizer ?
(c) What will Green Thumb’s average inventory be ?
(d) How often must the company order ?
Problem - 3
The Hedge Corporation manufactures only one product : planks. The
single raw material used in making planks is the dint. For each plank

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manufactured, 12 dints are required. Assume that the company

manufactures 150,000 planks per year, that demand for planks is
perfectly steady throughout the year, that it costs $200 each time dints
are ordered, and that carrying costs are $8 per dint per year.
a. Determine the economic order quantity of dints.
b. What are total inventory costs for Hedge (carrying costs plus
ordering costs) ?
c. How many times per year would inventory be ordered ?
Case Study
Now Ray Smith wants you to take a look at the company’s inventory
position because he thinks that inventories might be too high as a result
of the manager’s tendency to order in large quantities. Smith has decided
to examine the situation for one key product – fly rods, which cost $320
each to purchase and prepare for sale. Annual sales of the product are
2,500 units (rods), and the annual carrying cost is ten percent of
inventory value. The company has been buying 500 rods per order and
placing another order when the stock on hand falls to 100 rods. Each
time SSP orders, it incurs a cost equal to $64 Sales are uniform
throughout the year.
a. Smith believes that the EOQ model should be used to help
determine the optimal inventory situation for this product. What is
the EOQ formula, and what are the key assumptions underlying
this model ?
b. What is the formula for total inventory costs ?
c. What is the EOQ for the fly rods ? What will be the total inventory
costs for this product if the EOQ is produced ?
d. What is SSP’s added cost if it orders 500 rods rather than the EOQ
quantity ? What if it orders 750 rods each time ?

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