UNIT-5
INVENTORY
INVENTORY : Introduction – single item – deterministic models – purchase inventory models with one
price break and multiple price breaks – shortages are not allowed – stochastic models – demand may be
discrete variable or continuous variable – instantaneous production. Instantaneous demand and
continuous demand and no set up cost. ABC & VED Analysis.
DAY-37
Topics to Be Covered: Introduction Single item – deterministic models – purchase inventory models with
one price break and multiple price breaks
1. What are the Inventory Models? Explain Deterministic Models.
Ans: Economic Lot Size Models or Economic Order Quantity models (EOQ models) - with
uniform rate of demand F. Harries first developed the Economic Order Quantity concept in the
year 1916. The idea behind the concept is that the management is confronted with a set of
opposing costs like ordering cost and inventory carrying costs. As the lot size ‘q’ increases, the
carrying cost ‘C1’ also increases while the ordering cost ‘C3’ decreases and vice versa. Hence,
Economic Ordering Quantity – EOQ - is that size of order that minimizes the total annual (or
desired time period) cost of carrying inventory and cost of ordering under the assumed conditions
of certainty and those annual demands are known.
Economic Order Quantity by Trial and Error Method
Let us try to workout Economic Order Quantity formula by trial and error method to understand
the average inventory concept. The steps involved are:
1. Select the number of possible lot sizes to purchase.
2. Determine total cost for each lot size chosen.
3. Calculate and select the order quantity that minimizes total cost.
While working the problems, we will consider Average inventory concept. This is because, the
inventory carrying cost which is the cost of holding the inventory in the stock cannot be
calculated day to day as and when the inventory level goes on decreasing due to consumption or
increases due to replenishment. For example, let us say the rent for the storeroom is Rs.500/- and
we have an inventory worth Rs. 1000/-. Due to daily demand or periodical demand the level may
vary and it is practically difficult to calculate the rent depending on the level of inventory of the
day. Hence what we do is we use average inventory concept. This means that at the beginning of
the cycle the level of inventory is Worth Rs. 1000/- and at the end of the cycle, the level is zero.
Hence we can take the average of this two i.e. (0 + 1000) / 2 = 500.
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2. Explain Economic Lot Size (for manufacturing model) or Economic Order
Quantity.
Ans: When we consider a manufacturing problem, we call the formula as Economic Lot Size (ELS)
or Economic Batch Quantity (EBQ). Here the quantity manufactured per batch is lot size (order
quantity in manufacturing model), fixed charges or set up cost per batch, which is shared by all
the components manufactured in that batch is known as Set up cost (similar to ordering cost, as
the cost of order is shared by the items purchased in that order), the cost of maintaining the in
process inventory is the inventory carrying charges. Here a formula for economic lot size ‘q’ per
cycle (production run) of a single product is derived so as to minimize the total average variable
cost per unit time.
Assumptions made:
1. Demand is uniform at a rate of ‘r’ quantity units per unit of time.
2. Lead time or time of replenishment is zero (some times known exactly).
3. Production rate is infinite, i.e. production is instantaneous.
4. Shortages are not allowed. (I.e. stock out cost is zero).
5. Holding cost is Rs. C1 per quantity unit per unit of time.
6. Set up cost is Rs. C3 per run or per set up.
By trial and error method we have seen that economic quantity exists at a point where
both ordering cost and inventory carrying cost are equal. This is the basis of algebraic method of
derivation of formula. The figure 5.1 shows the lot size ‘q’, uniform demand ‘r’ and the pattern of
inventory cycle.
Total inventory in one cycle i.e. for one unit of time = Area or triangle OAB
= ½ the base (t) × altitude (q)
=½ × q × t = ½ qt
Carrying cost for‘t’ units of time = ½ qt× C1
Set up cost for one cycle is C3
Hence total cost for one unit of time = carrying cost + ordering cost
= ½ qt C1 + C3
Total cost per unit of time Cq= {½ qtC1 + C3} / t
= ½ q C1 + C3/t
(We know that q = r thence t = q/r), substituting this for t in the above equation, we get
Cq= ½ q C1 + C3r/q - this is known as COST EQUATION.
The optimum value of ‘q’, which minimizes Cq, is obtained by equating the first derivative of Cq
With respect q = zero.
dCq/dq= ½ C1 – C3r/q2 = 0
½ C1 = C3r/q2
Or
q2C1/2 = C3r
or
q2 = 2 C3r / C1
or
q0= 2C3r/C1
This is the formula for economic lot size or economic batch size. This is also known as
Harris’s formula or Wilson formula or square root formula. q0in manufacturing model is
abbreviated as EBQ, Economic Batch Quantity.
Economic order Quantity for purchase model
All the assumptions made in the Economic Batch Quantity model will remain same but we
will take annual demand ( ) and price per unit (i.e. Material cost) = p and inventory carrying
charges are expressed is ‘i’ % of average inventory value. Hence, we take inventory carrying
charges C1 = ip.
Let us work Economic Order Quantity (EOQ) formula for purchase model.
Average inventory = q/2
Inventory carrying charges = ip
Therefore inventory carrying charges = (q/2) × ipor = ipq/2
As the annual demand = and the order quantity = q, Number of orders = / q = N
Hence ordering cost = C3 × (/q)
Total cost = Cq= (ip) × q/2 + (/q) × C3
The minimum of Cqwill get when first derivative is equals to zero.
DC/dq= ½ ip– C3 / q2 = 0 i.e. ½ ip= C3/ q2, Simplifying, we get
q0 =√ ((2C3) / ip), This is known as Economic Order Quantity or EOQ.
Similarly, t0 = optimal order time = (2C3)/ (ip× )
Optimal cost = Cq0 = √ (2C3 × ip× )
Total cost including material cost is given by: Ordering cost + carrying cost + material cost.
= (/q) × C3 + (q /2) × ip+ pOR = √(2C3 × ip× ) +p
Important and previous JNTU examination questions:
1) Explain the types of inventory.
2) What are the assumptions involved in EOQ? Explain.
3) What are the various types of Inventories? Explain briefly?
4) What is inventory? Describe the types of inventory you know.
5) Explain the various costs associated with inventory with examples.
6) Describe the characteristics of inventory system
DAY-39
Topics to Be Covered: Stochastic models – demand may be discrete variable or continuous variable
3. Describe Economic Lot Size with finite rate of replenishment
Ans: Assumption: Manufacturing rate is greater than the demand rate. In previous discussed models
we have assumed that the replenishment time is zero and the items are procured in one lot. But in
real practice, particularly in manufacturing model, items are produced on a machine at a finite rate
per unit of time; hence we cannot say the replenishment time as zero. Here we assume that the
replenishment rate is finite say at the rate of k units per unit of time. The economic lot size is q0,
carrying cost is C1 and ordering cost is C3. The mode is given in the figure: 5.3
4. Explain the Instantaneous Production with back orders permitted.
Ans: The figure 5.4 shows the model of instantaneous production, deterministic demand and the
back orders permitted. Here the carrying cost is C1 and the ordering cost is C3. As the shortages
are allowed (backlogged), the shortage cost C2 is also taken into consideration. As usual, the lot
size is ‘q’ and the inventory replenishment time is ‘t’. In addition the level of inventory in the
beginning is shown as ‘S’ and the maximum level of short items is shown as ‘z’. Hence lot size q
= S + z. From the figure, inventory carrying cost = (S/2) × t1 × C1 = Area of triangle OBD × C1
Shortage cost = Area of triangle DAC × C2 = {(q – S) / 2} × t2 × C2
Ordering cost = C3
Hence the total cost for one run = (S/2) × C1 × t1 + {(q – S) / 2)} t2 × C2 + C3
Total cost per unit of time = Cq= {(SC1t1)/ 2} + {(q – S) C2t2 / 2)} + C3 / t
With mathematical treatment, we get:
Important and previous JNTU examination questions:
1) Explain the optimum order quantity models.
2) Didtinguish between P and Q systems of inventory.
3) Explain p– System and q – system of ordering material, which one you prefer? Give your
reasons.
DAY-40
Topics to Be Covered: Instantaneous demand and continuous demand and no set up cost
5. What is the Single period model with uniform demand (No set up cost model)?
Ans: In this model the following assumptions are made:
a) Reorder time is fixed and known say‘t’ units of time. Therefore the set up cost C3 is not
included in the total cost.
b) Demand is uniformly distributed over period. Here the term period refers for the time of
one cycle.
c) Production is instantaneous, i.e. lead-time is zero.
d) Shortages are allowed and they are backlogged. The costs included in this model isC1
carrying cost per unit of quantity per unit of time and C2 the shortage cost per unit of
quantity per unit of time.
e) Units are discrete and p(r) is the probability of requiring ‘r’ units per period. If ‘S’ is the
level of inventory in the beginning of each period, and we have to find the optimum value
of ‘S’.
Hence the decision variable is S. In this problem two situations will arise:
a) Demand r ≤ S,
b) Demand r >S.
The two situations are illustrated by means
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6. A contractor has to supply 10 000 bearings a day to an automobile manufacturer. When he starts a
production run, he can produce 25 000 bearings per day. The cost of holding one bearing in stock
for one year (365 days) is £0.02 and the set up cost for a production run is £18. How frequently
should production runs be made?
Ans: This is the standard batch production model with
d = 10, 000,
r = 25, 000,
h = 2 365
s = 1800.
A practical answer if T∗ = 10 with Q∗ = 100, 000.
Important and previous JNTU examination questions:
1) A particular item has demand of 9000 units per year. The cost of procurement is Rs.100
and the holding cost per unit is Rs.2.40/year. The replacement is instantaneous and no
shortages are allowed. Determine: (i) the economic order quantity (ii) the time between
orders (iii) the number of orders per year.
2) Contractor has to supply 10000 bearings per day to an automobile manufacturer. He
finds that when he starts production run, he can produce 25000 bearings per day. The cost
of holding a bearing in stock for a year is Rs 2 and the setup cost of a production run is Rs
[Link] frequently should production run be made.
DAY-41
Topics to Be Covered: ABC & VED Analysis.
7. WHAT IS THE ABC Analysis of Inventory?
Ans: This is sometimes known as Always Better Control. This system of control is also known as
Selective Approach System. In ABC system of inventory control, the materials are classified
depending on their turnover and annual consumption cost.
A - Class Items :
These items are less in number, but consumes large portion of the total inventory
investment.
Here annual consumption cost is important than the unit cost of the material. For example
let us consider, two materials Material X and material Y. The unit cost of material X is Re.1/- and
annual consumption is 1000 units. The unit cost of material Y is Rs.200 and the annual
consumption is 3 units. Then annual consumption cost of material X is Rs.1000/- and that of Y is
Rs. 600/-. Here Material X is considered as high consumption cost material than Y. Like that in
any industry, we may find that there will be certain Items which are few in number but they
consume nearly 70 % of inventory cost. Such items are classified as ‘A’ - class items.
B - Class Items:
There will be certain materials, whose total annual consumption cost will be somewhere,
in between 20 to 25 % of total inventory investment. These items are labeled as ‘B’ - class items.
These items will form 60 percent of number of items stored.
C- Class Items:
The last class of items which are labeled as ‘C’ - class items, will be large in number may
be 30 to 35 % of total number of items stored, but consumes only 5 to 10 % total inventory
investment.
Hence we can say that A - Class items are less in number and consumes more money, B -
Class items are medium in number and consumes 20 to 25 % inventory investment and C - Class
items are large in number and consumes only 5 to 10 percent of inventory investment
In fact ABC analysis cannot be restricted to inventory only. This ABC analysis is an
extension to Pareto’s 80 - 20 rule. The 80 - 20 rules states that 80 % countries economy is
controlled by 20% of people. Let us take for example the monthly bill of an organization. Let us
say it will workout to Rs. 10, 00,000/- If we classify according to ABC rule, we see that 70
percent of the bill i.e. 7, 00,000/- will be the bill of few people say some 10 percent of the
officers. Next 2, 00,000/- belongs to 40 percent of the people. And the balance of Rs. 1, 00,000
belongs to rest 50% of the workers
Figure: 5.5 ABC graph
8. Explain Procedure for ABC ANALYSIS?
Ans: ABC ANALYSIS:
1. List out all items in stores along with their unit price and annual consumption.
2. Calculate the annual consumption cost of each item, which is given by multiplying the
quantity consumed in the time period and the unit cost. If ‘q’ is the quantity consumed in
the time period and ‘p’ is the unit price then annual consumption value = q × p = qp
3. Rearrange the list in the descending order of the annual consumption cost. i.e. highest
cost at the top and next highest is the second and so on and the last item is the lowest
consumption value item
4. Calculate the cumulative total of annual consumption value.
5. Find the parentage of each cumulative value with respect to the total cost of inventory.
6. Mark a line at 70%, 90% and at 100%. All the items covered by 70% line are ‘A’ class
items, those which are covered between 70% line and 90% line are ‘B’ class items and
those are covered by 90% and 100 % are ‘C’ class items.
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9. What is VED analysis? How is it useful to an Inventory manager?
Ans: We have seen that ABC Analysis depends on the annual consumption value but not on the
unit price of the item. In VED analysis the criticality of the item is most important than the cost
factor of the item. Here V stands for vital items, E stands for Essential items and D stands for
Desirable items. The criticality may be of two types i.e.
(a) Technical criticality and
(b) Environmental criticality.
Vital items
V items are more critical in nature, that is, without which the system cannot run. In absence of
critical items the organization has to come to stand still and it cannot keep up delivery promises.
The idle cost and the penalty for not meeting the delivery promises may be a very big loss to the
organization. Say for example in an automobile, a clutch wire, spare tyre, are critical items. It is
because while we are on road, if clutch wire fails, then it is very difficult to drive the vehicle and
we have to stop the vehicle until it is replaced. Similarly if any one tyre punctures, unless it is
repaired we cannot run the vehicle, hence by replacing the punctured tyre by spare tyre we can
drive the vehicle. One more example of vital items say for example for an officer who is working
in forest area, the scorpion medicine or medicine for snake bite is more critical and he must have
a stock of it for the use in emergency. But for a person who is living in a multistoried building in
a posh locality of a city it is not vital item. So criticality of item depends on the nature of
requirement. Another example of this is for a man who is suffering from heart problem, the
medicine required for heart attack is so vital that he must always have it in his pocket to avoid the
causality due to non-availability of the medicine. For a healthy man it is not vital to have a stock
of the same pills. Hence the Vital situation varies from industry-to-industry, person-to-person
and situation-to-situation.
Essential items
Such items, which when demand arises are not available, they may not stop the operation of the
system, but they reduces the efficiency of the system. Say for example, for a automobile vehicle,
horn, head light bulb are essential item. If they are not there, the vehicle still can be run but with
risk. For a family the pain balms, headache medicine, are essential items. Even without them they
can work but with less efficiency. If they are available, they can apply the balm or take medicine
and get relieved of the pain and work efficiently.
Desirable items
These items are of the nature, if they are not available, they will not stop the system from working
nor they reduce the efficiency of the system. But it is better to have them in stock to run the
system without any difficulty.
The VED analysis as said above depends on the criticality of the item and not on the cost – either
unit cost or annual consumption value. Depending on the criticality and demand of the item one
has to decide how much the stores manager has to stock the material. This is particularly
important in capital intensive process industries and in case of stock controlling of spare parts
required for maintenance.
This analysis also helpful in stocking of raw materials which are rarely available and
which have demand in manufacturing the products. Any materials manager has to consider both
the cost factor and criticality of item while deciding how much to stock. The matrix shows that
vital and a class items must have 90% service level i.e. 90% of the time they must be available.
Important and previous JNTU examination questions:
1) Explain the steps involved in ABC analysis.
2) Differentiate between ABC and VED analysis.
3) Explain what ABC analysis is and what its significance is.
4) What is VED analysis? How is it useful to an Inventory manager?
Important and previous JNTU examination questions( April-2017)
1) Derive EOQ
2) What is ABC analysis? Why is it necessary?
3) Explain the optimum order quantity models.
4) Explain the types of inventory.
5) Differentiate between ABC and VED analysis.
6) Explain the steps involved in ABC analysis
7) What are the assumptions involved in EOQ? Explain.
8) What are the various types of Inventories? Explain briefly?
9) A shopkeeper has a uniform demand for an item at the rate of 50 items per month. He buys from
supplier at a cost of Rs.6 per item and the cost of ordering is Rs.10 each time. If the stock holding
costs are 20% per year of stock value, how frequently should he replenish his stocks? Now
suppose the supplier offers a 5% discount, on orders between 200 and 999 items and a 10%
discount on orders exceeding or equal to 1000. Can the shop keeper reduce his costs by taking
advantage of either of these discounts?
10) A contractor has to supply 10000 bearings per day to an automobile manufacturer. He finds that
when he starts production run, he can produce 25000 bearings per day. The cost of holding a
bearing in stock for a year is Rs 2 and the setup cost of a production run is Rs [Link] frequently
should production run be made.
11) An annual requirements for a particular raw material is 8000 units costing Rs.1 each for its
manufacture, the ordering cost is Rs.12.5 to carrying cost is 20% of average inventory planning.
Find the Economic order Quantity and Total cost for the year, Number of orders required and
How frequently should the orders to be placed?