Chapter Six
Inventory management
Learning objectives
Understand and explain the nature and importance of holding inventory
Define the term inventory in your own words
Describe the different inventory types.
Understand and describe control and turnover of inventory and to calculate
turnover of different inventory.
Understand and explain the methods to utilize stock
Describe and comment on the requirement for effective inventory
management.
Explain and apply the principles of :
- Different counting systems for inventory;
- Keeping accurate inventory records;
- Cycle counting
Understand and explain how to control service inventory.
Understand and explain the advantages and disadvantages of holding
inventory.
Understand, explain and apply the principles and calculations of:
- Economics order quantities models.
- Basic economic order quantity model.
- Economic production quantity model.
- Quantity discount model.
6.1 INTRODUCTION
Inventory = stockpile or store of goods
Type of business determines inventory type (raw material stock, work in
progress WIP and finished goods.
Inventory: one of the most expensive assets to invest in
Good indicator- number of times inventory is turned. (buying and selling)
6.2 THE NATURE AND IMPORTANCE OF HOLDING INVENTORY
Return of Investment (ROI), the faster you are going to sell the stock, the less
stock holding will be on the floor of the business, meaning the less of carrying
cost of the stock, the dead stock will be less and profits will be bigger. ROI will
be bigger.
Larger the reeducation in holding inventory, the higher the ROI
Manufacturing organizations hold stock items:
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- Raw materials
- WIP
- Finished goods
- Replacement parts
- Inventory in transit between the organizations and its customers
6.2.1 Reasons for holding inventory:
In order to decouple the production process
There is an insecure supply of raw materials
To distance an organization from uncertain demand
To facilitate availability of a wide variety of products for the customers
To take advantage of supplier discount if certain order quantities are placed
To avoid price increases
Items are in transit
To smooth the production requirements
To prevent stock-output from occurring
To take advantage of ordering cycles
6.2.2 Objective function of inventory control
Two types of stock holding are overstocking (too much stock) and
understocking (too little stock)
Inventory management concerns itself therefore with two main areas:
- Satisfaction of customers: correct goods are available, at right quantities at
the right location exactly when it is required
- Management of inventory cost: cost concern are in the area of ordering
and inventory carrying costs
Therefore inventory management can be seen as the achievement of
customer satisfaction while at the same time keeping control over the costs
associated with the inventory.
6.2.3 Inventory types:
- Inventory of raw materials
- WIP inventory
- Maintenance, repair and operating inventory
- Finished goods inventory
6.2.4 Control and turnover of inventory:
Manufacturers, wholesalers and retail organisations can use the turnover of
inventory to measure the efficiency of their inventory management systems.
The lower the turnover of inventory the poorer the performance of the
inventory system. Means that stock are moving slowly, and should be fast.
The faster the stock can get sold, the more the sales, the more the profit.
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Inventory turnover = Cost of goods sold
Average inventory level
Example:
ABC Discount Centre sells a certain brand of television sets. The cost of
these TV sets cost R3 000. The TV sets sell at a rate of 2 000 per annum. On
average the inventory is worth R1 000 000. Calculate the inventory turnover.
Explain this against the world-wide trend of 3 to 4 turns per year.
Inventory turnover = cost of goods sold
Average inventory level
= 2000 x 3000
1 000 000
= 6 turns per year
This performance is exceptional. 6 turns against the norm of 3 to 4 turns a
year
Methods utilised to reduce stock:
o A two-bin system: In this system two bins are employed, each bin
contains the same amount of parts that will be used to manufacture an
end item. It is important that each bin are of equal size. When the
manufacturing process starts, parts from the first bin are used in the
manufacturing process. When the inventory in the first bin is exhausted
the inventory in the second bin is used. At this time, an order is placed
to replenish the inventory for the first bin. This is a continuous process.
o Supply in line processing (SILS): With this method, the decision of
picking the right parts for each model of a product, for example a car
model, is taken away from the line operative. Instead all needed parts
are delivered to match each particular model as it arrives on line.
o Kanbans: There are cards or other devices that a station uses to
communicate demand for materials or work from the station proceeding
it.
o Milk runs: This method uses a route that involves the delivery of
shipments and the pickup of inbound materials in the same run or the
daily replenishment of materials by suppliers.
o Supplier sub-assembly of components on the organisations
premises: with this method, suppliers sub-assemble components on
the business premises of the organisation they are supplying.
6.3 Requirements for effective inventory management
Two basic functions:
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- Keeping track of the entire inventory
- Deciding how much to order and when
Counting systems for inventory:
o Periodic counting system – weekly or monthly
o Perpetual counting system
Batch perpetual system: whenever 20 withdrawals have taken
place, stock system will be updated
Online perpetual system: transactions are processed
immediately – accurate record keeping
Forecasting demand and information regarding lead time
Costs incurred when inventory is carried out:
- Holding cost
- Ordering cost
- Shortage cost
Need for accurate inventory records
- Range of error in inventory records – used to calculate safety stock
- Determine what & when to order, schedule jobs and shipping of finished
goods.
- Control access to warehouse and inventory withdrawals
- Good housekeeping
Cycle counting – Rules used:
- Count after a very busy period
- Count when inventory shows zero stock holding or very low levels
- Use the importance – ABC analysis
- Count when the inventory records reflect a positive balance but a stick –
out is recorded
Cycle counting – Advantages
- Cycle counting ensures the accuracy of inventory records.
- With cycle counting, there is no need to adjust inventory level on an
annual basis.
- Cycle counting enhances the detection of errors that occur and
ensures that remedial action is taken timeously.
- There is no need to close down the plant to facilitate cycle counting.
- There is no interference with the production process.
- Only trained warehouse staff members are allowed to do the audits
How to control service inventory
- Pilferage
- Inventory shrinkage
- Measures:
o Bar coding shipments
o Magnetics tags
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6.4 Economic order quantity models
There are 3 modules:
o The basic EOQ model
o The economic production quantity model
o The quantity discount model
• EOQ – model is used to order a fixed order size, and the cost
associated with ordering is minimised.
o The use of this model is an attempt to minimise inventory
holding and prevent stock-outs from occurring
• Production and Quantity (P & Q) model – will operate only in an
independent demand environment. These two systems are widely used
in the industry.
• Conditions where P will be better than Q
– Multiple items ordered from the same supplier
– Monitoring of inexpensive items for example bolts and
nuts
– When deliveries of inventories are required at specific
times.
• Q System:
– More advantages to use the Q system when high value
items are involve
–
• Economic production quantity model: (EPQ)
• Inventory is received over a period of time, rather all in one
shipment.
• In this system the items will be produced and consumed
simultaneously.
• I the EPQ system the production rate and demand rate per day
are very important