CHAPTER FOUR

4. INVENTORY MANAGEMENT
4.1. Introduction
Inventory is the stock of any item or resource used in an organization. An inventory system is
the set of policies and controls that monitor levels of inventory and determine what levels should
be maintained, when stock should be replenished, and how large orders should be.
By convention, manufacturing inventory generally refers to items that contribute to or become
part of a firm’s product output. Manufacturing inventory is typically classified into raw
materials, finished products, component parts, supplies, and work-in-process. In distribution,
inventory is classified as in-transit, meaning that it is being moved in the system, and warehouse,
which is inventory in a warehouse or distribution center. Retail sites carry inventory for
immediate sale to customers. In services, inventory generally refers to the tangible goods to be
sold and the supplies necessary to administer the service.

The basic purpose of inventory analysis, whether in manufacturing, distribution, retail, or

services, is to specify (1) when items should be ordered and (2) how large the order should be.
Many firms are tending to enter into longer-term relationships with vendors to supply their needs
for perhaps the entire year. This changes the “when” and “how many to order” to “when” and
“how many to deliver.”
4.2. Functions and Types of Inventory
4.2.1. Functions of Inventory
Inventory exists because supply and demand are difficult to synchronize perfectly and it takes
time to perform material related operations. For several reasons supply and demand frequently
differ in the rates at which they respectively provide and require stock. These reasons can best
be explained by four functional factors of inventory time, discontinuity, uncertainty and
economy.

The time factor involves the long process of production and distribution required before goods
reach the final consumer. Time is required to develop the production schedule, cut raw material
requisitions, ship raw materials from suppliers (transit time ), inspect raw materials, produce the
product and ship the product to the wholesaler or consumer (transit time). Few consumers would
be willing to wait for such an extended period of time on all their purchases. Inventory enables
 an organization to reduce the lead time in meeting demand. Profitability can be enhanced by a
reputation of having products available immediately or within a reasonable time.

The discontinuity factor allows the treatment of various dependent operations (retailing,
distributing, warehousing, manufacturing and purchasing) in an independent and economical
manner. Inventories make it unnecessary to gear production directly to consumptions or to force
consumptions to adapt to the necessities of production. Inventories free one stage in the supply-
production-distribution process from the next, permitting each to operate more economically.
Raw material inventory isolates the supplier from the user, in-process inventory isolates
production department from each other, and finished goods inventory isolates the customer from
the producer. The discontinuity factor permits the firm to schedule many operations at a more
desirable performance level than if they were integrated dependently.

The uncertainty factor concerns unforeseen events that modify the original plans of the
organization. It includes errors in demand estimates, variable production yields, equipment
breakdowns, strikes, acts of God, shipping delays and unusual weather conditions. When
inventory is available, the organization has some protection from unanticipated or unplanned
occurrences.

The economy factor permits the organization to take advantage of cost reducing alternatives. It
enables the organization to purchase or produce items in economic quantities. Bulk purchases
with quantity discounts can reduce cost significantly. Per unit costs can be excessive if items are
ordered separately without regard to transportation and lot size economies. Price hedging against
impeding material cost increases may also favor large quantity purchases. Inventories can be
used to smooth production and stabilize manpower levels in undulating and seasonal businesses.

In general, therefore, the basic functions and objectives of inventories are:

 To meet anticipated customer demand  Taking advantage of quantity discounts

 To smooth production requirements  To take advantage of order cycles and
 To decouple operations  To hedge against contingencies
 To protect against stock-out
 4.2.2. Types of Inventories

When we consider inventories in the context of manufacturing and distribution, there is a natural
classification scheme suggested by the value added from manufacturing or processing. There are
many types of inventories, such as raw materials and production inventories, components and
service parts, as well as work-in-process and finished goods inventories. All of them do not
necessarily require the same treatment and, therefore, policy with regard to each may also differ,
according to their types and need in different types of industries.
They may also be functionally classified as: movement inventories, lot-size inventories,
anticipation inventories, and fluctuation inventories, etc, according to the functions they are
required to perform. However, in general, their treatment follows from their needs and cost
benefit analysis. Thus broadly, inventories may be classified as follows:

Raw materials and production inventories: These are raw materials and other supplies, parts
and components which inter into the product during the production process and generally form
part of the product. Therefore, these are the resources required in the production or processing
activity of the firm.

In-process inventories: These are semi-finished, work-in-progress and partly finished products
formed at various stages of production. Work-in-process (WIP) is an inventory either waiting in
the system for processing or being processing. Work-in-process inventories include component
inventories and may include some raw material inventories as well. The level of work-in-
process inventory is often used as a measure of the efficiency of a production scheduling system.

MRO inventories: Maintenance, repair and operating supplies which are consumed during the
production process and generally do not form part of the product itself (e.g. oils, and lubricants,
machinery and plant spares, office supplies, tools and fixtures, stationary items etc.) are referred
to as MRO inventories. These are items that facilitate the production and administrative
functions. They are not part of the final item. The appropriate level to place on inventory
depends upon the context. For example, components for some operations might be the end
products for others.

Finished goods Inventories: These are complete finished products ready for sale. These are also
known as end items, these are the final products of the production process. During production,
value is added to the inventory at each level of the manufacturing operation, culminating with
finished goods.

4.3. Independent vs. Dependent Demand

An important characteristic of demand relates to whether demand is derived from an end item or
is related to the item itself. We use the terms independent demand and dependent demand to
describe this characteristic. Briefly, the distinction between independent and dependent demand
is this: In independent demand, the demands for various items are unrelated to each other. For
example, a workstation may produce many parts that are unrelated but that meet some external
demand requirement. In dependent demand, the need for any one item is a direct result of the
need for some other item, usually a higher-level item of which it is part.

In concept, dependent demand is a relatively straightforward computational problem. Needed

quantities of a dependent-demand item are simply computed, based on the number needed in
each higher-level item in which it is used. For example, if an automobile company plans on
producing 500 cars per day, then obviously it will need 2,000 wheels and tires (plus spares). The
number of wheels and tires needed is dependent on the production levels and is not derived
separately. The demand for cars, on the other hand, is independent —it comes from many
sources external to the automobile firm and is not a part of other products; it is unrelated to the
demand for other products.

4.4. Inventory Costs

Because we are interested in optimizing the inventory system, we must determine an appropriate
optimization or performance criterion. Virtually all inventory models used cost minimization as
the optimization criterion. An alternative performance criterion might be profit maximization.
However, cost minimizations and profit maximizations are essentially equivalent criteria for
most inventory control problems. Although different systems have different characteristics,
virtually all inventory costs can be placed in to one of the three categories; holding cost, order
cost, or penalty cost. Each will be discussed as follows:
 1. Carrying, Holding or Possession costs

Carrying, holding, or possession costs are costs associated with handling or having inventories.
Carrying costs increase when inventories increase and decrease when inventories decrease. The
best way of minimizing carrying cost is to keep minimum inventory in the stock. For any
organization, inventory is an investment where the capital is tied up in the form of material and
good. This tied up capital could be utilized in developing a new product or to buy new
equipment. Thus, by holding inventory the organization forgoes the use of invested capital in
some alternative way. This is an opportunity cost. Sometimes the inventory investment is made
by borrowing money on which interest is to be paid.

Carrying costs include handing costs; storage costs such as expenditure made on inventory staff;
expenditure on various facilities ( like heating, floor space ) ware house rentals, insurances,
breakage; pilferage, obsolescence; investment costs; theft; and the like carrying costs are
measured as a percentage of the total inventory costs. The general break up of inventory carrying
costs can be:

 Costs of money tied up (cost of capital or  Loss by accidental damage deterioration 1%

opportunity cost) 10-15 %  Loss due to pilferage obsolescence 1%
 Costs of storage space 1-3 %  Cost of insurance 1.5%
 The costs of packing to prevent  Administrative costs 19 - 26 %
deterioration in store 1-2%
Due to these reasons the organization may like to maintain low inventory size, i.e.; the
organization may like to keep the inventory as small as possible. The total carrying costs may be
around 20%. Obviously; the higher the caring costs, the smaller the quantity ordered and the
more the frequency of purchases/order.

The first item (opportunity cost) turns out to be the most significant in computing holding costs
for most applications. Inventory and cash are in some sense equivalent and capital must be
invested to either purchase or produce inventory, and decreasing inventory levels results
increased capital. This capital could be invested by the company either internally, in its own
operation, or externally.
 What is the interest rate that could be earned on this capital? You and I can place our money in a
saving account with an interest rate of 4%, or possibly invest in a high-yield bond with a return
of more than 4% per annum.

In general, however, most companies must earn higher rates of return on their investment than do
individuals in order to remain profitable. The value of the interest rate that corresponds to the
opportunity cost of alternative investment is related to (but not the same as) a number of standard
accounting measures, including the internal rate of return, the return on assets, and the hurdle
rate (the minimum rate that would make an investment attractive to the firm). The value of the
interest rate for the opportunity cost is usually estimated by the firms accounting department and
it is an amalgam of the accounting measures listed above. For example, we will use the term cost
of capital to refer to this component of the holding cost.

2. Ordering Costs

Obviously the higher the carrying / holding costs of inventories the smaller the quantity ordered
and the more the frequency of order. Costs that are associated with the purchase of items are
ordering costs. Ordering costs are inversely related to the volume of orders that an organization
makes in a given period of time. If the volume of purchase is in large quantities, the number of
orders in a given year will be smaller and total direct costs of inventories related to the frequency
of purchase order will be lower. Therefore, it is necessary to reduce the number of orders in a
given year to minimize ordering cost.

The holding cost includes all of those costs that are proportional to the amount of inventory on
hand, whereas, the order cost depends on the amount of inventory that is ordered or produced.
Placement of purchase order for a material is associated with certain obvious cost due to
advertising, consumption of stationary and postage, telephone charges etc. In fact all the annual
expenditure of the purchasing department of a company can be considered to be on the purchase
order it places during the year. The cost associated with ordering would, therefore, consist of;

 Salaries of the staffs in the purchasing  Rent for the space used by the purchasing
department. department.
 Negotiating purchases, placing orders and  The postage, telegram, telephone bills.
follow up.
 The stationary and other consumables used  Lawyers and court fees due to any legal
by the purchasing department. matters arising out of purchase.
 Entertainment charges for vendors.  Inspecting shipment & moving goods to
 Traveling expense. storage.

When more order placed in a period, the more would be the stationary and postage consumed,
more staff and officers will be required for handling the work, the more will be the space
required for accommodating them and soon. Thus the total expenditure on purchasing or
ordering would depend on the number of orders placed. It is assumed that the expenditure on
ordering of material is directly proportional to the number of orders placed. The ordering cost is
expressed as cost/order.

3. Set up costs

Set up costs are costs usually incurred whether an organization is producing or making its own
products. For different orders of production there is a cost of setting up or adjusting the
machinery such as cleaning the machinery. Learning costs are also included in set up costs.
Learning cost may be so high because the amount of material that an employee spoils is high and
the output that an employee produces is low at the early stage of set up. In addition to costs
related to learning, set up costs include machine down time and parts or equipment damaged
during setup.

4. Stock-out/Penalty Costs

The penalty cost, also known as the shortage cost or the stock-out cost, is the cost of not having
the required and sufficient material on hand to satisfy demand when it occurs. This cost has a
different interpretation depending on whether excess demand is back-ordered (orders that cannot
be filled immediately are held on the books until the next shipment arrives) or lost (known as lost
sales). In the book-order case, the penalty cost includes whatever bookkeeping and /or delay
costs might be involved. In the lost-sales case, it includes the lost profit that would have been
made from sales. In either case, it would also include the “lost good-will” cost, which is a
measure of customer satisfaction. Estimating the loss of goodwill component of the penalty cost
can be very difficult in practice. In general stock-out cost includes the loss of potential profit
through sales of items demanded and loss of good will, in terms of permanent loss of customers
and its associated loss profit in future sale. Stock-out cost increases if the organization suffers
frequent shortage of inventory. To minimize shortage penalty cost, additional inventory, called
safety stock or buffer stock is generally carried.
 5. Purchase costs

Purchase costs of inventory items are also main parts of total inventory costs. Purchase costs are
the actual price paid for the material to the supplier. The purchase price will become important
when quantity discounts can be generated. However purchase costs are not relevant costs for
EOQ model since they are constant.

The optimal inventory policy is usually based on the above discussed categories of costs and
their relationship to different inventory levels. Therefore, for any inventory situation total
inventory cost can be determined from the following relation:

Totaled inventory cost = purchase costs of inventory + ordering costs + carrying+ shortage
costs

Minimizing just one of these three costs namely ordering cost, carrying cost and shortage costs
of inventory is easy but of little value. For example to minimize carrying cost, an organization
can simply stop carrying any inventory. This action however can be expected to create
unreasonable shortage of items or very high ordering costs. The actual process for minimizing
total inventory costs entails two basic decisions- how much to order and when to order.

Economic order quantity (EOQ) is the optional quantity to be purchased at one lot that
minimizes the cost of inventory in year. As inventory is used to cover actual demand and there is
a need for replenishment, it is important to decide on how much to order at a time, it is desirable
to order in quantities that will balance the costs of carrying too much stock against that of
ordering in small quantities too frequently. This order quantity is called an economic order
quantity.

4.5. Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the optimum order size that minimizes the total inventory
cost. The quantity of inventory is optimal when the total cost of inventory is at its minimum
level. Too much or too little inventories causes too much costs to an organization and therefore
has to be avoided because too much inventory increases the cost of inventories and ties-up the
total working capital. On the other hand too little inventory increases the frequency of orders
 which on the other way increases ordering cost and causes loss of quantity discount and higher
transportation charges.

Therefore, the balance between too much and too little can be done by means of effective
inventory control (EOQ).

Assumptions of EOQ

 Demand rate is constant.  Order size is uniform throughout the year

 Ordering cost and carrying costs are known and quantity discount is ignored.
& constant.  The rate of use of inventory is uniform
 The lead time is zero.
It is indicated that EOQ is a level at which the total inventory cost is minimum. For this purpose
we have to know the relevant inventory costs. The main types of inventory costs relevant to the
EOQ model are the carrying and holding costs, ordering costs, setup cost and stock out costs.
Now our objective is to determine the minimum total inventory cost for the year by applying
EOQ. Therefore, for any inventory situations, total inventory costs can be determined as follows.

Total Inventory Cost = Purchase Price + Ordering Cost + Holding Cost

But to determine/apply the EOQ, the purchase price will be excluded and only the relevant are
taken cost (Ordering and Carrying Costs).

Therefore,

1. Total ordering cost = the cost to place an order X Number of orders per year.

D
OC  C 
Q
2. Total carrying cost = carrying cost per unit/year X Average inventory.

Q
CC  H 
2
3. Total inventory cost = Total ordering cost + Total carrying cost.

TC  OC  CC

 D  Q
TC   C     H  
 Q  2
The EDQ occurs at the point where ordering and carrying costs are equal, therefore the aim is to
determine the quantity that minimize the total cost, so we will take the first derivative of the total
cost equation with respect to the lot size (Q) and set it equal to zero.

 D  Q  CD   H 
TC  PD   C     H     2      0 Then we’ll transfer H/2 to
 Q  2 Q   2 
, therefore,
the other side of the equation
dTC  CD   HQ 
 dPD  d  d 0  CD  H
dQ  Q   2    2     Then we’ll consider cross
Q  2
CD HQ multiplication
d
d
dTC dPD Q 2  0 We
    HQ 2  2CD
dQ dQ dQ dQ
consider the inverse multiplication HQ 2  2CD

 CD 1   HQ 1  HQ 2 2CD

 0  0    0 H H
 Q Q  2 Q
2CD
 CD   HQ  Q2 
  2      0 When we cancel Q by H
 Q   2Q 
Q, we will get 2CD
Q 
H

Example 1:

An organization uses 2,500 quintals peryear. The cost of ordering is Birr 4 per order. The
carrying cost is Birr 2 for carrying one unit for one year andthe purchase cost is Birr 10.

Required: 1. How many ‘quintals’ should the organization order? (EOQ)

2. What is the minimum amount of total inventory cost?

3. What is the number of orders?
4. If the organ orders 200 units’ per order, what is the total cost of inventory?
5. If the organization orders 50 units per order, what is the total amount of cost of
inventory?

Solution:

Given: D=2,500; C=4; H=2

2DC 2(2500)4 20000

1. EOQ=    10000  100 quintals
H 2 2
 CD HQ (4)( 2500) 2(100)
2. TC=PD+   10(2500)  
Q 2 100 2
25000  100  100  25,200 Birr/year

D 2500
3. Number of orders =  =25 orders/year
Q 100

4. Where Q=200, the TC will be:

CD HQ 4(2500) 2(200)
TC  PD    10(2500)    2500  50  200
Q 2 200 2
=25,250 Birr/year

5. Where Q=50
CD HQ 4(2500) 2(200)
TC  PD    (10)( 2500)    25000  200  50
Q 2 200 2
=25250 Birr/year

Example 2:

A company requires 1000 units per month. Ordering cost is estimated to be Birr 50 per order. In
addition to Birr 1, the currying costs are 10% per unit of the purchase price per year. The
purchase price is Birr 10 per unit.

Required: 1. Determine the annual demand (D)

2. Find the EOQ & the total minimum cost of inventory.

Solution

D= 1000X12 months=12000/year
C= 50
H= 1+ (10%X10) =1+1=2

2 DC 2(12000(50)
EOQ    775 Units
H 2
CD HQ
TC  PD  
Q 2
50(12,000) 2(775)
 (10)(12,000)  
775 2
 120,000  775  775
 121,549birr / year
Exercise 1

ABC Company purchase raw materials from an outside supplier for its annual requirement.
During the coming year, the company wishes to manufacture at a constant rate, 100,000 units of
its product. The cost of placing each order is birr 160. The carrying cost is, for any annual cost
equal to 20% of the items cost. The product costs Birr 20 each. Answer the following questions.

1. What is the optimal order size

2. What is the total inventory cost
3. How many orders will be placed in the next year?

[Link] Controlling Systems

In any organization, depending on the type of business, inventory is maintained. When the
number of items in inventory is large and then large amount of money is needed to create such
inventory, it becomes the concern of the management to have a proper control over its ordering,
procurement, maintenance and consumption. The control can be for order quantity and order
frequency.
The different techniques of inventory control are: (1) ABC analysis, (2) HML analysis, (3) VED
analysis, (4) FSN analysis, (5) SDE analysis, (6) GOLF analysis and (7) SOS analysis. The most
widely used method of inventory control is known as ABC analysis. In this technique, the total
inventory is categorized into three sub-heads and then proper exercise is exercised for each sub-
heads.
1. ABC analysis: In this analysis, the classification of existing inventory is based on annual
consumption and the annual value of the items. Hence we obtain the quantity of
inventory item consumed during the year and multiply it by unit cost to obtain annual
usage cost. The items are then arranged in the descending order of such annual usage
cost. The analysis is carried out by drawing a graph based on the cumulative number of
items and cumulative usage of consumption cost. Classification is done as follows:

Once ABC classification has been achieved, the policy control can be formulated as follows:
(a) A-Item: Very tight control, the items being of high value. The control need be exercised at
higher level of authority.
(b) B-Item: Moderate control, the items being of moderate value. The control need be exercised
at middle level of authority.
(c) C-Item: The items being of low value, the control can be exercised at gross root level of
authority, i.e., by respective user department managers.
2. HML analysis: In this analysis, the classification of existing inventory is based on unit
price of the items. They are classified as high price, medium price and low cost items.
3. VED analysis: In this analysis, the classification of existing inventory is based on
criticality of the items. They are classified as vital, essential and desirable items. It is
mainly used in spare parts inventory.
4. FSN analysis: In this analysis, the classification of existing inventory is based
consumption of the items. They are classified as fast moving, slow moving and non-
moving items.
5. SDE analysis: In this analysis, the classification of existing inventory is based on the
availability items. They are classified as Scarce, difficult and Easley available items.
6. GOLF analysis: In this analysis, the classification of existing inventory is based sources
of the items. They are classified as Government supply, ordinarily available, local
availability and foreign source of supply items.
7. SOS analysis: In this analysis, the classification of existing inventory is based nature of
supply of items. They are classified as seasonal and off-seasonal items.
4.7. Just in Time (JIT)

Just-in-Time (JIT) Manufacturing is a philosophy rather than a technique. By eliminating all

waste and seeking continuous improvement, it aims at creating manufacturing system that is
response to the market needs.
The phase just in time is used to because this system operates with low WIP (Work-In- Process)
inventory and often with very low finished goods inventory. Products are assembled just before
they are sold, subassemblies are made just before they are assembled and components are made
and fabricated just before subassemblies are made. This leads to lower WIP and reduced lead
times. To achieve this organizations have to be excellent in other areas e.g. quality.
According to Voss, JIT is viewed as a “Production methodology which aims to improve overall
productivity through elimination of waste and which leads to improved quality”. JIT provides an
efficient production in an organization and delivery of only the necessary parts in the right
quantity, at the right time and place while using the minimum facilities”.
 4.7.1. Benefits of JIT

The most significant benefit is to improve the responsiveness of the firm to the changes in the
market place thus providing an advantage in competition. Following are the benefits of JIT:
1. Product cost—is greatly reduced due to reduction of manufacturing cycle time, reduction
of waste and inventories and elimination of non-value added operation.
2. Quality—is improved because of continuous quality improvement programs.
3. Design—Due to fast response to engineering change, alternative designs can be quickly
brought on the shop floor.
4. Productivity improvement.
5. Higher production system flexibility.
6. Administrative and ease and simplicity.