Chapter 6
Inventory Management
Learning outcomes
After studying this chapter, you should be able to:
• Define the term inventory
• Explain the nature and importance of holding inventory
• Describe the different inventory types
• Understand control and turnover of inventory and calculate turnover of different inventory
• Describe the requirements for effective inventory management
• Explain and apply the principles of:
• Different counting systems for inventory
• Keeping accurate inventory records
• Cycle counting
• Explain how to control service inventory
• Outline the advantages and disadvantages of holding inventory
• Understand and apply the principles and calculations of:
• Basic economic order quantity model
• Economic production quantity model
6.1 Introduction
• Inventory refers to all the items, goods, merchandise, and materials
held by a business for selling in the market to earn a profit.
• It is often seen as a stockpile of goods used in the production process
or ready to be
• Organisations manage large quantities of different inventories.
Inventory is the largest investment of an organisation and can be as
high as 50 per cent of the total investment of an organisation. sold to
customers.
• The influence of the high costs of inventory management has
forced organisations to manage their supply chains and quality more
efficiently.
6.2 The nature and importance of holding inventory
• The unavailability of goods or services is a cause for customer
dissatisfaction.
• The inventory held by these organisations is their largest asset.
• A manufacturing organisation may typically carry some or all the following
inventories:
• Raw materials and any parts that have been bought in
• Work-in-progress (WIP) inventory
• Finished goods in manufacturing and merchandise in the retail environment
• Replacement parts for machines, tools, and other supplies
• Inventory in transit between the organisation and its customers – this inventory
is sometimes known as pipeline inventory.
• Service organisations do not carry any of these types of inventories;
they usually carry inventories of supplies and equipment.
6.2.1 Reasons for holding inventory
• To decouple the production process
• There is an insecure supply of raw materials
• To distance an organisation from uncertain demand
• To facilitate availability of a wide variety of products for the customer
• To take advantage of supplier discounts if certain order quantities are placed
• To avoid price increases
• Items are in transit
• To smooth the production requirements
• To prevent stock-outs from occurring
• To take advantage of ordering cycles
6.2.2 Objective function of inventory control
• Inventory management concerns itself, therefore, with two main areas:
• Satisfaction of customers: This requires that the correct goods are available, in
the right quantities, at the right location, exactly when they are required.
• The management of the inventory costs: Cost concerns are in ordering
and inventory carrying costs.
• Inventory management can, therefore, be seen as the achievement of
customer satisfaction by the organisation’s ability to meet all demand
requirements, while controlling expenses by managing stock levels and
avoiding storage, insurance, and other holding costs.
6.2.3 Inventory types
Four most common types of inventory:
• Inventory of raw materials: This is the inventory that has been purchased but
has not yet been transformed into finished goods.
• Work-in-progress inventory: This type of inventory is classed as goods
that have entered the transformation process but have not yet emerged from
it.
• Maintenance, repair, and operating inventory: This type of inventory
ensures that the machines of an organisation can be maintained, repaired,
and operated at the desired levels.
• Finished goods inventory: This inventory is the goods that are ready for
delivery to the customer.
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 amount of waste because of too much inventory will be
determined if this measurement tool is used.
• The tool can also be used to determine the overall performance of an
organisation’s inventory policies.
6.2.4 Control and turnover of inventory
• Inventory turnover can be measured by dividing the cost of goods sold
by the value of the average inventory. This is represented by the
following formula:
6.2.5 Methods used to reduce stocks
The lower the inventory in the supply chain, the more flexible the chain will become. Reduction
in line side and store stock is the key to cutting costs.
Other methods used to reduce stocks include:
• A two-bin system: In this system, two bins of equal size are employed. 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.
• Supply-in-line sequencing (SILS): The decision of choosing the right parts for each model of a
product, for example, a car model, is taken away from the line operative. Instead, all the required
parts are delivered to match each model as it arrives on the line.
• Kanbans: These are cards or other devices that a station uses to communicate demand for materials
or work from the station preceding it.
• Milk runs: This method uses a route that involves both the delivery of shipments and the pickup of
inbound materials in the same run or the daily replenishment of materials by suppliers.
• Supplier sub-assembly of components on the organisation’s premises: Suppliers sub-assemble
components on the business premises of the organisation they are supplying.
6.3 Requirements for effective inventory
management
Management must establish the quantities of inventory to be held.
Organisations attempt to minimise the holding of inventory by holding as little as
possible.
Management of inventory entails:
• Counting inventory
• Placing orders to replenish inventory
• Receiving orders to replenish inventory.
There are two basic functions that management must perform regarding inventory:
1. The first is to keep track of the entire inventory held by an organisation.
2. The second is to decide how much to order and when orders should be placed.
6.3.1 Counting systems for inventory
[Link] Periodic counting system
• Periodic systems require regular inventory counts. This happens within
predetermined periods, for example, daily, weekly, monthly, or quarterly.
• [Link] Perpetual counting system: The perpetual counting system is also
known as the continuous counting system. It is called perpetual (ongoing)
because the inventory records are updated each time an item is withdrawn
from inventory.
• There are two basic types of the perpetual counting system, and the type of
business the organisation has will influence which type of perpetual system is
used.
1. Batch perpetual system
2. Online perpetual system
6.3.2 Forecasting demand and lead time
• The main reason for having inventory is to ensure that customer
demand can be satisfied the moment the demand occurs.
• It is, therefore, important that organisations have accurate estimates of
the quantity and timing of demand.
• Organisations also need to determine the time it will take to deliver and
receive orders. This is known as the lead time of an item.
6.3.3 Costs incurred when inventory is carried
There are a number of costs associated with inventory holding and
demand.
The following are the most common costs:
• Holding cost
• Ordering cost
• Shortage cost.
6.3.4 Need for accurate inventory records
• An organisation may have the best inventory policies in place, but these
are meaningless if management is unaware of the quantity of
items being held as inventory.
• The actual amount of inventory can differ from that reflected in
the records kept.
• It is important that record keeping is accurate as this will allow an
organisation to focus its attention on the items that need the most
attention – to ensure availability.
• If this is neglected, the organisation will have to keep inventory of
items not used on a regular basis and will incur unnecessary costs.
6.3.5 Cycle counting
• Regardless of how accurate an organisation may claim its inventory
records are, their accuracy should be confirmed through continuous audits
known as cycle counting, which is a method of physically auditing inventory
on a regular basis.
• The following guidelines can be used:
• Count after a very busy period of receiving and issuing
• Count when the balance of inventory shows zero stock holding or if inventory is at very
low levels.
• Use the importance of the items in inventory (ABC analysis, see Section 6.3.7) to
determine the frequency of cycle counting. Important items should be monitored more
frequently.
• Count when the inventory records reflect a positive balance but a stock-out is recorded.
This will indicate that a serious discrepancy exists.
6.3.5 Cycle counting
The advantages of cycle counting are that it:
• Ensures the accuracy of inventory records.
• Eliminates the need to adjust inventory levels on an annual basis.
• Enhances the detection of errors that occur and ensures that remedial
action is taken timeously.
• Eliminates the need to close the plant to facilitate cycle counting. There
is, therefore, no interference with the production process.
• Allows only trained warehouse staff to do the audits. Mistakes will
be minimised as a result.
6.3.6 How to control service inventory
• Service organisations also keep inventory, and it deserves special
attention.
• One of the more prominent service industries is the food industry.
In restaurant chains, the proper management of inventory can
make the difference between the success and failure of the business.
• In the service industry, if inventory is sitting idle in a warehouse
somewhere, that inventory is constantly losing money.
• The possibility of items being stolen (also known as pilferage) or
damaged also increases.
• When inventory is stolen or damaged, it is known as inventory shrinkage
and the organisation will incur a loss.
6.3.7 Inventory classification system: ABC
The ABC classification system is an example of an established inventory
control system that is often used for the management of inventory. It
assists with the effective and efficient management of sizeable quantities
of singular units (of a product).
These units are referred to as stock-keeping units (SKUs).
Organisations categorise the SKUs into three main categories:
• Class A (representing high monetary value items)
• Class B (representing moderate monetary value items)
• Class C (representing low monetary value items).
• Items that are identified as A-class
items are the items with the highest
annual demand in rand value (items 1
and 2 in Table 6.2).
• This is where the Pareto phenomenon
comes into play. Items 1 and 2
constitute only 20% (2 out of 10) of
the items but 72% of the total value
of inventory holding.
• Items classified as B-class items have
only medium annual demand in rand
value (items 3, 4 and 5 in Table 6.2).
Expressed in a percentage value, this
class forms 30% of total items held in
inventory and contributes about 24%
in value.
• The last class that can be identified is
the C-class. C-class items are items of
low value (represented by items 6 to
10 in Table 6.2). In total, these items
form roughly 4% of inventory value
but 50% of items held in inventory.
6.4 Examples of inventory management models
• Inventory management models are used to answer the important
question of how much to order based on demand and other factors or
constraints.
• Two inventory management models are discussed in this section:
1. The basic economic order quantity model
2. The economic production quantity model.
6.4.1 The basic economic order quantity model
• The basic economic order quantity (EOQ) model is one of the oldest
and frequently used methods of ordering and controlling inventory.
• The EOQ model is used to order a fixed order size, and the cost
associated with ordering is minimised.
• The usage and ordering of all inventories occurs in cycles.
• The cycle commences with the receipt of Q units of an item ordered.
• The inventory will then be withdrawn over a period of time at a constant rate.
• The next order of Q units will be placed with the supplier once just enough
inventory is available to satisfy demand over the lead time to receive that order.
• The optimum order size will be heavily influenced by the magnitude of
ordering and holding costs.
Slack, N., Chambers, S., Johnston, R., Pycraft, M., Singh, H., Phihlela, K. 2009. Operations Management: Global and Southern
African Perspectives. City: Pearson Education South Africa.
RU Library: [Link]
Slack, N., Chambers, S., Johnston, R., Pycraft, M., Singh, H., Phihlela, K. 2009. Operations Management: Global and Southern
African Perspectives. City: Pearson Education South Africa.
RU Library: [Link]
Slack, N., Chambers, S., Johnston, R., Pycraft, M., Singh, H., Phihlela, K. 2009. Operations
Management: Global and Southern African Perspectives. City: Pearson Education South Africa.
RU Library: [Link]
Economic Order Quantity
400
350
300
250 Total costs
Costs
200
150 Holding costs
100
Order costs
50
Economic order
quantity (EOQ)
50 100 150 200 250 300 350 400
Order quantity
6.4.2 Economic production quantity model
• In the economic production quantity (EPQ) model, inventory is received
over a period of time rather than in one shipment.
• Because this system is ideally suited for a production plant, it is known
as the economic production quantity model.
• The total ordering cost is set equal to the holding cost.
• Solving this type of model requires the use of the same formulae that
are used for the calculation of Q.
6.5 Cohesive supply chain inventory management
• Cohesion of supply chain inventory management can be achieved
through the continuous improvement of inventory performance.
• Two major initiatives have been identified to achieve the above goal.
• Vendor-managed inventory and
• collaborative planning, forecasting, and replenishment will assist in achieving
this goal.
• Vendor-managed inventory (VMI) changed this practice as well as
the overall duties and role of the operations manager. Since the advent
of VMI, organisations no longer keep inventory at their premises, and
the responsibility of keeping inventory has been moved to the supplier.
Collaborative planning, forecasting, and
replacement (CPFR)
• Collaborative planning, forecasting, and replacement (CPFR) is a further
strategy for managing inventory and the supply chain.
• Producers of fast-moving consumer goods (FMCG) started collaborating to
improve the availability of their products.
• Several merchandising associates share information about planning and
satisfying customer demand.
• Benchmarks are achieved through a blend of the best procedures of the
participating organisations. These benchmarks are then used in supply chain
planning and execution.
• The result is improved availability of products of the participants in CPFR.
• Furthermore, inventory holding costs as well as transportation and logistics
costs will decrease.
Summary
• In this chapter, we discussed inventory management. We began by considering the nature
and importance of holding inventory.
• We discussed reasons for holding inventory, the objective function of inventory control,
inventory types, and the control and turnover of inventory.
• We went on to explore the requirements for effective inventory management.
• We considered the steps to ensure the effectiveness of an inventory management system,
various counting systems for inventory (including periodic and perpetual counting systems),
forecasting demand and information regarding lead time, costs incurred when inventory is
held (including holding cost, ordering cost and shortage cost), the ABC classification
system, the need for accurate inventory records, and cycle counting.
• We talked through how to control service inventory and considered the advantages and
disadvantages of inventory.
• We then considered various economic order quantity models in detail: the basic
economic order quantity model and a review system that is continuous and one that is
periodic, and the economic production quantity model.