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InventoryManagement

byANOOP P. S.S3 MBA 2007-09

School Of Management Studies

Cusat, Kochi-22


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Inventory Definition A stock of items held to meet future

demand Inventory is a list for goods and

materials, or those goods and materialsthemselves, held available in stock by abusiness.


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Introduction

Constitute significant part of current assets

On an average approximately 60% of currentassets in Public Limited Companies in India

A considerable amount of fund is required

Effective and efficient management is imperative toavoid unnecessary investment

Improper inventory management affects long term

profitability and may fail ultimately 10 to 20% of inventory can be reduced without any

adverse effect on production and sales by usingsimple inventory planning and control techniques


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Types of Inventory

Work in

process

Work in

process

Work in

process

Finished

goods

Raw

MaterialsVendors Customer


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Nature of Inventories Raw Materials Basic inputs that are converted

into finished product through the manufacturingprocess

Work-in-progress Semi-manufactured

products need some more works before theybecome finished goods for sale

Finished Goods Completely manufacturedproducts ready for sale

Supplies Office and plant cleaning materialsnot directly enter production but are necessaryfor production process and do not involvesignificant investment.


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Reasons To Hold Inventory

Meet variations in customer demand: Meet unexpected demand

Smooth seasonal or cyclical demand

Pricing related: Temporary price discounts

Hedge against price increases Take advantage of quantity discounts

Process & supply surprises Internal upsets in parts of or our own processes

External delays in incoming goods


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Objective of Inventory Management

To maintain a optimum size of inventory forefficient and smooth production and salesoperations

To maintain a minimum investment in inventoriesto maximize the profitability

Effort should be made to place an order at theright time with right source to acquire the right

quantity at the right price and right quality


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An effective inventory management should

Ensure a continuous supply of raw materials tofacilitate uninterrupted production

Maintain sufficient stocks of raw materials inperiods of short supply and anticipate price

changes Maintain sufficient finished goods inventory for

smooth sales operation, and efficient customerservice

Minimize the carrying cost and time

Control investment in inventories and keep it at anoptimum level


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An optimum inventory level involves three

types of costs

Ordering costs:-

Quotation or tendering

Requisitioning

Order placing

Transportation Receiving, inspecting and

storing

Quality control

Clerical and staff

Stock-out cost

Loss of sale

Failure to meet deliverycommitments

Carrying costs:-

Warehousing or storage

Handling

Clerical and staff

Insurance Interest

Deterioration,shrinkage,

evaporation andobsolescence

Taxes

Cost of capital


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Dangers of Over investment

Unnecessary tie-up of firms fund and loss ofprofit involves opportunity cost

Excessive carrying cost

Risk of liquidity- difficult to convert into cash

Physical deterioration of inventories while instorage due to mishandling and improper

storage facilities


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Dangers of under-investment

Production hold-ups loss of labor hours

Failure to meet delivery commitments

Customers may shift to competitors whichwill amount to a permanent loss to the firm

May affect the goodwill and image of the firm


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-Track inventory

How much to order

When to order

Functions of Inventory Management


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Classification of inventory

ABC Classification

HML Classification

XYZ Classification

VED Classification

FSN Classification

SDF Classification GOLF Classification

SOS Classification


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ABC Classification

In most of the cases 10 to 20 % of theinventory account for 70 to 80% of the annualactivity.

A typical manufacturing operation shows thatthe top 15% of the line items, in terms ofannual rupees usage, represent 80% of totalannual rupees usage.

Next 15% of items reflect 15% of annualrupees Next 70% accounts only for 5% usage

A

B

C


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XYZ Classification

On the basis of value of inventory stored

Whereas ABC was on the basis of value ofconsumption to value.

X

High Value Y Medium value

Z Least value

Aimed to identify items which are extensivelystocked.


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HML Classification

On the basis of unit value of item

There is 1000 unit of Q @ Rs. 10 and10,000 units of W @ Rs. 5.

Aimed to control the purchase of raw materials.

H High, M- Medium, L - Low


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VED Classification

Mainly for spare parts because theirconsumption pattern is different from rawmaterials.

Raw materials on market demand

Spare parts on performance of plant andmachinery.

V Vital, E Essential, D Desirable

Therefore V items has to be stocked moreand D Items has to be less stocked


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FSN Classification

According to the consumption pattern

To combat obsolete items

F Fast moving

S Slow moving

N Non Moving


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SDF & GOLF Classification

Based on source of procurement

S Scarce, D- Difficult, E- Easy.

GOLF

G Government, O Ordinary, L Local, F Foreign.


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SOS Classification

Raw materials especially for agriculture units

S Seasonal

OS Off seasonal


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Deciding on the inventory model

Assume an analyst applies an inventorymodel that does not allow for spoilage to agrocery chains ordering policy for lettuce and

formulates the strategy of ordering lettuce inlarge amounts every 14 days. A little thoughtwill show that this is obliviously foolish. Thisstrategy implies that lettuce will be spoiled.However it is not a failure of inventory, it is afailure to apply the correct model.


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Different approaches

Certainty approach

Uncertain variables and risk are addressedseparately

Uncertainty approach

Uncertain variables and risk are addressedsimultaneously

Deterministic approach

Probabilistic approach


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Basic EOQ Model

Assumption

Seasonal fluctuation in demand are ruled out

Zero lead time Time lapsed between purchase

order and inventory usage

Cost of placing an order and receiving are sameand independent of the units ordered

Annual cost of carrying the inventory is constant Total inventory cost = Ordering cost + carrying

cost


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EOQ Three Approaches

Trial and Error method

Order-formula approach

Graphical approach


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EOQ & Re-order point

EOQ gives answer to

question How much to OrderRe-order point gives answer

to question when to order


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Trial & Error MethodAssumptions:-

Annual requirement (C)=1200 units

Carrying cost (I) = Rs.1

Ordering cost (O) =Rs.37.5

Order size Q 1200 600 400 300 240 200 150 120 100

Average inventory Q/2 600 300 200 150 120 100 75 60 50

No. of orders C/Q 1 2 3 4 5 6 8 10 12

Annual carrying cost

I* Q/2

600 300 200 150 120 100 75 60 50

Annual ordering costO*C/Q

37.5 75 112.5 150 187.5 225 300 375 450

Total annual cost 637.5 375 312.5 300 307.5 325 375 435 500


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Order- Formula approach1/2

EOQ =(2CO/I)

C = Annual demand

O = Ordering cost per order

I = Carrying cost per unit

1/2

EOQ =(2*1200*37.5/1) = 300 units


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Q

0 T1 T2 T3 T4

Average inventory = Q/2

Time

Inventory

level

orderquantity

Certainty case of the inventory cycle

1. Here the negative slope from Q to T1 represents the

inventory being used up

2. T1, T2, T3, T4 represents the replenishment points

3. The inventory varies between 0 and Q


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Graphical method to find EOQ

Cost

in

RS.

Order quantityEOQ0


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Extension of basic EOQ model

This model can be extended to includequantity discounts, were simple calculationfor quantity discount is added.

Non zero lead timeNon zero lead time


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Extension of basic EOQ model

Non zero lead timeIf the lead time is n then procurement must be

done prior to n days, i.e. T-n as shown in thefigure

T1 - n T2 - n T3 - n T4 - nT1 T2 T3 T4

Time

Q

0

Reorder point

Placement of a order


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Probabilistic inventory model

In practical inventory managementassumption may not be strictly correct.

1. Demand may fluctuate over time due to

seasonal, cyclical and random influences.

2. Lead time may also fluctuate because oftransportation delay, strikes or natural

disaster. For such reason most of thecompanies use safety stock.


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But in some cases even the safety stockbecomes ineffective to combat stock out. Like:-

Probabilistic inventory model contd

Reorder point

Safety stock

Placement

of order

Lead

time

T1 T2 T3 T4 T5 T6

Stock

out

A R i


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A Review

So we have dealt with

1. EOQ model

2. Its extension3. Probabilistic model

4. And now we will be dealing with specialinventory models

Sp ci l inv nt r m d l


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Special inventory model

Non Instantaneous replenishment

Quantity Discount

One period decision



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Non Instantaneous replenishment


A B C DA B C

Thus the inventory is replenished gradually than in lotsParticularly in situation were manufacturers use continuesproduction processe.g. FACT makes Ammonium on a continual basis

Capacity 10 units



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Discount Quantities

If discount increases with the orderquantity, then the price of inventory is nomore constant


Hence a new approach is needed to find thebest lot size

Totalcost

Annual holdingcost

Annualordering cost

Annual cost ofmaterials= + +



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One period decisions

If a newspaper seller does not buy enoughpapers to resell on the street corner, salesopportunity is lost. If the seller buys toomany, the overage cannot be sold becausenobody wants yesterdays newspaper.


Applicable to fashion goods, seasonal goods and

due to change in technology

The newsboy problem


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Inventory management underuncertainty

1. Option price model

2. Risk adjusted discount cash flow (DFC)Model

3. Dynamic inventory model


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Option price model

Option is a contract that gives the holder aright to acquire or sell certain things at apredetermined price without any obligation.

Calculated by integrating the marketinformation and inventory control.


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Risk adjusted discount cash flow (DFC)Model

Inventory control problem is converted tocapital budget problem

Suppose a television dealer decides to hold

an additional inventory of 1000 television permonth. The cost of holding inventory isspread overtime.

Inflows = no: of units probability presentvalue

Beneficial for projects like oil drilling were thebenefit is acquired only after a long time butonce oil is struck the additional expanse is covered.


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Dynamic inventory model

1. Uncertain variables are identified

2. Probability associated with them is taken3. Simulation techniques are applied


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Emerging trends in inventory management

Entering into log term contract at a fixed priceto reduce uncertainties

Just-in-time

Kanbans Japanese technique (Onlyproduce when demand comes)

Internet based ordering system

Supply chain management

Vendor development

Investment in plant and machinery


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Inventory control responsibility

Purchasing naturally has vest interest ininventories, even to the extend that in somecompanies the purchasing and stores functionsare combined.

Production looks after the work in progress Logistics plays a major role in inventory control Inventories are economic importance to finance

department The fact that materials must be moved from one

place to another is of importance to materialsdepartment

In effect the responsibility cannot be kept

on one head since inventory managementis a integrated effort


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THANK YOU

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