Inventory Control

12

Unit Introduction
Inventory management is very important to both product and service oriented
businesses. How much wealth to stock has been a puzzling question since man’s
existence as an economic being. While the accumulation of wealth has always
been cheered, subject to religious and moral constraints, the acquisition of goods
for anticipated use is of a peculiar nature. It is the stick that should be neither too
long nor too short, which King Solomon ordered his bird to find, and which,
according to Middle Eastern tale, the generations of that bird are still looking for
in the trees. Thus in real business life situation raw materials must be scheduled
and stock-piled for the production, operating supplies must be delivered and
placed on hand in the proper quantities for the operation, large stocks of materials
must be kept to operate, maintain, and expand the extensive distribution system.
If proper materials are not available when needed, it will be difficult to extend
services in a timely fashion. These demand large volumes of materials on hand to
ensure that there will be no shortage. This will increase cost, but the customers
prefer low rates. Thus a proper balance must be struck to maintain proper
inventory with the minimum financial impact on customers. This demands
maintaining stock keeping items at a level which is neither too much nor too less
and must be Just-In-Time (JIT). Focussing this the unit will cover the issues of
inventory concepts; inventory control; the operating doctrine of inventory, Just-
In-Time Management (JIT)
School of Business

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Lesson One: Why-What-How Issues of Inventory

Lesson Objectives
After completing this lesson you will be able to:
 Understand the meaning of inventory
 Identify the reasons for keeping inventory
 Explain the and inventory system concepts
 Discuss how to control the inventory
 Comments on the importance of different inventory

The pressure for operating capital has made business increasingly aware of
inventory as a form of earning investment. The basic problem of inventory policy
is to strike a balance between operating savings and costs of capital requirements
associated with larger stocks. Striking this balance is easier to say than to do.
Why are we always out of stock? A complaint from a large number of
businessmen faced with the dilemmas and frustrations of attempting
simultaneously to maintain stable operations, provide customers with adequate
service, and keep investment in stocks and equipment at reasonable levels. In
order to get the answer to this question as a basis for taking action, it is necessary
to step back and ask some rather different kinds of questions:
 Why do we have inventories?
 What affects the inventory balances that we maintain?
 How do these effects take place?
From these questions a picture of the inventory problems can be built up which
shows the influence on inventories and cost of various alternative decisions,
which the management may ultimately want to consider. Before answering these
questions let’s start defining inventory and understand different types of
inventory.

What is Inventory?
Inventory can be defined as idle resources awaiting activation. Inventory is made Inventory is an idle
of all those items ready for sale or of items, which keep the process running. resource for later use.
From firm’s point of view, inventories represent an investment; capital is
required to store materials at any stage of completion. Inventory is store of goods
and stocks. In manufacturing, items in inventory are called stock-keeping items
held at a stock (storage) point. Stock-keeping items usually are raw materials,
work-in-process, finished products and supplies stocked in order to meet an
expected demand for distribution in the future (figure 12.1.1).

Raw materials


Office Surplus  Ware House  Work-in-process


Finished goods

Figure 12.1.1: Different items of inventory in manufacturing kept in ware house

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Even though inventory of materials is an idle resource in the sense it is not meant
for immediate use. It is almost a necessity for some inventories for the smooth
functioning of an organization – manufacturing or service. Let us take the
example of a commercial bank with full-line services. The typical individual
account involves various transactions, such as, checking, savings, lock boxes,
and loans. For the teller operation, the service is to convert labor and materials
into money management. Such materials as deposit slips, withdrawal slips, and
loan payment coupons are more like operating supplies than raw materials. For
the accounting operation, slips and coupons could be viewed as work-in-process,
and money account statements awaiting mailing as finished goods (services).

Types of Inventory
Inventory can be classified into three different categories:
i. Transaction inventory
ii. Speculative inventory
iii. Precautionary inventory
i. Transaction inventory: It is formed basically of those items, which
are mainly needed for transaction, e.g., transaction of finished saleable
products or transaction of raw materials.
a. De-linking Production with Purchasing Department is one of the
functions of this, i.e., receipt of raw material is stored in the form of
inventory and whenever production department needs raw material
it put indent to inventory organization rather than to purchase
department.
b. De-linking Production with Sales Organization. Similarly it delinks
sales and production departments.
ii. Speculative inventory: It is basically kept as a measure of
speculation of increase in the price of raw material or increases the sale
price of finished goods. It is generally resorted to before the budget
proposals.
iii. Precautionary inventory: The machines are to be kept running.
There may be breakdown of machines at any time due to damage of any
part due to wear and tear. At that time it cannot be purchased immediately.
Therefore, such items, which are essential to keep the process running, are
to be stored like machine parts, tools, etc. It is also called maintenance
repair and operation inventory.

Why Inventory?
As noted, inventory is an idle resource for later use. An idleness is always
associated with a cost, maintaining inventories is expensive in terms of the
working capital tied up in them, either directly or indirectly through alternative
uses of the tied-up funds. In addition, the process of ordering goods, whether
from an external supplier or from the firm’s own production, is expensive due to
the costs arising from checking the actual levels of stock, contacting suppliers,
checking their products, and the applicable costs of credit facilities, shipping, and
forwarding. A parallel type of cost, the set-up cost, arises in production-by-lot
processes, where production is discontinuous and thus the equipment used, being
not strictly specialized, needs adjustment and retooling for every production run.
Uncertainty has also its cost. Uncertainly regarding demand expectations and
time lags between ordering and receiving, or starting a run and finishing it,

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results in overages and shortages. To these conflicting costs must be added the
cost of designing and handling inventory systems.

In some circles inventories are thought of as a sign of wealth, even excess

inventories in relation to the magnitude of production and distribution function Excessive inventories
are considered advantageous. On the other hand, the wise businessmen place have been the reasons
for death of many a
more emphasis on having working capital on the form of cash and securities. In business.
recent years a greater emphasis has been placed on having the means of
purchasing materials than having the materials themselves. Excessive inventories
have been the reasons for death of many a business and very high inventory
levels has tipped the scale in our economy. Finished product after packaging are
first stored and sent to the market as the need arises or orders are received. Also
the raw materials needed for the finished product cannot be directly fed to the
production department from the market. These have to be stored first after
procurement. These things put together give an idea of storing these items. This
process of storing is called inventory. The fundamental reason for carrying
inventories is that are:
 Physically impossible for each stock item to arrive exactly where and
when it is needed and
 Economically impractical for each stock item to arrive exactly where and
when it is needed.
Even if it were physically possible for a supplier to deliver raw materials every
few hours, for example, it could still be prohibitively expensive. The
manufacturer must therefore keep extra supplies of raw material inventory to use
when they are needed in the conversion process. The other reasons for keeping
inventories include:
a. Buffer stock: Buffer stock can be defined as the inventory against stock-
outs from uncertain demand during lead-time. When demand is highly
variable, some protection is needed against the chances of high stock-out
costs. In such cases inventory can be used as a buffer. Likewise this also
buffers against highly varied lead-time (time between ordering and
receiving goods).
b. Decoupling: Decoupling means breaking down operations apart so that one
operation’s supply is separated from another’s supply. Through decoupling Decoupling is breaking
by procuring inventories separately, breakdowns, material shortages, or down operations apart
other production fluctuations at one stage of operations do not cause any so that one operation’s
supply is separated
disruption in later stages of operation. Also through decoupling one from another’s supply.
organizational unit can schedule its operations independently. Decoupling
through in-process inventory is common in automobile industry, where,
engine build-up, seat assembly, body making, etc. are done separately (in
many cases in distant locations).
c. Production smoothing: Products can be built during slack demand periods
for using in peak demand periods. This will reduce high costs of production
rate, work force level changes, set-up costs, etc. Inventories can help in this
production leveling.
d. Materials handling: In some operations parts can be accumulated and
stocked in container (tote) boxes or baskets and transported hand-jack
dollies (wheelbarrow) or forklift trucks much more economically than can
be carried manually. This is particularly true of intermittent systems, since
they involve less automation of material handling than do continuous

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systems. In continuous manufacturing, automated materials handling

systems are designed to reduce overall handling costs, resulting in less
work-in-process.
e. Bulk purchase: Bulk purchase gives quantity discount. This also gives a
cost advantage of materials inventories.

Activity: Assume that you are the owner of an export quality man’s
garments manufacture firm. Do you think for your products
‘inventory management issue’ should be a key success factor? Why
or why not? Discuss with your study partners.

Evils of Excess Inventory

From the above discussion you can be well aware of the importance of inventory
and its management. But excess inventory is no doubt an evil for an organization.
It blocks the money taking away opportunities for the firm. Some of the bad
impacts of excess inventory are mentioned below:
 Essential though they are, inventories also mean lock up capital of
inventories, which could be invested in more profitable operations.
 Excess inventory adds to the cost of carrying the inventory more store
space, equipment and personnel, insurance, taxes, pilferage etc.
 Excess inventory invites risk of deterioration and obsolescence.
 Changes in the prices of inventory materials sometime go unfavorable.
 Maintenance of cost money.

Inventory Control
Inventory constitutes one of the most important elements of any system dealing
with the supply, manufacture and distribution of goods and services. The concept
of inventory control is very old but it came in light when F. W. Harris published
his work on classical order size model. F.E. Raymond (1931) and R.M. Wilson
(1934) extended this work. But only after the second world war with the
development of operational research and computer technology that the theoretical
concepts got a practical application. The basic purpose of inventory holding
stocks in a material flow system is to de-couple successive stages of system.
Following are important purpose of inventory:
 Existence of time lags between manufacturing and transport operations.
 The need to schedule various stages of the system independently.
 The need to meet the fluctuation in demand and production rates.
 The need to maintain control over the quality of the finished production.
 The need to exercise influence over changes of material prices
particularly basic raw materials.
The inventory control mainly concerned with making optimum decision with
The inventory control respect to the variables, which are subject to control. Inventory control is a multi-
mainly concerned with item and multi-stage in nature. As noted inventory is an idle resource, which is
making optimum useable, has value and awaiting activation. The idle resource may be men,
decision with respect to
the variables, which are
money, materials, and plant acquisition. The manpower, capital and plant
subject to control. acquisition problems are essentially control problems. Inventory control
determines the levels of composition of inventories of parts, materials and
products that will protect most effectively the production, sales, and financial

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requirements of the business. A system of production planning and control is not

and end in itself. It can only be justified because it (a) provides the means for
effective coordination of the Production department with other departments of
the business; and (b) promotes effective shop operation through its control of
activities within the production department itself.

Advantages of inventory control

i. Introduction of a proper inventory control system helps in keeping
the investment in the inventories as low as feasible.
ii. Ensures availability of material by providing adequate production
against uncertainties of supplies and consumption of materials.
iii. Allows full advantage of economies of bulk purchases and
transportation.
iv. Reduces changes of going out of stock.
v. Leads to reduction in inventory levels.
vi. Releases more of capital for other operations.
vii. Increases profitability of an organization.
viii. Adequate customer service.
ix. Advantage of price discounts by bulk purchasing.
x. Providing flexibility to allow changes in production lines due to
changes in demands or any other reason.

Which Inventory to Emphasize?

As you can understand that all the items held in inventory are not of equal
importance in terms of monetary value, profit potential, sales or usage volume, or
stock-out penalties. For example, a retail store can have a lot of items like, rice,
sugar, butter, pencil batteries, etc. It would be unrealistic to devote equal
attention to each of these items. Instead, a more realistic and reasonable approach
would be to allocate control efforts according to the relative importance of
various items in inventory. Hence the question arises which inventory to
emphasize?

A-B-C Classification
The simple answer to this question is to apply the theory of Vital Few and Trivial
A-B-C classification of
Many by Velfredo Pareto. When an organization’s inventory is listed by Taka inventory is listed by
values, generally a small number of items account for a large Taka volume, and a taka values.
large number of items for a small Taka volume. In inventory management we
focus this view by classifying the inventories into three categories A, B and C
(Figure 12.1.1).

An A-grouping is made for those few items with large Taka value; a B-grouping
for items with moderate unit and Taka value; and a C-grouping for the large
number of items accounting for a small Taka value. Thus A-group might contain,
for example, about 15% of the number of items in the inventory costing about
60-70% of the total Taka usage; B-group might contain, for example, about 30%
of the items costing about 25% of the total Taka volume; C group might contain,
for example, about 55% of the number of items costing only about 10% of the
total Taka volume 12.1.1. These percentages vary from firm to firm, but in most
instances a relatively small number of items will account for a large share of the
value or cost associated with an inventory.

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100
%of
total 85
Taka
usage 55

A B C

0 15 45 100
% of items used

Figure 12.1.1: A-B-C classification of items

These items (A-category) should receive relatively close attention through

frequent reviews of amounts on hand and control over withdrawals, where
possible to make sure that customer service levels are attained. The C-items
should receive only loose control, whereas, the B-category should have controls
that lie between the two extremes.

Activity: Chose a medium or big in size departmental store from any

super market. Carefully examine its inventory management system. Do
you think the store manager should take any further action(s) that will
help him/her to increase performance.

Exceptions to A-B-C classification

There are few exceptions to ABC classifications. Items in C category can
demand special emphasis if they meet in any of the following criteria:

 Materials critical to production

 Materials with short shelf lives
 Materials that are very large and bulky
 Valuables materials subject to pilferage
 Materials with highly erratic lead-times
 Materials with highly erratic demand
 Standard packaging, shipping, container, or vehicle size

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Questions for discussion

1. Give specific examples of each of the following types of inventories
(i) Raw materials; (ii) Work-in-process materials; (iii) Office supplies;
(iv) Finished goods.
2. What are the evils of excess inventory? Give some example with
respect of Bangladesh scenario.
3. You are a manufacturer of a product. You are using your own premises for
holding the finished goods. Do you think it has a cost? How will you calculate it?
4. Find the amount of average inventory carried for a family against
each of the following purchases for a period of one month. Make necessary
assumptions.
5. The family consumes 30 kg of rice @ Tk. 17.00. They purchase the
whole amount at the first day of the month.
a. The family consumes 4 kg of sugar @ Tk. 32.00. They purchase the
required sugar two times a month at equal gap.
b. The family purchases two bottles of pickle (@ Tk. 55.00 per bottle).
They purchase both the pickle bottles at the first day of the month.
c. The family makes weekly purchase of one 200 gm packet of butter (@
Tk. 50.00 per packet) for weekly consumption.
d. The family needs one 18-slice packet of bread (@ Tk. 20.00 per
packet) for their breakfast everyday. They purchase it from the local
grocery every morning.
7. A family with three children and their parents is living at
Dhanmondi. They have a working maid living with them. Normally
at the beginning of every month they make a shopping for the whole
month. The shopping chart follows:
Item Unit Price Quantity Item Unit Price Quantity
Rice Tk. 18.00 30 kg 10. Jelly Tk. 76.00 3 bottles
Flour Tk. 9.00 15 kg 11. Tooth pick Tk. 12 1 packet
Pulses Tk. 35 12 kg 12. Onion Tk. 14.00 7 kg
Pickle Tk. 42 2 bottles 13. Salt Tk. 8.00 5 kg
Biscuit Tk. 28 4 packet 14. Spices Tk. 22.00 1 kg
Potato Tk. 9.00 6 kg 15. Tooth Paste Tk. 36.00 2 pieces
Soap Tk. 6.00 4 pieces 16. Butter Tk. 64 3 pieces
Oil Tk. 105.00 6 litre 17. Hair Oil Tk. 25 1 bottle
Tang Tk. 85.00 2 bottles 18. Match box Tk. 1.00 5 boxes

The family also subscribes two newspaper (one Bengali and one English) every
day, each costing Tk. 8.00, which they sell at the end of the month for Tk. 24.
Also they purchase two cans of powder milk every month, one at the beginning
and one halfway through. Each of the cans costs Tk. 490. Considering above
make an ABC classification of the inventory items of the family.

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Lesson Two: The operating Doctrine

Lesson Objectives
After completing this lesson you will be able to:
 Understand the costs of inventory
 Explain the cost of tradeoff
 Discuss the Economic Order Quantity (EOQ) model

Costs of Inventory
Operations managers must make two basic inventory policy decisions. These are:
i. When to reorder stock and
ii. How much stock to reorder
These decisions are referred to as the inventory control operating doctrine. In
In the inventory system operating an inventory system managers should consider only those costs that
managers should vary directly with the operating doctrine in deciding when and how much to
consider only those reorder; costs independent of the operating doctrine are irrelevant. Basically,
costs that vary directly.
there are five types of relevant costs:
i. Cost of Item: The cost, or value, of the item is usually its purchase
price or the amount paid to the supplier for the item.
ii. Procurement Costs: It is the cost of placing a purchase order, or the
setup cost if the item is manufactured at the facility.
iii. Carrying Cost: Carrying or holding costs are the costs of maintaining
the inventory warehouse and protecting the inventoried item. It is
calculated on the basis of the percentage (%) of the average inventory
carried over a period of time.
iv. Stock Out Costs: Stock out costs are associated with demand when
stocks have been depleted, take the form of lost sales or backorder costs.
v. Cost Of Operating The Information Processing System: Whether by
hand or by computer, someone must update records as stock levels
change. For systems in which inventory levels are not recorded daily, the
cost is primarily incurred in obtaining accurate physical counts of
inventories.

Cost tradeoff
Our objective in inventory control is to find the minimum cost operating doctrine
over some planning horizon. We need to consider all relevant costs, which
discussed in inventory cost. Using a one-year planning horizon, these costs can
be expressed in a general cost equation:

Carrying cost Stock-out cost

Total
Total annual
annual Cost of Procurement Cycle cost Lost sales
relevant = the item + + +
relevant cost
cost Cost Buffer cost Back-orders

Economic Order Quantity Models

In a continuous, or fixed-order-quantity, system when inventory reaches a
specific level, referred to as the reorder point, a fixed amount is ordered. The
most widely used and traditional means for determining how much to order in a
continuous system is the Economic Order Quantity (EOQ) model, also referred to

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as the economic lot-size model. The earliest published deviation of the basic
EOQ model formula occurred in 1915 and is credited to Ford Harris, an
employee at Westing-house. The function of the EOQ model is to determine the
optimal order size that minimizes total inventory costs. There are several
variations of the EOQ model, depending on the assumptions made about the
inventory system.

The Basic EOQ Model

EOQ is the optimal order quantity that will minimize total inventory costs. The
simplest form of the economic order quantity model on which all other model EOQ is the optimal
order quantity that will
versions are based is called the basic EOQ model. It is essentially a single
minimize total
formula for determining the optimal order size that minimizes the sum of inventory costs.
carrying costs and ordering costs. The model formula is derived under a set of
simplifying and restrictive assumptions, as follows:
 Demand is known with certainty and is relatively constant over a period
of time.
 No shortage (stock outs) is allowed.
 Lead-time for the receipt of order is constant and independent of
demand.
 The order quantity is received all at once.

Figure 12.2.1 describes the continuous-inventory order cycle system inherent in

the EOQ model. An order quantity, X o, is received and is used up over time at a
constant rate. When the inventory level decreases to the reorder point, R *, a new
order is placed; a period of time, L, referred to as the lead-time, is required for
delivery.

The order is received all at once just at the moment when demand depletes the
entire stock of inventory, thus allowing no shortages. This cycle is repeated
continuously for the same order quantity, reorder point and lead-time. As we
have seen that the economic order quantity is the order size that minimizes the
sum of carrying costs and order costs. These two costs react inversely to each
other in response to an increase in the order size. As the order size increases,
fewer orders are required, causing the cost to decline, whereas the average
amount of inventory on hand will increase, resulting in an increase in carrying
costs. Thus, in effect, the optimal order quantity represents a compromise
between these two conflicting costs.

The total annual ordering costs is computed by simply multiplying the cost per
order, designated as Cr, times the number of orders per year. Since annual
demand (Z) is assumed to be known and to be constant, the number of orders will
be Z/X, where X is the order size and

Annual ordering cost = (Cr * Z) /X

The only variable is this equation is X; both Cr and Z are constant parameters.
Thus, the relative magnitude of the ordering cost is dependent upon the order
size.

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Total annual carrying cost is computed by multiplying the annual per unit
carrying cost (%), designated as C c, times the average inventory level,
determined by dividing the order size, X, by 2 (X/2):

Annual carrying cost = Cc  (CX) /2

The total annual inventory cost (TC) is simply the sum of the ordering and
carrying costs:

TC = Cr  Z/X + Cc  CX/2

These three cost functions are shown in figure 1.2. Notice the inverse relationship
between ordering cost and carrying cost, resulting in a convex total cost curve.

Differentiating the TC curve with respect to X and equating it to Zero can

calculate the economic order quantity (X o). By differentiating again with respect
to x we can check for minima of this cost curve. Hence,

dTC d d  Cr Z Cc C
 (C r Z / X )  (C c CX / 2)   0
dx dx dx X2 2
2C r Z
 Xo  , the economic order quantity
CC c
to check for min ima
d 2 TC 2C r Z
 , a positive number , hence min ima.
dx 2 X3

The optimal order quantity occurs at the point in figure 1.2 where the total cost
curve is at a minimum, which also coincides exactly with the point where the
carrying cost curve intersects with the ordering cost curve. This enables us to
determine the optimal value of Q by equating the two cost functions and solving
for Q, as follows:

(Cr Z)/Xo = (Cc CXo)/2

Xo 2 = (2Cr Z)/(CCc)

2 ZC r
Xo 
CC c

For example, the demand for a product over a period of one year is 75,000 units.
The unit cost of the items is Tk. 10. The ordering cost and carrying costs are Tk.
10 and 15% of the average carried inventory respectively. The company policy is
to place an arbitrary order of 2,000 units each time an order is placed. Find the
EOQ? See what affect the optimal order size has on current ordering and storage
costs? Now the EOQ would be,

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2  75,000  10
Xo   1,000 units
10  .15

If we order 1,000 units each time we place an order, we will need to place 75
orders per year, and our average inventory will be 500 units. Our total ordering
and storage cost will then be,

Total ordering and storage cost = 75  10 + 500  10  0.15 = Tk. 1,500

If they follow current order policy,

The order size = 2000 units
Average inventory = 1000 units
No of orders = 37.5 nos
Total ordering and storage cost = 37.5  10 + 1000  10  0.15
= Tk. 1,875
Hence the optimal policy would save approximately Tk. 375

Lead Time in Deterministic Model

In EOQ model we assumed that the lead-time is constant and independent of
demand. This model can easily be adjusted for lead-times with certainty. We can
calculate the reorder point (R*) as follows:

R* = Buffer stock + Demand during lead time (DL)

= 0 + (Lead time)(Demand/unit time)
= LdL

The reorder point is now set and shown in figure 13.3. At R*, an order will be
placed for Xo units, which will arrive L units of time later. During the time
between ordering and arrival, d L units per time unit, DL in total unit will be
demanded, and inventory will be reduced accordingly.

Xo

Units
in
inventory

R*
DL
L L

Time
Figure 12.2.1: the continuous-inventory order cycle system

For example assume that A restaurant uses 730 dozens of 8-ounce paper cups
annually. The cost per dozen of these cups is Tk.30.00. The ordering costs are
Tk.37.50.; carrying costs are 30% of average carried inventory. Delivery lead-
time is known with certainty to be five days. Establish the optimal operating
doctrine.

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2 ZC r 2(730)(37.50)
Here, X o    77.99  78 dozens
CC c (30.00)(0.30)

Reorder point, R* = LdL = 5  (730/365) = 10 dozens

The operating doctrine would be to order 78 dozens when stocks on hand reaches
10 dozens.

Using Computers to Manage Independent Inventory

Computers can use data on receipts and withdrawals to maintain the amount of
Computer software stock on hand for all the inventory items controlled by the computer system.
keep track of the
perform functions of
Computer companies and commercial software companies offer software
inventory that need the packages that will keep track of the on-hand balance and perform other functions,
economic quantity to such as reporting items that are below their reorder levels and recommending the
buy or produce. economic quantity to buy or produce. The computer may print a list each day,
showing the items that need to be replenished. Sometimes preferred vendor
identification for each item is stored in the database, so the computer can
automatically prepare the purchase orders if instructed to do so.

Use history can be used to calculate a forecast of the expected annual demand.
Estimates of the holding cost, setup cost, or order cost for each item can be stored
in the database, from which order quantity recommendations can be calculated.
The reorder level for each item can be stored in the database, but often only the
lead-time and the desired service level are stored. The program can compute the
reorder level on the basis of current estimates of the average use rate and a
calculation standard deviation or MAD. This type of system maintains a large
amount of data and performs numerous calculations to assist inventory managers.
Of course, the system only makes recommendations, which can be overridden or
implemented according to the decisions of the appropriate person.

Economic Order Quantity (EOQ) relevant cost determination

EOQ is the quantity of an inventory item to order so that total inventory costs are
minimized over the firm’s planning period. Information required to determine
optimal order size are:
 The total unit to be used during a period
 The cost associate with placing an order, i.e., ordering cost per order
 The cost of holding one unit in inventory for the entire period, i.e.,
carrying cost per unit per period.

Criteria for determining ordering cost

The company in the purchasing of raw materials incurs ordering costs. Included
in this cost are the processing and receiving costs incurred for the each purchase
order. Key to recognizing ordering cost is to ask if level of this cost will change
if we place two orders instead of one, i.e., whether total cost for a cost element
will change if more than one order is placed. Such as,
 For making an order Mr. Kamal needs to make a long distant telephone
call, which cost him Tk. 120. As more is the number of orders the more
is the cost arising from the telephone calls, e.g., for two orders it is Tk.
240, for 3 orders it is Tk. 360. Hence this is an ordering cost.

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 Again for example, let’s assume that Mr. Khaleque has a quarterly
demand for potatoes of 4500 kg for his grocery business and
transportation cost is Tk. 25 per kg. Now if only one order is placed the
transportation cost will be Tk. 112,500. But if Mr. Khaleque places two
orders, then each time his cost will be Tk. 56,250 without changing the
total cost. As the total cost remains the same irrespective of the number
of orders this is not an example of ordering cost in this situation.

Criteria for determining carrying cost

Carrying costs are those costs for holding inventory. These costs generally
The carrying cost can
include insurance, personal property tax, cost of storage space, breakage, be expressed as cost per
obsolescence, and the rate of return on the investment in inventory forgone by the unit per year or as a
company. The carrying cost can be expressed as cost per unit per year or as a percentage of unit
percentage of unit inventory value. Key to referring a cost element as carrying inventory value.
cost if the total cost for that element vary with respect to average number of units
in inventory (again not those costs that vary with the total number of unit
acquired). This time we have to ask whether total cost will change if we increase
the average number of units residing on inventory over the period by one unit.

Therefore a cost for having inventory may or may not be included in the carrying
cost depending on whether its total for the period depends on the average
inventory level. This is why fixed cost should not be included in the decision
process whether it is related to having inventory or not. As an example assume
that rent for inventorying bags of potato may or may not be a carrying cost
depending on whether total rent for the period depends on average level of
inventory. Following table illustrates this with quarterly demand of 4500 bags.

Rent Payment Agreement No. of Average Rent payment for

orders inventory The quarter
1. Taka 25 for each bag 1 2250 4500x25=112500
kept in inventory 2 1125 2250x25+2250x25 =112500
2. Taka 25 for each unit in 1 2250 2250x25=56250
the average inventory 2 1125 1125x25 = 28125

Here under agreement 1 rent is not a carrying cost because the total rent payment
for the period is same even if the average inventory level is changed. On the
other hand under agreement 2, rent is a carrying cost as total payment of rent for
the quarter is different for different level of average inventory. Hence we can
conclude that all cost of holding inventory is not relevant for determining
carrying cost. Only those costs of inventory that in total for the period varies with
the average inventory/order size should be included under carrying cost.

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Lesson Three: Just-In-Time Inventory System

Lesson Objectives
After completing this lesson you will be able to:
 Understand the Just-In-Time (JIT) inventory system
 Identify the different features and building blocks of JIT
 Explain the goal of JIT
 Analyze the advantages and disadvantages of JIT
 Discuss JIT in Bangladesh

What is Just-In-Time (JIT) inventory system

Harley-Davidson saw its commanding lead in heavyweight
motorcycle falter when powerful Japanese bikes appeared in the
U.S. market. If Harley was to stay on the road, the management
had to uncover the key element of Japanese success. Initially
they were baffled. Honda’s motorcycle plant in Maryville, Ohio
was staffed by US workers, just like Harley’s. It bought parts
from US suppliers, just as Harley did. And it had no clear
technological advantages. After touring the plant in Maryville,
they found what they were looking for. Honda turned out better
motorcycles because of their Japanese production system,
specifically -- the just in time inventory control system.

The term just-in –time is used to refer to a production system in which both the
JIT is a manufacturing movements of goods during production and deliveries from suppliers are
system with the goal to
optimize processes and carefully timed so that at each of the process the next (usually small) batch
procedures by arrives for processing just as the preceding batch is completed – thus the name,”
continuously pursuing
waste reduction Just–in-Time”. The result is a system with no idle items waiting to be processed.
Although it has no single, agreed-upon definition, one definition that can be
adopted for our discussion is: Just - in - time (JIT) is a manufacturing system
whose goal is to optimize processes and procedures by continuously pursuing
waste reduction.

“If American automobile king Henry Ford were alive today, I

am positive he would have done what we did with our Toyota
production system.”
- Taiichi Ohno
The Toyota Production System (1978)

The quotation above is the confidant word from the man behind the concept
itself. The JIT approach was developed and generated at the Toyota Motor
Company of Japan by Taiichi Ohno and several of his colleagues. They have
introduced a system, which concentrates on avoiding end-item and intermediate-
item storage. The benefits were Toyota’s no necessity of people to control
inventories, space for inventory, or borrowed money to finance inventory.
Besides it gives the Toyota officials to take a very little time (only three minutes)
to change the mold. It also allows Toyota to realign its workforce more
efficiently when business is bad because company can train workers to do more

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than one job. In the United States, JIT was first adopted by the automobile
industry. Leading firms in other industries – Xerox, IBM, Apple, Black &
Decker, and General Electric, has picked up the concept to name just a few.

Features of JIT
JIT manufacturing is a broad philosophy of continuous improvement, which
indicates three major categories of effort that are mutually supportive:
a. Low Inventory
b. People Involvement
c. Total Quality Control
a. Low inventory: ‘Inventory is regarded as evil’ according to JIT
philosophy. Its main purpose is to minimize the amount of idle resources.
That is why this effort is sometimes called zero inventory program of
stockless production.
b. People involvement: JIT has a strong management component. Much of
the success of JIT can be traced to the fact that the companies that use it JIT is a philosophy that
cuts across all phases of
train the employees to have the appropriate skills, give them responsibility the manufacturing and
and coordinate and motivate them. JIT philosophy of continuous marketing activities in
improvement and minimization of waste considers any activity that does an organization.
not add value to the product or serve the customers in some way to be
waste. One form of waste that is inconspicuous and difficult to combat is
the under utilization of human talent. JIT seeks to utilize more fully the
creative talents of the employees, suppliers, contractors, and others who
may contribute to the company’s improvement. JIT is a philosophy that
cuts across all phases of the manufacturing and marketing activities in an
organization. It is a strategy marked by an environment of cooperation and
coordination between buyers and sellers. Short-term relationships are
replaced by long-term commitments.
c. Total quality control: JIT interprets the term Total Quality Control as the
achievement of zero defect products that involves every department and
every employee of the company. According to the philosophy, quality
should be ensured at the source, that is quality should be assured for every
set of activities at the beginning level – automatically the output of the
corresponding activities will be improved quality.

Activity: How the JIT can help you to perform better with your
MBA program of Bangladesh Open University (BOU)?

Building Blocks of JIT

The design and operation of JIT (Figure 12.3.1) system provide the foundation
for accomplishing the aforesaid goal. The foundation is made up of four building
blocks. These blocks are:
a. Product design : In product design, three elements are key to the JIT
system – standard parts, modular design and quality. The first two elements
relate to speed and simplicity. Quality is the sine qua non (“Without which
not”) of JIT because poor quality can create major disruptions as the JIT is
designed to gear up a smooth flow of work; the appearance of problems due
to quality creates disruption in this flow.

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b. Process design: Some aspects of process design are important for JIT
system: small lot sizes, set up time reduction, manufacturing cells, limited
work in process, quality improvement, production flexibility and little
inventory storage.
c. Personnel / organizational elements: There are five elements of personnel
and organization that are particularly important for JIT system: workers are
assets, cross-trained workers, continuous improvement, cost accounting and
leadership / project management.

Ultimate goal A
A Balanced
Balanced
Rapid
Rapid Flow
Flow
Supporting goals

Eliminates disruptions Reduce setup Eliminate waste

Make the system flexible and lead times Minimize inventories

a. Product design b. Process Design c. Personnel / d. Manufacturing

Standard parts Small lot size organizational elements Planning & control
Modular design Setup time reduction Workers as assets Level loading
Quality Manufacturing cells Cross-trained workers Pull systems
Limited work in Continuous Visual systems
process improvement Close vendor
Quality improvement Cost accounting relationships
Production flexibility Leadership / project Reduced transactions
Little inventory storage management

Figure 12.3.1: Building blocks of JIT

d. Manufacturing planning and control: Under this, five elements are
considered vital: level - loading, pull systems, visual record systems
(Kanban system), close vendor relationships and reduced transaction
processing.

The JIT Goal

A major objective of JIT is to have only the right item at the right place at the
A major objective of right time, or to say it another way, to purchase and produce items only a short
JIT is to have only the time before they are needed so that work-in-process inventory is kept very low.
right item at the right The practice not only reduces working capital requirements, it also reduces the
place at the right time. need for floor space and shortens the flow through time because materials spend
very little time in queues. The ultimate goal of JIT is a balanced system that is,
one that achieves smooth, rapid flow of materials through the system. The goals
are:
 Eliminate disruptions
 Make the system flexible
 Reduce setup times and lead times
 Minimize inventory investment
 Eliminate waste associated with queues
 React faster to demand changes
 Uncover any quality problem
Disruptions are occurred by a variety of factors, such as poor quality, equipment
breakdowns, changes to the schedule, and late deliveries. These should be

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eliminated as much as possible. A Flexible System is one, which is robust enough

to handle a mix of products, often on a daily basis, and to changes in the level of
output while still maintaining balance and throughout speed. Setup Time And
Deliveries Lead Times prolong a process adding a value to the product. The
continuous process of JIT reduces the disrupting setup times and the lead times,
as next batch of production is ready exactly when the preceding batch is
completed. Inventory (idle resources) takes up space and adds cost to the system,
which should be minimized. JIT can minimize the inventory a lot. As the
requirements and the deliveries coincide, so no need of storing for the future
requirements. Waste represents an unproductive resource. In the JIT philosophy,
waste includes: over production, waiting line, unnecessary transporting,
inventory scrap, inefficient work.

The Seven Wastes

Shigeo Shingo, a recognized JIT authority and engineer at the Toyota motor
Company identifies wastes (Table 1) as being the targets of continuous
improvement in production processes. By attending to these wastes,
improvement is achieved.

Table 12.3.1: The Seven Wastes

Waste of Eliminate by reducing set up times, synchronizing quantities
production and timing between processes, compacting layout, visibility,
and so forth. Make only what is needed now.
Waste of Eliminate through synchronizing workflow as much as
waiting possible, and balance uneven loads by flexible workers and
equipment.
Waste of Establish layouts and locations to make transport and handling
transportation unnecessary if possible. Then rationalize transport and material
handling that cannot be eliminated.
Waste of First question why this part or product should be made at all,
processing then why each process is necessary. Extend thinking between
itself economy of scale or speed.

Waste of Reduce by shortening setup times and lead times, by

synchronizing work flows and improving work skills, and even
Stocks by smoothing fluctuations in demand for the product. Reducing
all the other wastes reduce the waste of stocks.
Waste of Study motion for economy consistency. Economy improves
productivity, and consistency improves quality. First improve
Motion the motions, then mechanize or automate. Otherwise there is
danger of automating waste.
Waste of Develop the production process to prevent defects from being
making made so as to eliminate inspection. At each process, accept no
defective defect and make no defect. Make processes failsafe to do this.
products From a quality process comes a quality product –
automatically.

Benefits of JIT System

JIT system has a number of overwhelming benefits that are attracting the JIT reduce process time
attention of traditional companies. The main benefits are: and increase product
quality & skill of the
 Reduced levels of in-process inventories purchased goods and finished workers.
goods.
 Reduced space requirements.
 Increased product quality and reduced scrap and rework.

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 Reduced manufactures lead times.

 Greater flexibility in changing the production mix.
 Smoother productivity flow with fewer disruptions caused by problems
due to quality, shorter setup times, and multi-skilled workers who can
help each other and substitute for others.
 Increased productivity levels and utilization of equipment.
 Worker participation levels and utilization of equipment.
 Worker participation in problem solving.
 Pressure to build good relationships with vendors.
 Reduction in the need for certain indirect labor, such as material
handlers.

JIT: A success story

There are numerous success stories of JIT. A review of successful
implementation in five US companies showed an average lead-time reduction of
90%. Inventory was reduced by 35 to 73%. Purchase cost was reduced by 6 to
11%. A few of the more specific examples are enumerated follows.

A Harley Davidson Case

Harley-Davidson, an eighty year old US motorcycle manufacturer, suffered such
strategic losses in 1981 and 1982 that the future of the company was seriously in
question. Some of the external problems were Honda, Suzuki, Kawasaki, and
Yamaha – four Japanese competitors that had taken most of the market. Harley –
Davidson’s major internal problem was an over-priced product that received
numerous customer complaints about quality – a result of what seemed to be a
long series of quick fixes to help the company get along. Between 1982 and
1986, the firm made significant improvements. Inventory turnovers increased
from less than seven to about twenty a year. Productivity per employee rose
about 50 %. Rework costs were reduced by 80% and warranty costs down by 46
%. The motorcycle part of the company has been profitable since 1983. The
reason for this dramatic turnaround is a company wide effort based on the JIT
manufacturing philosophy.

Chrysler Case
For Chrysler, a car manufacturing company, which has 70 percent of its parts,
made by outside suppliers, JIT is obviously quite critical. Chrysler achieved a 9
% reduction in inventory and an increase in average quarterly inventory turnover
from 6.38 times to 13.9 times. A single corporation wide network connects
Chrysler’s large and mid-sized computers from various vendors and gives
engineering workstations access to the large computers. This makes it easier to
transfer data from one system, stage of production, or plant to another and
facilitates just-in-time inventory management.

Activity: How the JIT can help the Bangladeshi manufacturing firm to
do a better competition within the global environment? Explain your
arguments with taking example from your chosen industry.

St. Luke’s Hospital

Organizations that use JIT report enormous return on investment. St. Luke’s
Episcopal Hospital in Houston saved $1.5 million over three years when it closed
its enormous supplies warehouse and set up “stockless distribution”. Rather than

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storing and handling thousands of items, the hospital receives daily deliveries
from Baxter International (the nation’s largest hospital supplier), whose
computers communicate directly with St. Luke’s inventory management system.
Each day, Baxter pulls together the materials needed and delivers them directly
to each area inside the hospital.

Drawbacks of JIT System

A recently published report in Business Week by Brian Milligan has stated:
“…… Those who believe in the (JIT) system say it eliminate
wastes and frees up much needed space that was once used to
house large chunks of inventory. But the system obviously has
some bugs in it, and purchasing managers say they need to be
worked out. This is evident from the survey, which reported that
47% of participants say … they are having efficiency problems.

……and partial success can be very troublesome. The 47% who

report JIT-related efficiency problems say these problems can
quickly become big problems when assembly lines are forced to
shut down.

Some purchasing managers say they have run into problems with
getting suppliers to keep the needed stock ready to be delivered. In
fact, 33% of the survey participants say missed supply deadlines
are a problem. Twenty one percent of those surveyed say supply
quality is a problem. And 33% say supplier commitment is an area
that needs to be improved.”

JIT is not free from defects. The potential shortcomings of the system are as
follows
JIT may increase
 JIT may result in increased worker idle time. worker idle time &
decrease the production
 May decrease the production rate.
rate.
 Slow to react to changes in demand.
 It ignores known information about future demand patterns.
 Decrease opportunity for multiple sourcing.
 Suppliers must react more quickly.
 Improved reliability required of suppliers.

Activity: Ask your study partners to do a debate with you regarding

the advantages and disadvantages of JIT. After that make new list of
advantages and disadvantages of JIT and compare with the old one.

The Instances of Failure

JIT makes manufacturers more vulnerable to work stoppages at suppliers’ plants
and to delivery disruptions. During the 199 Ontario truckers’ dispute, traffic tie-
ups at the Canada-United States border caused big losses to manufacturers and
showed them the importance of keeping their supply routes open. JIT poses even
bigger problems in international situations where supply channels are much
longer.

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General Motor Incident

In 1996, a 17-day strike by 3000 union employees at two of General Motor’s
Dayton, Ohio brake plants made it drop the production of 250,000 vehicles. The
resultant loss amounted to hundreds of millions of dollars and caused GM to lay
off 175,000 of its employees.

Comparison of JIT and Traditional Approach

Factors JIT Traditional Approach

A liability. Every effort must be An Asset. It protects against
Inventory
expended to do away with it. forecast errors, machine
problems, and late vendor
deliveries.
Immediate needs only. A minimum Formulas.
Lot Size
replenishment quantity is desired for
both manufactured and purchased
parts.
Make them insignificant. This requires Low priority issue. Maximum
Setups
either extremely rapid change over to output is the usual goal.
minimize the impact on production or
the availability of extra machines.
Eliminate them. When problem occur, Necessary investment. Queues
Queues
identify the causes and correct them. permit following operations to
continue in the event of a problem
with feeding operation.
Co-workers. Multiple deliveries for all Adversaries. Multiple source are
Vendors
active items are expected daily. The the rule, and it’s typical to play
vendor takes care of the needs of the them off against each other.
customer, and the customer treats the
vendor as an extension of the factory.
Zero effects. If quality is not 100 %, Tolerate some scram.
Quality
production is in jeopardy.
Constant. Machine breakdowns must It is not given that much
Equipment
be minimal. As required. Not critical importance.
Maintenance
because of queues.
Keep them short. This simplifies the The longer the better. Most
Lead Times
job of marketing, purchasing, and foreman and purchasing agents
manufacturing, as it reduces the need want more lead-time not less.
for expanding.

Plan for JIT Adoption

For successful conversion and adoption, companies should adopt a carefully
planned approach that includes the following elements:
 Top management must be sure about the commitment to the conversion
and necessary requirements.
 Management must be sure about this involvement in the process and
must be known to its cost, duration to complete the conversion and
expected results.
 They should study their operations critically and decide the most critical
parts.
 They should have the support and cooperation of the workers.
 Arrange necessary training programs to make JIT a success.

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 The workers must be fully aware of why JIT is desirable and also about
their job security.
 Once it is started, management should try to maintain the current system.
 They should identify and solve existing problems; find out and enlist
potential workers.

JIT in Bangladesh
The development of the JIT system in Japan was mainly due to the scarcity of
resources. The same situation prevails in Bangladesh as we have very limited
natural resources, but comparatively greater human resources. Therefore, JIT
could be a very effective system for a poor country like ours. But there are some
constraints in this regard. These might be,
 The most important problem in implementing JIT in Bangladesh is the People of Bangladesh
socio-cultural status. The people are not accustomed to such culture of are not accustomed to
the culture of JIT,
being in time, which is a hindrance to JIT system. More over, the which is a constraint to
existence of uncertain variables in Bangladesh is many (i.e. hartals, the system.
traffic jams). So accomplishing tasks in time is not at all expectable.
 Raw materials from agricultural and seasonal products are not suitable
for steady production in small lots.
 The infrastructure of Bangladesh is not developed enough to distribute or
collect goods or raw materials in time according to their needs.
 To apply JIT, it requires strong discipline, reliable operating conditions,
and support of the influential persons. The communication system is also
not of higher technological. So, the necessary materials, equipment and
others cannot arrive at the destination quite timely. The practice of
getting compensation because of the supplier’s delay is also not possible
in Bangladesh.
 JIT becomes a failure story where a co-operative spirit between
management and workers is absent or little, which is frequent in our
industries.
 Buyers may not be willing to commit the resources necessary to help the
suppliers adopt the JIT system. They may be uneasy about long term
commitments to a seller.
 Suppliers may not be frequent in small deliveries because it will be
difficult if they have other traditional buyers.
 The parties involved in this system need engineering and technological
changes resulting from continuing JIT improvements required by the
buyer as well as the suppliers.

Activity: Within the present global competitive market do you think

Bangladesh as a developing economy needs to consider JIT
seriously? Why or why not? Justify with good logic.

As Bangladesh passes through the above constraints, the rate of failure in

applying JIT is high here. Despite some of the fertilizer companies use JIT to
some extent, for example, they use natural gas from pipeline and use it only at
times of production, switching it off after use. In the same manner, we can hope
to see the implementation of JIT in other industries in the near future.

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