RIZAL TECHNOLOGICAL UNIVERSITY

Cities of Mandaluyong and Pasig

SESSION NO 6.

MODULE No. 6: Chapter 6 – Inventory

Management

Topics:
 The Nature and Importance of Inventories
 Requirements for Effective Inventory Management
 Economic Order Quantity Models
 Fixed Order Interval Models
 The Single Period Model

Overview

In this module we will discuss about the basic concepts of inventory management. It will further
discuss the importance and nature of inventory as core aspects of operations management. It will also
discuss different economic models that will lead to understanding of economic ordering, fixed ordering
intervals and single period models.

Inventory management, being one of the important core concepts of operations management, it is
necessary to know how this should be handled. Effective inventory management is one key point in the
success of the business as well as their supply chain. Once there are inefficiency and mismanagement of
the inventory, it will lead in hampering other functional areas of business such as in marketing, operation,
and finance. Once an operation is hampered the organization will not then meet the expectation of the
customers that will lead to dissatisfaction and of course an increase in operational cost.

Study Guide
Please refer to our Course Guide

Learning Outcomes

(1) To discuss the basic concept of inventory management;

(2) To discuss the nature and importance of inventories;
(3) To explain the importance and nature of inventory management and different economic models;
(4) To discuss the concept of economic ordering, fixed ordering and single period models.

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Topic Presentation

Inventory Management

Inventory management refers to the process of ordering, storing and using a company's inventory. This
includes the management of raw materials, components and finished products, as well as warehousing
and processing such items.(Investopedia)
Inventory refers to any safe keeping units which primarily use for production or it may be referred to any
finished goods that are stock for future use. Generally, the type of inventory that firms normally stocked is
those of units that are related to their operation and/or the industry it belongs. It can be into the form of
small pieces into large pieces of materials, equipment and other finished products.

The Nature and Importance of Inventories

Inventories play a vital part in any business. It is actually one of the components of customers’
satisfaction. Fast delivery of product and services are one of the values that customers are looking for.
Hence, proper management of this is one of the important things that operations’ manager and other
functional managers should look at.

Functions of Inventory
1. Ability of the organization to meet future customer demand. A customer can come into surprise and
buy your product and/or service. These inventories are also called anticipated stocks because they are
stocked in order to meet expected demand.

2. Ability of the organization to meet production requirements. Firms are stocking inventories when they
are experiencing seasonal demand. They tend to stock items during seasonal period to meet high demand
when season will be anticipated. These types of inventories are also called seasonal inventories.

3. To decouple operations. Generally, organizations are stocking inventories as buffer in order to

anticipate for breakdowns of the equipment or by the time that they are maintaining it in order for them
to continue the production. Similarly, they are stocking buffer inventories in anticipation of delay in
delivery from suppliers.

4. Ability of the organization to protect in stocking out of inventories. Anticipating delays from suppliers
and unexpected increase of demand are some of the reason for proper inventory management.

5. Ability of the organization to take advantage of order cycles. To minimize the purchasing and inventory
costs, organization tend to buy in quantities that will exceed the current requirements. This will be
anticipated for the future use of the inventory.

6. Ability of the organization to hedge against price increase. Normally, organization will also anticipate
increase in inventory price. The tendency for the organization in bulk is expected. Note that organization
can also get discount in bulk orders and will definitely give an advantage of it.

7. To permit operations. The fact that a production operation requires a certain amount of time, there will
be a work-in-progress inventory. Stocking intermediate inventories, raw materials, and semi-finished goods
and other finished goods in the warehouse is important.
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8. Ability of the organization to take advantage of quantity discounts. Suppliers normally give discounts
for bulk orders.

Objective of Inventory Control

Controlling inventories are important in a company. It will also help in satisfying the customers’
wants and needs. If there will be a little control in inventories it may result to overstocking or under
stocking. Under stocking will result for loss of sales, missed deliveries, and dissatisfied customers.
However, if there will be overstocking of inventories it will incur additional costs for the organization.
There’s a lot of measurement that managers are using in order to know the performance of effective
inventory management.

Inventory turnover It means the ratio of average cost of goods sold to the average inventory investment.
Normally, a high ratio is better than a low ratio. It means the higher the ration the higher the efficiency of
handling the inventory. Another measurement is the day of inventory on hand. The number of days is the
number of expected days of sale that can be supplied by the existing inventory. The high number of days
means there are excess inventory on hand on the other hand, the low number of days may imply the risk
of running out of inventories. Hence, balance is desirable for this one.

Requirements for Effective Inventory Management

1. Keep track of the inventory
2. Forecast of demand
3. Lead time and its variability
4. Holding costs, ordering costs and shortage costs
5. Classification system

Inventory Counting Systems

1. Periodic systems pertain to the physical count of items in inventory made at periodic intervals like
weekly or monthly.
2. perpetual inventory system pertains to the system that keeps track of removals from inventory
continuously, thus monitoring current levels of each item.
A. Two-Bin system it is a very simple system that pertains to two containers of inventory,
reordering is necessary if the first container is empty.
B. Universal Product Code, generally; supermarkets, discount markets and department store uses
periodic system, however because of the advancement of technology, they are now using computerized
system in monitoring inventory. Universal Product Code is also known as bar code that is printed in every
items or packaging of a certain item.
C. Point-of-Sale (POS) systems, it is an electronically records of all sales. Knowledge of the actual
sales can be greatly useful for forecasting as well as in inventory management.

Demand Forecast and Lead time

Inventory normally used for satisfying the requirements of the customers. Hence, the knowledge on
how long thus the demand should be delivered is important. Lead time is the interval between ordering
and receiving the order.

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Cities of Mandaluyong and Pasig

Inventory Cost
There are four basic costs that are associated with inventory and these are:
1. Purchasing cost – it is the amount paid to buy the inventory.
2. Holding cost – these are costs to carry an item in inventory for a length of time, usually in a period of
year.
3. Ordering cost – these are costs of ordering and receiving inventory.
4. Shortage cost – these are costs resulting when demand exceeds the supply of inventory; often
unrealized profit per unit.

Classification System
A significant feature of inventory management is that items held in inventory are not of equal
standing in terms of peso capitalized, profit prospective, sales or usage capacity, or stockout penalties.

A-B-C Approach – it is an approach that classifying inventory according to some measure of importance,
and allocating control efforts accordingly.
To illustrate the approach these are the following steps:
1. For each item, multiply annual volume by unit of price to get the annual peso value.
2. Arrange annual peso values in descending order
3. The few 10 to 15 percent with the highest peso values will be item A. then those items that with lowest
annual peso values for about 50 percent will be items C. then in the middle of the items A and C will be the
items B which is about 35 percent.

A manager then obtained 10 lists of items with their following unit cost and gets the peso value in
annual basis. By doing the A-B-C approach you will need to multiply the annual demand for the particular
items to its unit costs as follows:

Step 1. Multiply the annual demandper unit cost to get the annual peso values.

Item Number Annual Demand Unit Cost Annual Demand

1 2,500 360 900,000
2 1000 70 70,000
3 2,400 500 1,200,000
4 1500 100 150,000
5 700 70 49,000
6 1000 1000 1,000,000
7 200 210 42,000
8 1000 4000 4,000,000
9 8000 10 80,000
10 500 200 100,000

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Cities of Mandaluyong and Pasig

Step 2. Arrange the items descending order and facilitate the items with their respective categories.
Item Number Annual Peso Classification % of items % of Annual
Values Peso Values
8 4,000,000 A 10 52.7
3 1,200,000 B
6 1,000,000 B 30 40.8
1 900,000 B
4 150,000 C
10 100,000 C
9 80,000 C 60 6.5
2 70,000 C
5 49,000 C
7 42,000 C
100 100
Note that in the table, Item A has the fewer number of items however the highest peso values. On the
other hand, items in category C have the most number of items yet the small percentage of annual peso
values.

Other application of A-B-C approach is for cycle counting which means the physical count of items in
inventory.

The key concerns about cycle counting are as follows:

1. How much accuracy is needed?
2. When should cycle counting is performed?
3. Who should do it?

Inventory Order Policies

Inventory order policies are basically important for two issues in inventory management. These are
how much should be ordered and when to be ordered. Inventory that is intended to meet expected
demand is called cycle stock, on the other hand; inventory that is expected to eliminate stockout is called
safety stock.
On the issue of how much to order there are models that are considered such as:

1. Economic Order Quantity (EOQ) – it is a model that identifies the optimal order quantity by minimizing
the actual annual sum of the costs that varies depending on the order size and frequency of ordering.

There are order size models under EOQ:

a. The basic economic order quantity model.
b. The economic production quantity model.
c. The quantity discount model.

Basic Economic Order Quantity Model

Among the three this model is the simplest form. It is used to identify a fixed order size that will
minimize the annual cost of holding an inventory.

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These are the following assumptions for this model:

1. Only one product is involved.
2. Annual demand requirements are known.
3. Demand is range evenly throughout the year do that the rate of demand is reasonably constant.
4. Lead time is known and constant.
5. Each order is received in a single delivery,
6. There are no quantity discounts.

Economic Production Quantity (EPQ)

The batch mode is extensively used in production. Even in assembly operations, portions of the
work are done in sets. The purpose for this is that in certain cases, the volume to produce a part surpasses
the part’s usage or demand rate.

The basic assumptions are as follows:

1. Only one item is involved.
2. Annual demand is known.
3. The usage rate is perpetual.
4. Usage occurs constantly, but production is periodically.
5. The production rate is perpetual.
6. No variation in lead time.
7. There is no discounting in quantity.

Quantity Discounts - These are price reductions for a bulk orders of a certain products offered to
customers in order for them to buy in large quantities.

Reorder Point Ordering : It happens when the quantity on hand of an item drops to a particular amount,
therefore the item is reordered.
These are the following determinant of reorder point:
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability.
4. The degree of stockout risk acceptable to management.

Safety Stock – are stocks that are held in excess of the current requirements due to variable demand
and/or lead time.
The amount of safety stocks that are appropriate are depending on the following:
1. The average demand rate and lead time.
2. Variation in demand and lead time.
3. The desired service level.

Service level – is the probability that demand will not exceed supply during a lead time.

How much to Order: Fixed-Order-Interval Model

The Fixed-Order-Interval (FOI) Model is order placed at fixed interval time.

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Cities of Mandaluyong and Pasig

Reasons for using FOI model:

1. Supplier’s policy
2. Savings in shipping cost
3. It requires periodic checks of inventory levels.
Benefits
1. It can lead to tight control.
2. It can yield in savings if multiple items come from same supplier.
3. It is the practical approach when inventory are not closely monitored.
Disadvantage
1. It can lead to large amount of safety stock.
2. Increase in carrying cost
3. There are costs of the periodic reviews.

The Single-Period Model : It is a model for ordering of perishables and other items with limited useful lives.
The analysis of single-period model comes from two costs: shortage and excess.
Shortage cost may include a charge for loss in customer willingness as well as the lost in cost in
opportunity costs. Generally, shortage costs are unrealized profit per unit.
Excess costs are the difference between purchase costs and salvage value on items left over at the
end of a period.
These are the following formula
Shortage cost:
Cshortage = Cs = Revenue per unit – Cost per unit

Excess cost:
Cexcess = Ce = Original cost per unit – Salvage value per unit

Continuous Stocking Levels

It is easier to identify the optimal level of stocks when demand is constant. The service level is the
probability that demand will not exceed the stocking level and computation is the key determining the
optimal stocking level.
Service level = Cs / Cs + Ce
Where:
Cs – shortage cost per unit
Ce – excess cost per unit
Example:
Sweet candies are delivered weekly to Kristine’s Candy Bar. Demand varies uniformly between 300 grams
and 500 grams per week. Kristine’s pays 20 pesos per gram and charge 80 pesos per gram for it. Unsold
candies have no salvage value and cannot be carried over into the next week due to spoilage. Find the
optimal stocking level and its stockout risk for that quantity.
Ce = Cost per unit – Salvage value per unit
Ce = 20 – 0
Ce = 20 per unit
Cs = Revenue per unit – Cost per unit
Cs = 80 – 20
Cs = 60 per unit
SL = 60 / 60 + 20
SL = 60 / 80
SL = 0.75
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Optimal Stocking
So = 300 + 0.75(500-300)
So = 300 + 150
So = 450 grams 190
The stocking risk is 1.00 – 0.7 = 0.25

Discrete Stocking Levels

When stocking levels are discrete rather than continuous, the service level is computed as follows Cs/(Cs=Ce)
usually does not correspond with a practicable stocking level.
Example:
Cs = 4,200
Ce = 800
SL = 4,200/ (4,200+800)
SL = 4,200 / 5,000
SL = 0.84

Operational Strategy
Inventories often denote considerable investment. Hence, when inventories are handled correctly,
it may give the organization with a substantial competitive advantage in terms of cost and customer
satisfaction.

These are the areas with substantial potentials in inventory management:

1. Record Keeping. It is important to have an inventory records that are accurate and up-to-date, so it will
help in decision making. Estimation on demand and lead time should always be reviewed periodically to
ensure that variations are identified.
2. Variation reduction. Errors in lead time and forecasting are the two keys that will have significant impact
with inventory management. If variation is reduce it will lead to a yield significantly can improved the
inventory management.
3. Lean operation. Lean systems are demand driven, which means goods are pulled to the system to match
the demand instead of being pushed without a proper direction with the demand.
4. Supply chain management. Working closely with suppliers and coordination with shipments, will reduce
lead times and reduce supply chain inventories can lead to reduction of size and frequency of stockouts
with considering the lowering of carrying costs.

Key points

1. All businesses carry inventories, which are goods that are essential for future use or potential future use.

2. Inventory represents money as well as asset that are actually tied up with materials and goods.

3. Effective handling of inventory decisions depends on good information and record, good cost
information and demand.

4. The decision on how much demand to have on hand is depend on trade-off

5. In any operation variation is present and should be taken into consideration when doing decisions.

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Cities of Mandaluyong and Pasig

Guided Exercises / Learning Activities

REVIEW EXCERCISES:
A. Review Module 1 – 6 for the Midterms which will be on November 7, 2020: 8:00AM – 10:00AM –
Saturday.

B. 1. Answer the following as indicated: (Module 6)

A. There are four basic costs that are associated with inventory and these are the following. Match with
the definition below. Answer with letters only.

____1. ____2. ___3. ___4.

Purchasing Costs Holding Costs Ordering Costs Shortage Costs
A. These are B. These are C. These are D. These are the
costs of ordering costs to carry an costs resulting amount paid to
and receiving item in inventory when demand buy the inventory.
inventory. for a length of exceeds the
time, usually in a supply of
period of year. inventory; often
unrealized profit
B. Identification
________________1. It is used to identify a fixed order size that will minimize the annual cost of holding
an inventory
________________2. The batch mode is extensively used in production. Even in assembly operations,
portions of the work are done in sets. The purpose for this is that in certain cases, the volume to produce
a part surpasses the part’s usage or demand rate.
________________3. These are price reductions for a bulk orders of a certain products offered to
customers in order for them to buy in large quantities.
________________4. It happens when the quantity on hand of an item drops to a particular amount,
therefore, the item is reordered.
________________5. These are stocks that are held in excess of the current requirements due to
variable
demand and/or lead time.
________________6. It is a model for ordering of perishables and other items with limited useful lives.
________________7. It is easier to identify the optimal level of stocks when demand is constant. The
service level is the probability that demand will not exceed the stocking level and computation is the
key determining the optimal stocking level.
________________8. Pertains to a physical count of items in inventory made at a period ic intervals like
weekly or monthly.
________________9. It is also known as bar code that is printed in every items or packaging of a certain
items.
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_______________10. It is a very simple system that pertains to two containers of inventory,

reordering is necessary if the first container is empty.

C. Enumeration:
1. Requirements for Effective Inventory Management (5)
2. Functions of Inventory (7)
3. Determinant of Reorder Point (4)
4. Areas with substantial potential in Inventory Management (4)
5. Forms of Inventory Counting System (2)

C . Send your answer to chonamhalili28@gmail.com on or before November 14, 2020.

Good Luck and Keep Safe.

References

(1) Brennan, L.L. (2011). Operations Management, McGraw-Hill Publication

(2) De Felice, F; Monfreda, S.; Petrillo, A. et.al (2013). Operations Management, InTech Publication
(3) Marasigan, Matias & Noveda (2019). Operations Management with Total Quality Management.
House of Color Graphics and Services Inc. ISBN: 987-621-96052-1-9
(4) Slack, N.; Chambers, S.; Johnston R. (2010). Operations Management, Sixth Edition, Pearson
Publication.

Prepared By:

CHONA M. HALILI
Instructor

COURSE TITLE (Mgt 103)