CHAPTER FIVE

INVENTORY MANAGEMENT
5. Introduction
What is inventory?
Inventory or stock (in common terms) is considered to be the central theme in managing materials.
The inventory turnover ratio (ITR) is a barometer of performance of materials management function.
In the generally understood term, inventory means a physical stock of goods kept in store to meet the
anticipated demand. Inventory is quantities of goods in stock.
5.1. Concepts of Inventory Management
Inventory management is the process that is concerned with keeping enough inventories on hand to
avoid running out while at the same time maintaining a small inventory balance to allow for a
reasonable return on investment.
It is necessary to have physical stock in the system to take care of the anticipated demand because
non-availability of materials when needed will lead to delays in production or projects or services
delivered. However, keeping large inventory is not free from cost because there are opportunity costs
of “carrying” or “holding” inventory in the organization. Thus, the paradox is that we need inventory,
but it is not desirable to have large inventory. This paradoxical situation makes inventory
management is a challenging problem area in materials management. It also makes a high inventory
turnover ratio as a desirable performance indicator.
The various forms in which inventories exist in manufacturing company are;
 Raw material
 Work-in process
 Finished goods
Objectives of Inventory Management
The major objectives of the inventory management are as follows:
 To efficient and smooth production process.
 To maintain optimum inventory to maximize the profitability.
 To meet the seasonal demand of the products.
 To avoid price increase in future.
 To ensure the level and site of inventories required.
 To plan when to purchase and where to purchase
 To avoid both over stock and under stock of inventory.

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Inventory management must meet the problem of two conflicting needs of a company. These are;
1) To maintain a large size of inventory for efficient and smooth production and sales operation
2) to maintain minimum investment in inventories to maximize profitability. So, the objective of
inventory management is to determine and maintain optimum level of inventory avoiding excessive
and inadequate balance.
An effective inventory management should therefore ensure;
 Continues supply of raw material to facilitate uninterrupted production
 Maintain sufficient store of raw material in a period of short-supply, an anticipated price charge
(increase in price)
 Maintain sufficient finished goods inventory for smooth sales operation and efficient customer
service.
 Minimize the carrying cost and time
 Control investment in inventories and keeping at optimal level.
5.2. Purpose of Holding Inventory
There are three general motives for holding inventories:
1) Transaction motive: to facilitate smooth production and sales operation.
2) Precautionary motive: necessitates holding of inventories to guard against the risk of
unpredictable change in demand and supply forces and other factors.
3) Speculative motive- influence the decision to increase or reduce inventory levels to take
advantages of price fluctuations.

5.3. Techniques for managing inventory

The ultimate goal of an inventory management program is to provide maximum customer service at a
minimum cost. To manage inventories efficiently the following should be answered:
a) How much should be ordered?
b) When it should be ordered?
The first question ‘how much to order?’ relates to the problem of determining EOQ. And it is
answered by analyzing the level of inventories required. The second question ‘when to order?’ arises
because of uncertainty and is a problem of determining the re-order point.
Techniques that are commonly used in management of inventory are:-:
1. ABC system
2. Economic order quantity (EOQ) model
3. Reorder point
4. Material requirement planning (MRP) system and
5. Just-in-time (JIT) system
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 1. ABC system
Inventory is divided into three groups, A,B, and C. The A group includes those items that require the
largest birr investment. The B group consists of the items accounting for the next largest investment.
The C group typically consists of a large number of items accounting for a relatively small birr
investment. Dividing its inventory into A,B, and C items allows the firm to determine the level and
types of inventory control procedures needed. Control of ‘A’ items should be most intensive and the
use of perpetual inventory record keeping that allows daily monitoring of these inventory levels is
appropriate. B items are frequently controlled through Periodic checking- possibly weekly- of their
levels. C items could be controlled by using unsophisticated procedures such as a red ling method, in
which a reorder is placed when enough inventory has been removed from a bin containing the
inventory item to expose a red line that has been drawn around the inside of the bin.

2. Economic Order Quantity (EOQ)

Economic order quantity (EOQ) - it is one of the major inventory management problem to be
resolved is how much inventory should be added, when inventory is replenished. It takes into account
various operating and financial costs and determines the order quantity that minimizes total inventory
cost. Under this policy, the inventory status is continuously monitored.

Excluding the actual cost of the merchandise, the costs associated with inventory can be divided into
three broad groups: order costs, carrying costs, and total costs.
A. Ordering cost (set up cost) – the expenses in between placing an order for material and receiving
the material are called as ordering cost.
Example:
 Stationary charges
 salaries of the employees
 transportation charge
 telephone, telegraph, post, fax, e-mail charges
 Entertainment charges for supplies and customers and etc.
Order cost = O x S/Q
Where O is order cost per order
S is usage in units per period
Q is order quantity in units
B. Carrying Cost (Storage Cost) (Holding Cost) – these costs are losses and expenses in holding the
material inventory department are called as carrying cost? These costs are the variable costs per
unit of holding an item in inventory for a specified time period. These costs are typically stated as

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 birr per unit per period.
Example:
 rent for inventory department
 interest on money borrowed
 transportation charges within the organization
 electricity charges for only inventory department
 Salaries of inventory department employee and etc.

Carrying cost = C x Q/2

Where C is carrying cost per unit per period
Q is orderpoint
Reorder quantity
= leadintime
unitsin days x daily usage

C. Total cost is defined as the sum of the order and carrying costs. Total cost is important in the
EOQ model, since the model’s objective is to determine the order quantity that minimizes it.

The stated objective of the EOQ model is to find the order quantity that minimizes the firm’s total
inventory cost. The economic order quantity can be found with the following formula.

Example: Assume that XXX Company, a manufacturer of electronic test equipment, uses 1,600 units
of an item annually. Its order cost is birr 50 per order, and carrying cost is birr 1 per unit per year.

Required: Determine the economic order quantity?

Total cost = (O x S/Q) + (C x Q/2)
EOQ = 2xSxO
C

EOQ = 2 x 1600 x 50
1 EOQ = = 400
2 x Sunits
xO
C
3. Reorder Point
Once the firm has calculated its economic order quantity, it must determine when to place orders. A
reorder point is required that considers the lead time needed to place and receive orders. Assuming a
constant usage rate for inventory, the reorder point can be determined by the following formula.

For example, if a firm knows that it requires 10 days to place and receive an order, and if it uses five
units of inventory daily, the reorder point would be 50 units (10 days x 5 units per day). Thus as soon
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as the firm’s inventory level reaches 50 units, an order will be placed for an amount equal to the
economic order quantity. If the estimates of lead time and daily usage are correct, the order will be
received exactly when the inventory level reaches zero. Because of the difficulty in precisely
predicting lead times and daily usage rates, many firms typically maintain safety stocks, which are
extra inventories that can be drawn down when actual outcomes are greater than expected.

4. Materials requirement planning (MRP) system

In many manufacturing organizations, production requirements are based directly on the sales
forecast. Many companies use a materials requirement planning (MRP) system to determine what to
order, when to order, and in what quantity to order materials. The objective is to lower the firm’s
inventory investment without impairing production.
5. Just in time (JIT) system
It is part of a manufacturing approach that seeks to reduce the company’s operating cycle and
associated costs by eliminating wasteful procedure. All inventories are acquired and used in
production at the exact time and at the right quantity that is needed. While raw materials inventory
and work in process inventory can never be reduced to zero. JIT is one of the extremely tight controls
so as to minimize inventory size as law as possible. The use of JIT inventory system requires close
coordination b/n a company and its suppliers. A JIT requires extensive cooperation among all parties
involved in the process such as supplies, shipping companies, and the firm’s employees. Therefore
JIT requires a very accurate production and inventory information system, highly efficient
purchasing, very reliable suppliers, efficient transportation, and communication and an efficient
inventory handling system. This system is used to minimize inventory investment. Because its
objective is to minimize inventory investment, a JIT system uses no, or very little, safety stocks.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining
efficiency by emphasizing quality in terms of both the materials used and their timely delivery.