Chapter - Three

Inventory Management
 3.1 Meaning of Inventory
❖ They are materials or resources of any kind having some economic values, either
awaiting conversion or use in the futures.
❖ Inventory is a stock of materials that are used to facilitate production or to satisfy
customers’ demand.
❖ Inventories are stock of materials of any kind stored for future use.
❖ They include semi-finished goods awaiting release for sale, many indirect
materials such as maintenance materials, fuels and lubricants, etc.
❖ It is a major type of control system applied in most organizations.
❖ Here the responsibility of materials management is to maintain sufficient
inventories to meet demand for goods and at the same time incurring the lowest
inventory handling costs.
 3.2 Types of inventory

In this course we can classify inventories according to the form or

function items stocked as:
❖Production inventories,
❖Work in process inventory,
❖Finished goods inventories, and
❖MRO.
 1. Production inventories
• They are raw materials, parts, and components that enter the product in the
production process.
• They are usually primary products.
• In factories bulk of stores in terms of volume and value will be raw materials,
since bulk of raw materials only are processed to finished products in the same
form or in the processed form
 2. Work- in- process inventory
❖Work–in–process inventory is the semi-finished stock accumulated in
between two operations.
❖The size of the work-in-process inventory is dependent on the production
cycle time, percentage of machine utilization, & the make or buy policies of
the company.
❖This is usually due to unbalanced loading of machines, holdups during
manufacturing, shortage of tools due to high consumption and deterioration
of machines’ capability due to long use.
 3. Finished goods inventories
• They are completed products ready for sale.
• The finished goods inventories are maintained to ensure a free flowing of
supply to the customers, and to promote sales.
• The size of the inventory depends on how demand & the ability of the
marketing department to push the products, the organization’s ability to
have delivery schedule of the customers & the shelf-life of the product & the
warehousing capacity.
 4. MRO (Maintenance, Repair and Operating) supplies
• They are materials consumed in the production process but which do not
become part of the product.
• They are items that simply support production and administrate the operation
without becoming part of final product.
• They are usually called indirect materials to the finished product.
• Supplies include spare parts, fuel lubricants, oil stationery, packaging materials,
etc.
 3.3 Purpose of Inventories
1. To protect against uncertainties;
➢In inventory systems, there are uncertainties in supply, demand, price, and lead-
time of materials.
➢Safety stocks are maintained in inventory to protect against those uncertainties.
➢To assure product availability at a reasonable price, safety stocks are maintained
to provide this protection.
2.To hedge against contingencies;
❑Labor strikes, fires, floods, and earthquake, price inflation are just a few of the
contingencies that can befall an organization.
❑Maintaining backup inventories is one way in which normal supplies can be
maintained for a period of time.
 3. To achieve economies of scale;
❑Due to ordering costs and quantity discounts, it is often economical to
purchase in large lots because more can be purchased at one time than is
immediately needed.
❑Likewise, many purchases on small quantities can mean that the highest
transportation rates are paid; one purpose for establishing an inventory would
be to allow shipping to or form the inventory under the lower per unit rates of
full vehicle load quantities.
❑ In a similar way, the lowest per unit cost for producing products generally
occurs with long or continuous production runs at constant quantities.
 4. To cover anticipated changes in demand and supply;
❑There are several types of situations where changes in demand and supply
may be anticipated.
❑ One case is where the price or availability of raw materials is expected to
change.
❑ Another source of anticipation is planned market promotion where a large
amount of finished goods may be stocked prior to sale.
❑ Finally, companies in seasonal businesses often anticipate demand in order
to smooth employment.
 5. Provide and maintain good customer service;
• Inventories are carried in order to ensure an adequate and prompt supply of
items to the customer to avoid the reputation for constantly being out of stock
and avoid the shortage at a minimum cost.
6. To protect against stock outs;
• Delayed deliveries and unexpected increases in demand increase the risk of
shortages.
7. To decouple operations;
• When one manufacturing activity has to be completed before a second active
can be started.
• If there is no inventory, the activity of second process can be stopped.
• But if there is inventory, it can be used as buffer.
• Thus, the decoupling function of inventory implies inventory avoids many
delays and inefficiency.
 3.4 Nature of demand in inventories
❖ This distinction is important to selecting an appropriate inventory
management approach.
❖ The demand for inventory may be dependent or independent.
❑ Dependent demand items: are those items where their demand is related
to the demand for another item.
▪ When it is directly related, or derives from, the demand for another
inventory item or product.
▪ This demand is also known as Derived Demand.
❑ Independent demand items: are those items that are not influenced by
production/operation but by the market forces.
▪ When such demand is unrelated to demand for other items
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• Important point to remember is that developing inventory policies for items
exhibiting independent demand will require forecasting expected demand
for these items.
• Alternatively, forecasting is less relevant for items having dependent
demand, since the needed quantities of these items depend entirely upon
the demand for the end product being manufactured or assembled.
• For items having dependent demand, needed quantity projections and
receipts timing will rely wholly on the forecast needs for the end product.
 3.5 Inventory Cost
• The major goals of materials management are:
➢To minimize investment in inventories,
➢To maximize customer (beneficiary) service, and
➢To assure efficient (low cost) operation
• Reduction of inventory costs thus calls for the analyses of relevant cost
structure of inventories that primarily includes four major elements;
1. Item (Purchased) costs
• This is cost of the item whether it is manufactured or purchased.
• If it is manufactured, the unit production costs of the item.
• For the purchased items, it is the purchase price plus any freight cost.
 2. Ordering (setup) costs
❑These are fixed costs usually associated with the production of a lot internally
or the placing of an order externally with a vendor.
❑Ordering cost refers to the expense of placing an order for additional
inventory, and does not include the cost or expense of the product itself.
❑Setup cost refers more specifically to the expense of changing or modifying a
production or assembly process to facilitate product line changeovers.
❑The nature of ordering cost and set up cost is that the more quantities we order
in one, ordering cost per unit decreases and the less quantity we order, ordering
cost per unit increase.
❑Therefore, if one considers, the ordering cost alone the rule is to order as
much quantity as possible.
 3. Shortage (penalty, depletion costs or Stock-out) costs
• The cost of lost production or downtime due to stock out.
• Stocks out costs reflect the economic consequences of running out of stock.
• The costs are based on the concept of foregone profits.
• The result form external and internal shortages.
• External shortage occurs when a customer does not have his order filled;
• Result in backorder costs, present profit loss (lost sales), and future profit loss (loss of
potential sales and erosion of goodwill).
• Internal shortage occurs when operators within the organization do not have their orders
filled.
• Result in lost production, idle men and machines, and a delay in completion date.
• This cost depends on the reaction of the customer to the out-of-stock condition.
• If demand occurs for an item out of stock, the economic loss depends on whether the
shortage is backordered or cancelled.
 4. Holding (or carrying) costs
If the item is held in stock, the cost involved is the item carrying or holding cost.
❑ Opportunity cost: associated with inventory investment.
❑ Inventory-service costs: includes insurance and taxes.
– Insurance costs: most firms insure their assets against possible loss.
– Depending upon the product value and type, the risk of loss or damage may require high
insurance premiums.
– Property taxes: are levied on the assessed value of a firm’s assets.
❑ Storage-space costs: this category includes handling costs associated with moving products into
and out of inventory, and storage costs such as rent, heating, and lighting.
❑ Inventory-risk costs: reflects the very real possibility that inventory birr value may decline for
reasons largely beyond corporate control.
– Obsolescence is loss of value of inventories because of shift in style or consumer preference.
– Shrinkage is the decrease in inventory quantities over time from loss, theft or pilferage.
– Deterioration is change in properties due to age/other factors such as environmental degradation.
❑ Admin cost: cost of maintaining inventory records and the salaries/wages of storing, receiving and
issue of material personnel. 17
 3.6 Inventory Model
3.6.1 Inventory Model for Independent Demand
There are a number of mathematical models that can be applied to determine
the optimum (economical) level for independent demand materials.
I. Economic Order Quantity (EOQ) Model
❑ The EOQ model is one method of determining the adequate (optimum)
inventory level for independent demand materials.
❑ It is used to identify a fixed order size that will minimize the sum of the
annual costs of holding inventory and ordering inventory.

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 Assumptions of this model are;
- Only one product is involved - Lead time does not vary
- Annual demand requirement are known - Demand is constant
- Each order is received in a single delivery - There are no quantity discounts
→ As the order quantity increases, carrying costs rise-and at the same time ordering costs
decrease.
→ Therefore, at the point of EOQ, the total inventory cost will be kept at minimum level.
→ In constructing any inventory model, the first step is to develop a functional
relationship between the variables of interest and the measure of effectiveness.
Thus, total cost obtained by;
Total Annual Annual Annual
Annual cost = Ordering cost + Holding cost + Purchase cost
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❖ To develop an equation for total inventory cost and for the purpose of
analyzing inventory models, the following symbols will be used throughout the
chapter.
– TC = Total annual cost
– CO = Set up or Ordering cost
– D = Annual demand in units
– Q = Quantity to be ordered
– Cc = Carrying cost per unit
– P = Purchase price per unit or cost per unit.
❖ NB: D and Cc must be in the same units, e.g., months, years.

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 i. Annual Ordering Cost
Annual Ordering cost = Number of orders Placed per year x Ordering cost per order

NB - The number of orders per year will be D/Q, and hence:

x(order cost per order )
D annual demand
Annual Ordering cost = Co =
Q Number of units in each order

ii. Annual Holding Cost

Annual Holding cost = average inventory value x inventory carrying cost as a % of inventory value
› In order to calculate annual carrying cost (ACc) let us look at the concept of average inventory.
› The concept of average e inventory is based on the following assumption;
› Purchase is made at the beginning; usage rate is constant & the last item is used on the last date
› Then the average inventory will be Q/2 where Q is the order quantity in units.

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❖ The next step is to find that order quantity, Q, for which total cost is a minimum.
❖ This can be done by Equating ordering and carrying costs. i.e.

NB - Minimum inventory cost = ACc + ACo

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Example:
• A local distributor for Addis tire company expects to approximately 9,600 steel
belted tires of certain size next year. The annual carrying cost is 16.00 Birr per
tier per year and the ordering cost are 75.00 Birr per order. The distributor
operates 288 days a year.
• Required:
a) Determine EOQ.
b) What is the Ordering Cost per year and annual carrying cost at EOQ?
c) What is the total inventory cost at EOQ
d) If purchase price per tire is 80.00 Birr. What is the total cost at EOQ?
e) How many times per year the store does reorders.
f) Determine the length of an order cycle.
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Example 2: ABC Widgets Inc. is a manufacturing company that specializes in
producing high-quality widgets for various industries. As part of their supply chain
management, the company forecasts an annual demand of 10,000 units based on
historical sales data and market trends. Each order placed with suppliers incurs an
order cost of $50, while the carrying cost to hold one unit of inventory for a year is
estimated at $2. The purchase price of each widget is $85.
Required:
a) Determine EOQ.
b) What is the Ordering Cost per year and annual carrying cost at EOQ?
c) What is the total inventory cost at EOQ (ACc + ACo)
d) What is the total cost at EOQ? =Ordering Cost + Carrying Cost +
Purchase Cost
e) How many times per year the store does reorders.
f) Determine the length of an order cycle. 24
 3.7 Inventory Analysis System (Classification)

• Items that are in the inventory are not of equal importance in terms of

– The amount invested,

– Profit potential,

– Stock-out penalties…etc.

• Therefore, all items do not deserve the same degree of attention.

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Inventories can be classified in to various groups on the basis of the selective
inventory management approach as follows.
1. ABC Inventory Analysis (Always, Better, Control).
❖ Based on no_ of inventory item and value of item
2. VED Inventory Analysis (Vital, Essential, Desirable).
❖ Based on importance of the item.
3. SDE Inventory Analysis (Scarce, Difficulty, Easy).
❖ Based on problems faced in purchasing.
4. HML Inventory Analysis (High, Medium, Low).
❖ Based on cost of the item
5. FSN Inventory Analysis (Fast, Slow, and Non-Moving).
❖ Based on usage of item
6. XYZ Inventory Analysis (High, Moderate & Low closing inventory items)
❖ Based on the price of each item in the store. 26
1. ABC Inventory Analysis
❑ is an approach that helps the material manager to exercise selective control &
focus attention only on a few items when confronted with lack of store items.
❑ The technique tries to analyze the distribution of any characteristic by money
value of importance in order to determine its priority.
❑ In any large group there may have “significant few” and “insignificant many”.
❑ In materials management, this technique has been applied in areas needing
selective control, such as inventory, criticality of items, obsolete stocks, and
purchasing orders, receipt of materials, inspection, store keeping and
verification of bills.

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Even though there is lack of clear-cut principle to classify items in to A, B and C for
all organizations, the normal items in most organizations show the following pattern:

1. A items constitute about 5-10% of the total number of items purchased (in
inventory) that would account for about 70–80% of the total dollar value
(usage value).
2. B items constitute about 10-20% of the total number of items purchased (in
inventory) that would account for about 10–15% of the total dollar value.
3. C items constitute about 65-80% of the total number of items purchased (in
inventory) that would account for about 5 to 10% of the total dollar value.

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ABC procedure
The mechanics of classifying the items into ‘A’, ‘B’ and ‘C’ categories is described
in the following steps.
1. Calculate the annual usage in birr for each item by multiplying the annual
usage with unit price.
2. Rank the items from highest birr usage annually to the lowest annual usage
in birr.
3. Determine the cumulative annual usage value and total number of items.
4. Convert the annual usage value and total number of items in to percentage.
5. Categorize the items in A, B, and C categories

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• Example1: XYZ factory adopts the ABC method of classifying inventories.
Currently, the factory has 10 items.
• The following is the data related to the items.
Item No Annual usage, Q Unit cost (birr)
22 1100 2
68 600 40
27 100 4
03 1300 1
82 100 60
54 10 25
36 100 2
19 1500 2
23 200 2
41 500 2

Classify the items into ABC with A items taking 80%, B items taking about 15% and
C taking 5% of the total birr value
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 Implementing ABC analysis

Factor Item A Item B Item C

1-Degree of Control High Moderate Low
2-Ordring procedure High Moderate Low
3-Priority Treatment High Moderate Low
4-Safety Stock Low Moderate High
5- Price Discount Low Moderate High
6-Physical Stock Taking High Moderate Low
7-Nature of purchasing Centralized Combined Decentralized
 Example2: ABC method of classifying inventories.
The following is the data related to the items.
Item No_ Unit cost Annual usage
1 $60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120

❖ Classify the items into ABC with A items taking 75%, B items taking about 15%
and C taking 10% of the total birr value 32
2. VED (Vital, Essential, Desirable) Analysis
The analysis if based on the criticality of inventory.
• V-item – are items when go out of stock or when not readily available,
completely bring the production to a halt. So, they should be stored
adequately to insure continuous production.
• E-item – are items without which temporary losses of production or
dislocation of production work occurs.
• D-item – are all other items which are necessary but do not cause any
immediate effect on production.

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3. SDE (Scarce, Difficult, Easily) Analysis
This analysis is based on availability of items (raw materials).
• S-item – are items which are in small supply & are usually imported items.
• D-item – are items which are available in the market but cannot be
procured easily. For example, items which have to come from far off cities.
• E-item – are easily available items; mostly local items
4. HML (High, Medium, Low) Analysis
The cost per item is considered for this analysis.
▪ High - cost item (H),
▪ Medium cost items (M) and
▪ Low - cost items (L) help in bringing control over consumption.
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5. FSN (Fast, Slow, Non-Moving) Analysis
❑ Here the quantity and rate of consumption is analyzed to be classified as fast
moving, non moving, and slow moving.
❑ This classification helps in arranging stocks in the stores according to the
frequency that the items are used or consumed.
❖ Non-moving items must be periodically reviewed to prevent expiry and
obsolescence.
6. XYZ Analysis
The analysis is based on the value of closing inventory.
• X-items – Items with high closing inventory.
• Y-items – Items with moderate closing inventory.
• Z-items – Items with low closing inventory. 35
 3.8 Just in time (JIT) operation
❑ The JIT approach was developed at the Toyota Motor Company by Taiichi Ohno
(who eventually became vice president of manufacturing) & several of his colleagues.
❑ The development of JIT in Japan was probably influenced by Japan being a crowded
country with few natural resources.
❑ Not surprisingly, the Japanese are very sensitive to waste and inefficiency.
❑ They regard scrap and rework as waste and excess inventory as an evil because it takes
up space and ties up resources.
❑ “Production methodology which aims to improve overall productivity through
elimination of waste and which leads to improved quality”.
❑ JIT provides an efficient production in an organization and delivery of only the
necessary parts in the right quantity, at the right time and place while using
the minimum facilities”.

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❑ JIT aims to ensure that inputs into the production process only arrive when they
are needed.
❑ It means making only what is needed, when it is needed, the amount needed.
The objective of JIT is
▪ Elimination of waste in production
▪ Improved productivity
❑ The philosophy is based on removing waste from business processes to achieve a
stream lined highly efficient system that provides low cost / high quality products
to support customer need.
❑ Waste is any anything that doesn't add value to customer.
❑ Example:- inventory, waiting (queue), scrap and rework, returned goods.

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❑ The ultimate goal of JIT is a balanced system, that is, one that achieves a smooth,
rapid flow of materials and/or work through the system.
❑ Those goals are eliminating disruptions, make the system flexible, eliminate
waste, especially excess inventory.
❑ The idea is to make the process time as short as possible by using resources
in the best possible way.

Disadvantage
• High dependency on suppliers
• There is little / no room for mistakes as minimal stock is kept for reworking
faulty product
• There is no spare finished product available to meet unexpected orders, because
all product is made to meet actual orders. 38
 Benefits of JIT
The most significant benefit is to improve the responsiveness of the firm to the
changes in the market place thus providing an advantage in competition.
Following are the benefits of JIT:
Product cost—is greatly reduced due to reduction of manufacturing cycle time,
reduction of waste & inventories and elimination of non - value added operation.
Quality—is improved because of continuous quality improvement programs.
Design—Due to fast response to engineering change, alternative designs can be
quickly brought on the shop floor.
Productivity improvement.
Higher production system flexibility
Administrative and ease and simplicity
End of Chapter three. 39