1.

Definitions:

Inventory:

Inventory refers to the stock of goods and materials that a business holds to support production, sales,
and operations. It includes raw materials, work-in-progress (WIP), finished goods, and goods for resale.
Managing inventory effectively is critical for minimizing costs and ensuring a steady supply of products to
meet customer demand.

Carrying Cost (Holding Cost):

Carrying cost, or holding cost, is the expense incurred by a company for holding inventory over a period.
This includes costs related to storage, insurance, deterioration, obsolescence, and opportunity costs of
capital tied up in inventory. The carrying cost is typically expressed as a percentage of the value of the
inventory.

Ordering Cost:

Ordering cost refers to the costs associated with placing and receiving orders for inventory. This includes
costs related to the procurement process such as order preparation, transportation, handling, and
inspection. Ordering costs decrease as the order quantity increases, but there is a trade-off between
ordering costs and carrying costs.

Lead Time:

Lead time is the time between placing an order and receiving it. It includes the time taken to process the
order, manufacture (if applicable), and deliver the goods to the business. Lead time is crucial for
managing inventory levels, as longer lead times require higher safety stock to prevent stockouts.

Purchase Cost:

Purchase cost is the cost of acquiring inventory items, including the price paid for the goods,
transportation costs, and any other expenses directly related to the purchase. This cost does not include
storage or ordering costs, which are considered separately.

Reorder Point (ROP):

The reorder point is the inventory level at which a new order should be placed to replenish stock before
it runs out. It is calculated based on the lead time demand (demand during the lead time) and the
desired level of safety stock. Once inventory reaches this point, a reorder is triggered to avoid stockouts.
Ordering:

Ordering refers to the act of placing a request for inventory with a supplier to replenish stock. The
frequency and size of orders depend on various factors such as demand, lead time, and inventory
management strategy.

Cycle Stock:

Cycle stock is the portion of inventory that is regularly used or sold during the normal course of business.
It is replenished through routine ordering and is usually the result of typical demand. The amount of
cycle stock is based on average usage and order intervals.

Safety Stock:

Safety stock is the extra inventory kept on hand to protect against uncertainties in demand and lead
time. It serves as a buffer to prevent stockouts during unexpected spikes in demand or delays in the
supply chain. Safety stock is crucial when there are variations in demand or lead times.

2. Functions of Inventory:

Inventory plays several critical functions in business operations:

Decoupling Function:

Inventory helps decouple production processes that are not synchronized. This ensures that production
can continue even if one part of the production process experiences delays or disruptions.

Balancing Supply and Demand:

Inventory helps balance supply and demand. By maintaining an adequate amount of inventory,
companies can ensure they meet customer demand even if there are fluctuations in supply or lead time.

Buffer Against Uncertainty:

Inventory acts as a buffer against the uncertainties of demand and supply. It helps mitigate the impact of
variations in production schedules, supplier delays, or unforeseen spikes in demand.

Economies of Scale:
By purchasing in bulk and maintaining inventory, businesses can take advantage of economies of scale,
reducing per-unit costs for production and purchasing.

Seasonal Demand:

Inventory helps firms manage seasonal demand by allowing them to produce and stock goods in
advance of peak demand periods.

Enabling Smooth Production:

Inventory ensures that production can continue without interruption, even if there are delays in the
arrival of raw materials or components.

3. Types of Inventory:

Raw Materials:

Raw materials are the basic inputs needed for production. These are unprocessed materials that are
transformed into finished products through the manufacturing process.

Work-in-Progress (WIP):

WIP inventory includes partially finished goods that are at various stages of the production process.
These items are in between raw materials and finished goods.

Finished Goods:

Finished goods are products that have completed the manufacturing process and are ready for sale to
customers. They are the final output of production.

Maintenance, Repair, and Operating (MRO) Supplies:

MRO supplies include items that are used to maintain or repair production equipment and facilities.
These items are not part of the product itself but are necessary for the smooth operation of production
processes.

Transit Inventory:
Transit inventory refers to goods that are in transit between locations, such as from suppliers to
warehouses or from warehouses to retail stores. These goods are not available for sale until they reach
their destination.

4. ABC Classification of Inventory: (PDF page 558)

The ABC classification is a method used to categorize inventory based on its importance to the business.
It divides inventory into three categories:

A-items: These are high-value items that account for a significant portion of the total value of inventory,
but they represent a small proportion of the total number of items. These require close monitoring and
control.

B-items: These are of moderate value and make up a moderate proportion of the total inventory value.
B-items are managed with less frequent control compared to A-items.

C-items: These are low-value items that account for a large portion of the inventory count but a small
proportion of the total value. These items are typically ordered in larger quantities and require minimal
oversight.

ABC analysis helps businesses prioritize inventory management efforts, focusing on high-value items (A-
items) for more frequent review and better control.

5. EOQ (Economic Order Quantity):

EOQ is a formula used to determine the optimal order quantity that minimizes total inventory costs,
which include ordering costs and carrying costs. The EOQ formula is as follows:

𝐸
𝑂
𝑄
=

𝐷
𝑆
𝐻
EOQ=

2DS

Where:

D = Annual demand for the product

S = Ordering cost per order

H = Holding or carrying cost per unit per year

EOQ helps businesses determine the ideal order size that minimizes the total cost of ordering and
carrying inventory, balancing the need to place orders and the cost of holding inventory.

6. EOQ Assumptions and Limitations:

Assumptions:

Demand is constant and known.

Ordering cost and carrying cost are fixed.

Lead time is constant.

The order quantity is the same for every order.

There is no quantity discount.

Limitations:

Inflexibility in Demand: EOQ assumes that demand is constant, which may not be the case in real-world
scenarios where demand fluctuates.

No Quantity Discounts: The EOQ model does not account for potential discounts offered by suppliers for
larger order quantities.
Fixed Costs Assumption: It assumes that ordering costs and holding costs are constant, which may not
hold true as businesses experience economies of scale or changes in storage conditions.

Does Not Account for Stockouts or Safety Stock: EOQ assumes no disruptions, but businesses often face
supply chain issues or demand spikes, requiring safety stock to be considered separately.

7. Reorder Point Ordering:

Reorder point ordering refers to the inventory level at which a new order should be placed to avoid
running out of stock. The reorder point is typically calculated as:

𝑅
𝑂
𝑃
=

𝐷
𝑒
𝑚
𝑎
𝑛
𝑑

𝑝
𝑒
𝑟

𝑝
𝑒
𝑟
𝑖
𝑜
𝑑
)

𝐿
𝑒
𝑎
𝑑
𝑡
𝑖
𝑚
𝑒
)

ROP=(Demandperperiod)×(Leadtime)

Where:

Demand per period is the average usage of inventory per unit of time (e.g., per day, week, or month).

Lead time is the time it takes to receive an order after placing it.

The reorder point ensures that new stock arrives before existing stock runs out, preventing stockouts and
production delays. It can also be adjusted by adding safety stock to account for variability in demand or
lead time. If the lead time is long or demand fluctuates significantly, businesses may maintain higher
safety stock levels to avoid stockouts.