k,Module :

Inventory Management
Learning Objectives:
1.​ Identify the different types of inventories and their purposes
2.​ Describe the structure and parts of inventory system
3.​ Compare the cost involved in maintaining an inventory
4.​ Discuss the economic order quantity model
5.​ Compute Total annual inventory cost
6.​ Explain when to make an order for inventory replacement

Overview:
​ Inventory refers to goods held by a business for the purpose of resale. These items are
typically procured from suppliers and subsequently sold to customers. Effective inventory
management involves the systematic oversight, control, and tracking of inventory to ensure
optimal stock levels, minimize costs, and meet customer demand. It also includes implementing
safeguards to protect inventory from damage, loss, or theft, thereby maintaining operational
efficiency and financial accuracy.

Major type of inventories maintained by organizations

●​ Raw Materials
●​ Finished Goods
●​ Semi-finished Goods
●​ Spare parts/supplies

Purpose of maintaining ideal level of inventory:

●​ Protections against fluctuating demand
●​ Protections against delayed supply
●​ Protection against inflation
●​ Benefits of large quantities
●​ Primary basis for business
●​ Saving on ordering cost

Structure of Inventory System

●​ Inventory level refers to the size of the inventory or the inventory on hand.
●​ Demand and Depletion. The inventory gets depleted to serve demand. The rate of
demand is equivalent to the depletion rate. A higher rate of demand results to faster
reduction of inventory
●​ Reordering. A replenishment order is made when the inventory is reduced to a certain
level called the reorder point. A point in the inventory level that requires placing an
order.
●​ Replenishment, Shortages, and Surplus. When demand is constant reordering is
scheduled so that the replenishment will be delivered when the inventory level is fully
 depleted. When demand fluctuates and/or lead time varies, the arrival of delivering might
differ from the exact time the inventory reaches the zero level.
Shortage happens when the shipment arrives after depletion and surplus occur when the
shipment arrives before depletion.
●​ Safety Stocks and Average Inventory. A buffer or safety stocks level is established to
avoid shortages and an average inventory has to be calculated to aid managers in
decision making.

Major types of inventory cost

●​ Ordering cost is the cost of obtaining additional inventories and also expenses pertaining
to placing an order.
​ Total Annual Cost/number of times an order was made
●​ Holding Cost or carrying cost is the cost of keeping inventory in hand. It also include cost
to maintain data and the expense for physical inventory. It is expressed in terms of cost
per year or as a percentage of value of the inventory.
●​ Storage (or Stock Out) Costs.
●​ Item Cost also called unit cost, the price paid for one unit of product under consideration.

Economic Order Quantity (EOQ) Model

​ EOQ is an approach to build an idealized inventory system and calculate a fixed order
quantity that minimizes total quantity. It was developed by Ford W. Harris in 1913, but R.H.
Wilson who was given credit for establishing an in-depth analysis of the model. At the EOQ
level, the total cost of inventory is at its optimal level.

Two important questions answer by this model relative to inventory management:

1.​ How much goods should be ordered?
2.​ When should an order be made?

Assumptions of EOQ Model

1.​ The demand is considered normal and constant.
2.​ The ordering cost, carrying cost and purchase price are constant and not dependent on
the quantity ordered.
3.​ Shortages do not exist.
4.​ The lead time is constant.
5.​ The order quantity is the same for each order.

EOQ Formula:

​
Where:
​ EOQ - economic order quantity​ ​ D - annual demand
​ OC - ordering cost per unit ​ ​ ​ HC or CC - carrying cost per unit

At EOQ the total ordering and carrying cost are equal.

Formula:​
1.​ TAIC = TOC + TCC
​
Where:
TAIC - Total annual inventory cost
​ TOC - total ordering cost
​ TCC - total carrying cost

2.​ TCC = AI x CC

Where:
​ TCC - total carrying cost
​ AI - average inventory
​ CC - carrying cost per unit

3.​ AI = EOQ
2
4.​ TOC = (D/EOQ)(OC)
​
​ Where:
​ TOC - total ordering cost​ ​ D - annual demand
​ EOQ - economic order quantity​ OC - ordering cost
​
​ Therefore:
​ ​ TAIC = TCC + TOC
​ ​ = (½ EOQ) (CC) + (D/EOQ) (OC)

​ Note: EOQ is the optimal level when making an order.

​ ​ High total inventory cost when order is > EOQ

When to place and order?

Reorder point or a point in the

●​ Lead time is the time required between placing an order and its receipt by a business
●​ Lead time usage is the number of units demanded or consumed during the lead time
period

Formula to Order time

 1.​ Reorder Point (ROP) = ALTU + SS
Where:​ROP ​ - reorder point
ALTU​ - average lead time usage
SS​ - safety stock

2.​ Average Lead Time Usage (ALTU) = LT x (AU/UT)

where:​​ ALTU​ - average lead time usage
​ ​ LT​ - lead time
​ ​ AU/UT​- average usage per unit time

3.​ Average Unit per Unit of Time (AU/UT) = .​ D .

​ ​ ​ ​ ​ ​ WD/Y
Where:​D​ - annual demand
WD/Y​ - working days per year
​
4.​ Total Number of Orders Placed in a year (TNO/Y) = D
EOQ​
Where: ​ D​ - Annual Demand
EOQ​ - economic quantity order
​ ​ ​ ​
5.​ Cycle Time (CT) = WD/Y x EOQ
​ ​ ​ ​ D
​ Where:​WD/Y​ - working days per year
​ ​ ​ EOQ​ - economic quantity order
​ ​ ​ D​ - annual demand
​ Cycle time refers to the period between orders.

Illustrative Problem

​ The average annual requirement of a business product is 48,000 units. The purchase
cost per unit is P20, the cost per order is P60, and the carrying cost is 20% of the unit cost. The
business has 300 normal working days and experiences a six-day lead time. It maintains a
safety stocks of 2000 units.

Determine the following:

1.​ Economic order quantity
2.​ Total carrying cost
3.​ Total ordering cost
4.​ Total annual inventory cost
5.​ Average lead time usage
6.​ Reorder poitnt
7.​ Total number of orders in a year
8.​ Cycle time
Solution:

1.​ Economic Order Quantity

​
​ ​ = 2 x 48,000 x 60
​ ​ ​ (20 x 20%)

​ ​ = 1,440,000
​ ​
​ EOQ​ = 1,200 units

2.​ Total Carrying cost = AI x CC

​ Where: Average Inventory = EOQ/2
AI = 1,200/2
=P 600
​
​ Total Carrying cost = AI x CC
​ ​ TCC = 600 x 4
​ ​ TCC =P 2,400

3.​ Total Ordering Cost (TOC) = (D/EOQ)(OC)

​ ​ ​ ​ = (48,000/1,200) (60)
​ ​ ​ ​ = P 2,400

4.​ Total Annual Inventory Cost (TAIC) = TOC + TCC

​ ​ ​ ​ = 2,400 + 2,400
​ ​ ​ ​ TAIC = 4,800

5.​ Average Lead Time Usage (ALTU) = LT x (AU/UT)

Where: (AU/UT) = .​ D . 48,000
​ ​ ​ WD/Y 300
​ ​ = 160 unit

Therefore : (ALTU) = LT x (AU/UT)

​ ​ = 6days x 160
​ ALTU = 960

6.​ Reorder Point (ROP) = ALTU + SS

​ ​ ​ = 960 + 2,000
​ ​ ​ = 2,960
 7.​ Total Number of Orders Placed in a year (TNO/Y) = D
EOQ
= 48,000
1,200
= 40

8.​ Cycle Time (CT) = WD/Y x EOQ

​ ​ ​ ​ D
​ ​ = 300 x 1,200
​ ​ ​ 48,000
​ ​ = 7.5