INVENTORY PLANNING

& CONTROL
Introduction
 The term inventory denotes any idle resource that could be put to some future use.
 Inventories are materials and supplies that a business or institution carries either for
sale or to provide inputs or supplies to the production process.
 All businesses and institutions requires inventories. Often they are a substantial
part of total assets.
 As inventories are used, their values are converted into cash, which improves the
cash flow and return on investment.
 There is a cost for carrying inventories, which increases operating cost and
decreases profit. Good inventory management is essential.
 Inventory management is responsible for planning and controlling inventory from
the raw material stage to the customer.
Continuous & Intermittent Demand system
 If supply met demand exactly, there would be little need for inventory. Goods could be
made at the same rate as demand and inventory would built up. For this situation to exist,
demand must be predictable, stable, and relatively constant over long time period.
 Finished goods and spare parts typically belongs to independent demand items in
manufacturing organization. Independent demand items are in continuous demand.
 When there is a continuous demand for an item, constant availability of items and periodic
replenishment of stock are important elements of planning process.
 Non-availability of items translates into lost of sales, poor customer goodwill and
additional costs of servicing the promised deliveries.
 When events corresponding to positive demand occurs only sporadically, we refer to
demand intermittent.
 When the average size of customer order is large, a continuous distribution is suitable
description.
 The intermittent demand pattern makes it difficult to accurately estimate the safety stock
and service level inventory requirements needed for successful supply chain planning.
Because forecasts of intermittent demand have been so unreliable.
Independent vs. Dependent Demand

 Independent demand items are finished goods or

other items sold to someone outside the company
 Dependent demand items are materials or
component parts used in the production of another
item (e.g., finished product)
Need for Inventory
 Inventory is necessary part of any business. In order to manage
properly a good database system is required and this should be
kept up-to-date and take into account lead time for orders.
 Some Functions of inventories are;
 To protect against unpredictable variations (fluctuations) in demand
and supply.
 To take advantage of price discounts by bulk purchases.
 To take advantage of batches and longer production run.
 To provide flexibility to allow changes in production plan in view of
changes in demands, etc.
 To facilitate intermittent production
 The advantages include,
 Inventory allows customers to be served quickly and conveniently
(otherwise you would have to make everything as the customer requested
it).
 Inventory can be used so a company can buy in bulk, which is usually
cheaper.
 Inventory allows operations to meet unexpected surges in demand.
 Inventory is an insurance if there is an unexpected interruption in supply
from outside the operation or within the operation.
 Inventory allows different parts of the operation to be ‘decoupled’. This
means that they can operate independently to suit their own constraints and
convenience while the stock of items between them absorbs short-term
differences between supply and demand. In many ways this is the most
significant advantage of inventory.
 The disadvantages of inventory include,
 It is expensive. Keeping inventory means the company has to fund the
gap between paying for the stock to be produced and getting revenue
in by selling it. This is known as working capital. There is also the cost
of keeping the stock in warehouses or containers.
 Items can deteriorate while they are being kept. Clearly this is
significant for the food industry whose products have a limited life.
However, it is also an issue for any other company because stock could
be accidentally damaged while it is being stored.
 Products can become obsolescent while they are being stored. Fashion
may change or commercial rivals may introduce better products.
 Stock is confusing. Large piles of inventory around the place need to
be managed. They need to be counted, looked after and so on
Types of Inventory
 There are five types of inventory normally found in
organizations;
1. Seasonal Inventory
2. Decoupling Inventory
3. Cyclic inventory
4. Pipeline Inventory
5. Safety Stock
Seasonal Inventory
 Organizations carry inventory to meet fluctuations in demand
arising out of seasonality.
 During festival periods, the demand for consumer durables may be
high due to increase in disposable income in the hands of
consumers.
 In order to meet this surge in demand, inventory build up happens
during non-peak periods.
 Similarly, in a fast food restaurant, certain amount of inventory
build up happens during non-peak hours to handle the increase in
demand during peak hours.
 In all these cases, inventory plays the crucial role of addressing
short-term capacity issues in the organization.
Decoupling Inventory
 Manufacturing systems typically involve a series of production and
assembly workstations. Raw material passes through these stages before it
is converted into finished goods.
 Since each stage behaves idiosyncratically (uniquely) on account of
varying process time, downtimes and resource availability, planning and
control of such multi-stage production process becomes very complex.
 One way to simplify the production planning and control problem is to
decouple successive stages using inventory at some intermediate points.
 Each stage will have an input buffer and output buffer.
 The output buffer of preceding stage becomes the input buffer of
succeeding stage.
 Inventory decisions in this case require analysis of workstation capacities,
resource availability and bottlenecks.
Cyclic Inventory
 It is customary for organisations to order inventory in repeated
cycles and consume them over time.
 For e.g., a hospital may order disposable syringes in quantities of
10000. If consumption pattern is on an average 500 per day, then it
takes 20 days to deplete one order. On 21st day another order of
10000 will arrive and it will be consumed over the next 20 days
and so on.
 Cyclic inventory goes through saw-toothed pattern. Each cycle
begins with replenishment and ends with complete depletion of
inventory.
 If Q is the order quantity per cycle, I= Q+0/2= Q/2
 The average cyclic inventory
 Inventory Usage Over Time

Usage rate Average

Order inventory
quantity = Q on hand
Inventory level

(maximum Q
inventory
level) 2

Minimum
inventory
Pipeline Inventory
Safety Stock

Time
Pipeline Inventory
 Pipeline inventory pertains to the level of inventory
that organization carry in the long run due to non-zero
lead time for order, transport and receipt of material
from the suppliers.
 Due to geographical distances between the buyers and
the suppliers and host of business processes involved
in ordering and receipt of material, there is time delay
between order placement and order receipt.
 The inventory carried to take care of these delays is
known as pipeline inventory.
Pipeline Inventory
 Considering the above example pertaining to the
hospital. Suppose it takes 3-days to supply
disposable syringes. Then the hospital should place
an order at the end of day 17 in order to replenish
the stock of 10000. this means that when the
inventory level reaches 1500 ( 3-days @ 500 per
day), an order will be placed. This level of inventory
represents the reference for initiating action for
repeatedly replenishing the cyclic inventory. This is
referred to as the Re-Order Point (ROP).
Pipeline Inventory
 In general, if the lead-time for supply is L, and mean
demand per unit time is , then the pipeline inventory is L .
 In the long run, the system will always have this inventory
in order to take care of lead-time for supply. The only way
organizations can reduce this inventory is to cut-down lead-
time for procurement, production and distribution.
 Locating suppliers nearby, re-engineering the business
processes (BPR) related to procurement and distribution of
materials, using efficient alternatives for logistics are some
of the ways by which an organisation can reduce lead-time
and pipeline inventory.
Safety Stock
 Organizations also have additional investment in inventory to buffer
against uncertainties in demand and supply of raw material and
components.
 When demand is stochastic, carrying average inventory will ensure that
the demand is met only 50 percent of the times in the long run.
 However, in order to improve the availability to meet uncertain demand,
an additional quantity, known as safety stock is kept.
 The greater the investment in safety stock, the lesser are the chances of
it going out of stock. Similarly, the higher the uncertainty is, the greater
is the need for safety stock.
 Safety stock only serves to prevent the occurrence of shortages in the
short run. However, in the long-run, the demand will be tend to average
value and safety stock will not be consumed.
 INVENTORY
If you are producing the inventory
CYCLE instead of buying it, the order
arrives over time rather than all at
Cycle Inventory is the once.
average of what is
cycling up and down.
In this case it’s half of
the purchased lot size,
or if you are producing
it, it is half of the Q
production lot size. Order arrives
Slope
represents the
REORDER REORDER Rate of demand
POINT POINT
ORDER
QUANTITY
OR
LOT SIZE

Reorder point may SAFETY STOCK

be determined by
the level of inventory TIME
or by the lead time. Average Inventory is cycle
LEAD inventory + safety stock.
TIME
Inventory Costs
 There are several costs associated with inventory planning
and control. These costs could be classified under three
(3) broad categories.
1. Cost of Carrying Inventory- all costs related to
maintaining inventory will be classified under this.
2. Cost of ordering- associated with ordering material and
replenishing it in cyclic intervals.
3. Cost of shortages- cost arising out of shortages.
 Inventory control model should take these into
considerations and aim at minimizing the sum of all
these costs.
 Objective is to minimize total costs

Curve for total cost of

holding and setup

Minimum
total cost
Total cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order quantity Level of Inventory (Order quantity)
Inventory Carrying Cost
 Organizations need to spend a considerable amount of money to carry
inventory.
 Most significant component is the interest for the short-term borrowable
for the working capital required for inventory investment.
 The second significant cost relates to the cost of stores and warehousing
and administrative cost related to maintaining inventory and accounting
for it.
 Investment in store-space, storage & retrieval system, software for
maintaining the inventory status and managerial & other administrative
manpower to discharge various activities related to stores will form part
of cost of stores and warehousing.
 The other costs of inventory carrying includes insurance costs, cost of
obsolescence, pilferage, damages and wastages.
Inventory Carrying Cost
 The components of inventory to carrying costs exert
considerable pressure on an organization to keep
inventory to low levels.
 However, the ability of an organization to reduce
inventory depends on the nature of business processes
in place, the lead-time for procurement and the
quantity of planning.
 It is easy to note that all these cost related to carrying
inventory are directly related to the level of inventory.
 Since the interest component is the predominant part
of Cu (inventory carrying cost per unit time), it is
usually represented Cc as % of unit cost of item.

Thus if Cu is the unit cost of item, then

Cc = iCu, where i-is in %

For an order Quantity Q the avg. inventory carried by an

organization is Q/2

Therefore,
The cost associated with carrying inventories is (Q/2 * Cc)
Cost of ordering
 Replenishment of cyclic inventory is achieved by ordering
material with the suppliers. Organization performs series of
tasks related to ordering material. These includes search and
identification of appropriate sources of supply, price
negotiation, contracting and purchase order generation,
follow-up & receipt of material and eventual stocking in the
stores after necessary accounting and verification.
 All these involves manpower, resources and time that could
be classified under cost of ordering.
 Since several of these costs are fixed in nature, placing a
larger order quantity could reduce the total costs of ordering.
Cost of ordering
 A larger order quantity Q will require less number of
orders to meet a known demand D, and vice-versa.
 The number of orders to be placed to satisfy a
demand is D/Q.
If Co denotes the cost of ordering per order, then;
The total ordering cost = (D/Q * Co)
 Cost of Carrying and cost of ordering are
fundamentally two opposing cost structures in
inventory planning.
Cost of shortages
 Despite careful planning, it is likely that organization run out of stock.
 This disrupts production and has a cascading effect down the supply chain.
 Delivery schedules are missed, leading to customer dissatisfaction and loss
of goodwill.
 It is also introduces additional costs arises out of purchasing the order back
and rescheduling the production system to accommodate these changes.
 Rush purchases, uneven utilization of available resources and lower
capacity utilization escalate the costs further in the system.
 All these form part of cost of shortage.
 The cost of shortage per unit is denoted by Cs. Since the effects of shortage
are vastly intangible, it is indeed difficult to accurately estimate Cs.
 In practice, managers tend to use other measures to incorporate the cost of
shortage if estimation of Cs proves to be futile.
Three Mathematical Models for
Determining Order Quantity
 Economic Order Quantity (EOQ or Q System)
 An optimizing method used for determining order quantity
and reorder points
 Part of continuous review system which tracks on-hand
inventory each time a withdrawal is made
 Economic Production Quantity (EPQ)
 A model that allows for incremental product delivery
 Quantity Discount Model
 Modifies the EOQ process to consider cases where quantity
discounts are available
Economic Order Quantity (EOQ)
 The EOQ model is robust and could be applied in
several real life settings with some modifications.
 EOQ Assumptions:
 Demand is known & constant (with certainty) - no safety stock is
required
 Lead time is known & constant
 No quantity discounts are available
 Ordering (or setup) costs are constant
 All demand is satisfied (no shortages)
 The order quantity arrives in a single shipment
Inventory Levels
Usage rate (D)
 Inventory vs. time.
Inventory ( Q )

Reorder Point
(ROP)

time
Cycle time (T)
Lead time ( L, l )
EOQ Total Costs
Total annual costs = annual ordering costs + annual holding costs
The EOQ Model

Q= Number of pieces per order

Q*= Optimal number of pieces per order (EOQ)
D= Annual demand in units for the Inventory item
S= Setup or ordering cost for each order
H= Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order

= D (S)
Q
The EOQ Model
Q= Number of pieces per order
Q*= Optimal number of pieces per order (EOQ)
D= Annual demand in units for the Inventory item
S= Setup or ordering cost for each order
H= Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

= Q (H)
2
The EOQ Model
Q= Number of pieces per order
Q*= Optimal number of pieces per order (EOQ)
D= Annual demand in units for the Inventory item
S= Setup or ordering cost for each order
H= Holding or carrying cost per unit per year
Optimal order quantity is found when annual setup cost
equals annual holding cost
D Q
Solving for Q* S = H
Q 2
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H

2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected number Demand D

of orders =N= Order quantity = Q*

1,000
N= = 5 orders per year
200
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected time =T= days per year
between orders N

250
T= = 50 days between orders
5
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
TC = 200 ($10) + ($.50)
2

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

EOQ with discounts
 When material is purchased, suppliers often give a discount on orders over
a certain size. This can be done because larger orders reduce the supplier’s
cost; to get larger orders, they are willing to offer volume discounts. The
buyer must decide whether to accept the discount, and in doing so, must
consider relevant costs;
 Purchase cost

 Ordering costs.

 Carrying costs.

Total cost = Setup cost + Holding cost + Product cost

TC = D S + QH + PD
Q 2
Quantity Discount 2DS
Q* =
Models IP

Steps in analyzing a quantity discount

1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
Effect of Reduced Setup Costs
on Order Size and Total Costs
Quantity Discounts
PROBLEM:
A manufacturer of a hand grinder requires a special
roller bearing at the rate of 300 nos. per year. Each
bearing cost the company Rs. 36. The procurement
cost and the inventory carrying cost have been
calculated at Rs. 30 and 20% respectively.
If the supplier offers a discount of Rs. 2 per bearing
on an order of 200 or above, should higher quantity
be purchased?
 Solution:
From the data given above:
D = Annual consumption = 300 nos.
S = Procurement cost per order = Rs. 30.
Cu1 = Basic price per unit = Rs. 36
Cu2 = Discounted price per unit = Rs.34
i = Inventory carrying cost (decimals) = 0.20
The above prices are valid for the following quantities:
Price Range of quantity
Rs.36 0 < q < 200
Rs. 34 200 ≤ q
The procedural steps to determine optimal order quantity
are as under:
Step 1: Calculate EOQ at different price levels.
Two price levels are given which are valid for quantities
as shown below:
Price Range of purchase quantity EOQ Quantity to be purchased at
(Rs.) (q) the indicated price

2xDxS
Rs. 36 0 < q < 200 = Cu1 x i 50
2 x 300 x 30
= 36 x 0.20
= 50

2xDxS
Rs. 34 200 ≤ q = Cu2 x i 200
2 x 300 x 30
34x0.20
= 51
Step 2: Determine the quantity to be purchased at
each price level.
This equals EOQ or price- break- quantity. The
latter being necessary if EOQ at particular price
level works out to be lower than corresponding
price break quantity.
These have been entered in column 3 of the above
table.
Step 3: Calculate annual total cost at the quantities
fixed under step 2.
Table below shows annual total cost calculations
which are self explanatory.
 Cost elements Order quantity
50 200
1. Annual cost of 300 x 36 300 x 34
materials =10800 = 10200
(D x Cu)
1. Annual procurement 300/50 x 30 300/200 x 30
cost = 180 = 45
(D /Q x S)
1. Annual inventory ½ x 50 x 36 x 0.20 ½ x 200 x 34 x 0.20
carrying cost = 180 = 680
( ½ x Q x Cu x i)
TOTAL COST (TC) 10800+180+180= 11160 10200+45+680 = 10925

Step 4: Select an optimal purchase quantity.

From the annual total cost figures calculated above. We find that cost incurred is the
least when quantity purchase is 200 nos.
Therefore, Economic purchase quantity = 200 nos.
Inventory Control
 Managing an inventory is an issue pertaining to large
number and variety of items. Inventory control is the
technique of maintaining stock-items at desired levels.
Control of inventory is exercised by controlling
individual items called Stock-Keeping-Units (SKUs). In
controlling inventory, four questions must be answered;
1. What is the importance of the inventory item?
2. How are they to be controlled?
3. How much should be ordered?
4. When should an order be placed?
Inventory Control
 The ABC inventory classification system answers
the first two questions by determining the
importance of items and thus allowing different
levels of control based on the relative importance
of items.
 Most companies carry large number of items in
stock. To have better control at a reasonable cost, it
is helpful to classify the items according to their
importance.
ABC-Analysis
 The ABC principle is based on the observations that a small number of
items often dominate the results, achieved in any situation. (this observation was
first made by an Italian Economist, Vilfredo Pareto, and is called Pareto’s Law/ Analysis). As applied

to inventories ABC is based on the cost (value) of items consumed.

 Very high value of items are- A Class and may require higher control.

 Medium value items are- B Class

 Low value items are- C Class.

 A Items – typically 20% of the items accounting for 80% of the

inventory value-use Q system

 B Items – typically an additional 30% of the items accounting for 15%

of the inventory value-use Q or P

 C Items – Typically the remaining 50% of the items accounting for

only 5% of the inventory value-use P

Steps in making ABC-Analysis
 Establish the item characteristics that influence the
results of inventory management. This usually
annual Rupees usage but may be other criteria,
such as scarcity of material.
 Classify items into groups based on established
criteria.
 Apply degree of control in proportion to the
importance of group
Different Classification Systems
 There are numbers of classification systems besides
ABC classifications that are used in the Industry.
 HML-Analysis
 VED-Analysis
 FSN-Analysis
 SDE-Analysis
 GOLF-Analysis
 SOS-Analysis
HML-Analysis
 HML-analysis is similar to ABC analysis except the difference that
instead of “Annual Inventory turnover (usage value)”, cost per unit
(price) criterion is used.
 The items under this analysis are classified based on their prices. They
are categorized into three groups, which are as follows,
 H- high price items
 M-medium price items
 L- low price items
 Objectives:
 Determine the frequency of stock verification
 To keep control over the consumption at the department level.
 To evolve buying policy, to control purchase.
 To delegate the authority to different buyers.
VED-Analysis
 It is a classification of material used in inventory management. The
classification is based on “vitality” of the material. In this analysis:
 V-stands for Vital
 -Vital category items are those items without which the production activities or any
other activity of the company, would come to halt, or at least be drastically affected.
 E-stands for Essential
 -Essential items are those items whose stock-out cost is very high for the company.
 D-stands for Desirable
 - Desirable items are those items whose stock-out or shortage caused only minor
disruption for short duration in the production schedule. The cost incurred is very
nominal.
 In this analysis, the classification of existing inventory is based on criticality
of the items. It is mainly used in spare parts inventory.
FSN-Analysis
 Here the items are classified into;
 F-fast moving items
 S-slow moving items
 N- non-moving items
 The non-moving items are items not consumed for a long period
say 24-months. Such non-moving items block quite a lot of
capital and as such, they should be disposed of as quickly as
possible without further deteriorating.
 The classification of fast moving & slow moving items is
determined on the basis of stores turnover and it helps in proper
arrangement of stocks in stores and distribution and handling
methods.
SDE-Analysis
 In this analysis, the classification of existing inventory is based on the
items availability and purchasing problems.
 S- Scare Material, i.e. hardly available
 These materials always in shortage & difficult in procurement. Such materials
sometimes requires govt. approvals, advance payment or purchase through govt.
agencies.
 D- Difficult Material, i.e. difficult in sourcing
 These materials though not easy to procure but are available at a longer lead times.
Procurement requires advance planning & scheduling. Particular OEM spares of
Machineries falls under this category.
 E- Easy material, i.e. material available easily.
 Purchasing department classifies these materials and formulate the
strategy & policy of procurement of these items accordingly.
 So classification of material is done on level of difficulty in sourcing.
GOLF- Analysis
 This stands for Government, Open Market, Local and Foreign source of
supply.
 For many items, imports are canalized through govt. agencies (State trading
corp. Minerals & Metals Trading Corp., Indian drugs & Pharmaceuticals, etc.)
 For such items, the buying firms cannot apply any inventory control and
hence have to accept allocated quota by the govt.
 Open market category refers to those who form bulk of suppliers and
procurement is rather easy.
 Local category includes those local suppliers from whom, items can be
purchased off-the-shelf on cash purchase basis.
 Foreign category indicates foreign suppliers since an elaborate import
procedure is involved, it is better to buy imported items in bigger lots usually
covering the annual requirements.
SOS- Analysis
 SOS-Analysis is based on seasonality of items and it
classifies all the items into two categories;
 S-seasonal materials
 Perishable items (fruits & vegetables)
 Non-perishable-for longer period or season (grains)- but
price variation as per season of production
 OS- Off-seasonal Material.
 Non-seasonal material are available throughout the year
without any significant price variation. (Plastics, metals
etc.)