Inventory Management

Compiled by Fisseha kebede

January 2018
THIS TRAINING MATERIAL ENABLES THE
TRAINEE GRASP THE MAJOR TECHNICS OF
INVENTORY MANAGEMENT AND THEREBY
EXERCIS THEM IN THE REAL WORK AND BRING
REMARKABLE CHANGE ON THE CURRENT
PROBLEMS THAT ARE SEEN IN THE
DEPARTMENT
 Training objectives
• Define the term inventory and list the major reasons for holding
inventories; and list the main requirements for effective inventory
management.
• Costs associated with inventory
• Optimum inventory
-when to order
-How much to order
-Lead time
-safety stock
-Max-min
-Minimum stock
• Selective control techniques/ABC,FSN,VED/
• Inventory counting techniques
What is inventory?
Inventory is the raw materials, component parts,
work-in-process, or finished products that held at a
location in the supply chain
Inventory is the quantity of goods ,raw materials
or other resources that are idle at any given point of
time.
 In simple words ‘inventory’ refers to stocks held by the firm
Consists of :
• Raw materials
•Component parts
•Supplies
•WIP
•Finished goods
Types of Inventories
 Need for Inventory

• Ensuring a constant rate of production for the

firm.
• To gain economies in purchasing beyond
current requirement
• To carry a reserve in order to prevent stock out
• To maintain service stocks while replacement
stocks are in transit
• To protect against variation in demand
Why do we care?

– It accounts our company biggest asset/70-75%/

– Sales growth: right inventory at the right place
at the right time
– Cost reduction: less money tied up in inventory,
inventory management, obsolescence

Higher profit
Contradicting ideas on inventory
 Inventory management
These the above ideas of inventory call for an effective management
• So, inventory management can be defined as the process
of planning, organizing, directing and controlling of the
inventory resource as to ensure optimum level.
• Harmonizing the two contradicting views of inventory.
• Answers-What should be done? to balance of
inventory which is neither excessive nor
inadequate.
• Inventory Management is “the art and science of
managing to have the right product, at the RIGHT TIME
and place, in exactly the right amount, at the best
possible price”.
 Symptoms of poor inventory management
• High rate of order cancelation
• Excessive down time due to material shortage
• Periodic lack of adequate storage space
• Disposal of obsolete & slow moving items
• Large write downs at the time of physical count
• Continuous growing inventory quantities
• Inability to meet delivery schedule
• Uneven production
 A systems approach for inventory
management
These are
 Better forecasting /material planning/
 Fewer varieties
 Centralized inventories
 Developing batch of reliable vendors
 Motivating and capacitating inventory staff
 Effective follow up
 Control through reports at regular frequency
 Effective budgetary control
 Following the scientific tools like EOQ,SELECTIVE COTROL
TECHNIQUES ETC
 Inventory control
Our major focus here is the control part of the over all inventory
management
– Inventory control is the means by which materials of the correct
quantity and quality is made available as and when required with
due regard to economy in storage & ordering costs & working
capital
• Defined as :
 The systematic location, storage & recording of goods in such a
way that desired degree of service can be made to the operating
shops at minimum cost.
• The need of inventory control
 To smooth factory operation
 To prevent piling up of stock
 Functions of Inventory control

Following are the most important functions of

inventory control
 To run the stores effectively
 To ensure timely availability of material and avoid build up of
stock levels
 Technical responsibility for the state of materials
 Maintenance of specified raw materials
 Protecting the inventory from lose due to improper handling
&storing of goods &unauthorized removal from stores
 Pricing all material supplied to the shops as to estimate the material
cost.
 Physical verification ,maintenance records ordering policies
 Advantage of inventory control

• It creates buffer between input & out put

• It ensures against delays in deliveries
• It allows for possible increase in out outs
• It allows advantage of quantity discounts
• It ensures against scarcity of materials in the
market
• It utilizes the benefit of price fluctuation
 Selective Inventory Management
(SIM):
 Therefore, to ensure optimum level of inventory, several classifications are
employed to render selective treatment to different types of inventory each
classification emphasize on a particular aspect.
The right choice of a method depends upon several factors like
 Optimum level/optimum cost/EOQ/
 price of the item, ABC
 Criticality-VED
 Consumption-FSN
 lead time
 procurement difficulties, etc.
 Economic Order Quantity (EOQ) Model:
The primary function of inventory management is to determine
(a) When to order? and
(b) How much to order?
Re-order level:
‘When to order’ is an important query which requires suitable answer. Buying and
issuing the inventories are the foremost tasks of all types of organizations.
Re-order level = Average usage x Lead time
i.e., R = Au L
Re-order point example:
Demand = 10000 units/year
Store open = 320 days/year
Average usage (Au) = 10000/320=33.33 units/day
Lead time (L) = 10 days
R = AuL = (33.33) (10) = 333.33 units
CON’T…
• How much to order?
After solving the problem of ‘when to order’, next immediate issue is ‘how
much to order’. Considering over-buying can lead to unproductive use of
working capital and under buying leads to unwanted emergency orders and
ultimately increases the workload of purchase department, issue of ‘how
much to order’ is of vital significance. Hence a balance is achieved by
selecting the right quantity for each order. This quantity in short is known as
Economic Order Quantity (EOQ).
• EOQ is an important technique of inventory management. The EOQ refers to
the optimal order size that will result in the lowest total of order and carrying
costs for an item of inventory given its expected usage, carrying costs and
ordering cost. By calculating an economic order quantity, the firm attempts
to determine the order size that will minimize the total inventory costs .
CON’T…

ECONOMIC ORDER OF
QUANTITY(EOQ)

PURCHASING CARRYING
COST COST
 Inventory costs
The following costs are associated with inventory
Ordering Cost
• Clerical costs of preparing purchase orders
• Some spent finding suppliers and expediting orders
• Transportation costs
• Receiving costs (E.g. unloading and inspection)
• Generally it includes costs related to the clerical work of preparing, calling, issuing, transportation, following and receiving orders,
the physical handling of goods, inspections and machine set-up costs. This cost does not depend or vary on the number ordered.

Holding Costs
• Costs of storage space (E.g. warehouse depreciation)
• Security
• Insurance
• Forgone interest on working capital tied up in inventory
• Deterioration, theft, spoilage, or obsolescence
• Generally it includes store related expenses like salaries of store keepers, electricity expenses, handling, insurance, pilferage,
breakage, obsolescence, depreciation, taxes, and the opportunity cost of capital.

Shortage Costs
• Disrupted production when raw materials are unavailable :
 Idle workers
 Extra machinery setups
• Lost sales resulting in dissatisfied customers
• Loss of quantity discounts on purchases
CON’T…
• The relationship between ordering cost and carrying cost can be
understood as follows:
Con’t…
• EOQ is simple to understand and use but it has several restrictive
assumptions which are also disadvantages in practice. Even with these
weaknesses, EOQ is a good place to start to understand inventory systems.
EOQ assumes:
1. Demand rate is constant, uniform, recurring, and known.
2. Lead time is constant and known in advance.
3. Price per unit of product is constant; no discounts are given for large orders.
4. Inventory holding cost is based on average inventory.
5. Ordering or setup costs are constant.
6. All demands will be satisfied; no stock outs are allowed.
 Con’t…
The EOQ is calculated as follows:

Where:
D = Annual Demand
C0 = Ordering cost per order
P = Unit price of an item
Cc = Percentage of annual carrying cost to the unit
A BASIC EOQ EXAMPLE:
A store keeper issues 10 cutting discs each week. Each discs costs Birr 80. The cost of placing an order
is birr.10. Holding or carrying cost is estimated to be 30% of the inventory value per year.
So the variables are defined as:

How often is the cutting discs ordered?

520/21 = 25 orders per year. Or every 15 days (365/25= 15)
What is the main insight from EOQ?

There is a tradeoff between holding costs and ordering costs

Total cost

Cost
Holding costs

Ordering costs

Order Quantity (Q*)

Economic Order Quantity - EOQ
2SD
Q =
*
H

Example:
Assume a car dealer that faces demand for 5,000 cars per year, and
that it costs $15,000 to have the cars shipped to the dealership.
Holding cost is estimated at $500 per car per year. How many
times should the dealer order, and what should be the order size?

* 2(15,000)(5,000)
Q  548
500
 If delivery is not instantaneous, but there is a lead
time L:
When to order? How much to order?
Order
Quantity
Q
Inventory

Lead Time
Time
Place Receive
order order
 If demand is known exactly, place an order when
inventory equals demand during lead time.

•Order
•Quantit Q: When shall we order?
y A: When inventory = ROP
•Q Q: How much shall we order?
Inventory

A: Q = EOQ

Reorder
Point
(ROP)
ROP = LxD

Lead Time
Time
D: demand per period
Place Receive
L: Lead time in periods
order order
Example (continued)…

What if the lead time to receive cars is 10 days?

(when should you place your order?)

Since D is given in years, first convert: 10 days = 10/365yrs

10 10
R = D = 5000 = 137
365 365

So, when the number of cars on the lot reaches 137,

order 548 more cars.
ROP = ???

Place Receive
order Lead Time order
If Actual Demand > Expected, we Stock Out
Order
Quantity

Stockout
Point
Inventory

Time

Lead Time Unfilled demand

Place Receive
order order
 To reduce stockouts we add safety stock
Inventory
Level

Ex Order Quantity
ROP = L e pe c Q = EOQ
D e ad - t t e d
Safety ma im
Stock + Expected nd e
Expected LT Demand
LT
Demand Safety Stock
Lead Time Time

Place Receive
order order
 Decide what Service Level you want to provide
(Service level = probability of NOT stocking out)

Service level Probability

of stock-out

Safety
Stock
 Safety stock =
(safety factor z)(std deviation in LT demand )

Service level Probability

of stock-out

Safety
Stock
Read z from Normal table for a given service level
 Caution: Std deviation in LT demand

Variance over multiple periods = the sum of

the variances of each period (assuming
independence)

Standard deviation over multiple periods is

the square root of the sum of the variances,
not the sum of the standard deviations!!!
 Average Inventory =
(Order Qty)/2 + Safety Stock
Inventory
Level

Order
Quantity

EOQ/2
Average
Inventory

Safety Stock (SS)

Lead Time Time

Place Receive
order order
 How to find ROP & Q
2SD
1. Order quantity Q = EOQ 
H
2. To find ROP, determine the service level (i.e., the
probability of NOT stocking out.)
 Find the safety factor from a z-table or from the graph.
 Find std deviation in LT demand: square root law.
std dev in LT demand  ( std dev in daily demand ) days in LT
 LT  D LT
 Safety stock is given by:
SS = (safety factor)(std dev in LT demand)
 Reorder point is: ROP = Expected LT demand + SS
3. Average Inventory is: SS + EOQ/2
Example (continued)…

Back to the car lot… recall that the lead time is 10 days
and the expected yearly demand is 5000. You estimate the
standard deviation of daily demand demand to be d = 6.
When should you re-order if you want to be 95% sure you
don’t run out of cars?
Since the expected yearly demand is 5000, the expected
demand over the lead time is 5000(10/365) = 137. The z-
value corresponding to a service level of 0.95 is 1.65. So
ROP 137  1.65 10(36) 168

Order 548 cars when the inventory level drops to 168.

 ABC ANALYSIS
(ABC = Always Better Control)
This is based on cost criteria.
It helps to exercise selective control when confronted with
large number of items it rationalizes the number of orders,
number of items & reduce the inventory.
About 10 % of materials consume 70 % of resources
About 20 % of materials consume 20 % of resources
About 70 % of materials consume 10 % of resources
 ‘A’ ITEMS
Small in number, but consume large amount of
resources
Must have:
•Tight control
•Rigid estimate of requirements
•Strict & closer watch
•Low safety stocks
•Managed by top management
 ‘C’ ITEMS
Larger in number, but consume lesser amount of
resources
Must have:
•Ordinary control measures
•Purchase based on usage estimates
•High safety stocks
ABC analysis does not stress on items those are less
costly but may be vital
 ANNUAL COST CUMMULATI VE
ITEM % ITEM COST %
ABC [Rs.] COST [Rs.]
1 90000 90000
10 % 70 %
A 2 50000 140000
3 20000 160000
N 4 7500 167500
20 % 20 %
A 5 7500 175000
6 5000 180000
L
7 4500 184500
Y 8 4000 188500

S 9 2750 191250
10 1750 193000
I 11 1500 194500

S 12 1500 196000
13 500 196500 10 %
70 %
14 500 197000
15 500 197500
WORK 16 500 198000
SHEET 17 500 198500
18 500 199000
19 500 199500
20 500 200000
 ‘B’ ITEM
Intermediate
Must have:
•Moderate control
•Purchase based on rigid requirements
•Reasonably strict watch & control
•Moderate safety stocks
•Managed by middle level management
 VED ANALYSIS
•Based on critical value & shortage cost of an item
–It is a subjective analysis.
•Items are classified into:
Vital:
•Shortage cannot be tolerated.
Essential:
•Shortage can be tolerated for a short period.
Desirable:
Shortage will not adversely affect, but may be using more resources.
These must be strictly Scrutinized

V E D ITEM COST

A AV AE AD CATEGORY 1 10 70%

B BV BE BD CATEGORY 2 20 20%

C CV CE CD CATEGORY 3 70 10%

CATEGORY 1 - NEEDS CLOSE MONITORING & CONTROL

CATEGORY 2 - MODERATE CONTROL.
CATEGORY 3 - NO NEED FOR CONTROL
SDE ANALYIS
Based on availability
Scarce
Managed by top level management
Maintain big safety stocks
Difficult
Maintain sufficient safety stocks
Easily available
Minimum safety stocks
FSN ANALYSIS
Based on utilization.
Fast moving.
Slow moving.
Non-moving.
Non-moving items must be periodically reviewed to prevent expiry
& obsolescence
HML ANALYSIS
Based on cost per unit
Highest
Medium
Low
This is used to keep control over consumption
at departmental level for deciding the frequency of physical verification.
 Conclusion

• The training will be given

 Practical exercises
 Group and individual assignments
 Field exercise