Inventory

Management
Managing Operations and supply
Chain
 Inventory
• An inventory is a stock or store of goods.
• The amounts and dollar values of inventories carried by different types of firms
vary widely. A typical firm probably has 30% of its current asset and 90% of its
working capital invested in inventory.
Return On Investment (ROI) = Profit After Tax /
Total Asset

Different kinds of inventories -

 Raw materials and purchased parts (Clay used in tiles production firms)

 Work in Progress - WIP (Tiles under production)

 Finished good inventories (Ready tiles)

 Replacement parts, tools and supplies (Replacing defective tiles)

 Goods in transit to warehouses or customers - Pipeline inventory (Tiles for

sale)
Functions of Inventory (Why we need it)

 To meet anticipated customer demand

 To smooth production requirements
 To decouple operations
 To protect against stockout
 To take advantage of order cycles
 To hedge against price increase
 To permit operations
 To take advantage of quantity discount
 Inventory Counting System

 Periodic System – Under this system a physical count of the items in

inventory is made at periodic intervals (e.g. – weekly, monthly) to
determine how much to order.
 Many small retailers use this approach.
 An advantage of this system is that orders for many items occur at the
same time and helps to save ordering and shipping cost.
 One of the major disadvantage is the shortages between review
 Perpetual
periods.Inventory System – This system keeps track of removals from
inventory on a continuous basis, so the system can provide information on
the current level of inventory for each item.
 An obvious advantage is continuous monitoring of inventory
withdrawals. Also helps to order optimum quantity.
 One disadvantage of this system is added cost of record keeping.

 Two-Bin System: Two Containers of inventory; reorder when the first is

empty.
 Inventory Counting System

Universal Product Code or Bar Code – Universal product code or bar

code printed on a label that has information about the item to which it is
attached.

Identifies
Product 0
Category

21480 320877 Indicates the

0 68 specific Item
Radio
Frequency
Identification
System will
replace UPC Identifies
in near future Manufacturer
 Requirements for Effective Inventory Management

 A system to keep track of the inventory on hand and on order.

 A reliable forecast of demand that includes an indication of possible forecast
error.
 Knowledge of lead times and lead time variability.
 Reasonable estimates of inventory holding costs, ordering costs and shortage
costs.
 A classification system for inventory requirements.
ABC classification and inventory analysis
 ABC classification, based on Pareto’s principle or the 80/20 rule, assumes that 20% of
the items in a list will account for 80% of the significant measurement.
 For example, in a shopping list, 80% of the cost will be due to only a few high-cost
purchases such as oil, milk. Other items such as bread, vegetable, pasta etc. will be
relatively low in cost.
A Category Items Comprise 20% of SKU & Contribute to 70% of
$ spend.
B Category Items Comprise 30% of SKU & Contribute to 25%
of $ spend.
 ABC Classification Example

Item Annual Unit Cost Annual Classificatio Annual Classificati

No. Deman ($) Dollar Value n Dollar Value on
d ($) ($)
8 1000 4000 4,000,000 A
5 3900 700 2,730,000 A
3 1900 500 950,000 B
6 1000 915 915,000 B
1 2500 330 825,000 B
4 1500 100 150,000 C
12 400 300 120,000 C
11 500 200 100,000 C
9 8000 10 80,000 C
2 1000 70 70,000 C
7 200 210 42,000 C
10 9000 2 18,000 C
 ABC Classification Example

Annual Percentage of Unit

Unit cost Usage in Item Usage
Item unit total dollar Cost($)
($) dollar
usage usage
K34 50 1200
PA
5,000 1.50 7,500 2.94
01 K35 20 400
PA
1,500 8.00 12,000 4.71 K36 72 300
02
PA M10 160 400
10,000 10.50 105,000 41.22
03
PA M20 40 600
6,000 2.00 12,000 4.71
04 Z45 60 1600
PA
7,500 0.50 3,750 1.47 F14 40 160
05
PA
6,000 13.60 81,600 32.03
06
PA Do it Home
5,000 0.75 3,750 1.47
07
PA
4,500 1.25 5,625 2.21
08
PA
 Benefits of ABC Classification

Area of use Benefit of ABC classification system

Cycle Counting Using ABC classification in cycle counting, A class items will be counted more
Frequency frequently than B or C class items.

Order quantity and safety stock levels are established according to the
Customer Service criticality and cost of each item. Generally this is approached from a dollar
accuracy perspective.
The engineering department may use ABC classification to identify items
Engineering
of high cost or high usage and concentrate their efforts accordingly. There is
Priorities
little point re-engineering products of little value or low usage.
Inventory replenishment systems will vary according to the importance of the
inventory items. For example, C class items may be controlled with a simple
Replenishment
two-bin system if they are not particularly bulky. This minimizes the cost of
Systems
control and replenishment and does not significantly increase inventory
carrying costs.
As A class items form a larger investment in inventory, these items are closely
analyzed to ensure appropriate order quantities and safety stocks are used. A
Investment
class items are always the focus of attempts to improve inventory turns as
Decisions
changes in the way A class items are procured and managed will have the
most significant effect on the overall inventory investment level
 Inventory Costs

Three basic costs are associated with inventories:

Holding or Carrying Cost – The cost to carry an item in inventory for a length
of time.
 Holding or carrying cost is a variable cost. Costs include warehousing cost
(heat, light, rent, security), insurance, spoilage, breakage cost etc.
 Typically annual holding costs range from 20% to 40% of the value of an item.

Ordering Cost – Ordering costs are the costs of ordering and receiving
inventory.
 Ordering cost is a fixed type cost. Costs include invoice cost, shipping cost,
inspection cost etc.

a d T i me -
Shortage Cost – Costs resulting when demand texceeds
L e
e rval the supply of inventory
tim e i n
(Result – Not making a sale, loss of customer goodwill etc.).
between
g and
orderin
e c e i vi n g the
r
order
 Inventory Costs

Holding
Annual Carrying/Holding
costs are
Cost: linearly
Annual Holding Cost : related to
order size
Where,
Q = Order quantity in units
H = Holding (or carrying)
cost per unit
Total Cost = Annual Holding Cost + Ordering
Cost

Ordering Cost:
Ordering Cost :
Ordering
costs are
Where, inversely and
Q = Order quantity in units nonlinearly
D = Demand, in units per year related to
S = Ordering cost order size
 Economic Order Quantity (EOQ)

Economic Order Quantity (EOQ)

- EOQ is a fixed order size that will
minimize the sum of the annual
costs of holding inventory and
ordering inventory.

Deriving the EOQ:

Using calculus, we take the derivative of the total cost function and set the
derivative (slope) equal to zero and solve for Q.

Total Cost = Annual Holding Cost + Ordering Cost ()

The total cost curve

√ √
𝟐 𝑫𝑺 𝟐 ( 𝑨𝒏𝒏𝒖𝒂𝒍 𝑫𝒆𝒎𝒂𝒏𝒅 ) (𝑶𝒓𝒅𝒆𝒓 𝑪𝒐𝒔𝒕 ) reaches its minimum
𝑸 𝑶𝒑𝒕 = = where the carrying and
𝑯 𝑨𝒏𝒏𝒖𝒂𝒍 𝑯𝒐𝒍𝒅𝒊𝒏𝒈 𝑪𝒐𝒔𝒕 ordering costs are
equal.
 Math on EOQ

A local distributor of National Tire company expects to sell 9600 tires next
year. Annual carrying cost is $16 per tire and ordering cost is $75. The
distributor operates 288 days a year.

a) Calculate the EOQ.

b) How many times per year does the store reorder?
c) What is the length of the order cycle.
d) Calculate the total annual cost.