INVENTORY ANALYSIS

INTRODUCTION
Inventory or stock refers to the goods and materials that a business holds for the
ultimate purpose of resale (or repair).
Inventory management is a science primarily about specifying the shape and
percentage of stocked goods. It is required at different locations within a facility or
within many locations of a supply network to precede the regular and planned
course of production and stock of materials.
Inventory analysis refers to a technique that is used to determine a companys
optimum level of inventory. This ensures that a company has the appropriate
amounts of inventory at any given time.
Inventory is an important aspect of a companys operations, and usually consists of
finished products, raw materials and work in process. It takes up significant
amounts of a companys expenses, thus it needs to be controlled effectively. Too
much inventory can seriously deplete a companys financial resources, while low
inventory levels can bring a companys operations to a halt. In performing an
inventory analysis, the company ensures that it has the appropriate levels of
inventory in order to operate efficiently.
The inventory of a given company mainly depends of the type of business that it is
involved in, thus different companies have different types of inventory.Inventory
analysis is usually conducted not only to increase efficiency, but also to support a
companys strategic plan. As indicated earlier, inventory takes up significant
financial resources of a company; therefore, it needs to be planned for in advance.
You can envision a situation in which a company does not include inventory
analysis in its strategic plan. There will certainly be excess or insufficient
allocation of resources, which will both impact the company negatively.
Using inventory analysis, a company is able to identify what to purchase, when to
purchase and the amount of inventory to be purchased. If a company cannot be
able to determine what to purchase, when and in what amounts, it will not be able
to meet the customers needs sufficiently. In view of this, failure to perform an
inventory analysis will have a negative impact on the companys profitability.
Inventory analysis also enables a company to determine what to sell and what to
discard. In this regard, to discard inventory does not entail throwing it away as you
would something that you do not need. Instead, it usually involves selling products
at a cheaper price, particularly if such products can easily become obsolete.
Although selling them at a cheaper price may not be in the companys best
interests, it is certainly better than having obsolete inventory that no one will buy.
This also creates room for new inventory, helping to save on storage costs.
In the absence of inventory analysis, a company may incur heavy losses through
obsolete inventory, in addition to unnecessary storage costs.Companies also use
inventory analysis in order to assess their performance. This is done by assessing
the flow of different types of inventory through the company. You need to realize
that each type of inventory in a company is aimed at enhancing its profitability in
the long term. If, for instance, there is a shortage of finished products despite the
presence of enough raw materials, it shows that there is a problem in the
production process. In assessing its inventory therefore, a company can identify
areas that need improvement. Inventory analysis usually has significant
implications for a companys performance; hence it should be a top priority for all
companies.
Careful inventory management is critical to the financial health of businesses
whose primary venture is manufacturing or retailing. In retail and manufacturing
companies, huge amounts of time and money are expended in keeping and
managing inventory. Many of the techniques that we have applied to tables,
graphs, and what-if analysis also apply to inventory analysis. We need to
understand the situation, develop a spreadsheet model, then apply the results of the
model to the decision making process.

There are three basic types of inventory - raw materials, work-in-process, finished
good. Our analysis may apply to any of the three with minor variations. The
principle remains the same. Another way to differentiate inventory is by its use.
There are four basic uses - cycle inventory, safety stock, anticipation inventory,
and in-transit inventory. You may have also heard about independent and
dependent demand inventories. We will work with independent demand in our
analysis. Independent demand is most frequently associated with
Finished goods where the demand is more or less unknown. Dependent demand
inventory is associated with MRP systems and bills of materials
The costs associated with inventory fall into two broad categories or components.
All the costs associated with carrying too much inventory can be "lumped"
together; we will call this the holding cost component. All the costs associated with
carrying too little inventory can also be "lumped" together; we will call this the
ordering cost component. Some costs which may be included in the holding cost
component are:

opportunity cost
taxes
insurance
storage
shrinkage
Some costs which may be included in the ordering cost component are:
ordering costs
set-up costs
transportation costs
small lot costs
stockouts and backorders

We will first build a mathematical (analytical) model. Following typical
conventions, we will need some descriptions and shorthand notation for variables
used in the model.

Order quantity (Q) - Number of units ordered, also called the lot or batch size.

Demand (D) - Usually the annual demand. You may need to convert available
information to annualized data.

Item Cost (C) - Purchase price of raw materials or value of finished goods or WIP.

Carrying charge rate (i) - Composite % or decimal fraction of the item's cost that
reflects the cost of keeping one unit in inventory for one year. Usually, but not
always, expressed in % per unit per year.

Holding Cost per unit (H) - Cost, in dollars, to keep one unit in inventory for one
year, H = i x C.
Make sure you don't confuse this with the holding cost component.

Ordering Cost (Co) - Cost to place one order, not to be confused with the Ordering
Cost Component. Frequently, this is designated S, the set-up cost, when dealing
with WIP or finished goods inventory.

Lead Time (LT) - The time that elapses between placing an order and receipt of
that order.

ReOrder Point (ROP) - The on-hand inventory level at which we should place the
order for the next batch.

Stockout Cost (S)- The cost incurred when there is insufficient inventory.

TYPES OF INVENTORY MODELS

1. Simple inventory model

In this model we assume:
1. Supply: the ordered items arrive instantaneously
2. We do not allow any shortages, i.e. we do not take any backorders and the sale is lost
3. Demand: constant and known
4. There is a constant cost for each item we obtain from the supplier
5. The quantity we order is always going to be the same
In this model we have already noted that orders only need to be placed when inventory
falls to zero. That is, the reorder level is 0; we only
need to calculate the quantity we need to order.


2. Backorder Model, i.e. Shortages are now allowed

A backorder occurs when a customer is prepared to wait for items when the stock level
has fallen to zero, i.e. the item is out of stock.
When stock does arrive the customers who have placed a backorder are served first. Thus
eventually all demand is satisfied. There is however a cost associated with taking
backorders. This cost is expressed as an annual penalty,
p for each item short. The backorder model results in an overall smaller average
inventory and will thus have a lower total annual cost than a policy not allowing
backorders. If this were not so, a company would simply not take any backorders.


3. Specifying a Service Level

This is a method of determining inventory policy in a Backorder Model by specifying the
proportion of demand that is met on time, that is, when the backorders have been dealt
with. This can also be related to the proportion of time inventory is at a positive level.
Either of these measures can be related to the shortage penalty, p, defined earlier.


4. QUANTITY DISCOUNT

Quantity discount is the case when the cost of an item purchased does not remain
constant. That is, discounts on the unit price are offered for larger orders .This means that
we can no longer ignore the annual purchasing cost when we compute the order quantity
that minimises the total annual cost, since the purchase cost depends on order quantity. If
the holding cost is expressed as a percentage of an items purchasing cost, the annual
holding cost will also depend on the size of the order.

5. Production Model

For this particular model the orders are not filled instantaneously. Instead, ordered
material arrives at a constant rate until the complete order has been filled. The arrival rate
of material then drops to zero until the inventory level drops to zero. A new cycle then
starts. We assume there will be no backorders. Note that the arrival rate of ordered material
must exceed the demand rate.