C h a p t e r —

INVENTORY MANAGEMENT

7.1 INTRODUCTION

Control of inventories is one of the prime concerns of management, as they often represent as much as 40% of
owner’s investment and 20% of total assets. Moreover, it cost about 20% of values of inventories to carry them for
a single year. These costs include interest on capital tied up in inventory stocks, expenses on storage, insurance
and taxes. This also includes loss due to deterioration and obsolesces. It is obvious that efficient management of
inventories results in considerable cost savings and also in operating flexibility as well as liquidity.

Many businesses go bankrupt because of holding excessive inventories. But, it does not mean that industry
should not hold inventories. An unbalance emphasis on reducing inventories cost may have unfavorable
repercussions on production, and sales. Both of them need adequate inventories in order to achieve their
performance goals. Inventory control therefore, needs close coordination with sales and production. This
emphasized a system approach to management inventories.

7.1.1 NATURE AND CLASSIFICATION OF INVENTORIES

Fundamentally inventory refers to:

- Stock of the product
- Component and accessories that make up the product
These stocks and component for a manufacturing company could be described as follows:

(a) Raw material

Every manufacturing firm processes certain raw materials into finished product. Commercial chemicals,
metals, agricultural products including jute, cotton, flour, ghee, oil etc. are raw materials. Heavily used raw
materials and those, which deteriorate in quality through passage of time such as sugar cane, are usually
purchased at short intervals to maintain production schedules. In case the supplies are not available locally
or regularly, a safety stock equal to few days (determined by manager) requirement is kept to provide
cushion against delayed delivers.

Larger the inventories of raw material, greater the production flexibility and lesser the possibility of
interruptions in operation due to stock out. But larger inventories also results in higher cost of acquiring and
carrying them as well as losses due to deterioration. Efficient management of raw material inventories
demand, if carried out balance the benefits of production flexibility against cost.

(b) Supplies
Supplies consists of material which are consumed during the manufacturing process and do not form part of
finished products. Fuel, lubricants, packaging material, stationary, furniture and fixtures are the examples of
supplies. These are also called indirect material that becomes the part of finished product.

(c) Purchase part

Purchase part represent those terms that do not require any processing before they are assembled into
finished product. E.g., a scooter manufacturer may not manufacture items like spark plugs, shock absorbers,
tiers, tubes etc. It buys them from the market or gets it from the suppliers. Large manufacturing companies
 Inventory Management

often make long-term arrangement with suppliers who make part to standard specification under the
formers’ brand name.

(d) WIP materials

WIP inventories consist of all raw material and purchase parts that have entered the manufacturing process
but not yet converted in finished goods. These inventories depend largely on the length of manufacturing
cycle e.g. brewing industries.WIP inventories also include materials in transit from one stage of production
to another. Continuous process manufacturing as in case of fertilizers, aluminum, and food products like
biscuits and noodles do not have WIP inventories. Inventories of this kind exist in other manufacturing
industries due to bottlenecks and constraints in manufacturing facility. Inventory in transit can be managed
by line balancing, good layout and efficient selection of machine

(e) Finished products

Finished product inventories consist of goods that have been manufactured but not dispatched to dealers,
distributors or customers. It includes stock hold in warehouse, owned by manufacturer as well as those with
dealers on consignment.

Finished goods inventories provide flexibility to production as well as sale. To the extent, a company carries
stock of finished goods, it can carry production schedule regarding own convenient. On the other hand, a
company aiming lower level of finished goods inventory will have to link production closely with sales to
meet the varied demand of sale. In any cases, every manufacturing enterprise has to carry a certain quantity
of finished goods inventories because production is based on the sales forecasts, which are seldom accurate.
Moreover, there is always a time lag between the timing of production and sales.

7.1.2 FUNCTIONS OF INVENTORIES : NEED TO HOLD INVENTORIES

Various kinds of inventories are maintained by business enterprises because they perform a number of vital
functions. Mainly, they provide flexibility to operations and selling, permit efficient utilization of plant and
equipment, prevent interruptions in operations due to stock out, provide a hedge against variation in supplies
and prices and enable the company to take advantage of quantity discounts and so forth. These functions of
inventories are discussed as follows:

(a) Provide flexibility to manufacturing:

Inventories reduce interdependence among various stages of operations. Raw material inventories permit
manufacturing operations to continue smoothly without interruption resulting from delays in delivers. WIP
inventories allow production process to proceed uninterrupted because of a temporary failure at a preceding
stage in operations. Finished goods inventories reduce the need of scheduling production according to sale
order. Inventories thus provide the production system flexibility on operation.

(b) Efficient utilization of production facility

In many plants, some machines have capability of producing various kinds of products for example lathe
may be used for manufacturing gears as well as bearings. Yet production of anyone product or its part does
not utilized it continuously. Most machines are generally limited to production of one item at a time. In such
case, inventories allow continuous use of common purpose machine and other facilities. A part may be
manufacture in bulk on a machine and stocked before starting operation on another part. Inventories thus
allow most efficient utilization of production facilities. They also reduced the need of investment in buying
duplicated machine unless the scale of operation needs them.

(c) Production and purchasing in economic lot sizes

Inventories allow manufacturing to plan long production runs. Manufacturing can proceed at a uniform rate
if inventories are stocked when sales are slack and are released when demand picks up. This function of
inventories become particularly important incase of products which have either seasonal demand such as air
conditioners or seasonal supply of perishable raw material as incase of fruit canning and sugar industries.
Products are manufactured in economic lot sizes and store in anticipation of demand. Inventories also
permit purchasing in economic lot sizes. A firm that does not want to carry inventories of raw material will
have to buy its requirements almost daily. This will be decrease cost of carrying inventories but additional
cost of ordering, transportation and stock out may be so high as compared to saving from not carrying
inventories. Inventories thus permit a firm to purchase its material and suppliers in economic lot sizes so
that all cost of production is minimized.

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(d) Buffer against fluctuation on demand

Production is based on sales forecast and forecasts are seldom perfectly accurate. Inventories allow
continuous production despite deviation of sales from forecasts. When sales are less than the forecast,
inventories of finished goods are allowed to accumulate. However when sales exceed forecast, demand are
mate by drawing from these accumulate inventories. This avoids dislocations caused by rush orders.
Inventories of raw material and part also permit increase production by working overtime or adding another
shift when demand exceeds production.

(e) Promote prompt delivery

Customers seldom wait for a particular firm to supply their needs, if they have alternative sources of supply,
which they generally do have. A firm’s success depends on its ability to meet customers demand and when
it exists quick delivers depend on inventories of finished goods as well as flexibility in manufacturing. The
later, at least partially depends on the availability of materials, supplies and purchase part.

(f) Advantage of quantity discounts

Generally suppliers of raw material, supplies etc., offer quantity discounts. A firm cannot take advantages of
these discounts if their current needs of material, supplies etc., are not of a magnitude at which such
quantity discounts are offered and if it is also unwilling to build inventories. Purchasing a large quantity
generally increases carrying cost but these increases in cost could be over come by minimizing ordering cost
and from quantity discounts.

(g) Hedge against shortage and price increase

Sometimes certain kinds of a materials and suppliers are in short supply. Some materials particularly of a
seasonal nature such as oil seeds, cotton, jute etc., are cheaper during the season. In such case, a
manufacturer can protect him against shortages and off-season price increase by building inventories during
favorable time period.

7.1.3 OBJECTIVES OF INVENTORY CONTROL

In context of inventories management, the firm is faced with the problem of meeting two conflicting needs.

(1) To maintain the large size of inventory for efficient and smooth production and sales operation.
(2) To maintain the minimum investment in inventories (minimizes total inventory cost) to maximize
profitability.

Both excessive and inadequate inventories are not desirable. These are two danger points within which the firm
should operate. The objective of inventory control is to find the optimum level of inventory, which will lie
between these to extreme conditions. Regarding investment, the firm should always avoid a situation of over
investment or under investment in inventories. The investment in inventories should be just sufficient at the
optimum level. The major dangers of over investments are :

• The unnecessary tie of firm’s fund

• Excessive carrying cost
• The risk of liquidity

The excessive level of inventories consume fund of the firm, which can be used for any other purpose and thus it
involves an opportunity cost. The carrying cost, such as the cost of storage, handling, insurance, recording and
inspection also increase in proportion to the volume of inventory. These costs will impair the firm’s profitability
further. Excessive inventories carried for a long period increases the chance of liquidity. It may not be possible to
sell inventories in time at full value. Raw materials are generally difficult to sell as the holding period increases.
There are exceptional circumstances where it may pay to the company to hold stocks of raw material. This is
possible under condition of inflation and scarcity e.g., flour mills often stock wheat, analyzing the national
production.

Work in progress is far more difficult to sell, if it is kept in excess. Similarly, difficulties may be faced in disposing
of finished goods inventories, if it is not sold till the expiry date. The downward shift in market and the seasonal
factors may cause finished goods to be sold at low prices.

Another danger of carrying excessive inventory is the physical deterioration of inventories while in storage. In
case of certain goods or raw materials, deterioration occurs with the passage of time or it may be due to
mishandling and improper storage facilities. These factors are within the control of management, the
unnecessary investment in inventories can thus be cut down.

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As we have studied under topic “ Need to hold inventories” an inadequate level of inventories is also dangerous.
The consequences of under investment in inventories are:
• Production hold ups
• Failure to meet delivery commitment

Inadequate raw materials and WIP inventories will result in frequent production interruptions. Similarly, if
finished goods inventories are not sufficient to meet the demand of customers regularly, customers may shift to
competitors, which will amount to a permanent loss to the firm. The aim of inventory management, thus should
be to avoid excessive and inadequate levels of inventories and to maintain sufficient inventory for the smooth
production and sales operation. Effort should be made to place an order at the right time with the right source to
acquire the right quantity at right price and quality.

To summarize, an effective inventory management should:

• Ensure a continuous supply of material to facilitate uninterrupted production.
• Maintain sufficient stocks of raw materials in periods of short supply and anticipate price change.
• Maintain sufficient finished goods inventory for smooth sales operation and efficient customer service.
• Minimize carrying cost and time.
• Control investment in inventories and keep it at an optimum level.

To meet these objectives or to manage inventories efficiently and effectively, in spite of other managerial
decisions, the manager should sought the answer of following two questions

1. How much should be ordered?

2. When should it be ordered?

The first question “how much to order” relates to the problem of determining economic order quantity (EOQ)
and second question “When to order” relates to the determination of reorder level (point).

If price, quality, other associated factors are constant and to be simple, the objective of inventory management is
to find out EOQ (Economic order quantity) and reorder level (point) under various circumstances. If inventories
are ordered in EOQ (though it has various limitations) the losses from excessive inventory and inadequate
inventory is minimized i.e. total inventory cost is minimized.

7.2 RELEVANT INVENTORY COST & COST TRADE OFFS

As we studied, the objective of inventory control is to hold inventory in such a manner that it exclude the evils of
excessive and inadequate inventory. Under this topics we will be dealing with the cost associated with holding
the inventory and cost associated with procuring them and other relevant cost associated with investment. Our
ultimate objective after understanding inventory cost is to find a doctrine that minimizes the total inventory cost,
which is also called Cost trade offs.

Basically, total inventory cost can be shown on following equation:

Total inventory cost = Cost of the items + Procurement cost + Carrying cost + Stock out cost.
These costs are described individually in following topics:

1) Cost of the items (purchase cost) : The cost or value of the item is usually a purchase price i.e. the amount
paid to the supplier for the item. In some instances, however, transportation, receiving or inspection cost for
example may be included as a part of cost of item. If the cost of item per unit is constant for all quantities
ordered, the total cost of item becomes fixed in nature, which cannot be optimized. But, if the unit cost varies
with the quantity ordered, i.e. if quantity discounts are available; the purchase price is also variable in nature
and this can be optimized by adequate Inventory Management Practice.

2) Procurement costs / Ordering or set up cost : Procurement costs are the cost of placing a purchase order, or
the set up cost if the item is manufactured at the facility. This cost varies directly with each purchase
order placed. Procurement cost (ordering cost) includes cost of
- Postage, telephone calls to reorder.
- Labor cost of purchasing.
- Accounting.
- Receiving cost.
- Computer time for record keeping.
- Purchase order suppliers.

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Most of the ordering cost varies directly with the number of orders. In other word, if purchases are made in
large quantities, the number of orders will be smaller and direct cost of inventories will be lower.

3) Carrying cost / Holding costs

Carrying costs are the cost of maintaining the inventory warehouse and protecting the inventoried items.
The typical carrying cost / holding costs are:
(a) Interest on capital held up: All kinds of inventories including material, purchased part, supplies, WIP
and finished products involve investment of funds. Hence, the invested money has interest cost, if it is
borrowed or loss in business opportunities in case of owned funds. Thus a company incurs costs in
terms of interest or loss of profitable opportunities when it invest its funds in inventories, Larger the
size of inventories, higher will be the cost of inventories.
(b) Storage cost: Inventories occupy space in the stores, which has its cost. These costs are those of space,
heat, light and repairs and maintenances. These costs are increased on increase of inventory.
(c) Depreciation costs: Like all physical assets, inventories are also subjected to depreciate. Thus, while the
money in the bank grows with the passage of time, those invested in inventory declines due to
depreciation. Higher the value of inventories more is the depreciation.
(d) Deterioration and obsolesce cost: Inventories in stock are subjected to deterioration. Materials and
finished product also obsolete while staying in company’s store. Fashion goods like garments, shoes etc.
are often subjected to rapid obsolesce. If a company using parts, changes its product design, these parts
may become obsolete. All this result, costs to the company. These costs are greater in high amount of
inventories.
(e) Loss of quantity discounts: A company is often able to take advantage of quantity discounts, if it
purchases its material, supplies and component parts in bulk. It can thus, reduce cost of inventories.
Thus, quantity discounts encourage the maintenance of larger inventories.
Carrying costs are calculated in terms of carrying cost per unit of inventory per year. Sometimes
carrying cost is also expressed in terms of percentage of purchase price.

4) Stock out costs / Shortage and customer service cost

Stock out cost is associated with demand when stock have been depleted, take the firm of lost sales or back
order costs. When sales are lost because of stock outs, the firm losses both the profit margin on unmade
sales, and also customer’s good will. If the customers take their business elsewhere, future profit margin
may also be lost. When customers agree to come back after inventories have been replenished, they make
back orders. Back order cost includes loss of good will and money paid to reorder goods and notify
customers when goods arrive. Stock out costs is expressed as stock out cost per unit per year.

Cost trade off

The objective in inventory control is to find the minimum operating doctrine over some planning horizon. This
minimizing total cost means cost trade off. For a simple model in which cost of item and cost of stock outs are
irrelevant, the trade off is between only two costs i.e. carrying costs and ordering cost.The graphical
representation of carrying cost and ordering cost is shown on figure 7.1.

Figure 7.1: Trade-off between EOQ and inventory costs

Cost

Aggregate cost
Total
minimum
variable cost Carrying cost

Ordering cost

O Q* (EOQ) order size (Q)

In the above figure, it is noticed that if the number or units of inventory per order is larger, the ordering cost
decreases but carrying cost increases. If the ordering cost and carrying cost are added, a total cost curve
(aggregate cost) is obtained. We found that the total cost is minimum at the quantity level Q, where the
ordering cost line and carrying cost line intersect each other. It means that total cost is minimum where,
Total ordering cost = Total carrying cost

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The quantity of inventory per order, when there is minimum total cost is called economic order quantity. It
means to minimize total inventory cost; the order should be placed on amount equal to EOQ.
Here,
Total ordering cost = Ordering cost per order x Number of orders
Total carrying cost = Carrying cost per unit per year x Average inventory

If O = Ordering cost per order

C = Carrying cost per unit per year
D = Annual demand
Q = Quantity ordered per order
Q/2 = Average inventory
D/Q = Number of order (N)
Total ordering cost = Total carrying cost
D= D 2DO
Ox C× or Q =
Q 2 C
The amount of inventory per order when ordering is equal to carrying cost is known as EOQ. Therefore,
2DO
EOQ =
C

7.3 TECHNIQUES OF INVENTORY MANAGEMENT / INVENTORY MODEL

The techniques of inventory management or inventory models can be classified as follows:

Inventory models

Deterministic Inventory Model Probabilistic inventory

Economic order quantity Economic order quantity EOQ with price model
with no shortage with shortage (Quantity discount model)

Basic EOQ model EOQ model with finite replacement rate

(Gradual replacement model)

7.3.1 BASIC EOQ MODEL (EOQ MODEL WITH NO SHORTAGE)

The inventory control system in this case is characterized in terms of the following assumptions:

(1) Demand (D) rate is constant and known.

(2) Production rate is infinite.
(3) Lead time (LT) is constant and known with certainly and independent of demand.
(4) Cost per unit i.e., purchase price (P) is constant and there is no quantity discount.
(5) Carrying cost (C) and ordering cost (O) are known and constant.

The purpose of the study of this model is to find and optimum order quantity EOQ, so that the total inventory
cost is minimized. The inventory system which operates on the above assumption is shown on the following
figure.
Figure 7.2: Graphical representation in EOQ

EOQ = Q Q Q Q

Inventory level

ROP

Safety stock

LT LT L
LT = lead time
Time

Cycle time

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At the beginning of the cycle time, we start with a maximum amount of inventory equal to the order quantity ‘Q’.
As this amount is used up, the level of inventory drops at a fixed rate equal to the demand rate D, when it
reaches or reorder level ROL, enough inventory is available to cover expected demand during the lead time LT.
At this an order is placed equal to Q’ which arrives at end of lead- time, when the inventory level reaches zero.
This amount is placed in stock all at once and the inventory level goes up to its maximum value.

The formula derived under basic EOQ model is as follows:

2DO
Economic order quantity (EOQ) = (expressed as unit/order)
C
D D
(2) Optimal no. of orders (N) = or (expressed in number)
EOQ Q
EOQ Q
(3) Optimal inventory cycle time (t) = or (expressed in year or day)
D D
(4) Total variable cost = Total carrying cost + Total ordering cost
D D
C× + ×O
2 Q
= 2DOC (Here for economic order quantity Q = EOQ)
(5) Reorder level (ROL) = Buffer stock + Demand during lead time

Solved Example 1
A canning industry has to supply his customer with 600 cans of his product per year. Shortage is not allowed and
shortage cost amount to 60 paisa per can be year. The set up cost per run is Rs. 80 find:
(i) The economic order quantity (EOQ)
(ii) The total variable inventory cost (TVC)
(iii) The optimum number of orders per year (N)
(iv) The optimum period of supply per optimum order (t)
(v) The increase in the total cost associated with ordering: (a) 20% more (b) 40% less than EOQ.

Solution,
Here, D = 600 units per year.
C = 0.60 per unit/year
O = 80 per production run.
2DO 2 × 600 × 80
(i) EOQ = = = 400 unit.
C 0.60
(ii) TVC = 2DOC = 2 × 600 × 80 × 0.60 = Rs. 240
D 600
(iii) N = = = 1.5 orders.
EOQ 400
EOQ 400 2
(iv) t = = = year.
D 600 3
(v) a. Ordering 20% more than EOQ
i.e. Q = 400 + 20% of 400
= 400 + 80 = 480 unit.
D Q
∴ TVC = ×O + ×C
Q 2
600 480
= × 80 + × 0.60
480 2
= 100 + 144 = 244

Here increased in cost is 244 – 240 = Rs. 4

(v) b. Ordering 40% less than EOQ.

Here, Q = 400 – 40% of 400 = 240
Q D 240 600
∴ TVC = ×C + ×O = × 0.60 + × 80 = 72 + 200 = Rs. 272
2 Q 2 240
Here increased in cost is 272 – 240 = Rs. 32

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Solved Example 2

A fast food chain has a local retail out let that uses 730 cases of paper cups annually. Ordering costs are Rs. 15
per order. Carrying cost is 30% of purchase price per case. The purchase price is Rs. 12 per case. Delivery lead-
time is known with certainty to be five days. Establish to optimal operating doctrine.

Solution
Here, D = 730
O = 15/order
C = 30% of 12 = 3.6 per unit/year.
Lead- time = 12 days.
2DO 2 × 730 × 15
Now, EOQ = = = 78
C 3.6
730
Reorder level (ROL) = Lead time x Demand during lead time (Remember these is no buffer stock) = 5 ×
365
= 10
Here the operating doctrine would be to order 78 cases when stock in hand reaches 10 cases.

7.3.2 EOQ MODEL WITH FINITE REPLACEMENT RATE (GRADUAL REPLACEMENT MODEL)

A gradual replacement model sometimes called production run model is characterized by the following
assumptions.

(1) Annual demand (D) is constant and known.

(2) The production rate (P) per unit is greater than the demand rate (d).
(2) The lead- time (LT) is constant and known with certainty and independent of demand.
(3) Cost per unit (p) is constant.
(4) Production begins immediately after production setup.
(5) The supply rate is finite and constant.

Note that this model is also based on the assumption is previous model except that of instantaneous
replenishment (supply). This is because of the fact that in many situations the amount ordered is not delivered all
at once, but will be supplied at some uniform rate ‘P’. This situation can arise in case of and order being filled by
machine having finite production rate.

The formula derived under this model all as follows:

2DO  P 
(1) Economic order quantity (EOQ) =  
C P−d
Q
(2) Optimum production cycle time (t) =
D
D
(3) Optimum number of production run per year (N) =
Q
EOQ
(4) Optimum length of each production rate (tp) =
P
(P − d)
(5)Total minimum inventory variable cost (TVC) = 2DOC
P
Q  P − d  D 
=    × C +   x O 
2
  P  Q
  

Solved Example 3

A mineral water company uses 10000 units of particular bottle per year. Each bottle cost Rs. 32. The production
engineering department estimates set-up cost of Rs. 55, and accounting department estimates the holding cost as
12.5% of the value of inventory. Production rate is uniform 120 bottles per day. Assuming 250 working days.,
calculate (1) optimal order quantity (2) total inventory cost on the basis of optimal policy (3) optimal number of
set ups.

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Solution:

Here, D = 10000 bottle/year

Purchase price = Rs. 32/bottle.
Set up cost (O) = Rs. 55 per set up.
Carrying cost (c) = 12.5% of Rs. 32 = Rs. 4 bottle/year
Production rate (P) = 120 bottle/day
10000
Demand rate (d) = = 40 bottle/day.
250
Now,
2DO  P  2 × 10000 × 55  120 
(a) EOQ =   =   = 642.26 bottle = 642 bottle.
C P−d 4  120 − 40 
(P − d) (120 − 40)
(b) Optimal total inventory cost (TVC) = 2DOC = 2 × 10000 × 55 × 4
P 120
= Rs. 1712.69/year
D 10000
(c) Optimal number or setups (N) = = = 16 set ups.
EOQ 642.26

7.3.3 QUANTITY DISCOUNT MODEL (EOQ WITH PRICE BREAKS MODEL)

To increase sales, many companies offer quality discounts to their customers. A quantity discount is supply is
reduction on the purchase price for an item when it is purchased in large quantities. As with other inventory
models discussed so far the overall objective is to minimize the total variable cost i.e. carrying cost and ordering
cost. As the discount of quantity increases, the material cost decreases, the order are placed in large quantity,
hence ordering cost also decreases, however the carrying cost increases. Here the trade off lies between carrying
cost, ordering cost and material cost. The formula for carrying cost and ordering cost is as same as basic EOQ
model. However only difference is reduction on purchase price i.e. quantity discount are incorporated on solving
problem.

Solved Example 4:

Nebico biscuit industries have given the following quality discounts schedule for its distributors.

Quantity discount table

Discount on purchase
Order size
price
0 – 999 0
1000 – 1999 4%
2000 and over 5%

Further, more purchase price is Rs. 5 per CBB; ordering cost is Rs. 4 per order. Annual demand of a distributor is
5000 CBB. Inventory carrying charge is 20% of purchase price. Determine the order quantity for the distributor
that minimizes total cost.

Solution:

Here, D = 5000 CBB

O = Rs. 49/order
C = 20% of Rs. 5 = Rs. 1

2DO 2 × 5000 × 49
Now, EOQ = = = 700
C 1

To find the quality discount, the total cost associated with order quantity 700 units, 1000 unit and 2000 unit
are determined.

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Order quantity (Q) 700 1000 2000

Purchase price 5 4.80 4.75
Carrying cost/unit 20% of Rs 5 =1 20% of Rs 4.80 =0.96 20% of Rs 4.75
= 0.95
Ordering cost/order 49 49 49
Q  700 1000 2000
a. Carrying cost  x C × 1 =350 × 0.96 =480 × 0.95 =950
2  2 2 2
D  5000 5000 5000
b. Ordering cost  x O × 49 = 350 × 49 =245 × 49 =1225
Q  700 1000 2000

c. Purchase cost 5000 x 5 = 25000 5000 x 4.80 =24000 5000 x 4.75 =23750
(Demand x purchase cost/units)

Total cost (a + b + c) 25700 24725 248225

Here total cost associated with ordering 1000 units is least among all there, so the distributor should order 1000
unit at a time that will minimize his total cost.

7.3.4 PROBABILISTIC INVENTORY MODEL

Type of problem to be discussed under probabilistic models is commonly known as “Christmas tree” problem.
There is only a single time period for making a single procurement. The vendor of Christmas tree should decide
the number of trees he has to purchase for the season at the commencement of the season, just like a boy selling
newspaper has to decide in the morning about the number of he should buy for the day.

In most situation demand is probabilistic since only probability distribution of future demand, rather than the
exact value of demand itself is known. The probability distribution of future demand is usually determined from
the data collected from past experience. In such situations we choose policies that minimizes the expected costs
or maximize expected profit, rather than the actual cost or profit. Expected costs are obtained by multiplying the
actual cost for a particular situation with the probability of occurrence of that situation and summing the
expected costs.

Costly spare parts, perishable goods, seasonal items and fashion goods are example of probabilistic models.
Under this model it is assumed that the inventory carrying cost for season are fixed and independent of the
quantity purchased and further that the ordering cost is negligible.

The model is based on the equation:

• Expected marginal profit ≥ Expected marginal loss.

• Marginal profit = profit from sell of one extra unit.
• Marginal loss = loss from un-sell of one unit.
ML
The decision rule will be, by a maximum quantity Q such that: P ≥
ML + MP

Solved example 5

A newspaper boy purchase paper for 25 paisa each and sells them for 30 paisa each. He cannot return the unsold
newspaper. The last 100 days demand pattern is as follows. Determine the optimal stock doctrine.

No. of copies sold No. of days

30 10
31 20
32 30
33 20
34 10
35 5
36 5

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Solution
Here,
Marginal profit (MP) = 30 – 25 = 5 Paisa
Marginal loss (ML) = 25
ML
Then, probability is given by: P≥
ML + MP
25
= = 0.833
25 + 5
To find the optimum stock level the following profitability table is made.

Demand Days Probability Cumulative probability

30 100 .1 1
31 20 0.2 0.9 ← Prob. ≥ 0.833
32 30 0.3 0.7
33 20 0.2 0.4
34 10 0.1 0.2
35 5 0.05 0.1
36 5 0.05 0.05
Total 100 1

Hence, optimal policy is to order 31 newspapers each day.

Solved Example 6:

A retailer purchase cherries every morning at Rs. 50 a case and sells them for Rs. 80 a case. Any case remaining
unsold at the end of the day can be disposed of next day at the salvage value of Rs. 20 per case. Past sales have
ranged from 15 to 18 cases per day. The following is the record of sales for the past 120 days.

Case sold - 15 16 17 18
No. of days 12 34 48 36

Find how many cases retailer should stock per day.

Solution:
Here, Marginal profit (MP) = 80 – 50 = 30
Marginal loss (ML) = 50 –20 = 30
ML
∴ Probability P≥
ML + MP
30 30
= =
30 + 30 60
P ≥ 0.5

Construction of probability table

Case sold No. of days Probability Cumulative Probability
15 12 0.1 1
16 34 0.28 0.9
17 48 0.32 0.62 ← P ≥ 0.5
18 36 0.3 0.3
Total 120 1

Hence, optimum inventory doctrine is stock 17 units.

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7.4. SELECTIVE INVENTORY MANAGEMENT (ABC ANALYSIS)

The inventory of an industrial firm generally comprises thousands of items with diverse price, usage and lead-
time, as well as procurement and or technical problem. It is neither desirable nor possible to exercise the same
degree of control over all those items. The organization should pay more attention and case to those items whose
usage value is high and less attention to those whose usage and consumption value is low. The organization has
therefore, to be selective in its approach to control its investment in various types of stocks and inventories. Such
a system is known as “selective inventory control”. Among various “selective inventory control system”, ABC
analysis is used widely.

7.4.1 ABC analysis

In ordinary parlance, ABC analysis can be best compared with our class society where the population is
categorized into top middle and lower classes. In the case of inventories also it has been noticed that out of a
large number of items, some are of quite importance and others may not. ABC analysis contemplates to classify
all inventory items in number of categories, generally in three categories based on their value. Item of high value
but small in number are classified as ‘A’ items, which would be under a strict control. ‘C’ items represent
relatively small value items and would be under simple control items of moderate value and sizes are classified
at ‘B’ items and would attract reasonable attention of the management. Since this plan concentrates attention on
the basis of relative importance of the various items of inventory, it is also known as “control by importance and
exception”.

It has been found that normal inventory items in most organization show the following distribution pattern.
A -- 5 to 10% total number of items account for about 70% of the total consumption value.
B -- 10 to 20% total number of items account for 20% of total consumption value.
C -- The remaining large number of items account for the balance 15% of the consumption value.

The objective of ABC analysis is to develop policy guidelines for selective control. Such policy can be designed in
a variety of ways. In general ‘A’ items tightly control inventory system with constant attention, ‘B’ items
moderately through routine inventory system with periodic attention and ‘C’ items to subject to loose control
with casual attention.

Table 7.1: Showing features of ABC analysis

Nature A items :high value B items : moderate value C items : low value
Extent of control Rigid control Moderate control Loose Control
Safety stock Low safety stock Medium safety stock Large safety stock
Frequency of order Frequently Less frequently Bulk ordering
Degree of posting Individual posting Small group posting Group posting
Level of management Senior management Middle management Store supervisor
% of stock 5% 10% 85%
% of value 50% 35% 15%

Advantage and Disadvantage of ABC Analysis

Advantage:
• Facilities selective control and there by saves valuable time of busy executives .
• Eliminates lot of unnecessary paper work involved in various other control procedures: Tangible
savings can be effective in this behalf by following two-bin system which is very closely related with
this technique.
• Facilitates inventory control and control over usage of stores materials which ultimately results in cost
control.

Drawbacks
• Although ABC analysis is a fundamental tool for exercising selective control over numerous inventory
items, it does not permit precise consideration of all relevant problems of inventory management.
• Besides, if ABC analysis is not periodically reviewed and updated, the very approach of control may be
defeated, for example, ‘C’ items like diesel oil is a firm will become most high value items during power
crisis and should therefore, deserve more attention, but this point may be overlooked if classification of
item is not reviewed and updated.

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Solved problem 7:

Carryout ABC analysis from the following data :

Item Annual usage (unit) Value per unit (Rs.)

1 200 40
2 100 360
3 2000 0.20
4 400 20
5 6000 0.04
6 1200 0.80
7 120 100
8 2000 0.70
9 1000 1.00
10 80 400

Solution
Usually ‘A’ category items constitute 5 to 10% of total items and 70 to 85% of material cost. ‘B’ category items are
10 to 20% of total items and 20 – 30% of material cost. The rest of items fall under ‘C’ category. In order to classify
the ten items kept in inventory as A, B & C items:

First step Calculate the annual usage value of each item by multiplying the per unit value with the
annual usage.
Second step Assign appropriate rank to the items based on the annual usage value in descending order.
Third step Accumulate items in order of their ranks along with their annual usage value so as to cover the
accumulated values into their percentage of grand totals.

The table 7.2 classifies above items under three categories A, B & C.

Table 7.2 : Determination of rank according to annual usage

S.N. Annual usage (in units) Value per unit Rs.) Annual usage value (Rs.) Ranking
(1) (2) (3) 4 = (2) x (3) (5)
1 200 40 8000 IV
2 100 360 36000 I
3 2000 0.20 400 IX
4 400 20 8000 V
5 6000 0.40 240 X
6 1200 0.80 960 VIII
7 120 100 12000 III
8 2000 0.70 1400 VI
9 1000 1.00 1000 VII
10 80 400 32000 II

Table 7.3 : Categorizing items in A, B & C according to their usages.

Items at Annual usage Annual usage % of total items % of total annual usage
Rank Class
S.N. value (Rs.) value in each class in each class value in class
2 I 36000 68000
A 2/10 = 20% 68000/100000 = 68%
10 II 32000
7 III 12000
1 IV 8000 B 28000 3/10 =30% 28000/100000 = 28%
4 V 8000
8 VI 1400
9 VII 1000
6 VIII 960 C 4000 5/10 = 50% 4000/100000 = 4%
3 IX 400
5 X 240

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From table 7.3 it is clear that it is necessary to control tightly only 20% of the inventory items belonging to A
class, to achieve control over 68% of the total annual usage value. 30% of items fall under B class and these items
constitute 28% of total annual usage value. On the other hand, 50% of the items (C class) can be virtually ignored
and there will be less control over 4% of total inventory.

If a graph is plotted on % item in class against % value the following curve will be obtained.

Item Annual % of Annual Cumulative % of

no. usage usage annual usage
2 36000 36% 36%
10 32000 32% 68%
7 12000 12% 80%
1 8000 8% 88%
4 8000 8% 96%
8 1400 1.4% 97.4%
9 1000 1% 98.4%
6 960 0.96% 99.36%
3 400 0.4% 99.76%
5 240 0.24% 100%
100000 100%

Figure 7.3 : Graph of ABC analysis

ABC analysis
100%

80%
%Usage

60%
Class A Class B Class C
40%

20%

0%
1 2 3 4 5 6 7 8 9 10
Item

7.5 OTHER TERMINOLOGIES ASSOCIATED WITH INVENTORY MANAGEMENT

Lead- time

The time between ordering an item and actually receiving the item is referred as lead- time. The lead- time
plays an important role in determination of buffer stock. If the lead this is low, then a small stock will be
required but if the lead- time is significant then the company will have to maintain higher buffer level to
avoid stock out. Thus the capital tied up in inventory will be high.

Normally, the lead- time will be short in case of local supplies and off shelf items and greater in case of made
to order outstation suppliers. During seasonal fluctuations, lead time increases significantly. In such cases,
safety stocks should be sufficiently raised only near about these periods, not all through the year.

Re-order level

Once the order is placed, the inventory takes time equal to “lead time” to reach the factory or to receive the
inventory. However, these should be sufficient inventory in head to meet the demand of lead- time. These
amounts of inventory to be maintained, to cover the uses of lead- time is called re-order level. Re-order level
can be derived from following formula.

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Re-order level = lead time x average consumption per unit time

= Consumption of inventory in lead- time.

If safety stock or buffer stock are also maintained the re-order level will be:

Re-order level = safety stock + lead time x average consumption per unit time

Example:
Annual demand = 9000 unit (300 day/year)
Lead-time = 4 days.
9000
∴Re-order level = × 4 unit
3000
= 120 units.

Safety stock/Buffer stock/Reserve stock

In real life situation, firm operate under the condition of uncertainty, relative both to demand as well as
procurement time. The total actual demand may be more or less than the forecasted demand. Similarly
actual procurement time may very form the estimated time. In order to minimize the effect of uncertainty in
demand and/or lead time, a firm maintains safety stock. The safety stock may be defined as the minimum
additional inventory to serve as a safety margin (or cushion) to meet and unanticipated increase in usage
resulting from various uncontrollable increase in usage resulting from various uncontrollable factor like and
unusual high demand or late receipt of incoming inventory. As the uncertainties are unpredictable, these is
no accurate method of determining what should be the most economic safety stock, though, these are
certain methods based on statistics and simulation for calculating safety stock. However, the normal trend in
keeping safety stock is to determine the days of safety stock can be modulated as :

Safety stock = days of safety stock required x average consumption

Sometime safety stocks are also called minimum stock level. If safety stocks are placed than re-order level
will be

ROL = Safety stock + (Lead time x average consumption)

∴ Safety stock or Minimum stock level = ROL – (Lead time x average consumption)

7.6 EXERCISES

(1) A manufacturing company has determined from an analysis of its accounting and production data for
certain part that (a) its demand is 9000 units per year and is uniformly distributed over the year (b) its cost
price is Rs. 2 per unit (c) its ordering cost is 40 per order (d) the inventory carrying charge is 9% of the
inventory value. Further it is known that the lead- time is uniform and equals and working days and that the
total working days in year are 300, determine.
(a) The economic order quantity.
(b) The total ordering and holding cost associated with the policy of ordering and amount equal to EOQ.
(c) The Re-order level.
(d) The length of the inventory cycle.
(e) The amount of savings that would be possible by switching to the policy of ordering EOQ determined
in (a) from the present policy of ordering the requirements of this part thrice a year.
(f) The increase in the total cost associated with ordering (i) 20% more (ii) 40% less than EOQ.
Ans. (a)2000 units (b) Rs. 360 (c) 240 units (d) 66.7 days (e) Rs. 30/year (f) (i) Rs. 6 (ii) Rs. 48

(2) Amit manufactures 50000 bottle of tomato ketchup in an year. The factory cost per bottle is Rs. 6. The set up
cost per production run is estimated to be Rs. 90 and the carrying cost on finished goods inventory amount
to 20% of the cost per annum. The production rate is 600 bottle per day and sales amount to 150 bottle/day.
What are the optimum lot size and the number of production runs?
Ans : 3625 bottle/15 runs.

(3) The annual demand for a product is 100000 unit. The rate of production is 20000 units per year. The set up
cost per production run is Rs. 5000 and the variable production cost of each item is Rs. 10. The annual

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holding cost per unit is 20% of its value. Find the optimum production lot size and the length of production
run.

(4) The annual demand for a product in 64000 unit. The buying cost per order is Rs. 10 and the estimated cost of
carrying one unit in stock for a year is 20%. The normal price of the product is Rs. 10 per unit. However the
supplies offers a quantity discount of 2% on an order of at least 1000 units at a time and a discount of 5% if
the order is for at least 5000 unit. Suggest the optimum inventory doctrine.

(5) Assume the following quantity discounts schedule for a particular type of digestive biscuits that is available
to a retail store.
Order size Discounts Unit cost

0 – 50 0% Rs. 3000
51 – 100 5% Rs. 2850
101 – 200 10% Rs. 2700
201 and above 12% Rs. 2640

The annual demand is 250 units, ordering cost is Rs. 2000 per order and annual inventory carrying cost is Rs.
400 per order. What order quantity would you recommend? What is the total minimum inventory cost?

(6) From the following figure carry out ABC analysis and present in form of graph also.

Item Price (Rs) Annual use

1 40 200
2 360 100
3 0.20 2000
4 20 400
5 0.04 6000
6 0.80 1200
7 100 120
8 0.70 2000
9 1 1000
10 400 60

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