INVENTORY CONTROL

Inventory Meaning, Definition, types

Inventory Costs, Inventory Models and
Inventory Control Techniques

Inventory Definition
A stock of items held to meet
future demand
Inventory is a list for goods and
materials, or those goods and
materials themselves, held
available in stock by a business.

Introduction
Constitute significant part of current assets
On an average approximately 60% of current
assets in Public Limited Companies in India
A considerable amount of fund is required
Effective and efficient management is
imperative to avoid unnecessary investment
Improper inventory management affects long
term profitability and may fail ultimately
10 to 20% of inventory can be reduced without
any adverse effect on production and sales by
using simple inventory planning and control
3
techniques

Reasons To Hold Inventory

Meet variations in customer demand:
Meet unexpected demand
Smooth seasonal or cyclical demand

Pricing related:
Temporary price discounts
Hedge against price increases
Take advantage of quantity discounts

Process & supply surprises

Internal upsets in parts of or our own processes
External delays in incoming goods

Types of Inventory
1. Nature of Material
I. Direct Material
. Production Inventories
. In-Process Inventories
. Finished-Goods Inventories
II. Indirect Materials
. MRO Inventories
. Consumables

Types of Inventory

Work in
process
Vendors

Raw
Materials

Work in
process

Finished Customer
goods

Work in
process

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Nature of Inventories
Raw Materials Basic inputs that are
converted into finished product through the
manufacturing process
Work-in-progress Semi-manufactured
products need some more works before they
become finished goods for sale
Finished Goods Completely manufactured
products ready for sale
Supplies Office and plant cleaning materials
not directly enter production but are necessary
for production process and do not involve
significant investment.
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Type of Inventories Continued

2. According to Use of Materials
I. Transaction Inventory
II. Speculative Inventory
III. Anticipation Inventories
IV. Buffer or Precautionary Inventories
V. Cycle Inventories

Objective of Inventory Management

To maintain a optimum size of inventory for
efficient and smooth production and sales
operations
To maintain a minimum investment in
inventories to maximize the profitability
Effort should be made to place an order at the
right time with right source to acquire the
right quantity at the right price and right
quality
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Functions of Inventory
Management
-Track inventory
How much to order
When to order

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10

INVENTORY COSTS
1. Purchase Cost
2. Ordering Cost
3. Carrying Cost
.Direct Costs:
i.

Capital Costs (Inventory Investments),

ii. Storage Space Costs (Facilities: Raw materials, Work in

progress (WIP), Finished goods, Field Service Stocks)
iii. Service Costs
iv. Risk Costs

An optimum inventory level involves

four types of costs
Purchase Costs
Ordering costs: Quotation or tendering
Requisitioning
Order placing
Transportation
Receiving, inspecting and
storing
Quality control
Clerical and staff

Stock-out cost
Loss of sale
Failure to meet delivery
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commitments

Carrying costs: Warehousing or storage

Handling
Clerical and staff
Insurance
Interest
Deterioration,shrinkage,
evaporation and
obsolescence
Taxes
Cost of capital
12

INVENTORY COSTS continued

Indirect Costs
i.

Business Risk

ii. Opportunity Costs

iii. Incremental increase in infrastructure costs
4. Stock-out Costs
5. Warehousing Costs
6. Damage, Pilferage and Obsolescence Cost
7. Exchange Rate Differentials

Inventory Order Cycle

Inventory Level

Order quantity, Q

Deman
d rate

Reorder point, R

Lead
time
Order Order
placed
receipt

Lead
time
Order Order
placedreceipt

Time

Various Levels of Inventory

1. Minimum Inventory Level
Minimum Stock level = Re-Ordered Level (Average Rate of Consumption
* Lead Time)

1) Lead Time
2) Inland or Importable Inventory
3) Availability of Inventory
4) Possibility of Interruption in Production
5) Nature of the Material
6) Rate of Consumption of the material

II. Maximum Inventory Level

Maximum Level = Re-Order Level + Re-Order Quantity Minimum Consumption * Minimum
ReOrder Period

III. Re-Order or Ordering Inventory Level

Ordering Level/Re-order Level = Maximum Usage per day * Maximum Re-order period or
Maximum Delivery Time

IV. Average Inventory Level

Average Stock Level = [Minimum Level + Maximum Level]/2

V. Danger Inventory Level

Optimum Level of Inventory

Factors responsible for maintaining optimum level of inventory are:

1) Rate of Inventory Turnover

2) Type of Product
3) Market structure
4) Economies of Production
5) Costs
6) Financial Position of the firm
7) Inventory policy and Attitude of management

Inventory Control Techniques

ABC Analysis
HML Analysis
XYZ Analysis
VED Analysis
FSN Analysis
SDE Analysis
GOLF Analysis
SOS Analysis

ABC Analysis
In most of the cases 10 to 20 % of the inventory
account for 70 to 80% of the annual activity.
A typical manufacturing operation shows that the top
15% of the line items, in terms of annual rupees usage,
represent 80% of total annual rupees usage.
Next 15% of items reflect 15% of annual rupees
Next 70% accounts only for 5% usage

XYZ Analysis
On the basis of value of inventory stored
Whereas ABC was on the basis of value of consumption
to value.
X High Value
Y Medium value
Z Least value
Aimed to identify items which are extensively stocked.

HML Analysis
On the basis of unit value of item
There is 1000 unit of Q @ Rs. 10 and
10,000 units of W @ Rs. 5.
Aimed to control the purchase of raw
materials.
H High, M- Medium, L - Low

VED Analysis
Mainly for spare parts because their consumption
pattern is different from raw materials.
Raw materials on market demand
Spare parts on performance of plant and machinery.
V Vital, E Essential, D Desirable

Therefore V items has to be stocked more

and D Items has to be less stocked

FSN Analysis
According to the consumption pattern
To combat obsolete items
F Fast moving
S Slow moving
N Non Moving

SDE Analysis
Based on source of procurement
S Scarce, D- Difficult, E- Easy.

SOS Analysis
Raw materials especially for agriculture units
S Seasonal
OS Off seasonal

INVENTORY MODELS
Outline
Deterministic models

The Economic Order Quantity (EOQ) model (

only in syllabus)
Sensitivity analysis
A price-break Model
Probabilistic Inventory models
Single-period inventory models
A fixed order quantity model
A fixed time period model
27

Basic EOQ Model

Assumption
Seasonal fluctuation in demand are ruled out
Zero lead time Time lapsed between purchase order
and inventory usage
Cost of placing an order and receiving are same and
independent of the units ordered
Annual cost of carrying the inventory is constant
Total inventory cost = Ordering cost + carrying cost

EOQ Three Approaches

Trial and Error method
Order-formula approach
Graphical approach

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29

EOQ & Re-order point

EOQ gives answer to
question How much to
Order
Re-order point gives
answer to question when
to order
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30

Certainty case of the inventory cycle

Inventory
level order
quantity

Average inventory =
Q/2

T
1

T
2

T
Time 3

T
4

1. Here the negative slope from Q to T1

represents the inventory being used up
2. T1, T2, T3, T4 represents the replenishment
points
3. The inventory varies between 0 and Q

Extension of basic EOQ model

This model can be extended to include quantity
discounts, were simple calculation for quantity discount
is added.
Non zero
Nonlead
zerotime
lead time

Extension of basic EOQ

model

Non zero lead time

If the lead time is n then procurement must

be done prior to n days, i.e. T-n as shown in
the figure
Q

Reorder
point
0

T1 - n T1

Placement of a
order

T2 - n T2
Time

T3 - n T3

T4 - n T4

Determining Lot Size or EPQ

Parameters
Q*

= Optimal production quantity (or EPQ)

Cs = Setup cost
D = annual demand
d = daily demand rate
p = daily production rate

Production Quantity Model

An inventory system in which an order is received
gradually, as inventory is simultaneously being depleted

Also known as non-instantaneous receipt

model
Now replenishment not at once

Assumption
Q is received all at once is relaxed
p - daily rate at which an order is received over time,
or production rate
d - daily rate at which inventory is demanded

Production Quantity Model

(cont.)
p = production rate
rate

d = demand

Maximum inventory level = QQp

=Q1Q
Average inventory level =
2
TC =

CoD CcQ
d
+
1 -p
Q
2

d
d
p

d
1p

Qopt =

2CoD
d
Cc 1 - p

Average Inventory Level

We will need the average inventory level for finding
carrying cost
Average inventory level is the maximum
Max inventory = Q x (1- d/p)
Ave inventory = Q x (1- d/p)

Total Cost
Setup cost
Carrying cost

= (D/Q) x Cs
= [ Q x (1- d/p)] x Ch

Production cost= P x D
= Total cost
As in the EOQ model:
The production cost does not depend on Q
The function is nonlinear

Finding Q*
As in the EOQ model, at the optimal
quantity Q* we should have:
Setup cost = Carrying cost
(D/Q*) x Cs = [ Q* x (1- d/p)] x Ch
Rearranging to solve for Q*:
Q* =

( 2 DC s /[Ch (1 d / p )]

EPQ for Brown Manufacturing

Produces mini refrigerators (has 167

business days per year)
D
d
p
Ch

= 10,000 units annually

= 1000 / 167 = ~60 units per day
= 80 units per day (when producing)
= $0.50 per unit per year

Cs = $100 per setup

P = $5 to produce each unit
Go to file 12-4.xls

Length of the Production Cycle

The production cycle will last until Q* units
have been produced
Producing at a rate of p units per day
means that it will last (Q*/p) days
For Brown this is:
Q* = 4000 units
p = 80 units per day
4000 / 80 = 50 days