Inventory Management

by
ANOOP P. S.
S3 MBA 2007-09 School Of Management Studies Cusat, Kochi-22
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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.

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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 techniques 1/19/2012 3

Types of Inventory

Work in process
Vendors

Raw Materials Work in process

Work in process

Finished Customer goods

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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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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

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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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An effective inventory management should



 

Ensure a continuous supply of raw materials to facilitate uninterrupted production Maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes Maintain sufficient finished goods inventory for smooth sales operation, and efficient customer service Minimize the carrying cost and time Control investment in inventories and keep it at an optimum level
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An optimum inventory level involves three types of 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 commitments
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Carrying costs: Warehousing or storage  Handling  Clerical and staff  Insurance  Interest  Deterioration,shrinkage, evaporation and obsolescence  Taxes  Cost of capital

Dangers of Over investment



  

Unnecessary tie-up of firms fund and loss of profit involves opportunity cost Excessive carrying cost Risk of liquidity- difficult to convert into cash Physical deterioration of inventories while in storage due to mishandling and improper storage facilities

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Dangers of under-investment
  

Production hold-ups loss of labor hours Failure to meet delivery commitments Customers may shift to competitors which will amount to a permanent loss to the firm May affect the goodwill and image of the firm

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Functions of Inventory Management

-Track inventory How much to order When to order

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Classification of inventory

ABC Classification HML Classification XYZ Classification VED Classification FSN Classification SDF Classification GOLF Classification SOS Classification

ABC Classification

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

A B C

XYZ Classification
 

  

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 Classification
 

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 Classification
Mainly for spare parts because their consumption pattern is different from raw materials. Therefore V items has to be stocked more Raw materials on market demand and D Items has to be less stocked Spare parts on performance of plant and machinery. V Vital, E Essential, D Desirable

FSN Classification
    

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

SDF & GOLF Classification

 

Based on source of procurement S Scarce, D- Difficult, E- Easy. GOLF G Government, O Ordinary, L Local, F Foreign.

 

SOS Classification
  

Raw materials especially for agriculture units S Seasonal OS Off seasonal

Deciding on the inventory model



Assume an analyst applies an inventory model that does not allow for spoilage to a grocery chains ordering policy for lettuce and formulates the strategy of ordering lettuce in large amounts every 14 days. A little thought will show that this is obliviously foolish. This strategy implies that lettuce will be spoiled. However it is not a failure of inventory, it is a failure to apply the correct model.

Different approaches


 

Certainty approach Uncertain variables and risk are addressed separately Uncertainty approach Uncertain variables and risk are addressed simultaneously Deterministic approach Probabilistic approach

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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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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Trial & Error Method

Assumptions:Annual requirement (C)=1200 units Carrying cost (I) = Rs.1 Ordering cost (O) =Rs.37.5
Order size Q Average inventory Q/2 No. of orders C/Q Annual carrying cost I* Q/2 Annual ordering cost O*C/Q Total annual cost
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1200 600 1 600 37.5 637.5

600 300 2 300 75 375

400 200 3 200 112.5 312.5

300 150 4 150 150 300

240 120 5 120 187.5 307.5

200 100 6 100 225 325

150 75 8 75 300 375

120 60 10 60 375 435

100 50 12 50 450 500

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Order- Formula approach

1/2 EOQ =(2CO/I) C = Annual demand O = Ordering cost per order I = Carrying cost per unit 1/2 EOQ =(2*1200*37.5/1) = 300 units

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Certainty case of the inventory cycle

Inventory level order quantity

Q Average inventory = Q/2

T1

T2 Time

T3

T4

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

Graphical method to find EOQ

Cost in RS.

EOQ Order quantity

Extension of basic EOQ model



This model can be extended to include quantity discounts, were simple calculation for quantity discount is added. Non zero lead time Non zero 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 T2 - n T2 Time T3 - n T3 T4 - n T4

Placement of a order

Probabilistic inventory model



1.

2.

In practical inventory management assumption may not be strictly correct. Demand may fluctuate over time due to seasonal, cyclical and random influences. Lead time may also fluctuate because of transportation delay, strikes or natural disaster. For such reason most of the companies use safety stock.

Probabilistic inventory model contd



But in some cases even the safety stock becomes ineffective to combat stock out. Like:-

Reorder point Safety stock

T1 T2 T3 T4 T5 T6

Placement of order

Lead time

Stock out

A Review
So we have dealt with
1. 2. 3.

EOQ model Its extension Probabilistic model And now we will be dealing with

4.

special

inventory models

Special inventory model



Non Instantaneous replenishment Quantity Discount One period decision

Special inventory model Non Instantaneous replenishment

Capacity 10 units

Thus the inventory is replenished gradually than in lots Particularly in situation were manufacturers use continues production process e.g. FACT makes Ammonium on a continual basis

Special inventory model

Discount Quantities


If discount increases with the order quantity, then the price of inventory is no more constant

Hence a new approach is needed to find the best lot size

Total cost Annual holding cost

Annual ordering cost

Annual cost of materials

Special inventory model One period decisions

The newsboy problem


If a newspaper seller does not buy enough papers to resell on the street corner, sales opportunity is lost. If the seller buys too many, the overage cannot be sold because nobody wants yesterdays newspaper.

Applicable to fashion goods, seasonal goods and due to change in technology

Inventory management under uncertainty

1. 2.

3.

Option price model Risk adjusted discount cash flow (DFC) Model Dynamic inventory model

Option price model



Option is a contract that gives the holder a right to acquire or sell certain things at a predetermined price without any obligation. Calculated by integrating the market information and inventory control.

Risk adjusted discount cash flow (DFC) Model

Inventory control problem is converted to capital budget problem Suppose television dealer decides to hold Beneficial foraprojects like oil drilling were the an is acquired only after a long time but benefitadditional inventory of 1000 television per month. The cost additional expanse is once oil is struck theof holding inventoryis covered. spread overtime. Inflows = no: of units probability present value

Dynamic inventory model

1. 2. 3.

Uncertain variables are identified Probability associated with them is taken Simulation techniques are applied

Emerging trends in inventory management

Entering into log term contract at a fixed price to reduce uncertainties Just-in-time Kanbans Japanese technique (Only produce when demand comes) Internet based ordering system Supply chain management Vendor development Investment in plant and machinery

Inventory control responsibility

Purchasing naturally has vest interest in inventories, even to the extend that in some companies the purchasing and stores functions are combined. In effect the responsibility cannot be kept Production looks after the work in progress on one head since inventory management Logistics plays a major role effort is a integrated in inventory control Inventories are economic importance to finance department The fact that materials must be moved from one place to another is of importance to materials department

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