Inventory may be defined as any resource (raw material, fuels and lubricants, components, spare parts, tools, maintenance

consumables, semifinished products, finished products) that has a certain value and can be used at a later time, when the demand for it arises. Inventory can also be defined as physical stock of items that a business or production enterprise keeps on hand for efficient running of affairs or its production. In simple words inventories refer to the stocks held by the firm.

 Economic Lot Inventories: All industrial units purchase some resources from an outside source. Every time an order is placed for stock replenishment, there are certain costs involved called Ordering Cost. Ordering cost includes paper work cost, cost involved in dispatching, follow up costs to ensure timely supply, costs involved in receiving the order is checking, inspection etc, installation costs charged by the supplier etc. If a manufacturing unit places order for only small quantities which satisfy just its current requirements, time and again it will have to place orders

 The purchaser orders quantities beyond the immediate needs and keeps excess of them as inventories. Fixed cost of ordering gets divided amongst a large number of units. Also the supplier gains when he supplies in larger quantities and a portion of this gain can be passed to the purchaser in the form of discounts.

Production Inventories: A major reason to maintain inventories is to keep the production operations going without interruption due to shortages of components, raw materials etc. When inventories are kept with this purpose in mind, they are termed as Production Inventories.

 Fluctuation/ Stabilizing Inventories: It is not always possible to match the timing of production and sales. Inventories are collected because of this time lag. Generally, demands are not accurately forecasted, so some reserve stocks are necessary to avoid stockouts or lost sales. Such inventories are called Fluctuation or stabilizing Inventories.

Anticipation Inventories: These inventories are required for the following purposes: To meet seasonal demands. The items are produced and stocked throughout the year to meet high demands during the season. To meet high demands during periods of promotion programmes launched by the firm. To meet the demand of periods during temporary shut down. Manufacturing organizations generally shut down production for some period during the year for maintenance/repair/installing new facilities etc. The demand of this period is fulfilled through stocked inventories.

Ordering/Set-up Costs: If an item is to be purchased from an outside supplier, an order has to be placed. Each order has a fixed cost associated with it called, the Ordering Cost. It includes paper work cost; cost involved in dispatching, follow-up cost to ensure timely supply, cost involved in receiving the order which includes checking, inspection etc.

Holding Costs/Carrying Costs: Holding Cost or Carrying Cost is the cost incurred by a manufacturing organization because of the items and products kept on-hand in inventory. Holding cost is a variable cost and it depends on the number of units contained in the inventory and it changes with it. Holding cost comprises of the following expenses:

Interest or Opportunity Costs: Inventories are idle resource but have an economic value. To keep the items in inventory requires capital. Manufacturing organizations either obtain loan on interest to carry inventories or pays cash to carry inventories. In either of the cases, the capital gets blocked in this idle resource (inventories) which otherwise could have been used for more productive purposes.

Storage and Handling Costs: Inventories take up storage space and have to be handled in and out of the storage area. If the organization, rents the storage space, it pays for it and so costs are involved. Even if the organization has its own storage area, there is an opportunity cost as the space could haven utilized for a more productive purpose.

Insurance and Shrinkage Costs: More inventories mean more Insurance and Shrinkage Costs. Shrinkage involves pilferage or theft, obsolescence, deterioration etc. Pilferage or theft of inventories by employees/customers can be significant in some businesses. Deterioration through physical spoilage/damage results in lost value. Obsolescence occurs when inventory cant be sold at full value

Inventory Behaviour in EOQ Model

Total Cost (annual) involved in inventory (TC) is calculated as follows: Total Cost = Annual Holding Cost + Annual Ordering Cost Annual Holding Cost = (Holding Cost per unit)*(Average number of units held in inventory) = H * Q/2 Annual Ordering Cost = (Ordering Cost/lot) * (number of orders placed annually) = S * D/Q

Substituting values from these equation, the total cost involved in inventory is given by:

Q D T .C. H . S. 2 Q

If for a lot size, the annual holding cost exceeds the annual ordering cost, it means the lot size (Order Quantity, Q) is too big and needs to be reduced. If the lot size is 390 units, the annual holding cost is much more than the annual ordering cost, and the total cost involved in inventory (T.C) is much more than the minimum possible total cost.

Minimum possible total cost would be achieved for a lot size corresponding to which annual holding and ordering costs are equal. For a lot size equal to 75 units, both these costs are equal and hence total cost is minimum. Hence in the figure above, EOQ = 75. If for a lot size, the annual ordering cost exceeds the annual holding cost, it means the lot size or order quantity is too small and needs to be increased.

When an item is purchased from outside, an ordering cost per order is associated with the inventory of the item. For such items, an economic lot size is calculated called EOQ. EOQ tends to minimize the total cost involved in inventory. EOQ is based on the assumption that supply of the item is instantaneous. The supply begins and ends at one instant and there is no consumption during the supply period. After the supply is received, the item is consumed at some constant demand rate. As the inventory of the item becomes zero, at that instant itself, fresh supply is received and a new cycle begins.

When a manufacturing organization produces an item in-house rather than purchasing it, ordering cost is replaced by set-up cost and the term, Economic Order Quantity (EOQ) is replaced by the term Economic Run Length (ERL). Economic Run Length (ERL) of an item refers to the lot size of that particular item that should be manufactured with one set-up before switching over to the lot of some other item.

While calculating the economic run length (ERL), the expression for ordering cost remains the same (as was in the expression for EOQ) but here this cost is replaced by setup cost. The expression for holding cost changes, because a proportion of the production is consumed and does not go into inventory.

Suppose, d = demand rate of the item (units/day) p = production rate of the item (units/day) d/p = proportion of production allocated to daily demand 1-d/p = proportion of production that goes into inventory

So the inventory carrying cost is not equal to H (as in EOQ) but will be lesser and equal to H (1- d/p). If this decreased carrying cost of this reduced level of inventory is taken into account, the expression for Economic Run Length (ERL) in number of units to be produced per production set-up is given as follows:

ERL

2SD H (1 d / p)

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