Inventory Control

Inventory is the stock of raw materials, semi processed material, finished products
and any other item held by the organization for further processing or for sale.
Inventory is the stock of those goods which are procured and stored for smooth
functioning of the organization.
Even though an inventory is a must for any organization, yet higher inventory
blocks the capital employed of the organization and creates an additional burden in
the form of opportunity cost of interest on money blocked.
Types

of

Inventory: inventory

can

be

classified

into

the

following

categories.
1. Raw Material Inventory: A company keeps raw material inventory so that it
can be benefitted by economic bulk purchasing where it gets a huge amount
of discount. Also when there is variation in demand it can meet the changes
in production rate. It serves as a buffer stock against delay in transportation
2.

and to meet seasonal fluctuations.

Inventory of semi-finished goods: it is also known as work-in-progress

inventory and it serves the following purpose:

1. Provides economic lot production
2. Cater to variety of products
3. Replacement of wastage
4. Maintain uniform production if sales varies
3. Finished goods inventory: this is the stock of the products which company is
going to sell to the buyer party. Inventory of finished goods ensures the
adequate supply to the customers and maintains its goodwill, which helps in
promoting sales.
4. Spare parts inventory: it is the inventory of the various parts of the products
which company is selling. It helps in providing after sales service to the
customers and also in utilizing the equipment fully by the buyer.
5. MRO inventory: maintenance, repair and operating supplies which are
consumed/used in the production process but which do not become part of
the product. For example tools, equipments, lubricating oil, machine repair
parts etc.

Inventory Costs: Inventory cost include ordering cost, carrying cost and out of
stock and shortage cost.
Procurement cost or Ordering cost: these are the costs of getting an item
into the firms inventory. They are incurred each time when order is placed or the
machine is set up for production. They are expressed as cost per order in rupees.
These costs vary directly with each purchase order placed each time or each
time the machine is set up for production and is usually independent of the
quantity ordered or produced. Procurement cost include cost of administration
such as salaries of persons engaged in purchasing department, stationary,
telephone

expenditure,

computer

costs,

transportation

of

item

ordered,

expediting and follow up, receiving and inspection of goods, processing

payments and preparing a purchase order etc. if a machine is set up for
production the set up cost in that case include cost of start-up scrap generated
from getting a production run started.
Carrying and Holding costs: These are the costs incurred because a firm owns
or maintains inventory. It includes:
a.
b.
c.
d.
e.
f.

Interest on money investment in inventory

Obsolescence
Storage space rent
Wages of the persons working in the stores
Insurance
Deterioration: fresh seafood, meats and poultry products, backed products
are subject to rapid deterioration and spoilage. Dairy products, medicines,

batteries and film have limited shelf life.

g. Taxes
h. Safety measures: some items are easily concealed (e.g. pocket camera,
calculators, mobiles etc.) or fairly expensive (cars, TVs etc) are prone to theft.
Shortage and stock out costs: it is the costs that arise due to not fulfilling the
demand. It may include the cost of lost sales, cost of the lost goodwill, cost of idle
equipments and penalty of missing delivery etc.
Advantages of Inventory:
1. To maintain independence of operations: the time that it takes to do identical
operations will vary from one unit to the next. Therefore it is desirable to
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have a cushion of several parts within two workstations so that shorter

performance time can compensate for longer performance time.
2. To meet variations in product demand: the demand forecast of any product
can never be exact or accurate. There is likely to be some difference in
predicted demand and actual demand of the product. If sufficient items are
available in the inventory then fluctuations in demand can easily be adjusted
and the organisation can protect itself from unforeseen economic losses.
3. To allow flexibility in production scheduling: A stock of inventory relieves the
pressure on the production system to get the goods out. It results into
smooth flow of production planning and lower cost operation through larger
lot production.
4. To provide safe guard for variation in raw material delivery time: delays can
occur for a variety of reasons- a normal variation in shipping time, a shortage
of material at vendors place , transporters strike etc., inventory is also held
to provide safeguard for variation in raw material delivery time.
5. To take advantage of economic purchase order size: there are costs to place
order i.e. labour, phone calls, typing etc. Therefore larger order means, less
ordering cost.

Inventory Systems:
An inventory system provides the organizational structure and operating policies for
maintaining and controlling goods to be stocked. The system is responsible for
ordering and receipt of goods, timing of the order placement and keeping track of
what has been ordered, how much and from whom. The inventory system can be
classified into two: Single period systems and multiple period systems. The
classification is based on whether the decision is just a onetime purchasing decision
where the purchase is designed to cover a fixed period of time and item will not be
reordered, or the decision involves an item that will be purchased periodically where
inventory should be kept in stock to be used on demand.

Single period inventory model: In this model the unfulfilled demand

cannot be back-ordered to the next period because the demand ceases to
exist after the period for which planning is done. In other cases, even though
demand exists in the future, what is ordered for a period could not be used
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for future periods due to the perishable nature of the item. Examples include
demand for morning newspapers, tickets for journey, advertising space for a
mega entertainment event etc. often there is a high degree of uncertainty
involved in estimating the demand for a single period. Planning for
appropriate level of inventory in such situations requires a careful balancing
of two opposite costs. Carrying fewer inventories than demand directly
results into lost opportunity to make profit. This represents the cost of under
stocking. In the same way any excessive inventory cannot be consumed in
the next period.
Applications:
Fashion items, Seasonal items, High tech goods, Holiday items e.g. Christmas
trees, toys, flowers on valentines day, perishable products e.g. meals in
cafeteria, Dairy food, newspapers etc.
Let Cos = cost of over stocking per unit
Cus = cost of under stocking per unit
Q = optimal number of units to be stocked
d = single period demand
P (d<Q) = the probability of the single period demand being at most Q units.
If d>Q then the cost of under stocking is incurred. On the other hand if d < Q
then we incur the cost of over stocking. At very low values of Q we tend to
experience costs arising out of under stocking and as we increase Q
incrementally we will approach optimal Q. At very high values of Q, we will
incur cost of over stocking. By incremental analysis we find that while taking
a decision to stock Q units, we would like to ensure that
The expected cost of over stocking < the expected cost of under stocking
P (d < Q) * Cos

<

P (d > Q) * Cus
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P (d < Q) * Cos

<

[1- P (d < Q) ] * Cos

P (d < Q) * (Cos + Cus) < Cus

1. Overbooking of airline flights. It is common for customers to cancel flight
reservations for a variety of reasons. Here the cost of underestimating the
number of cancellations is the revenue lost due to an empty seat on a flight.
The cost of overestimating cancellations is the awards, such as free flight s or
cash payments, that are given to customers unable to board the flight.
2. Ordering of fashion items. A problem for a retailer selling fashion items is that
often only a single order can be placed for the entire season. This is often caused by
long lead times and limited life of the merchandise. The cost of underestimating
demand is the lost profit due to sales not made. The cost of overestimating demand
is the cost that results when it is discounted.
3. Any type of one-time order. For example, ordering T-shirts for a sporting event
or printing maps that become obsolete after a certain period of time.

Multi Period Inventory System:

These are of two types:
a. Fixed Order Quantity model (Q-model) [ basic EOQ model and
EOQ with safety stock]
In this a fixed quantity of material is ordered whenever the stock on
hand reaches the re-order point. The fixed quantity is nothing but the
economic order quantity.

At A a supply equal to EOQ is received and the stock position reaches point
E. materials are issued and when the stock reaches F (Reorder point) an
order is placed and issues continued. At B, the supplies of order placed at F
are received and the stock reaches G. in the further part of the cycle, it
should be noted that at C there is delay in the arrival of supplies and the
issues cross minimum safety level.
Fixedorder quantity models attempt to determine the specific point, R, at
which an order will be placed and the size of that order, Q. The order point,
R, is always a specified number of units. An order of size Q is placed when
the inventory available (currently in stock and on order) reaches the point R.
Inventory position is defined as the on-hand plus on-order minus
backordered quantities. The solution to a fixedorder quantity model may
stipulate something like this: When the inventory position drops to 36, place
an order for 57 more units.
The simplest models in this category occur when all aspects of the situation
are known with certainty. If the annual demand for a product is 1,000 units, it
is precisely 1,000not 1,000 plus or minus 10 percent. The same is true for
setup costs and holding costs. This model is known as
Basic EOQ model which is based on the following assumptions:
Demand for the product is constant and uniform throughout the period.
Lead time (time from ordering to receipt) is constant.
Price per unit of product is constant.
Inventory holding cost is based on average inventory.
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 Ordering or setup costs are constant.

All demands for the product will be satisfied. (No backorders are allowed.)

The Exhibit shows that when the inventory position drops to point R, a
reorder is placed. This order is received at the end of time period L, which
does not vary in this model.
Total annual cost = Annual purchase cost + Annual ordering cost + Annual
holding cost
TC

= DC

D/Q *S

Q/2 * H

where
TC = Total annual cost
D = Demand (annual)
C = Cost per unit
Q = Quantity to be ordered (the optimal amount is termed the economic
order
quantity EOQor Q opt )
S = Setup cost or cost of placing an order
R = Reorder point
L = Lead time

H = Annual holding and storage cost per unit of average inventory (often
holding cost
is taken as a percentage of the cost of the item, such as H = iC , where i is
the
percent carrying cost)
On the right side of the equation, DC is the annual purchase cost for the
units, (D/ Q) S is the annual ordering cost (the actual number of orders
placed, D/Q , times the cost of each order, S ), and ( Q /2) H is the annual
holding cost (the average inventory, Q/2, times the cost per unit for holding
and storage, H ).

The second step in model development is to find that order quantity Q opt at
which total cost is a minimum. In the next Exhibit, the total cost is minimal at
the point where the slope of the curve is zero. Using calculus, we take the
derivative of total cost with respect to Q and set this equal to zero. For the
basic model considered here, the calculations are
T C = DC + D/Q S + Q/2 H
d_T_C /dQ = 0 + ( DS/Q
Qopt =

+ H/2 = 0

2DS/H
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Because this simple model assumes constant demand and lead time, neither
safety stock nor stock-out cost is necessary, and the reorder point, R, is
simply
R=dL
where
_
d = Average daily demand (constant)
L = Lead time in days (constant)
Find the economic order quantity and the reorder point, given
Annual demand ( D ) = 1,000 units
Average daily demand ( d ) = 1,000/365
Ordering cost ( S ) = $5 per order
Holding cost ( H ) = $1.25 per unit per year
Lead time ( L ) = 5 days
Cost per unit (C ) = $12.50 What quantity should be ordered?

The previous model assumed that demand was constant and known. In the
majority of cases, though, demand is not constant but varies from day to
day. Safety stock must therefore be maintained to provide some level of
protection against stock outs. Safety stock can be defined as the amount of
inventory carried in addition to the expected demand. In a normal
distribution, this would be the mean. For example, if our average monthly
demand is 100 units and we expect next month to be the same, if we carry
120 units, then we have 20 units of safety stock.

Flow Chart:

Idle state
Waiting for demand

Demand occurs
Units withdrawn from
inventory or backordered

Compute inventory
position
Position = On-hand +
On-order Backorder

Is position
Reorder point?

F I X E D T I M E P E R I O D MODELS (P model)
Issue an order for
exactly Q units

In a fixedtime period system, inventory is counted only at particular times,

such as every week or every month. Counting inventory and placing orders
periodically are desirable in situations such as when vendors make routine
visits to customers and take orders for their complete line of products, or
when buyers want to combine orders to save transportation costs. Other
firms operate on a fixed time period to facilitate planning their inventory
count; for example, Distributor X calls every two weeks and employees know
that all Distributor Xs product must be counted.
In this model, the stock position of each item is regularly reviewed. When the
stock level of a given item is not sufficient to sustain production operation
until the next review, an order is placed to replenish the supply. The
frequency of review varies from firm to firm. It also varies among materials
within the same firm, depending upon the importance of the material,
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specific production schedules, market conditions and so forth. Order

quantities vary for different materials. Suppose we fix review period for an
item as two months and the lead time is 15 days. Then the order would be
placed every two months i. e. ordinates of R1, R2 and R3 etc. the supplies
would be received at ordinates S1, S2 and S3 etc. (15 days after R1, R2 and
R3).

At R1, let us assume that the stock available be Y1, then the stock together
with the quantity ordered at R1 (supplies received at S1) should be sufficient
to last till the next supplies are received at S2 i.e. to last a total period of two
and half months. (Review + lead time)
Advantages:
1. Items can be grouped and ordered, so ordering cost is considerable
reduced.
2. The suppliers also offer attractive discounts as sales are guaranteed.
Limitations:
1. It compels a periodic review of all items that in itself makes the system
inefficient. Because of difference in usage rates supplies may not have
to be ordered until the succeeding review. Conversely the usage of
some items during the period may have increased to the point where
they should have been ordered before the current review date, but the
manager may not notice it, since review period has not been arrived.
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Idle state waiting for

demand

Has review time

arrived?

Demand occurs units

withdrawn from
inventory or
backordered

Compute inventory
position = on hand +
on order - backorder

Compute order
quantity to bring
inventory up to
required level

Issue an order for the

number of units
Difference of Fixed-order
quantity (Q system) and fixed time period system
needed

(p-system)
Features
Order Quantity

Q model
Q-constant
(the

When to place order

amount ordered each time)

time order is placed)
R- when inventory position T when the review
drops to reorder level

P model
same q-variable (varies each

period

arrives

time

Record keeping

event triggered
triggered
Each time a withdrawl or Counted only at review

Size of inventory

addition is made
Less than P model
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period
Larger than Q model

Time to maintain

Higher

due

to

Types of items

record keeping
Higher priced,

perpetual
critical

or

important items
Selective Inventory Control
The principle of selective inventory control is based on the fact that it is
impossible to manage and control every item of the inventory holding in the
same way and still meet the objectives of the inventory management.
ABC Analysis approach is based on the annual usage value of various items.
The ABC approach is a means of categorizing inventory items into three
classes A, B and C according to the potential amount to be controlled.
Once inventory is classified, we have a firm base for deciding where we will
put our efforts. Logically we expect to maintain strong control over the A
item taking whatever action needed to maintain availability of these items
and holds stock at the lowest possible level consistent with meeting demand.
At the other end of the scale we can not afford to expense of rigid control,
frequent ordering etc. because of low amount in this area. Thus with the C
group we may maintain somewhat higher safety stock and order more
months of supply.
The inspiration behind ABC analysis has been drawn from Pareto, an Italian
economist. Paretos studies showed that a very small percentage of total
population always receive the bulk of the income. Extending Paretos
principle to inventory, it is always possible to separate Vital Few from
Trivial Many of the stock items for their effective control. Separating vital
few from trivial many is what is precisely done in ABC Analysis.
Procedure:
1. Find the usage value of each item by multiplying the number of units of
that items by its per unit price.
2. Arrange the usage value obtained in (1) in descending order.

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3. Find cumulative usage value, categorize the items on the basis of

annual usage value and calculate the total number of items in each
class.
4. Represent the cumulative usage value and total number of items into
percentages.
5. Plot the two percentages on graph paper by taking percentage of items
on X axis and corresponding percentage usage value on Y axis.
6. Mark the points in the curve where the curve sharply changes its
shape. This will give three segments which classify items as A class, B
Class and C class items, depending upon the percentages for A, B and
C items fixed by the management.

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