INVENTORY MANAGEMENT

Dr J R SHARMA

entory Management:

escribes various concepts pertaining to inventory

plain xplain the need and objectives of inventory manageme

scuss various factors affecting inventory

evelop simple deterministic inventory models

evelop and comprehend probabilistic/stochastic mode

ork out modalities associated with dynamic demand m

Inventory Defined
An inventory is a stock of an item or idle resource held for future use. Inventories represent investments designed to assist in production activities and/or serve customers. Inventory is simply a stock of physical assets having some economic value, which can be either in the form of material, money or labour. Inventory consists of physical items moving through the production system. Inventory originates with the shipment of raw materials and parts from the supplier and ends with a delivery of the finished product to the end-user. The cost of storing inventory accounts for a substantial portion of manufacturing cost, often 20% or more.

Inventory Defined
Inventory can be regarded as those goods which are procured, stored and used for day to day functioning of the organization. This can be in the form of physical resources such as manufacturing inventories; human resource such as unutilized labour, or financial resource such as working capital etc. Different departments within the organization adopt different attitudes towards inventory. This mainly because the particular functions performed by a department influence the departments motivation.

Why inventory is needed?

Inventory will always exist. Inventory, like money, is a necessary evil. Inventory is a part and parcel of every facet of business life. Whether its a service organization, or production setup or even trading centre inventories are necessary evil without which they cant do without.

Objectives of Inventory
To maintain the overall investments in inventory at the lowest level, consistent with operating requirements. To supply the product, raw material, sub-assemblies, semifinished good, etc. to its users as per their requirements at the right time and at the right price. To keep inactive, waste, surplus, scrap and obsolete items at the minimum level. To minimize holding, replacement and shortage cost of inventories and maximize the efficiency in production and distribution.

Classification of Inventory
Manufacturing inventories
Production Inventory: Items that go into final product also ensure availability of production such as raw materials, components, sub-assemblies purchased from outside. Work in Process: All items in semi finished form or products at different stages of production. Finished Product: Final/Completed product ready for dispatch/shipment to users/distributors. MRO: Maintenance, Repairs and Operating supplies like spares, consumables which though needed for final product dont actually into it oil, grease, cotton wastes, tools, etc.

Classification of Inventory
Manufacturing inventories
Miscellaneous Inventory: eg. scrap, wastes, stationery, etc. Movement Inventory or Pipeline or Transit Inventories

Buffer Inventories:
Buffer inventories are held to protect against the uncertainties of demand and supply. The inventories which are in excess of those necessary just to meet the average demand, held for protecting against the fluctuation in demand and / or lead time. They are also known as Safety Stocks.

Classification of Inventory
Other Inventories
Lot size (to avail bulk purchase discount, to reduce purchasing, ordering and transportation, to minimize handling and receiving costs), Anticipation stock (kept to meet the predictable demand or unavailability of items crackers before Diwali, raincoats & umbrellas in rainy season, etc.), Fluctuation stock (kept to offset uneven demand peaks or to meet and ensure ready supplies in face of irregular fluctuations in their demands) Risk stocks (items needed to ensure that there is no risk of complete breakdown of production, these are the items with long lead time for supply, but are vital and critical for production).

Decoupling Inventories:
The idea of the decoupling inventories is to decouple, or disengage, different phases of the production system. Inventories in between the various machines are held in order to disengage the processing on those machines. The decoupling inventories works as shock-absorbers and have a cushioning effect of varying work-rates for man as well as machines, because of breakdowns, failure, absenteeism, time-cycle, line imbalance, etc.

Inventory decisions
How much to order? Quantity. When to order? Time. How much safety stock should be kept? Level of Safety Stock.

Factors affecting inventory

Purchase Price / Production Cost:
This refers to the nominal cost of inventory. It is the purchase price for the items that are bought from outside sources, and production cost if the items are produced within the organization. This cost may be constant per unit, or it may vary with as the quantity purchased/produced increases/decreases. If the unit cost is constant, it does not affect the inventory control decisions because then whether all the requirements are bought / produced just once, or whether they are obtained / produced in installments, the total amount of money involved would be the same. However, we do consider the quantity discounts when they occur, because they affect these decisions.

Selling Price:
The inventory model are usually based on profit maximization criterion which includes the revenue from selling the commodity. The unit selling price may be a constant or variable, depend upon whether quantity discount is allowed or not. (Factored in case of Single Period Inventory Models) This represents the cost that is associated with storing an item in inventory. It is proportional to the amount of inventory and time over which it is held. This is usually expressed as a rate per unit or as a percentage of the inventory value. It is taken to be fixed for each unit of a certain item of inventory held for a unit time. The elements of carrying cost includes the opportunity cost of capital invested in the stock; the costs directly associated with storing goods store mans salary, rent, heating and lighting, racking and palletization, protective clothing, stores transport, temperature maintenance, etc; the obsolescence cost (including scrapping and possible rework); deterioration costs and costs incurred in preventing deteriorations; and fire and general insurance, etc.

Carrying Cost / Holding Costs / Storage Cost:

Procurement cost / Ordering cost / Setup costs:

Ordering costs are incurred when the inventories are replenished. It includes costs associated with the processing and chasing of the purchase order, transportation, inspection, expediting overdue orders and so on. When the units are produced within the organization then its known as set-up cost. It refers to the cost incurred in relation to developing the production schedules, the resources employed in making the production system ready and so on. These costs are taken to be independent of the order size/production size.

Shortage cost / Stockout cost / Backorder costs:

Stockout cost mean the cost associated with not serving the customers. Stockouts imply shortages. If the stockout is internal (within the system) it would

 Backorder Sales: In case of a backorder the sales are not lost, they are only delayed. When the new shipment arrives, a customer who was denied earlier would be immediately supplied the goods. But it would involve costs like those of expediting and, maybe, also packaging and shipment costs. Lost Sales: On the other hand, when the sales are lost forever, it is difficult to assess the costs involved in terms of the profit on potential sales lost, profit on whatever the customer would have bought in all future periods in case he decides not to turn to the organization for anything in future, and so on and so forth. Such costs are exorbitantly high.

2. Demand
Demand is a key component affecting an inventory policy. Projected demand patterns determine how an inventory problem is modeled. The demand for the period of time may be satisfied instantaneously at the beginning of the period or uniformly during that period. The effect of this instantaneous or uniform demand reflects directly on the total cost of holding inventory. Typical Demand Patterns are: Constant over time (Deterministic Inventory Models) Changing but known over time (Dynamic Models) Variable (randomly) over time (Probabilistic Inventory Models)

3. Ordering Cycle: It is identified by the time period between two successive placement of orders and is concerned with the time measurement of the inventory situation.
Continuous review Q System 2 Bin System (ROL): The system is continuously monitored. A new order is placed when the inventory reaches a critical point. Periodic review P System: The inventory position is investigated on a regular basis. An order is placed only at these times.

4. Delivery Lag or Lead Time: The time between placement of the requisition of an item and its receipt for actual use is called lead time. This again can be deterministic or probabilistic. 5. Time Horizon: This is the planning period over which inventory is to be controlled. This may be finite or infinite. Usually it is done on yearly basis.

Overview of Inventory Issues

DETERMINISTIC INVENTORY MODELS PROBABLISTIC / STOCHASTIC INVENTORY MODELS

Typical Inventory Problems include:

Basic Inventory (EOQ) Quantity Discount Production Lot Size (EPQ) Planned Shortage Continuous Review System (Q) Periodic Review System (P)

 Demand for the product is uniform, continuous, constant and deterministic i.e. the item is in the maturity phase of its PLC. The item is replenished in lots or batches, and the quantity need not be an integral number of units, and there are no restrictions on its size. The unit variable cost does not change appreciably with time; in particular inflation is at low level. The unit variable cost does depend on the replenishment quantity; and there are not bulk discounts on unit cost or transportation cost. The item is treated entirely independently of other items; i.e. benefits from the joint review or replenishment do not exist or are simply ignored. The lead time is zero and the entire ordered quantity is delivered as soon as the order is placed. Delivery is instantaneous, so that all the order arrive at the same time and can be used immediately. No shortages are allowed. (Shortage cost is prohibitive or very large or infinite) The planning horizon is very long and we assume that all parameters will continue at the same value for a long time.

Economic Order Quantity Model Assumptions

Economic Order Quantity Model

BASIC EOQ MODEL

Some of these assumptions may appear far removed from reality, but as we will see this basic EOQ model forms an important building block in more complex inventory decision making systems. Most of these assumptions will be relaxed in the subsequent models. In determining the appropriate order quantity, we use the criterion of minimization of total relevant costs; relevant in the sense that they are truly affected by the choice of the order quantity. Q - Order size / replenishment quantity in units Co - Ordering costs / cost of replenishment / setup cost of manufactured items.

The fixed cost component independent of the magnitude of the replenishment quantity. Rs / order C - Purchase price / Production cost - unit variable cost of the item. Rs./unit Ch - Cost of holding the stock. The cost of having one rupee item tied up in the inventory for a unit time interval usually one year. Rs/unit/unit time. Also expressed as %charge of purchase price of the item. D - Demand rate of the item. units/unit time. T - Cycle time is the time between two consecutive replenishments. This depends on the order size, with large orders leading to a longer cycle times. LT - Lead time (delivery lag) TC (Q) - Total relevant costs Rs. per unit time influenced by the order quantity.

For this model the various levels of stock are as follows:

Minimum level = safety stock (buffer) = zero Maximum level = min level + order quantity = zero + EOQ = Q Reorder level = min level + consumption during lead time = zero + LT*D Average inventory per cycle = (max level + min level) / 2 = Q / 2

TC = PC + OC + HC + SC = purchase + ordering + holding + shortage

PC = price/unit * quantity purchased = C * D OC = cost of ordering per order * number of orders = Co * D/Q HC = cost of carrying one unit * average number of units in stock = Ch * Q/2 SC = zero (no shortage allowed)

TC = C * D + Co * D/Q + Ch * Q/2
The EOQ is the quantity which minimizes the total costs. Total cost is the sum of fixed cost and variable cost. Fixed cost component C*D is independent of order size, while the variable component is dependent on the order size.

Cycle Time:
The cycle time, T, represents the time that elapses between the placement of orders.

T=Q/D
Note, if the cycle time is greater than the shelf life, items will go bad, and the model must be modified.

Number of Orders per Year:

To find the number of orders per years take the reciprocal of the cycle time.

N=D/Q=1/T
Example: The demand for a product is 1000 units per year.
The order size is 250 units under an EOQ policy. How many orders are placed per year? N = 1000/250 = 4 orders. How often orders need to be placed (What is the cycle time)? T = 250 / 1000 = years. T = years * 365 days = 91 days {Note: The four orders are equally spaced}.

Cost Equation for the EOQ Model

Total Annual = Total Annual Total Annual+ Total Annual + Inventory Costs Holding Costs Ordering Costs Procurement Costs

TC(Q) = (Q/2)*Ch(D/Q)*Co + + D*C The Optimal Order Size

Q* =

2 Co D

Ch

TVC(Q) and EOQ*

r de r lo a im t d op an e h ts tt os A c e: t ng t s No e ldi os tal o c siz al h g To t n to eri ual d or eq e ar

i ng old H

sts Co

* ** o * *

TVC( Q)

ing r de Or tal To sts Co

Q*
Optimal Order Size

1. A manufacturer uses Rs. 10000 worth of an item during the year. He has estimated the ordering costs as Rs. 25 per order and carrying costs as 12.5% of average inventory value. Find the optimal order size, no. of orders per year, time period per order and total cost. 2. An item is required at a rate of 18000 units per year. Storage cost is Rs. 0.10 per unit per month. If the cost of placing an order is Rs. 400, find EOQ, no. orders per year, cycle period, total annual cost if the unit price is Rs. 2.00 3. Easton Electronics produces 2000 TV sets in a year for which it needs an equal number of tubes of certain type. Each tube costs Rs. 10 and the cost to hold a tube in stock for a year is Rs. 2.40. Besides, the cost of placing an order is Rs. 150, which is not related to the size. No of working days in the year 250 days. Lead-time is 15 days. Now if an order of 2000 tubes is placed, only one order per annum is required. When 1000 units are ordered there are two orders per annum, etc. Naturally, as the no. of orders increases the ordering costs goes up. More orders however would also imply smaller order quantity and, therefore, decreasing holding costs. Show the trade-off between the ordering and the holding cost, by considering various quantity levels, and find EOQ, ROL, TVC, inventory cycle, no. of orders, and rupee value of EOQ.

4. An item is used at a uniform rate of 50000 units per year. No shortages are allowed and delivery is at infinite rate. The ordering, receiving and hauling cost is Rs. 13 per order, while inspection cost is Rs. 12 per order. Interest cost Rs. 0.056 and deterioration cost and obsolescence cost Rs. 0.004 resp. per year for each item actually held in inventory plus Rs. 0.02 per unit based on the maximum no. of units in inventory. Calculate the EOQ and if lead time is 20 days, find the reorder level. 5. A Mng. Company has determined form an analysis of its accounting and production data for a certain part that its demand is 9000 units per annum and is uniformly distributed over the year, its cost price is Rs. 2 per unit, its ordering cost is Rs. 40 per order, the inventory carrying charge is 9% of its inventory value. Further, it is also known that the lead-time is uniform and is 8 working days, and that the working days in a year are 300. Find all the parameters. (EOQ, No., TVC, ROL, T) a. when Q=3000 b. Q is 20% more and also c. 40% less, find TVC.

As shown in cost curves the total cost curve is quite flat near the point of minimum cost ie Q* and TC*. This indicates small variations in optimal order size will have little impact on total system cost. With this sensitivity analysis, we try and prove that costs are insensitive to errors in selecting the exact size of a replenishment quantity.

Sensitivity Analysis in EOQ Models

Q*

Sensitivity Analysis in EOQ Models

The insensitivity of total costs to the exact values of Q has two major implications: Use of an inaccurate value of Q can result from inaccurate estimates of one or more parameters like holding costs, ordering costs, or even demand levels. The conclusion is that its not worth making accurate/exact estimates of these input parameters if considerable efforts and/or resources (capital) are involved. In most cases, inexpensive crude estimates would suffice. Certain order quantities may have additional appeal over the EOQ, because of certain nonfinancial, physical, logistical reasons like pallet size, truck size, container shape, etc.

Lead Time and the Reorder Point:

In reality lead time always exists, and must be accounted for when deciding when to place an order. The reorder point, R, is the inventory position when an order is placed.

R=L*D
L and D must be expressed in the same time unit.

Safety Stock:
Safety stocks act as buffers to handle: Higher than average lead time demand. Longer than expected lead time. With the inclusion of safety stock (SS), R is calculated by

R = L * D + SS
The size of the safety stock is based on having a desired service level.

Service Level:

Lead Time and the Reorder Point: Graphical demonstration: Short Lead Time
Reorder Point
v In ry to en si Po n tio

Place the order now

R = Inventory at hand at the beginning of Lead Time

Lead Time and the Reorder Point: Graphical demonstration: Long Lead Time
Outstanding order= inventory at hand R at the beginning of lead time + one outstanding order = demand during lead time = L*D

Inventory at hand

Place the

Safety Stock
Planned situation

Reorder Point

Actual situation

Place the order now R=L*D

Inventory Costs: Including

Safety Stock

Total Annual Total AnnualTotal AnnualTotal Annual Inventory Costs Ordering Costs Procurement Costs = Holding Costs

TC(Q) = (Q/2)*Ch(D/Q)*CoD*C + Ch*SS + +

Safety Stock Holding Cost

Price Break Model:

A number of assumptions have been made to arrive at Basic EOQ Model. One of the most unreal and impractical was that the unit variable cost of the item did not depend on the size of the order. In many practical situations, quantity discounts do exists, and taking advantage of this results in substantial savings. When discount is applicable to all units, it is known as All-units Discount. However, if discounts are offered only for the items which are in excess of the specified quantity, it is known as Incremental Discount. Lets discuss All-units Discount

Economic Production Run/ Economic Manufacturing Quantity/ Economic Run Quantity:

One of other assumption inherent in the derivation of basic EOQ Model was that the whole replenishment quantity arrives at the same time. As soon as the order is made, the replenishment is received i.e. the lead time was supposed to be zero. If instead, we assume that the items become available at a rate of P units per unit of time (or we can also take this to be a manufacturing set up where the items, instead of being purchased from outside are produced inside, then this P is the rate of production per unit of time). The other considerations in this case is that the rate of production or the supply rate of the

Shortages (Back-orders):
One of the earlier assumptions which had been considered during the development of the basic EOQ Model was there were no stockouts i.e. shortages were not allowed. Only in case of very ideal scenario, this assumption works out well. In real life situations, there are so many variations in the affecting parameters that shortages do come into picture. There are two type of reactions towards the shortages from the potential customer: 1. Either he/she withdraws the order and shifts to another source for requirement - which is the case of lost sales

Basic EOQ Model with Planned Shortages (Back-orders):

With the assumption of back-ordering, shortages may in fact be deliberately planned to occur. The planned shortages can sometimes be a sound decision based on certain economic considerations, specially when the value of the item in question is very high with consequent high cost of holding it in the inventory. Generally, its a trade off between the cost of shortages as against the cost of holding the item. T1 - the time when inventory is on hand and orders filled as and when they occur T2 - when there is a stockout and all the orders

INTERVAL
This also known as perpetual inventory system, reorder inventory system or Q system. In this system, the count of the number of units in inventory is continuously maintained. With lead time less than the reorder cycle, an order for a fixed quantity Q (mostly EOQ) is placed when the inventory level drops to a predetermined reorder level R.

P SYSTEM / FIXED PERIOD SYSTEM

The system involves the reviewing of stock levels at a fixed interval of time known as review period and placing replenishment orders at the end of each period. The replenishment quantity is variable and corresponds to the amount of stock required