Inventory Management
Topic
I. General Objectives:
1. Define the term inventory.
2. List the different types of inventory.
3. Describe the main functions of inventories.
4. Discuss the main requirements for effective management.
5. Explain periodic and perpetual review systems.
6. Describe the costs that are relevant for inventory management.
7. Describe the A-B-C approach and explain how it is useful.
8. Describe the basic EOQ model and its assumptions and solve typical
problems.
9. Describe the economic production quantity model and solve typical problems.
10. Describe the quantity discount model and solve typical problems.
II. Summary of Chapter:
Inventory management is a core operations management activity. Good inventory
management is often the mark of a well-run organization. Inventory levels must be
planned carefully in order to balance the cost of holding inventory and the cost of
providing reasonable levels of customer service. Successful inventory management
requires a system to keep track of inventory transactions, accurate information about
demand and lead times, realistic estimates of certain inventory-related costs, and a
priority system for classifying the items in inventory and allocating control efforts.
Four classes of models are described: EOQ, ROP, fixed-order-interval, and single-
period models. The first three are appropriate if unused items can be carried over
into subsequent periods. The single period model is appropriate when items cannot
be carried over. EOQ models address the question of how much to order. The ROP
models address the question of when to order and are particularly helpful in dealing
with situations that include variations in either demand rate or lead time. ROP
models involve service level and safety stock considerations. When the time
between orders is fixed, the FOI model is useful for determining the order quantity.
The single-period model is used for items that have a “shelf life” of one period. The
models presented in this chapter are summarized in Table 13.4 .
Key points:
1. All businesses carry inventories, which are goods held for future use or potential
future use.
2. Inventory represents money that is tied up in goods or materials.
3. Effective inventory decisions depend on having good inventory records, good cost
information, and good estimates of demand.
4. The decision of how much inventory to have on hand reflects a trade-off, for
example, how much money to tie up in inventory versus having it available for
other uses. Factors related to the decision include purchase costs, holding costs,
ordering costs, shortage and backlog costs, available space to store the
inventory, and the return that can be had from other uses of the money.
5. As with other areas of operations, variations are present and must be taken into
account. Uncertainties can be offset to some degree by holding safety stock,
although that adds to the cost of holding inventory.
III. Questions and Answers:
1. Define the term inventory.
Answer:
An inventory is a stock or store of goods. Firms typically stock hundreds or
even thousands of items in inventory, ranging from small things such as
pencils, paper clips, screws, nuts, and bolts to large items such as machines,
trucks, construction equipment, and airplanes. Naturally, many of the items a
firm carries in inventory relate to the kind of business it engages in.
2. What are the different types of inventory?
Answer:
a. The different kinds of inventories include the following:
b. Raw materials and purchased parts.
c. Partially completed goods, called work-in-process (WIP).
d. Finished-goods inventories (manufacturing firms) or merchandise
(retail stores).
e. Tools and supplies.
f. Maintenance and repairs (MRO) inventory.
g. Goods-in-transit to warehouses, distributors, or customers (pipeline
inventory).
3. Describe the main functions of inventories.
Answer:
Inventories serve a number of functions. Among the most important are the
following:
a. To meet anticipated customer demand. A customer can be a person
who walks in off the street to buy a new stereo system, a mechanic
who requests a tool at a tool crib, or a manufacturing operation. These
inventories are referred to as anticipation stocks because they are held
to satisfy expected (i.e., average ) demand.
a. To smooth production requirements. Firms that experience seasonal
patterns in demand often build up inventories during preseason periods
to meet overly high requirements during seasonal periods. These
inventories are aptly named seasonal inventories.
b. Companies that process fresh fruits and vegetables deal with seasonal
inventories. So do stores that sell greeting cards, skis, snowmobiles, or
Christmas trees.
c. To decouple operations. Historically, manufacturing firms have used
inventories as buffers between successive operations to maintain
continuity of production that would otherwise be disrupted by events
such as breakdowns of equipment and accidents that cause a portion
of the operation to shut down temporarily. The buffers permit other
operations to continue temporarily while the problem is resolved.
Similarly, firms have used buffers of raw materials to insulate
production from disruptions in deliveries from suppliers, and finished
goods inventory to buffer sales operations from manufacturing
disruptions. More recently, companies have taken a closer look at
buffer inventories, recognizing the cost and space they require, and
realizing that finding and eliminating sources of disruptions can greatly
decrease the need for decoupling operations. Inventory buffers are
also important in supply chains. Careful analysis can reveal both points
where buffers would be most useful and points where they would
merely increase costs without adding value.
d. To reduce the risk of stock outs. Delayed deliveries and unexpected
increases in demand increase the risk of shortages. Delays can occur
because of weather conditions, supplier stock outs, deliveries of wrong
materials, quality problems, and so on. The risk of shortages can be
reduced by holding safety stocks, which are stocks in excess of
expected demand to compensate for variability in demand and lead
time.
e. To take advantage of order cycles. To minimize purchasing and
inventory costs, a firm often buys in quantities that exceed immediate
requirements. This necessitates storing some or all of purchased
amount for later use. Similarly, it is usually economical to produce in
large rather than small quantities. Again, the excess output must be
stored for later use. Thus, inventory storage enables a firm to buy and
produce in economic lot sizes without having to try to match purchases
or production with demand requirements in the short run. This results in
periodic orders or order cycles.
f. To hedge against price increases. Occasionally a firm will suspect that
substantial price increase is about to occur and purchase larger-than-
normal amounts to beat the increase.
g. To permit operations. The fact that production operations take a certain
amount of time (i.e., they are not instantaneous) means that there will
generally be some work-in-process inventory. In addition, intermediate
stocking of goods—including raw materials, semi-finished items, and
finished goods at production sites, as well as goods stored in
warehouses—leads to pipeline inventories throughout a production-
distribution system.
h. To take advantage of quantity discounts. Suppliers may give discounts
on large orders.
4. What are the main requirements for effective management?
Answer:
Management has two basic functions concerning inventory. One is to
establish a system to keep track of items in inventory, and the other is to
make decisions about how much and when to order. To be effective,
management must have the following:
4.1. A system to keep track of the inventory on hand and on order.
4.2. A reliable forecast of demand that includes an indication of possible
forecast error.
4.3. Knowledge of lead times and lead time variability.
4.4. Reasonable estimates of inventory holding costs, ordering costs, and
shortage costs.
4.5. A classification system for inventory items.
5. Explain periodic and perpetual review systems.
Answer:
Inventory counting systems can be periodic or perpetual. Under a periodic
system, a physical count of items in inventory is made at periodic, fixed
intervals (e.g., weekly, monthly) in order to decide how much to order of each
item. Many small retailers use this approach: A manager periodically checks
the shelves and stockroom to determine the quantity on hand. Then the
manager estimates how much will be demanded prior to the next delivery
period and bases the order quantity on that information.
A perpetual inventory system (also known as a continuous review system)
keeps track of removals from inventory on a continuous basis, so the system
can provide information on the current level of inventory for each item. When
the amount on hand reaches a predetermine minimum, a fixed quantity, Q, is
ordered.
6. Describe the costs that are relevant for inventory management.
Answer:
Four basic costs are associated with inventories: purchase, holding, ordering,
and shortage costs.
Purchase cost is the amount paid to a vendor or supplier to buy the
inventory. It is typically the largest of all inventory costs.
Holding, or carrying, costs relate to physically having items in storage.
Costs include interest, insurance, taxes (in some states), depreciation,
obsolescence, deterioration, spoilage, pilferage, breakage, tracking, picking,
and warehousing costs (heat, light, rent, workers, equipment, security ). They
also include opportunity costs associated with having funds that could be
used elsewhere tied up in inventory.
Ordering costs are the costs of ordering and receiving inventory. They are
the costs that occur with the actual placement of an order. They include
determining how much is needed, preparing invoices, inspecting goods upon
arrival for quality and quantity, and moving the goods to temporary storage.
Setup costs are the costs involved in preparing equipment for a job.
Shortage costs are costs resulting when demand exceeds the supply of
inventory; often unrealized profit per unit.
7. Describe the A-B-C approach and explain how it is useful.
Answer:
The A-B-C approach classifies inventory items according to some measure of
importance, usually annual dollar value (i.e., dollar value per unit multiplied by
annual usage rate), and then allocates control efforts accordingly. The actual
number of categories may vary from organization to organization, depending
on the extent to which a firm wants to differentiate control efforts. A-B-C
approach is very useful because it will categorize the items into very
important, moderately important and least important. The manager can decide
which item needs close attention. Managers use the A-B-C concept in many
different settings to improve operations. One key use occurs in customer
service, where a manager can focus attention on the most important aspects
of customer service by categorizing different aspects as very important,
important, or of only minor importance. The point is to not overemphasize
minor aspects of customer service at the expense of major aspects.
8. Describe the basic EOQ model and its assumptions and solve typical
problems.
Answer:
The basic EOQ model is the simplest of the three models. It is used to identify
a fixed order size that will minimize the sum of the annual costs of holding
inventory and ordering inventory. The unit purchase price of items in inventory
is not generally included in the total cost because the unit cost is unaffected
by the order size unless quantity discounts are a factor. If holding costs are
specified as a percentage of unit cost, then unit cost is indirectly included in
the total cost as a part of holding costs.
The basic model involves a number of assumptions.
a. Only one product is involved.
b. Annual demand requirements are known.
c. Demand is spread evenly throughout the year so that the demand rate is
reasonably constant.
d. Lead time is known and constant.
e. Each order is received in a single delivery.
f. There are no quantity discounts.
Example: A local distributor for a national tire company expects to sell
approximately 9,600 steel-belted radial tires of a certain size and tread design
next year. Annual carrying cost is $16 per tire, and ordering cost is $75. The
distributor operates 288 days a year.
a. What is the EOQ?
b. How many times per year does the store reorder?
c. What is the length of an order cycle?
d. What is the total annual cost if the EOQ quantity is ordered?
D = 9,600 tires per year
H = $16 per unit per year
S = $75
Note that the ordering and carrying costs are equal at the EOQ
9. How do you determine the numbers to use in the EOQ formula?
Answer: To determine which numbers to use you must look for the following
items. The number of items per order is the quantity (Q). The number of items
that can be sold is D. D may be the forecast demand for that particular good.
The cost of placing the order is used for S. The final number to find is the
carrying cost (C) which is the cost of the item to be held in inventory.
10. Illustrate the economic production quantity model and solve typical
problems.
Answer:
The batch mode is widely used in production. Even in assembly operations,
portions of the work are done in batches. The reason for this is that in certain
instances, the capacity to produce a part exceeds the part's usage or demand
rate. As long as production continues, inventory will continue to grow. In such
instances, it makes sense to periodically produce such items in batches, or
lots, instead of producing continually.
During the production phase of the cycle, inventory builds up at a rate equal to
the difference between production and usage rates. For example, if the daily
production rate is 20 units and the daily usage rate is 5 units, inventory will
build up at the rate of 20 - 5 = 15 units per day. As long as production occurs,
the inventory level will continue to build; when production ceases, the
inventory level will begin to decrease. Hence, the inventory level will be
maximum at the point where production ceases. Inventory will then decrease
at the constant usage rate. When the amount of inventory on hand is
exhausted, production is resumed, and the cycle repeats itself. Because the
company makes the product itself, there are no ordering costs as such.
Nonetheless, with every production run (batch) there are setup costs—the
costs required to prepare the equipment for the job, such as cleaning,
adjusting, and changing tools and fixtures. Setup costs are analogous to
ordering costs because they are independent of the lot (run) size. They are
treated in the formula in exactly the same way. The larger the run size, the
fewer the number of runs needed and, hence, the lower the annual setup
cost.
The assumptions of the EPQ model are similar to those of the EOQ model,
except that instead of orders received in a single delivery, units are received
incrementally during production.
The assumptions are:
a. Only one product is involved.
b. Annual demand is known.
c. The usage rate is constant.
d. Usage occurs continually, but production occurs periodically.
e. The production rate is constant when production is occurring.
f. Lead time is known and constant.
g. There are no quantity discounts.
Example: A toy manufacturer uses 48,000 rubber wheels per year for its
popular dump truck series. The firm makes its own wheels, which it can
produce at a rate of 800 per day. The toy trucks are assembled uniformly over
the entire year. Carrying cost is $1 per wheel a year. Setup cost for a
production run of wheels is $45. The firm operates 240 days per year.
Determine the
a. Optimal run size.
b. Minimum total annual cost for carrying and setup.
c. Cycle time for the optimal run size.
d. Run time
IV. Reactions:
According to Stevenson (2010), Inventory Management is defined as a framework
employed in firms in controlling its interest in inventory. It includes the recording and
observing of stock level, estimating future request, and settling on when and how to
arrange. On the other hand, Deveshwar and Dhawal (2013) proposed that inventory
management is a method that companies use to organize, store, and replace
inventory, to keep an adequate supply of goods at the same time minimizing cost.
Competitive advantage comprises capabilities that allow an organization to
differentiate itself from its competitors and is an outcome of critical management
decisions (Li, Ragu-Nathan, Ragu-Nathan, & Subba Rao, 2006).
The inventory investment for a small business takes up a big percentage of the total
budget, yet inventory control is one of the most neglected management areas in
small firms. Many small firms have an excessive amount of cash tied up to
accumulation of inventory sitting for a long period because of the slack inventory
management or inability to control the inventory efficiently. Poor inventory
management translates directly into strains on a company’s cash flow.
The challenge in managing inventory is to balance the trade-off between the supplies
of inventory with demand. Ideally a company wants to have enough inventories to
satisfy the demands of its customers no lost sales due to inventory stock-outs. On
the other hand, the company does not want to have too much inventory staying on
hand because of the cost of carrying inventory. Inventory decisions are high risk and
high impact for the supply chain management of an organization. According to
Dimitrios (2008), inventory management practices have come to be recognized as a
vital problem area needing top priority. As a rule of thumb in most manufacturing
organizations, direct materials represent up to 50% of the total product cost, as a
result of the money entrusted on inventory, thereby affecting the profitability and
competitiveness of the organization. According to Sander, Matthias, and Geoff
(2010), historically, however, organizations have ignored the potential savings from
proper inventory management, treating inventory as a necessary evil and not as an
asset requiring management.
As a result, many inventory systems are based on arbitrary rules. Inventory
management according to R.M, Onyango (2013) is a fundamental pillar in an
organization and it should be taken seriously.
The inventory investment for a small business takes up a big percentage of the total
budget, yet inventory control is one of the most neglected management areas in
small firms. Many small firms have an excessive amount of cash tied up to
accumulation of inventory sitting for a long period because of the slack inventory
management or inability to control the inventory efficiently. Poor inventory
management translates directly into strains on a company’s cash flow.
According to Stevenson (2010), Inventory Management is defined as a framework
employed in firms in controlling its interest in inventory. It includes the recording and
observing of stock level, estimating future request, and settling on when and how to
arrange (Adeyemi & Salami, 2010). On the other hand, Deveshwar and Dhawal
(2013) proposed that inventory management is a method that companies use to
organize, store, and replace inventory, to keep an adequate supply of goods at the
same time minimizing cost. Choi (2012) indicates that effective inventory
management is essential in the operation of any business. Thus, keeping stock is
used as an important strategy by companies to meet customers’ needs without
taking the risk of frequent shortages while maintaining high service level. As Axsäter
(2006) describes, inventories make high cost, both in the sense of tied up capital and
also operating and administrating the inventory itself. It is argued that time from
ordering to delivery of replenishing the inventory, referred to as the lead time, is often
long and the demand from customers is almost never completely known (Axsäter,
2006). Therefore, managers should consider how to achieve the balance between
good customer service and reasonable cost, which is the purpose of inventory
management, involving the time and volume of replenishment. To this end, inventory
in many business owners is one of the most visible and tangible aspects of doing
business. Raw materials, goods in process, and finished goods all represent various
forms of inventory. Each type represents money tied up until the inventory leaves the
company as purchased products. Likewise, merchandise stocks in a retail store
contribute to profits only when their sale puts money into the cash register. In a literal
sense, inventory refers to stocks of anything necessary to do business. These stocks
represent a large portion of the business investment and must be well managed in
order to maximize profits. In fact, many small businesses cannot absorb the types of
losses arising from poor inventory management. Unless inventories are controlled,
they are unreliable, inefficient, and costly. Inventory is an idle stock of physical goods
that contain economic value, and are held in various forms by an organization in its
custody awaiting packing, processing, transformation, use or sale in a future point of
time. Ballon (2004) defined inventories as stockpiles of raw materials, supplies,
components, work-in-process, and finished goods that appear at numerous points
throughout a firm’s production and logistics channels. Inventory is the stock of any
item or resource used in an organization. Inventory is generally made up of three
elements such as raw materials, work-in-progress (WIP), and finished goods (Arnold,
2008; Cinnamon, Helweg-Larsen, & Cinnamon, 2010; Gitman, 2009). Raw materials
are concerned with the goods that have been delivered by the supplier to
purchaser’s warehouse but have not yet been taken into the production area for
conversion process (Cinnamon et al., 2010). WIP concerns are when the product
has left the raw material storage area, until it is declared for sale and delivery to
customers. In this process, the working capital must be considered in terms of
reducing the buffer stocks, eliminating the production process, reducing the overall
production cycle time. The raw materials and finished goods must be minimized in
the production area. WIP must be carefully examined to justify how long it takes for
products to be cleared for sale. This stage is normally done by the quality control
procedures (Birt et al., 2011; Cinnamon et al., 2010). Finished goods refer to the
stock sitting in the warehouse waiting for sale and delivery to customers. They could
be sitting in the warehouse or on the shelf for quite some time. The owner/manager
of the business should find what options are available to dispose the slow moving
items. Should the stock be repacked or reprocessed, and sold at lower discount
prices? Sales and operations planning can reduce or eliminate the need for finished
goods. The best example of stock management is car manufacturing. The
manufacturers normally used the Just in Time (JIT) system to deliver finished
products. In this way they minimize or eliminate both raw material stock and work in
progress, as the stock is now in finished goods (Brealey et al., 2006; Cinnamon et
al., 2010; Van Horne & Wachowicz, 2008). There are theories utilized in carrying
clarity to the investigation of the role of stock administration on operational
performance. The major theories include the theory of Constraints and Lean Theory
to build the critical concerns regarding the impacts of inventory management
approaches on the profitability of manufacturing firms.
The Theory of Constraints is an administration reasoning that looks to expand
manufacturing throughput proficiency evaluated on the bases of recognizable proof
of those procedures that are obliging the industrial system. There are various
challenges experienced in the application of the Theory of Constraints. For instance,
there is a long lead time, significant number of unsatisfied requests, irregular state of
meaningless inventories or nonexistence of appropriate inventories, wrong materials
request, expansive number of crisis requests and endeavor levels, absence of
clients engagement, nonattendance of control identified with need orders which
suggests on timetable clashes of the assets. The theory focuses on adequately
dealing with the limit and ability of these limitations to enhance efficiency and this
can be accomplished by manufacturing firms applying fitting inventory control
practices. Theory of constraints is an approach whose proposition is connected to
generation aimed at achieving a reduction of the organizational inventory. Atnafu &
Balda, Cogent Business & Management (2018),
Lean theory Lean theory is an augmentation of thoughts of JIT. The theory disposes
of buffer stock and minimizes waste in production procedure. Inventory leanness
decidedly influences the productivity of a business firm and is the best inventory
control tool. The theory expounds on how manufacturers’ adaptability in their
requesting choices diminish the supplies of stock aimed at eliminating costs
associated with the transportation of inventory. Feedback presented against the
theory insinuates that materials must be available when dealing in long haul
cooperation constituting data and information sharing and the exchange of
accomplices between firms.
Inventory management techniques Inventory management is very vital to an
enterprise since it is custom-made to reducing costs or proliferating profits while
satisfying customer’s demands by guaranteeing that balanced items of stock are
sustained at the right quality, quantity, and that are obtainable at the right time and in
the right place.
Economic order quantity According to Bowersox (2002), the inventory management
needs to be organized in a logical way so that the organization can be able to know
when to order and how much to order. This must be attained through calculating the
Economic Order Quantity (EOQ). Monetary request amount engages correlation to
arrange their stock re-establishment on an ideal premise. For instance, the
arrangement can be scheduled to happen from month to month, quarterly, half
yearly, or yearly. By so doing, it enables firms to have insignificant limit costs or zero
inside their circulation focuses. Along these lines, as associations attempt to
enhance the stock administration, the EOQ and Re-Order Point (ROP) are
necessary instruments that associations can utilize.
Just in time technique: The JIT technique is a Japanese philosophy, rationality
associated with assembling which comprises having the right things in the right
quality and amount in the correct place and at the opportune time. Utilization of JIT
technique brings about the increment in quality, profitability, and effectiveness,
enhanced correspondence, and abatements in expenses and squanders. Hutchins
(1999) characterizes JIT as a process that is prepared for moment response to the
request without the necessity for any overstocking, either in the desire of the
application being approaching or as a concern of improvident characteristics all the
while. Hutchins (1999) additionally concentrated on that the prime objective of JIT
technique is the accomplishment of zero stock, not simply inside the bounds of a
single association at the end of the day all through the whole production network. It
can be connected to the assembling procedure inside any organization as it is
additionally being adjusted inside administration associations. The components of
JIT technique incorporate consistent change, taking out the seven sorts of
squanders among others. The fundamental reason of JIT is to have as of late the
proper measure of stock, whether rough materials or finished stock, open to meet
the solicitations of your creation strategy and the solicitations of the enterprise’s end
customers. The less a firm spends to store and pass on the stock, the less obsolete
quality it has to markdown.
