Inventory management is a very important function that determines the health of the

supply chain as well as the impacts the financial health of the balance sheet. Every
organization constantly strives to maintain optimum inventory to be able to meet its
requirements and avoid over or under inventory that can impact the financial figures.

Inventory is always dynamic. Inventory management requires constant and careful evaluation
of external and internal factors and control through planning and review. Most of the
organizations have a separate department or job function called inventory planners who
continuously monitor, control and review inventory and interface with production,
procurement and finance departments.

Defining Inventory

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.

Any organization which is into production, trading, sale and service of a product will
necessarily hold stock of various physical resources to aid in future consumption and sale.
While inventory is a necessary evil of any such business, it may be noted that the
organizations hold inventories for various reasons, which include speculative purposes,
functional purposes, physical necessities etc.

From the above definition the following points stand out with reference to inventory:

 All organizations engaged in production or sale of products hold inventory in one

form or other.
 Inventory can be in complete state or incomplete state.
 Inventory is held to facilitate future consumption, sale or further processing/value
addition.
 All inventoried resources have economic value and can be considered as assets of the
organization.

Different Types of Inventory

Inventory of materials occurs at various stages and departments of an organization. A

manufacturing organization holds inventory of raw materials and consumables required for
production. It also holds inventory of semi-finished goods at various stages in the plant with
various departments. Finished goods inventory is held at plant, FG Stores, distribution centers
etc. Further both raw materials and finished goods those that are in transit at various locations
also form a part of inventory depending upon who owns the inventory at the particular
juncture. Finished goods inventory is held by the organization at various stocking points or
with dealers and stockiest until it reaches the market and end customers.

Besides Raw materials and finished goods, organizations also hold inventories of spare parts
to service the products. Defective products, defective parts and scrap also forms a part of
inventory as long as these items are inventoried in the books of the company and have
economic value.

Types of Inventory by Function

 INPUT PROCESS OUTPUT

Raw Materials Work In Process Finished Goods

Consumables required Semi Finished Finished Goods at

for processing. Eg : Production in various Distribution Centers
Fuel, Stationary, Bolts stages, lying with through out Supply
& Nuts etc. required in various departments Chain
manufacturing like Production, WIP
Stores, QC, Final
Assembly, Paint Shop,
Packing, Outbound
Store etc.

Maintenance Production Waste and Finished Goods in

Items/Consumables Scrap transit

Packing Materials Rejections and Finished Goods with

Defectives Stockiest and Dealers

Local purchased Items Spare Parts Stocks &

 
required for production Bought Out items

Defectives, Rejects and

   
Sales Returns

Repaired Stock and

   
Parts

Sales Promotion &

   
Sample Stocks

Reasons why organizations maintain Inventory

Most of the organizations have raw material inventory warehouses attached to the production
facilities where raw materials, consumables and packing materials are stored and issue for
production on JIT basis. The reasons for holding inventories can vary from case to case basis.

1. Meet variation in Production Demand

Production plan changes in response to the sales, estimates, orders and stocking
patterns. Accordingly the demand for raw material supply for production varies with
the product plan in terms of specific SKU as well as batch quantities.
 Holding inventories at a nearby warehouse helps issue the required quantity and item
to production just in time.

2. Cater to Cyclical and Seasonal Demand

Market demand and supplies are seasonal depending upon various factors like
seasons; festivals etc and past sales data help companies to anticipate a huge surge of
demand in the market well in advance. Accordingly they stock up raw materials and
hold inventories to be able to increase production and rush supplies to the market to
meet the increased demand.

3. Economies of Scale in Procurement

Buying raw materials in larger lot and holding inventory is found to be cheaper for the
company than buying frequent small lots. In such cases one buys in bulk and holds
inventories at the plant warehouse.

4. Take advantage of Price Increase and Quantity Discounts

If there is a price increase expected few months down the line due to changes in
demand and supply in the national or international market, impact of taxes and
budgets etc, the company’s tend to buy raw materials in advance and hold stocks as a
hedge against increased costs.

Companies resort to buying in bulk and holding raw material inventories to take
advantage of the quantity discounts offered by the supplier. In such cases the savings
on account of the discount enjoyed would be substantially higher that of inventory
carrying cost.

5. Reduce Transit Cost and Transit Times

In case of raw materials being imported from a foreign country or from a far away
vendor within the country, one can save a lot in terms of transportation cost buy
buying in bulk and transporting as a container load or a full truck load. Part shipments
can be costlier.

In terms of transit time too, transit time for full container shipment or a full truck load
is direct and faster unlike part shipment load where the freight forwarder waits for
other loads to fill the container which can take several weeks.

There could be a lot of factors resulting in shipping delays and transportation too,
which can hamper the supply chain forcing companies to hold safety stock of raw
material inventories.

6. Long Lead and High demand items need to be held in Inventory

Often raw material supplies from vendors have long lead running into several months.
Coupled with this if the particular item is in high demand and short supply one can
expect disruption of supplies. In such cases it is safer to hold inventories and have
control.
Holding inventories help the companies remain independent and free from vendor
dependencies.

Inventory Costs
Inventory procurement, storage and management is associated with huge costs associated
with each these functions.

Inventory costs are basically categorized into three headings:

1. Ordering Cost
2. Carrying Cost
3. Shortage or stock out Cost & Cost of Replenishment

a. Cost of Loss, pilferage, shrinkage and obsolescence etc.

b. Cost of Logistics
c. Sales Discounts, Volume discounts and other related costs.

1. Ordering Cost

Cost of procurement and inbound logistics costs form a part of Ordering Cost.
Ordering Cost is dependant and varies based on two factors - The cost of ordering
excess and the Cost of ordering too less.

Both these factors move in opposite directions to each other. Ordering excess quantity
will result in carrying cost of inventory. Where as ordering less will result in increase
of replenishment cost and ordering costs.

These two above costs together are called Total Stocking Cost. If you plot the order
quantity vs the TSC, you will see the graph declining gradually until a certain point
after which with every increase in quantity the TSC will proportionately show an
increase.

This functional analysis and cost implications form the basis of determining the
Inventory Procurement decision by answering the two basic fundamental questions -
How Much to Order and When to Order.

How much to order is determined by arriving at the Economic Order Quantity or

EOQ.

2. Carrying Cost

Inventory storage and maintenance involves various types of costs namely:

 Inventory Storage Cost

 Cost of Capital
 Inventory carrying involves Inventory storage and management either using in house
facilities or external warehouses owned and managed by third party vendors. In both
cases, inventory management and process involves extensive use of Building,
Material Handling Equipments, IT Software applications and Hardware Equipments
coupled managed by Operations and Management Staff resources.

 Inventory Storage Cost

Inventory storage costs typically include Cost of Building Rental and facility
maintenance and related costs. Cost of Material Handling Equipments, IT
Hardware and applications, including cost of purchase, depreciation or rental
or lease as the case may be. Further costs include operational costs,
consumables, communication costs and utilities, besides the cost of human
resources employed in operations as well as management.

 Cost of Capital

Includes the costs of investments, interest on working capital, taxes on

inventory paid, insurance costs and other costs associate with legal liabilities.

The inventory storage costs as well as cost of capital is dependant upon and
varies with the decision of the management to manage inventory in house or
through outsourced vendors and third party service providers.

Current times, the trend is increasingly in favor of outsourcing the inventory management to
third party service provides. For one thing the organizations find that managing inventory
operations requires certain core competencies, which may not be inline with their business
competencies. They would rather outsource to a supplier who has the required competency
than build them in house.

Secondly in case of large-scale warehouse operations, the scale of investments may be too
huge in terms of cost of building and material handling equipments etc. Besides the project
may span over a longer period of several years, thus blocking capital of the company, which
can be utilized into more important areas such as R & D, Expansion etc. than by staying
invested into the project.

EOQ (Economic Order Quantity)

The EOQ refers to the order size that will result in the lowest total of order and carrying costs
for an item of inventory. If a firm place unnecessary orders it will incur unneeded order costs.
If a firm places too few order, it must maintain large stocks of goods and will have excessive
carrying cost. By calculating an economic order quantity, the firm identifies the number of
units to order that result in the lowest total of these two costs. The constraints and assumption
followed:
1. Demand is known-- Using past data and future plans a reasonably accurate prediction of
demand can often be made. This is expressed in unit sold in a year.
2. Sales occur at a constant rate-- This model may be used for goods that are sold in
relatively constant amount throughout the year. A more complicated model is needed for
firms whose sales fluctuate in response to their seasonal cyclical factors.
3. Cost of running of goods are ignored-- Cost associated with storage, delays or lost sales
are not considered. These costs are considered in the determination of safety level in the re-
order point subsystem.
4. Safety stock level is not considered-- The safety stock level is the minimum level of
inventory that the firm wishes to hold as a protection against running out. Since the firm must
always be above this level the EOQ need not be considered the safety stock level.

Total Ordering Cost (TOC) = (A/Q)*O

Average Inventory= Q/2
Total Carrying Cost (TCC) = (Q/2)*C
Total Inventory Cost= TOC+TCC
Total Cost= (AO/2) + (QC/2)
Where A=total annual demand
Q=Quantity order in units
O=Order cost per order
C=Carrying cost per unit
The basic formula is
EOQ = 2(U)(OC)/ CC%PP
Where 2=mathematical factor that occurs during the deriving of the formula, U-Units sold per
year, a forecast provided by the marketing department. OC=Cost of placing each order for
/more inventory provided by cost accounting. CC% = Inventory carrying cost expressed as a
percentage of the average value of the inventory, an estimate usually provided by cost
accounting. PP = Purchase price per each unit of inventory supplied by the purchasing
department.
EOQ generally minimizes the total inventory cost. However, EOQ may not be optimal when
discounts are factored into the calculation.

The optimal order quantity when discounts are involved is either:

 EOQ; or
 Any one of the minimum order quantities above EOQ that qualify for additional
discount.

The optimum quantity is determined by comparing the total inventory cost of the different
order quantities listed above.

For example, if the EOQ is 1000 units and discounts of 2%, 5% and 8% are offered at 500
units, 1000 units and 2000 units, the order quantity that shall lead to the lowest total
inventory cost will either be the EOQ (i.e. 1000 units) or 2000 units. In order to determine the
optimum quantity, we need to compare the total inventory cost of order quantities of 1000
units and 2000 units. We can ignore the total inventory cost of 500 units as it is below the
EOQ level.

Example

BIKO is a bike retailer located in the outskirts of Ranchi.

BIKO purchases bikes from PMX in orders of 250 bikes which is the current economic order
quantity.

PMX is now offering the following bulk discounts to its customers:

 2% discount on orders above 200 units

 4% discount on orders above 500 units

 6% discount on orders above 600 units

BIKO is wondering if the EOQ model is still the most economical and whether increasing the
order size would actually be more beneficial.

Following information is relevant to forming the decision:

 Annual demand is 5000 units

 Ordering cost is Rs100 per order

 Annual holding cost is comprised of the following:

 5% insurance premium for the average inventory held during the year
calculated using the net purchase price

 Warehousing cost of Rs 6 per unit

  Purchase price is Rs 200 per unit before discount

Solution

We need to compare the total inventory cost of the order quantities at the various discount
levels with that of the economic order quantity.

Since the holding cost is partially determined on the basis of purchase price, we need to re-
calculate the EOQ by applying a discount. As the EOQ seems likely to fall within the 200 to
400 units range, we should use 2% discount in our calculation.

2 x 100 (Order Cost) x 5000 (Annual

EOQ = √ Demand)
0.05x( 200x0.98) + 6 (Holding Cost)

≈ 252 units

Order
252 units 500 units 1,000 units
Quantity

Number of
orders
(Annual
5,000 ÷ 252 = 19.84 5000 ÷ 500 = 10 5,000 ÷ 1,000 = 5
demand ÷
Order
Quantity)

Ordering
Cost
(number of 19.84 x 100 = 1,984 10 x 100 = 1,000 5 x 100 = 500
orders ×
Rs100)

Warehousin
g Cost (Rs6
× Average 6 × 252/2 = 756 6 × 500/2 = 1,500 6 × 1000/2 = 3,000
number of
units)

Insurance
Cost (5% ×
Purchase 0.05×(200×0.98)×(252/ 0.05×(200×0.96)×(500/ 0.05×(200×0.94)×(1000
Price × 2) = 1,235 2) = 2,400 /2) = 4,700
Average
Inventory)

Cost of 200×5000×(1.0-0.02) = 200×5000×(1.0-0.04) = 200×5000×(1.0-0.06) =

 Purchase
(Purchase
Price ×
Annual 980,000 960,000 940,000
Demand ×
(100 -
discount%)

Total
Inventory Rs 983,975 Rs 964,900 Rs 948,200
Cost

Based on the above analysis, the optimum order quantity is 1000 units.