Inventory Management and Control

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 to large items such as machines, trucks and construction equipment.

Dependent and Independent Demand Items:

The inventory models described in this chapter relate primarily to independent-
demand items and dependent demand items.

Independent-demand are those items that are ready to be sold or used. Dependent-
demand items are those which are components of finished products, rather than the
finished products themselves. For example, a computer would be an independent-
demand item, while the components that are used to assemble a computer would be
dependent-demand items: The demand for those items would depend on how many
of each item is needed for a computer, as well as how many computers are going to
be made.

NATURE AND IMPORTANCE OF INVENTORIES

Inventories are a vital part of business. Not only are they necessary for operations,
but they also contribute to customer satisfaction. a typical firm probably has about 30
percent of its cur- rent assets and perhaps as much as 90 percent of its working
capital invested in inventory.

One widely used measure of managerial performance relates to return on investment

(ROI), which is profit after taxes divided by total assets. Because inventories may
represent a significant portion of total assets, a reduction of inventories can result in a
significant increase in ROI

Inventory decisions in service organizations can be especially critical. Hospitals, for

example, carry a stock of drugs and blood supplies that might be needed on short
notice. Being out of stock on in emergency situation can cost lives. On the other hand,
many of these items have a limited shelf life, so carrying large quantities would mean
having to dispose of unused, costly supplies. Therefore, the purpose should be to
keep balance in supply and demand.

The Purpose of Inventory:

The purpose of inventory is to keep a balance in the rate of demand and supply. No
matter what is being stored as inventory, or where it is positioned in the operation, it
will be there because there is a difference in the timing or rate of supply and demand.

If the supply of any item occurred exactly when it was demanded, the item would
never be stored. For example, a water tank. If the rate of supply of water to a house is
lesser than the rate at which water is used, a tank of water (inventory) will be needed.

When the rate of supply exceeds the rate of demand, inventory increases; when the
rate of demand exceeds the rate of supply, inventory decreases. So if an operation
can match supply and demand rates, it will also succeed in reducing its inventory
levels.

In business terms, the objective of inventory management is to strike a balance

between inventory investment and customer service. The decision maker must make
two fundamental decisions: the timing and size of orders (i.e., when to order and how
much to order).

TYPES OF INVENTORY:
Buffer inventory
Buffer inventory is also called safety inventory. Its purpose is to compensate for the
unexpected fluctuations in supply and demand.

Cycle inventory
Cycle inventory occurs because one or more stages in the process cannot supply all
the items it produces. For example, suppose a baker makes three types of bread, each
of which is equally popular with its customers. Because of the nature of the mixing
and baking process, only one kind of bread can be produced at any time. The baker
would have to produce each type of bread in batches. The batches must be large
enough to satisfy the demand for each kind of bread between the times when each
batch is ready for sale. The excess amount in each batch is Cycle inventory.

De-coupling Inventory
In most of the production processes, if a problem occurs at once stage, it causes the
whole system to delay because defected part of process stops supplying materials for
next parts of system. Therefore, it is a common practice to keep inventories before
each step of process. de-coupling inventory creates the opportunity for independent
scheduling and processing speeds between process stages.

Anticipation inventory:
When a firm can forecast (anticipate) an increase in demand, it may keep some extra
inventory to be utilized in future when demand will rise. Anticipation inventory is
most commonly used when demand fluctuations are large but relatively predictable.
It might also be used when supply variations are significant.

Pipeline inventory:
Pipeline inventory exists because material cannot be transported instantaneously
between the point of supply and the point of demand.

Some other kinds of inventories include the following:

o Raw materials and purchased parts.
o Partially completed goods, called work-in-process (WIP).
o Finished-goods inventories (manufacturing firms) or merchandise (retail stores).
Tools and supplies.
o Maintenance and repairs (MRO) inventory.
o Goods-in-transit to warehouses, distributors, or customers (pipeline inventory).
 FUNCTIONS OF INVENTORY:
Inventories serve number of functions. Among the most important are the following:

1. To meet anticipated customer demand. Inventories are stored so that products can
be delivered on time even if demand changes over time.

2. To smooth production requirements. Firms that experience seasonal patterns in

demand. It can build piles of inventory in off season, and can create shortage in peak
season. The objective is to keep sufficient inventory in all seasons that are feasible
with cost.

3. To decouple operations. In most of the production processes, if a problem occurs

at once stage, it causes the whole system to delay because defected part of process
stops supplying materials for next parts of system. Therefore, it is a common practice
to keep buffers of inventories before each step of process.

4. To protect against stockouts. As mentioned earlier, in peak season, inventory can

run out. It can occur because of weather conditions, supplier stockouts, deliveries of
wrong materials etc. The risk of shortages can be reduced by holding safety stocks,
which are stocks in excess of expected demand

5. To take advantage of order cycles. To minimize purchasing and inventory costs, a

firm often buys in large quantities because it is usually economical to produce in
large rather than small quantities. Again, the excess output must be stored for later
use.

6. To hedge against price increases. Occasionally a firm will suspect that a

substantial price increase is about to occur and purchase larger-than-normal amounts
to beat the increase. A good example is petrol stations in Pakistan.

7. To permit operations. The fact that production operations take a certain amount of
time (i.e., they are not instantaneous) means that there should generally be some
work-in-process inventory.

8. To take advantage of quantity discounts. Suppliers may give discounts on large

orders.

REQUIREMENTS FOR EFFECTIVE INVENTORY MANAGEMENT

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:

INVENTORY COUNTING SYSTEMS

Inventory counting systems can be periodic or perpetual.
 Periodic System
Under a periodic system, a physical count of items in inventory is made at periodic
intervals (e.g., weekly, monthly) in order to decide how much to order of each item.

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

Perpetual Inventory System

A perpetual inventory system (also known as a continual system) keeps track of
removals from inventory on a continuous basis, the system provides information on
the current level of inventory for each item. When the amount on hand reaches a
predetermined minimum, a fixed quantity is ordered.
Perpetual system can be very simple or can be complicated. Example of simple
system is two bin system. That is, to have two containers of stock, when one is empty,
order a new one. Today most of the businesses use universal product code (UPC), or
bar code, printed on an item tag or on packaging that has information about the item
to which it is attached.

On the other hand, example of complicated system is Point-of-sale (POS) systems

which electronically record actual sales. Knowledge of actual sales can greatly
enhance forecasting and inventory management. The order is placed at the supplier
as soon as the item is sold at the point of sale. Digital feul meter

DEMAND FORECASTS AND LEAD-TIME INFORMATION

It is essential to know how long it will take for orders to be delivered. The time
between submitting an order and receiving it is called lead time. It may vary. In case
of greater variability in lead time, there is more need for additional stock to reduce
the risk of a shortage between deliveries. Thus, there is a crucial link between
forecasting and inventory management.

INVENTORY COSTS
In making a decision on how much to purchase, operations managers must try to
identify the costs which will be affected by their decision. Several types of costs are
directly associated with order size.

1. Cost of placing the order. Every time that an order is placed, a number of
transactions are needed which incur costs to the company. These include the clerical
tasks of preparing the order and all the documentation associated with it, arranging
for the delivery to be made, arranging to pay the supplier for the delivery, and the
general costs of keeping all the information which allows us to do this.
2. Price discount costs. In many industries suppliers offer discounts on the normal
purchase price for large quantities; alternatively they might impose extra costs for
small orders.

3. Stock-out costs. If we misjudge the order-quantity decision and our inventory runs
out of stock, there will be costs to us incurred by failing to supply our customers. If
 the customers are external, they may take their business elsewhere; if internal, stock-
outs could lead to idle time at the next process.

4. Working capital costs. Soon after we receive a replenishment order, the supplier will
demand payment for their goods. Eventually, when (or after) we supply our own
customers, we in turn will receive payment. However, there will probably be a lag
between paying our suppliers and receiving payment from our customers. During
this time we will have to fund the costs of inventory. This is called the working capital
of inventory.

5. Storage costs. These are the costs associated with physically storing the goods.
Renting, heating and lighting the warehouse etc.

6. Obsolescence costs. When we order large quantities, this usually results in stocked
items spending a long time stored in inventory. Then there is a risk that the items
might either become obsolete (in the case of a change in fashion, for example) or
deteriorate with age (in the case of most foodstuffs, for example).

7. Operating inefficiency costs. According to lean synchronization philosophies, high

inventory levels prevent us seeing the full extent of problems within the operation.

CLASSIFICATION SYSTEM
All the items in the inventory are not equally important. Therefore, there is a need to
classify these items based on their relative importance. Following are different ways
for classification of inventory.

i. Usage Value
It is computed by multiplying usage rate of various items with their individual value.
Items with a particularly high usage value are must be controlled very carefully with,
whereas those with low usage values need not be controlled quite so rigorously.

ii. Pareto law

Generally, a relatively small proportion of the total range of items contained in an
inventory are responsible for a large proportion of the total usage value. This
phenomenon is known as the Pareto law.

It is similar to the 80/20 rule. That 20% of the products account for 80% of company
sales.

iii. A.B.C Classification:

ABC inventory control allows inventory managers to concentrate their efforts on
controlling the more significant items of stock. A (very important), B (moderately
important), and C (least important). However, the actual number of categories may
vary from organization to organization
o Class A items are those 20 per cent or so of high-usage-value items which account
for around 80 per cent of the total usage value.
o Class B items are those of medium usage value, usually the next 30 per cent of
items which often account for around 10 per cent of the total usage value.
o Class C items are those low-usage-value items which, although comprising
around 50 per cent of the total types of items stocked, probably only account for
around 10 per cent of the total usage value of the operation.

iv. Cycle Counting:

Another application of the A-B-C concept is as a guide to cycle counting, which is a
physical count of items in inventory. The purpose of cycle counting is to reduce
discrepancies between the amounts indicated by inventory records and the actual
quantities of inventory on hand

The key questions concerning cycle counting for management are

1. How much accuracy is needed?
2. When should cycle counting be performed?
3. Who should do it?

HOW MUCH TO ORDER

ECONOMIC ORDER QUANTITY MODELS
The question of how much to order can be determined by using any of the following
models described below.

1. The basic economic order quantity model.

2. The economic production quantity model.
3. The quantity discount model.

Economic Order Quantity (EOQ) Model

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 basic model involves a number of assumptions which are listed below.
1. Only one product is involved.
2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year (demand rate is constant).
4. Lead time is known and constant.
5. Each order is received in a single delivery.
6. There are no quantity discounts.

The actual model can be seen in the following figure, (one must focus on the lecture
to understand and explain the models illustrated below)
The total annual carrying cost is computed as

The Economic Production Quantity Model.

The Quantity Discount Model.

 LEAN & JUST IN TIME (JIT) PRODUCTION SYSTEMS
As business organizations tend to maintain competitiveness in an ever-changing
global economy, they are increasingly seeking new and better ways of operating.
Some organizations change from the traditional ways of operating to lean operation.
A lean operation is a flexible system of operation that uses considerably fewer resources

Lean systems are sometimes referred to as just-in-time (JIT) system which is A

highly coordinated processing system in which goods move through the system, and
services are performed, just as they are needed.

Features and Philosophy of Lean Systems:

A widely held view of JIT/lean production is that it is simply a system for
scheduling production that results in low levels of work-in-process and inventory.
But in its truest sense, JIT/lean production represents a philosophy that encompasses
every aspect of the process, from design to after the sale of a product. The philosophy
is to pursue a system that functions well with minimal levels of inventories, minimal
waste, minimal space, and minimal transactions.

Companies that use lean operations have achieved a level of quality that enables
them to function with small batch sizes and tight schedules. Lean systems have high
reliability; major sources of inefficiency and disruption have been eliminated, and
workers have been trained not only to function in the system but also to
continuously improve it. The ultimate goal of a lean operation is to achieve a system
that matches supply to customer demand

The building blocks and supporting goals for a lean system are demonstrated in the
following figure.

Supporting Goals:
The ultimate goal of lean is a balanced system, that is, one that achieves a smooth,
rapid flow of materials and/or work through the system. The idea is to make the
process time as short as possible by using resources in the best possible way. The