Inventory Management

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Inventory Inventory DefinitionDefinition A stock of items held to meet future

demand Inventory is a list for goods and

materials, or those goods and materials themselves, held available in stock by a business.

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Introduction Constitute significant part of current assets On an average approximately 60% of current

assets in Public Limited Companies in India A considerable amount of fund is required Effective and efficient management is imperative to

avoid unnecessary investment Improper inventory management affects long term

profitability and may fail ultimately 10 to 20% of inventory can be reduced without any

adverse effect on production and sales by using simple inventory planning and control techniques

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Types of Inventory

Work inprocess

Work inprocess

Work inprocess

Finishedgoods

RawMaterials

Vendors Customer

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Nature of Inventories Raw Materials – Basic inputs that are converted

into finished product through the manufacturing process

Work-in-progress – Semi-manufactured products need some more works before they become finished goods for sale

Finished Goods – Completely manufactured products ready for sale

Supplies – Office and plant cleaning materials not directly enter production but are necessary for production process and do not involve significant investment.

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ReasonsReasons To Hold To Hold InventoryInventory Meet variations in customer demand:

Meet unexpected demand Smooth seasonal or cyclical demand

Pricing related: Temporary price discounts Hedge against price increases Take advantage of quantity discounts

Process & supply surprises Internal – upsets in parts of or our own processes External – delays in incoming goods

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Objective of Inventory Management

To maintain a optimum size of inventory for efficient and smooth production and sales operations

To maintain a minimum investment in inventories to maximize the profitability

Effort should be made to place an order at the right time with right source to acquire the right quantity at the right price and right quality

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An effective inventory management should Ensure a continuous supply of raw materials to

facilitate uninterrupted production Maintain sufficient stocks of raw materials in

periods of short supply and anticipate price changes

Maintain sufficient finished goods inventory for smooth sales operation, and efficient customer service

Minimize the carrying cost and time Control investment in inventories and keep it at an

optimum level

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An optimum inventory level involves three types of costs

Ordering costs:- Quotation or tendering Requisitioning Order placing Transportation Receiving, inspecting and

storing Quality control Clerical and staffStock-out cost Loss of sale Failure to meet delivery

commitments

Carrying costs:- Warehousing or storage Handling Clerical and staff Insurance Interest Deterioration,shrinkage, evaporation and

obsolescence Taxes Cost of capital

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Dangers of Over investment

Unnecessary tie-up of firm’s fund and loss of profit – involves opportunity cost

Excessive carrying cost Risk of liquidity- difficult to convert into cash Physical deterioration of inventories while in

storage due to mishandling and improper storage facilities

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Dangers of under-investment

Production hold-ups – loss of labor hours Failure to meet delivery commitments Customers may shift to competitors which

will amount to a permanent loss to the firm May affect the goodwill and image of the firm

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-Track inventory

–How much to order

–When to order

Functions of Inventory Management

Classification of inventory

• ABC Classification• HML Classification• XYZ Classification• VED Classification• FSN Classification• SDF Classification• GOLF Classification• SOS Classification

ABC Classification

• In most of the cases 10 to 20 % of the inventory account for 70 to 80% of the annual activity.

• A typical manufacturing operation shows that the top 15% of the line items, in terms of annual rupees usage, represent 80% of total annual rupees usage.

• Next 15% of items reflect 15% of annual rupees

• Next 70% accounts only for 5% usage

A

B

C

XYZ Classification

On the basis of value of inventory stored Whereas ABC was on the basis of value of

consumption to value. X – High Value Y – Medium value Z – Least value

Aimed to identify items which are extensively stocked.

HML Classification

On the basis of unit value of item There is 1000 unit of Q @ Rs. 10 and

10,000 units of W @ Rs. 5.Aimed to control the purchase of raw materials.H – High, M- Medium, L - Low

VED Classification

• Mainly for spare parts because their consumption pattern is different from raw materials.

• Raw materials on market demand• Spare parts on performance of plant and

machinery.• V – Vital, E – Essential, D – Desirable

Therefore V items has to be stocked more

and D Items has to be less stocked

FSN Classification

According to the consumption pattern To combat obsolete items F – Fast moving S – Slow moving N – Non Moving

SDF & GOLF Classification

Based on source of procurement S – Scarce, D- Difficult, E- Easy.

GOLF G – Government, O – Ordinary, L – Local, F

– Foreign.

SOS Classification

Raw materials especially for agriculture units S – Seasonal OS – Off seasonal

Deciding on the inventory model Assume an analyst applies an inventory

model that does not allow for spoilage to a grocery chain’s ordering policy for lettuce and formulates the strategy of ordering lettuce in large amounts every 14 days. A little thought will show that this is obliviously foolish. This strategy implies that lettuce will be spoiled. However it is not a failure of inventory, it is a failure to apply the correct model.

Different approaches

Certainty approach

Uncertain variables and risk are addressed separately

Uncertainty approach

Uncertain variables and risk are addressed simultaneously

Deterministic approach Probabilistic approach

Basic EOQ Model

Assumption• Seasonal fluctuation in demand are ruled out• Zero lead time – Time lapsed between purchase

order and inventory usage• Cost of placing an order and receiving are same

and independent of the units ordered• Annual cost of carrying the inventory is constant• Total inventory cost = Ordering cost + carrying

cost

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EOQ – Three Approaches

Trial and Error method Order-formula approach Graphical approach

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EOQ & Re-order point

EOQ – gives answer to question “How much to Order”

Re-order point – gives answer to question “when to order”

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Trial & Error MethodAssumptions:-

Annual requirement (C)=1200 units

Carrying cost (I) = Rs.1

Ordering cost (O) =Rs.37.5

Order size Q 1200 600 400 300 240 200 150 120 100

Average inventory Q/2 600 300 200 150 120 100 75 60 50

No. of orders C/Q 1 2 3 4 5 6 8 10 12

Annual carrying cost

I* Q/2

600 300 200 150 120 100 75 60 50

Annual ordering cost O*C/Q

37.5 75 112.5 150 187.5 225 300 375 450

Total annual cost 637.5 375 312.5 300 307.5 325 375 435 500

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Order- Formula approach 1/2

EOQ =(2CO/I)

C = Annual demand

O = Ordering cost per order

I = Carrying cost per unit

1/2

EOQ =(2*1200*37.5/1) = 300 units

Q

0 T1 T2 T3 T4

Average inventory = Q/2

Time

Inve

ntor

y le

vel

orde

r qua

ntity

Certainty case of the inventory cycle

1. Here the negative slope from Q to T1 represents the inventory being used up

2. T1, T2, T3, T4 represents the replenishment points3. The inventory varies between 0 and Q

Graphical method to find EOQ

Cost

in

RS.

Order quantity

Ordering cost = DS/Q

Carrying cost = CQ/2Total cost

EOQ0

Extension of basic EOQ model

This model can be extended to include quantity discounts, were simple calculation for quantity discount is added.

Non zero lead timeNon zero lead time

Extension of basic EOQ model Non – zero lead time

If the lead time is ‘n’ then procurement must be done prior to ‘n’ days, i.e. T-n as shown in the figure

T1 - n T2 - n T3 - n T4 - nT1 T2 T3 T4

Time

Q

0

Reorder point

Placement of a order

Probabilistic inventory model

In practical inventory management assumption may not be strictly correct.

1. Demand may fluctuate over time due to seasonal, cyclical and random influences.

2. Lead time may also fluctuate because of transportation delay, strikes or natural disaster. For such reason most of the companies use safety stock.

But in some cases even the safety stock becomes ineffective to combat stock out. Like:-

Probabilistic inventory model contd…

Reorder point

Safety stock

Placement of order

Lead time

T1 T2 T3 T4 T5 T6

Stock out

A Review

So we have dealt with

1. EOQ model2. Its extension3. Probabilistic model

4. And now we will be dealing with

special inventory models

Special inventory model

Non – Instantaneous replenishment

Quantity Discount

One – period decision

Non – Instantaneous replenishment

Special inventory model

A B C DA B C

Thus the inventory is replenished gradually than in lots

Particularly in situation were manufacturers use continues production processe.g. FACT makes Ammonium on a continual basis

Capacity 10 units

Discount Quantities If discount increases with the order

quantity, then the price of inventory is no more constant

Special inventory model

Hence a new approach is needed to find the best lot size

Total cost

Annual holding cost

Annual ordering cost

Annual cost of materials= + +

One period decisions

If a newspaper seller does not buy enough papers to resell on the street corner, sales opportunity is lost. If the seller buys too many, the overage cannot be sold because nobody wants yesterdays newspaper.

Special inventory model

Applicable to fashion goods, seasonal goods and due to change in technology

The newsboy problem

Inventory management under uncertainty

1. Option price model

2. Risk adjusted discount cash flow (DFC) Model

3. Dynamic inventory model

Option price model

Option is a contract that gives the holder a right to acquire or sell certain things at a predetermined price without any obligation.

Calculated by integrating the market information and inventory control.

Risk adjusted discount cash flow (DFC) Model

• Inventory control problem is converted to capital budget problem

• Suppose a television dealer decides to hold an additional inventory of 1000 television per month. The cost of holding inventory is spread overtime.

• Inflows = no: of units × probability × present value

Beneficial for projects like oil drilling were the benefit is acquired only after a long time but once oil is struck the additional expanse is covered.

Dynamic inventory model

1. Uncertain variables are identified

2. Probability associated with them is taken

3. Simulation techniques are applied

Emerging trends in inventory management• Entering into log term contract at a fixed price

to reduce uncertainties• Just-in-time• Kanbans – Japanese technique (Only

produce when demand comes)• Internet based ordering system• Supply chain management• Vendor development• Investment in plant and machinery

Inventory control responsibility• Purchasing naturally has vest interest in

inventories, even to the extend that in some companies the purchasing and stores functions are combined.

• Production looks after the work in progress• Logistics plays a major role in inventory

control• Inventories are economic importance to

finance department• The fact that materials must be moved from

one place to another is of importance to materials department

In effect the responsibility cannot be kept

on one head since inventory management

is a integrated effort

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