Download Ordering Cost Annual Costs of Carrying Inventory

Managing Inventory
TYPES OF INVENTORY
 Manufacturing Inventory
• Raw Material
• Work-In-Process
 Maintenance Repair Operating Supplies

Distribution Inventory
• Finished Goods
• Saleable Spares

Echelon Inventory
Total Supply Chain Inventory
Multi- Echelon Inventory
Suppliers
Supplier
Echelon Lead time
Supplier
Echelon Inventory
Holding Stores
Receiving Stores
Factory
Echelon
Lead time
Plant
Plant
Plant
Plant
FPS
Factory
Echelon
Inventory
Depot
Depot
Echelon Lead time
Dealer
Dealer
MULTI-ECHELON INVENTORY
Dealer
Dealer
Depot
Echelon Inventory
INVENTORY MANAGEMENT
 Inventory Management Comprises
 Inventory Planning
 Inventory Control
 Inventory Created By Production Also Supports it & Needs to
be Managed Together in a Coordinated Way (Not Separately)
 Inventory Planning Carried Out at All Levels of Management
 Master Planning Level – End Products
 Overall Inventory Level
• Production Planning – Overall Company
• Master Production Scheduling (MPS) – End Items/ Finished Goods
• Material Requirement Planning (MRP) – Components/ Parts/ Raw Material
 Value of Inventory Converts into Cash as Inventories Used by
Operations Resulting in improved Cash Flow/ Return on Investment
 Carrying Inventory Absorbs Costs Increasing Operating Costs
& Decreasing Profits
 Good Inventory Management Essential for Profitable Running of
Any Organization
LEVELS OF INVENTORY MANAGEMENT
 Aggregate Inventory Management
 Manage Inventory as Per Classification & Functions They Perform
• Raw Material
• Work-in-Process
• Finished Goods
 Financially Oriented & Concerned with Costs & Benefits of Carrying Different
Classifications of Inventory
 Aggregate Inventory Management Looks into
 Flow & Kinds of Inventory Needed
 Supply & Demand Patterns
 Functions that Inventories Perform
 Objectives of Inventory Management
 Inventory Costs
 Item-Level Inventory Management Involves Establishing Decision Rules
for Controlling Inventory at the Item Level & Includes
 Identifying Items Most Important for Business
 How Individual Items Will be Controlled
 How Much to Order at One Time
 When To Place an Order
INVENTORY CLASSIFICATION BY FLOWS
 Major Classification of Inventory Based on Flow of Material Into/ Through
and Out of a Manufacturing Organization
 Raw Material – Purchased Items Received But Not Issued to Production
& Include Component/ Parts/ Sub-assemblies
 Work-In-Process (WIP) - Raw Materials Issued to Production Being Processed/
Waiting for Next Stage in Processing
 Finished Goods – End Product of the Production Process Ready for Sale Held at
Factory/ Central Warehouse
 Distribution Inventories – Stocked in Various Points in the Distribution System
 Maintenance, Repair & Operational Supplies (MRO) – Items that Support the
Production Process But Do Not Become Part of Product – Hand Tools/ Machine
Spares/ Lubricants/ Cleaning Supplies
Warehouse
Supplier
Supplier
Raw Materials
Purchased Parts
Sub-Assemblies
Work
In
Process
Finished
Goods
Warehouse
Warehouse
Supplier
Inventories/ Flow of Materials
C
U
S
T
O
M
E
R
S
FUNCTIONAL VIEW OF INVENTORY
 Anticipation Inventory
 In Anticipation of Future Demand Ahead of Peak Selling Season/ Sales
Promotion/ Vacation Shutdown/ Threat of Strike
 Fluctuation Inventory (Safety Stock)
 To Cover Random Unpredictable Fluctuations in Supply/ Demand/ Lead Time
 Safety Stock/ Buffer Stock/ Reserve Stock Prevents Disruption in Manufacturing/
Deliveries To Customers Due To Stock Out Resulting from Un-Anticipated Delays
 Lot-Size Inventory (Cycle Stock)
 Purchased/ Manufactured Quantities Greater Than Immediate Need Create Cycle
Stock
 To Take Advantage Of Quantity Discounts/ Reduce Shipping/ Set Up Costs
 When Making/ Purchasing of Items at Rate Same as These Will Be Used/ Sold
 Cycle Stock is Portion of Inventory That Depletes Gradually as Customer Order
Comes in and is Replenished Cyclically When Suppliers Deliver Supplies
 Maintenance, Repair & Operating Supplies (MRO)
 Items that Support the Production Process But Do Not Become Part of Product –
Hand Tools/ Machine Spares/ Lubricants/ Cleaning Compounds/ Pencils/ Erasers
FUNCTIONAL VIEW OF INVENTORY
 Hedge Inventory
 Inventory Procured To Take Benefit of Low Prices When Supply More Than
Demand in Global Markets
 Such Products Normally are Minerals/ Grains/ Animal Products
 Transportation Inventory (Pipeline/ Movement Inventory)
 Inventory in Transit
 Created as Time Required to Move Inventory from Plant To Distribution Centre/
Customer
 Transit Inventory Not Dependent on Shipment Size But on Transit Time-T, in
Days & Annual Demand-A, in Units
 Average Annual Inventory in Transit, I=TA/ 365 in Units
 Reduction in Annual Average Transit Inventory Possible by Reducing
Transportation Time
Delivery of goods from a supplier is in transit for ten days. If the annual
demand is 4, 200 Units, what is the Average Annual Inventory in Transit?
Average Annual Inventory in Transit, I = TA/ 365
= (10×4200)/ 365=115.06 Units
EXAMPLES
1. Delivery of goods from a supplier is in transit for twelve days. If the annual
demand is 5, 500 Units, what is the Average Annual Inventory in Transit?
Average Annual Inventory in Transit, I = TA/ 365
= (12×5500)/365=180.82 Units
2. If Transit Time is eleven days and the Annual Demand for an item is
10, 000 Units. What is the Average Annual Inventory in Transit?
Average Annual Inventory in Transit, I = TA/ 365
= (11×10000)/365=301.36 Units
3. A company is using a carrier to deliver goods to a major customer.
Annual demand is Rs 2,000,000 and the average transit time is 10 days.
Another carrier promises delivery in 7 days. What will be the reduction in
transit inventory if the company accepts the offer?
Current Average Annual Inventory in Transit= TA/ 365
= (10×2000000)/365=Rs 54,794.52
If offer Accepted, Average Annual Inventory in Transit= TA/ 365
= (7×2000000)/365=14000000/365= Rs. 38,356.16
Reduction in transit inventory= 54, 794.52-38, 356.16=Rs. 16, 438.36
INVENTORY MANAGEMENT OBJECTIVES
 Maximum Customer Service
 Increased Efficiency in Operations
 Minimum Investment in Inventory
Effective Inventory Management Helps in
Maximizing Profits
While Providing Excellent Customer Service
as Desired By Customers
PROVIDING CUSTOMER SERVICE
 Making Products Available Exactly When Needed By Customer
is Providing Customer Service in Terms of Inventory
 Customer Could Be Purchaser/ Distributor/ Another Plant in the
Organization/ Next Workstation Where Next Operation will
Take Place
 Stock Availability is a Tool to Measure Effectiveness of Inventory
Management System in Organization
 Inventory Helps to Maximize Customer Service By Protecting
Against Uncertainty
 Condition of Stock-Out Occurs If No Stock Available When
Customer Requires it
 Stock-Out Leads to Customer Dissatisfaction
 Often Extra Inventory Held as Safety Stock to Avoid Stock-Outs
IMPROVING OPERATING EFFICIENCY
 Inventories Help Manufacturing Operations To be More Productive in
4 Ways
 Inventories Allow Operations with Different Rate of Production To
Operate Separately and More Economically
 Subsequent Operations That Have Different Production Rates & Must be
Operated More Efficiently Will Build Up Inventories Between Them
 Strategy of Satisfying Need for Seasonal Products with Non-uniform
Demand Using Anticipatory Inventory Built Up Through Uniform Level
Round the Year Production Result in Lower
 Overtime Costs
 Hiring/ Firing Costs
 Training Costs
 Sub-Contracting Costs
 Capacity Requirement
 Inventories Allow Longer Production Runs That Result in
 Reduced Setup Costs Per Item - With Single Set Up More Quantities Produced
 Increase in Production Capacity as Processing Time Greater Than Setup Times
 Inventories Allow Purchase in Larger Quantities Lowering Ordering
Cost Per Unit While Taking Advantage of Quantity Discounts As well
Quantity
OPERATION LEVELING
Jan
Mar
Jun
Seasonal Demand
Production
Sep
Dec
INVENTORY COSTS
 Item Cost/ Landed Cost
 Purchased Item=Purchase Price+Transportation Cost+Insurance+Customs Duties
 Manufactured Item= Direct Material + Direct Labour + Factory Overhead
 Carrying Costs/ Holding Costs: Incurred Due To Volume of Inventory
Carried that Increases/ Decreases When Volumes Increase/ Decreases
 Capital Costs: Depends On Interest Rate/ Credit Rating of Firm/ Other Investment
Opportunities
• Money Invested in Inventory & Not Available for Other Uses Thus Representing
Loss Opportunity Cost.
• Minimum Cost is Loss of Interest
 Storage Costs: Depends on Location & Type of Storage Needed
• Costs Related to Storing Space/ Workers/ Handling Equipment
 Risk Costs: Normally Low Value But 100% of Item Value for Perishable Items
• Obsolescence-Loss of Product Value Due to Model/ Style/ Technology Change
• Damage – Product/ Packaging Damage in Store/ Transit
• Pilferage – Goods Lost/ Stolen
• Deterioration – Rots/ Dissipates in Storage/ Limited Shelf Life
 Carrying/ Holding Costs Expressed as Percentage of Rupee Value of Inventory per
Unit of Time (Usually One Year)–Normally 20-35 % Per Year/Higher for Fashion Items
EXAMPLES
A company carries average annual inventory of Rs. 2, 000,000. They
estimated their costs of capital, storage and risk are 10%, 7% and 6%
respectively. Calculate how much it costs annually to carry the inventory
Total Cost of carrying Inventory = Cost of Capital + Storage Cost + Risk Cost
= 10% + 7% + 6% = 23%
Annual cost of carrying Inventory = 23/100 ×2,000,000 = Rs. 460,000.00
Given the following percentage costs of carrying inventory, calculate the
annual carrying cost if the average inventory is $1 million. Capital costs
are 10%, storage costs are 6% and risk costs are 7%.
Total Cost of carrying Inventory = 10%+6%+7% = 23%
Annual cost of carrying Inventory = 0.23×1,000,000 = $230,000.00
A florist carries an average inventory of $10, 000 in cut flowers. The
flowers need special storage and are highly perishable. The florist
estimates capital cost at 10%, storage cost at 25% and risk costs at 50%,
What is his annual carrying cost?
Total Cost of carrying Inventory = 10%+25%+50% = 85%
Annual cost of carrying Inventory = 0.85×10,000 = $8,500.00
INVENTORY COSTS
 Ordering Costs
 Costs Associated With Placing an Order with Factory/ Supplier
 Not Dependent on Quantity Mentioned in the Order
 Annual Cost of Ordering Depends On Number of Orders Placed During the Year
 Ordering Costs in Manufacturing Include
 Production Control Costs
• Annual Costs & Effort Expended in Production Control Depend on Number of
Production Orders Placed Not the Quantities Ordered in Each
• Costs Related to Issuing/ Closing Orders/ Scheduling/ Machine Loading/
Dispatching/ Expediting
 Set Up & Teardown Costs
• Work Centres Need to be Set Up Every Time To Run New Production Order & Tear
Down The Set Before New Order is Taken Up
• Costs Not Dependent On Order Quantity But on Number of Orders Placed Per Year
 Lost Capacity Costs
• Every Time Order Placed with Work Centre Time Taken to Set Up is Lost Productive
Output Time
• Particularly Important & Costly are Set Up Costs at Bottleneck Work Centres
INVENTORY COSTS
 Ordering Costs in Purchasing
 Purchase Order Cost
• Costs Incurred to Place an Order Depends on Number of Orders Not Ordered Quantities
• Related to Order Preparation/ Follow Up/ Expediting/ Receiving/ Authorizing Payments
• Quality Inspection/ Transportation Costs
• Accounting Cost of Receiving/ Paying the Invoice
 Stock-Out Costs
 When Demand During Lead Time of Supply Exceeds Forecast Stock- Out
Costs Increases due to
• Back-Order Costs
• Lost Sales
• Lost Customers
 Carrying Extra Inventory Protects Against Stock Outs
 Capacity-Associated Costs
 When Output Levels Need To be Changed Cost incurred in Overtime/ Hiring/
Training/ Running Extra Shifts / Layoffs
 Costs Can be Avoided By Leveling Production & Producing at Same Rate During
Slack Times for Sale During Peak Periods
 Production Leveling Builds Inventory During Slack Periods
EXAMPLE
Calculate average cost of placing one order with the annual costs given
below:
• Production Control department salaries= Rs60,000
• Supplies & operational expenses for PC department= Rs15,000
• Cost of setting up work centres for an order= Rs120
• Orders placed each year= 2,000
Average cost of One order= Fixed Cost/ No. of orders + Variable Cost
= (60000+15000)/2000 + 120= Rs157.50
Annual purchasing salaries are $65,000, operating expenses for the purchasing
Department are $25,000 and inspecting & receiving costs are $25/ order. If the
purchasing department places 9,000 orders a year, what is the average cost of
ordering? What is the annual cost of ordering?
Average cost of ordering=Fixed Cost/ No. of Orders + Variable Cost
= (65000+25000)/ 9000 + 25=$35.00
Annual cost of ordering=Fixed Cost + Variable Cost × Annual No. of Orders
= (65000+25000) + 9000 × 25=$315,000
EXAMPLE
An importer operates a small warehouse that has the following annual costs
Wages for purchasing are $45,000, purchasing expenses are $30,000, customs
and brokerage costs are $25/ order, the cost of financing the inventory is 8%,
Storage costs are 6% and the risk costs are 10%. The average inventory is
$250,000 and 5,000 orders are placed in a year. What are the annual ordering
and carrying costs?
Total Cost of carrying Inventory = Cost of Capital+Storage Costs+Risk Costs
= 8% + 6% + 10% = 24%
Annual cost of carrying Inventory = 0.24 ×250,000 = $60,000
Average cost of One Order= Fixed Cost/ No. of Orders + Variable Cost
= (45000+30000)/5000 + 25= $40
Annual cost of Ordering=Average Cost of One Order × No. of Annual Orders
= 40 × 5000=$200,000
EXAMPLE
A company makes and sells a seasonal product. Quarterly Sales forecasts
for the product are 2,000, 3,000, 6,000, 5,000 Items for the next year.
Calculate level production plan, quarterly ending inventory and average
quarterly inventory.
If inventory carrying costs are $3 per unit per quarter, what will be the
annual cost of carrying inventory? Assume opening and closing inventories
as zero.
Q1
Q2
Q3
Q4
Total
Sales Forecast
2000
3000
6000
5000
16000
Production Plan
4000
4000
4000
4000
16000
2000
3000
1000
0
1000
2500
2000
500
Inventory Cost ($3/Unit) 3000
7500
6000
1500
Ending Inventory
Average Inventory
0
18000.00
Average Inventory = Opening Inventory + Ending/Closing Inventory
2
EXAMPLE
A company manufactures and sells a seasonal product. Based on the
Quarterly sales forecasts that follows, calculate level production plan,
quarterly ending Inventories and average quarterly inventories. Assume that
the average quarterly inventory is the average of starting and ending
inventory for the Quarter. If inventory carrying costs are $3 per unit per
quarter, what will be the annual cost of carrying this anticipation inventory?
Opening and ending Inventories are zero.
Q1
Q2
Q3
Q4
Total
Sales Forecast
1000
2000
3000
2000
8000
Production Plan
2000
2000
2000
2000
8000
1000
1000
0
0
500
1000
500
0
Inventory Cost($3/ Unit) 1500
3000
1500
0
Ending Inventory
Average Inventory
0
$6,000
Annual cost of carrying anticipatory Inventory = $6,000
EXAMPLE
Given the following data, calculate a level production plan, quarterly ending
Inventory and average quarterly inventory. If inventory carrying costs are
$6 per unit per quarter, what is the annual carrying cost? Opening and ending
Inventories are zero.
If the company always carries 100 units of safety stock, what is the annual
cost of carrying it?
Q1
Q2
Q3
Q4
Sales Forecast
5000
8000
8000
10000
31000
Production Plan
7750
7750
7750
7750
31000
2750
2500
2250
0
1375
2625
2375
1125
$6
8250
15750
14250
6750
Ending Inventory 100
2850
2600
2350
100
Average Inventory
1475
2725
2475
1225
8850
16350
14850
7350
Ending Inventory
0
Average Inventory
Inventory Cost
Inventory Cost
$6
Total
$45,000
$47,400
SELECTIVE CONTROL OF INVENTORY
 Inventory Managed By Controlling Individual Items – Stock-Keeping
Units (SKU) & That Involves Costs
 For Effective Inventory Control at Reasonable Cost Large Number of
Items in Inventory Are Classified According To Importance of The SKU
for Operations/ Business
 Classifications Used To Render Selective Treatment to Different
Category of Material
 Different Inventory Control Methods Used for Items Based On Different
Selection Criteria
 Each Classification Emphasizes On a Particular Aspect
 Annual Usage Value
 Unit Price of Item
 Criticality of Item
 Difficulties in Procurement
 Procurement Source
 Seasonality
 Stock Turnover Rate
 Consumption Rate
 Value of Stocks
SELECTIVE INVENTORY MANAGEMENT
Item Classification
Criteria for Selection
A-B-C (Always Better Control)
Annual Usage Value
H-M-L (High, Medium, Low)
Unit Price of Item
V-E-D (Vital, Essential, Desirable)
Criticality of Item
S-D-E (Scarce, Difficult, Easy)
Difficulties in Procurement
G-O-L-F (Government, Ordinary,
Local, Foreign)
Procurement Source
S-OS (Seasonal, Off- Seasonal)
Nature of Supplies
M-N-G (Moving, Non Moving, Ghost Items)
Stock Turnover Rate
F-S-N (Fast, Slow, Non Moving)
Consumption Rate
XYZ
Value of Items in Stores
Categorizing Items in Stock Into Manageable Groups
Facilitates Inventory Control with the Right Focus
A-B-C CLASSIFICATION - METHODOLOGY
1. Determine Annual Usage of Each Item
2. Multiply Annual Usage of Item by Its Cost To Get Total Annual
Usage Value
3. List Items According to Annual Usage Value in a Descending
Order
4. Calculate the Cumulative Annual Usage Value & Cumulative
Percentage of Items
5. Examine Annual Usage Distribution & Group Items into A/ B/ C
Groups Based on Percentage of Annual Usage
Used in Controlling Inventories of Raw Material/
Components/ WIP/ Finished Goods
A-B-C CLASSIFICATION
Cumulative
Value %
A-
100
10% of Items
75% of Value
15% of Items
B - 15% of Value
90
75% of Items
C - 10% of Value
75
A–Frequently Monitored+
Lower Safety Stock
To Avoid Stock Outs
C– Least Frequently
Monitored+
Highest Safety Stock
A
10
B
25
100
C
% Items
EXAMPLE
Item
Unit
Usage
Unit Cost
Rs.
Annual
Usage Rs
A
1100
2
2200
B
600
40
24,000
C
100
4
400
D
1300
1
1,300
E
100
60
6,000
F
10
25
250
G
100
2
200
H
1500
2
3000
I
200
2
400
J
500
1
500
A company manufactures a
line of 10 items. Their usage
and unit cost are shown in
the accompanying table
along with annual Rupee
value usage of each.
Group items into ABC
Classification.
SOLUTION
Item
Unit
Usage
Unit
Cost
(Rs.)
Annual Cum Cum %
Usage Usage of Rs
(Rs)
(Rs) Usage
B
600
40
24,000
24,000
62.75
A
E
100
60
6,000
30,000
78.43
A
H
1500
2
3,000
33,000
86.27
B
Class
A
1100
2
2,200
35,200
92.03
B
D
1300
1
1,300
36,500
95.42
B
J
500
1
500
37,000
93.73
C
I
200
2
400
37,400
97.78
C
C
100
4
400
37,800
98.82
C
F
10
25
250
38,050
99.48
C
G
100
2
200
38,250
100.00
C
A-Class
• 20% - Items
• 78.43%-Value
B-Class
• 30% -Items
• 16.99%-Value
C-Class
• 50% -Items
• 4.58%-Value
INVENTORY CLASSIFICATION - ABC ITEMS
 A-Class Items
 High Priority Items Represent About (10-15)% of Items that Account
for About 70-80% of Value
 Tight Control on Inventory
• Keep Complete & Accurate Records
• Regular + Frequent Review of Demand Forecasts
• Close Follow-Up + Expediting Supplies To Reduce Lead Time
 B-Class Items
 Medium Priority Items Represent About (10-15)% of Items that Account
for About (10-15)% of Value
 Normal Control on Inventory
• Keep Good Records
• Regular Attention To Demand Forecasts
• Normal Processing
 C-Class Items
 Lowest Priority Items Represent About (70-50)% of Items that Account
for About (10-15%) of Value
 Simplest Possible Control On Inventory - Stock Large Quantities
• Simple Records with Periodic Review of Stocks
• Order Large Quantities & Carry Safety Stocks
H-M-L ANALYSIS
 H - Category of Items
 High Priced Items
• Tight Control on Consumption
• More Frequent Verification of Stocks
• Purchase Policies for Closer Control on Purchase
• Higher Storage Security (Locked in Steel Cupboards)
 M - Category of Items
 Medium Priced Items
• Medium Control on Consumption
• Frequent Verification of Stocks
• Medium Control on Purchase
• Medium Security of Storage
 L - Category of Items
 Low Priced Items
• Less Control on Consumption
• Less Frequent Verification of Stocks
• Less Stringent Control on Purchase
• Standards Security Provided
Used In Controlling Purchased Inventory
V-E-D ANALYSIS
 V - Category of Items: Vital for Production/ Consumers
 Item in C Category May Come Under Vital Category If
• Non-Availability Will Cause Serious Problems/ High Stock-Out Costs
• Large Lead Time for Procurement
• Non-Standard Item Purchased Against Purchaser’s Design
 E - Category of Items: Essential Items
 High Cost of Stock-Out
 D - Category of Items: Desirable Items
 Nominal Cost of Stock-Out Not Affecting Business in a Big Way
 Factors for Deciding VED Category of Items
 Stock-Out Costs
 Lead Time for Procurement
 Nature of Item: Standard/ Supplier Designed/ Buyer Designed
 Source of Supply: Local/ Outstation/ Imported/ Controlled Item
 ABC & VED Analysis Normally Used Together for Controlling
Inventory of Spares/ Parts
Criteria of Selection - Criticality of Item
S-D-E ANALYSIS
 S-D-E Analysis Based on Problems Related To Procurement
 Non-Availability/ Scarcity of Items
 Unusually Long Lead Time
 Geographical Location of Suppliers
 Reliability of Suppliers
 Items Classified Under 3 Groups
 Scarce
• Short Supply/ Long Lead Time/ Imported/ Through Govt. Agencies
• Best to Limit No. of Times to Order
 Difficult
• Available Locally
• No/ A Few Reliable Source Available
• Needs Advance Notice/ Long Lad time of Procurement
 Easy: Readily Available Standard Products
 S-D-E Analysis Mostly Used in Purchase Department
 For Deciding Purchase Methods of Different Category of Items
 Allocating Responsibility By Seniority Levels of Purchasers/ Buyers
Used in Lead Time Analysis & Purchase Strategy Formulation
G-O-L-F ANALYSIS
 Based on Nature of Suppliers that Determine
 Quality of Items
 Lead Time of Supply
 Terms of Payment
 Continuity of Supplies
 Administrative Work Involved
 Classifies Items into 4 Groups By Source of Supplies
 G: Government Suppliers – Public Sector Undertakings
• Involves Long Lead Times
• Payment in Advance/ Against Delivery
 O: Ordinary (Non-Government) Suppliers
• Moderate Delivery Lead Times
• Credit Facility Available
 L: Local Suppliers
• Easy Availability
• Purchased Against Cash/ Blanket Orders
 F: Foreign Suppliers
• Large Amount of Administrative/ Procedural Time & Costs Involved
• Extensive Sourcing Necessary for Identifying the Right Supplier
• Letter of Credit Method for Payment
• Shipping/ Port/ Customs Clearance Needs Special Efforts/ Costs
Used in Procurement Strategies
S-OS ANALYSIS
 Items Grouped into 2 Groups Based on Seasonality of Product
 S: Seasonal
 OS: Off Seasonal
 Seasonal
 Seasonal Availability But Marketing Round the Year
• Items Available Only During Season – Mangoes/ Oranges/ Fruits
• Procured for Use in Packaged Food Industry for the Whole Year
 Seasonal But Available Round the Year
• Price Lowest During Harvesting Time
• Procurement Based on Cost Comparison Between
• Buying at Lower Price During Harvest Season & Holding Stocks for
Whole Year
• Buying Throughout the Year
 Seasonal Market But Available Round the Year – Winter Garments
• Produced Round the Year to Meet High Seasonal Demand
• Higher Inventory Carrying Cost Balanced By Lower Cost of
Producing at Uniform Level in Meeting The Seasonal Demand
 Off Seasonal – Non-Seasonal Items
Used in Procurement/ Holding Strategies for
Seasonal Items – Agricultural Products
M-N-G ANALYSIS
 Based on Stock Turnover Rate Items Classified as
 M: Moving Items – Regular Consumption
 N: Non-Moving Items – Not Consumed for last 1 Year
 G: Ghost Items – No Stocks/ No Receipt & Issue Last Financial Year
F-S-N ANALYSIS
 Used in Controlling Stock Obsolescence
 Last Date of Receipt/ Issue Considered To Calculate Period When
Stocks Did Not Move for Classifying Items
 F: Fast Moving
 S: Slow Moving
 N: Non-Moving
 S & N Category of Items Further Analyzed Conducting Ageing
Analysis To Decide on Appropriate Ways of Disposing Stocks
X-Y-Z ANALYSIS
 Used to Review Inventories & Consumption at Scheduled Intervals
 Based On Value of Stocks in Stores
 X Items: High Value of Inventory
 Y Items: Moderate Value of Inventory
 Z Items: Low Value of Inventory
INVENTORY CONTROL IN COMBINATION
 X-Y-Z Analysis Used Along with ABC/ FSN Analysis Helps
 To Identify Few Items Comprising Large Value Locked Up in Inventory
 Indicate Actions Need to be Taken for Improving Company’s Stock Profile
 X Items: High Value of Inventory
 Y Items: Moderate Value of Inventory
 Z Items: Low Value of Inventory
Class of Items
A
B
X
Work to Reduce
Stocks To Z category
Y
Convert To Z category
Z
Y
Z
Dispose Off
Surplus Stocks
Tighten Control
Review Stock Levels More Often
Class of Items
X
Work to Convert
To Y Category
C
F
Tighten Control
S
N
Reduce Stocks
To Low Levels
Dispose Off
at Optimum Prices
Reduce Stocks
Dispose Off Earliest
Lessen Control
Dispose Off Even
To Reduce Admin Costs
At Lower Prices
INVENTORY CONTROL
 Manage & Control Inventory To Balance
 Required Level of Product Availability
 Cost of Providing Desired Product Availability
 Inventory Management & Control Affects
 Customers
 Suppliers
 Major Departments in Organization
Inventory Control Exercised Through
Inventory Performance Measures
INVENTORY PERFORMANCE METRICS
 Product Availability (Service Level)
Quantity of An Item Available as Required During a Period
=
Total Demand for The Item During That Period
Higher Service Level Implies
Higher SC Responsiveness
 Inventory = Throughput × Cycle Time
Reduce Inventory By Reducing Cycle Time
× 100
FINANCIAL PERFORMANCE METRICS
 Inventory Turnover Ratio/ Inventory Turns
Financial Measure of How Effectively inventory is Used in Making Sales
Inventory Turns=
Annual Costs of Goods Sold
Average Inventory in Money Value
 Days of Supply
Financial Measure of Equivalent Number of Days of Inventory On Hand
Based on Daily Usage Rate
Inventory On Hand
Inventory in Days of Supply=
Average Daily Usage
 Higher Inventory Turns Imply Higher Efficiency in Using Inventory Asset
 Financial Metrics Relates To Sales/ Revenues Generated By the Inventory
 Financial Metrics Measure Inventory Management Performance Better
than Just Measuring Cost of Inventory Managed
EXAMPLE
A company has 9000 Units on hand and the annual usage is 48,000 units.
Assuming 240 working days in a year calculate what is the inventory in terms
of days of supply?
If the annual cost of the goods sold is Rs 24 million a year and Value of
Average inventory held is Rs 6 million what will be the inventory turns? What
will be the reduction in inventory if the turns are increased to 12 times/ year?
If cost of carrying inventory is 25% of average inventory, calculate the Savings
1. Inventory in days of supply= Average inventory on hand/ Average daily use
= 9000/ (48,000÷240) = 45 Days of Sales
2. Inventory turns=Annual Cost of Goods Sold/ Average inventory = 24 ÷ 6 = 4
3. When Inventory turns increased to 12,
Average Inventory= Annual COGS/ Turns
= 24 ÷ 12 = $2 Million
4. Reduction in average inventory= 6,000,000 – 2,000,000 = $4 Million
Carrying cost of inventory=25%
Savings=25%× 4,000,000= $1,000,000
DEFINITIONS IN INVENTORY CONTROL
 Stock Keeping Unit - Items Packed as Individual Units in Inventory
Controlled By Quantity & Time of Procurement
 Same Products with Different Colour/ Size/ No. Packed – Different SKU
 Lot/ Batch – Quantity Produced/ Purchased Together Sharing Same
Production/ Purchase Costs & Specifications
 Lot-for-Lot Rule–Order Exactly As Needed & When Required
 Ordered Quantity Changes Every Time Requirement Changes
 Unused Lot-Size Inventory Not Created as SKU Ordered When Needed
 Applicable for High Value Items & JIT Applications
 Fixed-Order Quantity Rule – Arbitrarily Specifies No. of Units/ SKU
To Order Each Time Order is Placed
 Based On Usage Rate/Lead Time/Future Demand For Given Time Period
 Does Not Minimize Costs Involved
 Min-Max System – A Variation of Fixed Order Rule
 When Quantity On Hand Reaches Reorder Level New Order Placed for
Quantity = Max Level – Quantity On Hand
INVENTORY COSTS
 Ordering/ Set Up Costs
 Transportation/ Receiving/ Inspection
 Carrying/ Holding Costs
 Space
 Capital
 Inventory Servicing
 Inventory Risk
 Stock-Out Costs
 Inventory Costs are in Trade-Off With Each Other
Total Annual Inventory Costs (TAIC) =
Annual (Material Cost + Ordering Cost + Carrying Costs)
CARRYING COST ELEMENTS
 Interest & Opportunity Costs
…….
82%
 Obsolescence & Physical Depreciation Costs ..
14%
 Storage & Handling Costs
…….
3.25%
 Taxes
……..
0.50%
 Insurance
………
0.25%
Annual Carrying Costs 20% to 35% of Value of Inventory
ANNUAL TOTAL COST
 Cost of Ordering & Carrying Inventory Depend on No. of Orders
Placed in a Year & Quantity Ordered Each Time
 Relevant Costs for Inventory Control
 Annual Costs for Placing Order: Ordering Cost
 Annual Costs of Carrying Inventory: Annual Carrying Cost as % of
Annual Average Inventory
S = Annual Demand in Units
Cu = Unit Price (Rs)
q = Order Quantity in Units
Cp = Ordering Cost/ Order (Rs)
i = Inventory Carrying Cost as Percentage of Average Inventory Investment
• Annual Ordering Cost = No. of Orders/Year × Ordering Cost = S/q × Cp
• Annual Carrying Cost = Average Inventory × Inventory Carrying Cost
= ½ × Order Quantity × Carrying Cost(%) × Unit Price =
q/2 × i × Cu
• Annual Total Cost = Annual Ordering Cost + Annual Carrying Cost
ATC = (S/q × Cp) + (q/2 × i × Cu)
EOQ FORMULA DEVELOPMENT
 Optimizing of Inventory Model Involves Calculating Order Quantity
‘q’ That Minimizes Annual Total Cost (ATC)
 Differentiating ATC with Respect to ‘q’ & Setting First Derivative to
Zero will Minimize Annual Total Cost
ATC= (S/q × Cp) + (q/2 × i × Cu)
d(ATC)
Or
dq
=–
S × Cp
q²
+
i × Cu
i × Cu
=0
Or
S × Cp
=
2
2
2.S.Cp
2.S.Cp
Or q =
Or q² =
i.Cu

i.Cu
2 × Annual Demand × Ordering Cost/ Order
EOQ =

Inventory Carrying Cost × Unit Price
q²
ECONOMIC ORDER QUANTITY
Cost
Total Cost/Unit Time
Inventory Carrying Cost
Ordering/ Set up Cost
EOQ
Quantity
 Ordering Cost vis-à-vis Carrying Cost Trade-off
 Total Annual Cost Gets Optimized When Ordering Cost=Carrying Cost
 Economic Order Quantity Ensures Optimal Annual Total Cost of Inventory
EOQ = 
2 × Annual Demand × Ordering Cost/ Order
Inventory Carrying Cost × Unit Price
EXAMPLE
A company uses 75 number of an item per month. Each unit costs
the company Rs 25/-. Cost of placing each order & inventory carrying
charges per month are computed at Rs 36/- and 1.5% of the average
inventory investment respectively. Calculate the economic lot size for
purchase of the item to minimize total cost.
2 × Annual Demand × Ordering Cost/ Order
EOQ =

Inventory Carrying Cost × Unit Price
Annual Demand = 75 × 12 = 900 Units
Ordering Cost/ Order = Rs 36
Inventory Carrying Cost/ Year = 1.5/100 × 12 = 0.18
2 × 900 × 36
EOQ =
= 120 Units

0.18 × 25
ASSUMPTIONS IN EOQ MODEL
 Annual Demand is Known & Remains Constant
 Known Delivery Time that Does Not Change
 Replenishment of Stock is Instantaneous
 Unit Price Fixed & No Quantity/ Price Discounts Allowed
 Inventory Carrying Cost Known and Remains Constant
 Ordering Cost is Known and Remains Constant
 No Stock-Outs Allowed
 Items Can be Procured Free From Any Restriction
One Variation of Classical EOQ Model
is Quantity Discount/ Price-Break Model
QUANTITY DISCOUNT/ PRICE-BREAK MODEL
 Constant Unit Price Condition Relaxed & Purchase Quantity
Discounts Allowed
 Purchase Cost & Total Annual Inventory Cost are Important
Criteria For Determining Optimal Order Size
 Lowest TAIC (Total Annual Inventory Costs)
= Annual Material Costs + Annual Ordering Costs +
Annual Carrying Costs
 Procedure to Arrive at Best Order Quantity
 For Each Purchase Price Calculate EOQ
 If EOQ Too Low To Qualify for Price Discounts Increase Quantity to
Match Lowest Qualifying Order Quantity
 Calculate TAIC for Each Price & Corresponding Quantity
 Select Price/ Quantity Combination that Results in Lowest TAIC
(Total Annual Inventory Costs)
QUANTITY DISCOUNT/ PRICE-BREAK MODEL
Soccer Ball Example
Supplier’s Offer:
Order Qty. of Soccer Balls
Below 1, 000
Between (1, 001 – 2, 000)
Above 2, 000
Price ($)
5.00
4.50
4.00
Customer Data:
Ordering Cost = $40
Annual Demand = 15, 000
Carrying Cost = 25%
2 × Annual Demand × Ordering Cost
EOQ =  ----------------------------------------------Carrying Cost × Unit Price
 EOQ with $5 price =  [2×15000×40] ÷ [0.25 × 5] = 980 Balls
 EOQ with $4.5 price =  [2×15000×40] ÷ [0.25 × 4.5] = 1, 032 Balls
 EOQ with $4..0 price =  [2×15000×40] ÷ [0.25 × 4)] = 1, 095 Balls
Right Quantity & Price to Achieve Best Savings is the Combination
That Results in Lowest Total Annual Inventory Cost (TAIC)
QUANTITY DISCOUNT/ PRICE-BREAK MODEL
Soccer Ball Example
Total Annual Inventory Costs (TAIC) = Annual Material Cost (AMC)
+ Annual Holding Cost (AHC) + Annual Ordering Cost (AOC)
TAIC = (Annual Demand × Unit Price) + {(EOQ ÷ 2)×(Carrying %)
×Unit Price} + {(Annual Demand÷ EOQ) × Ordering Cost}
 TAIC ($5) = (15, 000×5) + {(980/ 2)(0.25)×5} + {(15, 000/ 980)(40)}
= $ 76, 225
 TAIC ($4.5) = (15, 000×4.5)+{(1,032/ 2)(0.25)×4.5}+{(15, 000/ 1,032)(40)}
= $ 68, 662
 TAIC ($4.0) = (15, 000×4)+{(2,001/ 2)(0.25)×4}+{(15, 000/ 2,001)(40)}
= $ 61, 300
Best Combination for Purchase of Soccer Ball Is the
Combination of Lowest Quantity Providing Highest Savings
i.e. 2, 001 Balls at Discounted Price of $4 per Ball
EOQ MODEL IN BUSINESS
 EOQ Derived From Mathematical Model Used as Guideline &
Often Modified To Suit Business Requirements & Constraints
 A Few Constraints That Demands Modification of EOQ Model
 Supplier’s Minimum Order Quantity Conditions
 Lead Time
 Government Regulations  Seasonal Availability
 Packing Size
 Space Restriction
 Price Discounts
 Risk of Obsolescence & Deterioration
 Unstable Market Conditions
 EOQ Normally Modified To Take Care of Current Business
Environment – MOQ (Modified Order Quantity)
Top Management Involved in Developing Inventory Policy To
Match Company’s Strategic/ Marketing/ Financial/ SCM Goals
INVENTORY POLICY ELEMENTS
 Quantity To Order/ Lot Size Decision
 Time To Order
 Safety Stock To Insure Against Uncertainty
 Use Factor Z from Normal Distribution Chart
 Supply Lead Time Variability
 Desired Delivery Service Level
 Product Fill Rate
 Order Fill Rate
 Cycle Service Level (CSL)
Inventory Policy Implemented Through
Stock Replenishment Models
STOCK REPLENISHMENT MODELS
 Fixed Order Quantity (FOQ) Replenishment Model – Also Known as
Order Point Systems
• A Critical Stock Level of Each Item is Defined Based On
Average Demand During Lead Time: Reorder Level
• If Stock Falls below This Level a Replenishment Order Placed
• Plot of Stock Against Time will Follow a Saw-Tooth Pattern
• Requires Continuous Monitoring of Stock Levels
• Assumes Past Demand Good Indication of Future Demand
• Order Quantity Fixed But Order Interval Varies with Demand
• Perpetual & Two-Bin Systems Follow the Fixed Order Quantity Models
 Fixed Review Period (FRP) Replenishment Model
• Stocks of Group of Products Reviewed at Regular Intervals
• Sufficient Quantity Ordered so that Stock Levels Fall to
Safety Levels by the Time of Delivery after Next Review Period
• Fixed Interval Between Orders But Quantity Varies with Demand
• Periodic & Optional Replenishment Systems (Min-Max System) Follow
Fixed Review Models
Order Point System Works Well With Steady & Continuous Demand
INVENTORY MODELS
Q - Fixed Order Quantity
L – Lead Time of Supply
FOQ Model
Quantity
Maximum Level
Q
Q
Q
Q
Average Level
Reorder Level
L
Buffer
Time
P - Fixed Review Period
FRP Model
L – Lead Time of Supply
Order Up to Level
Quantity
L
P
Buffer
P
P
P
Time
INVENTORY COMPOSITION
 Cycle Stock
 EOQ × ½
 Safety/ Buffer Stock
 Based on Variation in Demand & Lead Times
 Random Variation with Normal Distribution
Assumed
 Average Stock
 Cycle Stock + Safety Stock
 Seasonal Stock
 To Counter Predictable Demand Variability
Reduce Variations to Reduce Safety Stock
SAFETY STOCK
 Extra Stock To Protect from Stock Out Due To Uncertainty in
Supply & Demand
 Uncertainty in Supply & Demand Occurs in 2 Ways
 Quantity Uncertainty - Occurs When Amount of Supply/ Demand
Varies – Demand Greater/ Less Than Expected in a Given Period
 Timing Uncertainty - Occurs When Time of Receipt of Supply/ Demand
Differs From That Expected
 Quantity Uncertainty is Protected By Carrying Safety Stocks &
Timing Uncertainty Handled By Ordering/Receiving Early/ Late
 Safety Stock Mostly Used To Buffer Against Uncertainty
 Quantity of Safety Stock Required Depends on
 Variability of Demand During Lead Time
 Desired Service Level
 Reordering Frequency
 Lead Time Duration
 Safety Stock Quantities Calculated Using Statistical Tools