Inventory Control

• Inventories are a vital part of business. Not only are

they necessary for operations, but they also
contribute to customer satisfaction.
• 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, although that
benefit has to be weighed against a possible risk of a
decrease in customer service.
• Inventory decisions in service organizations can be
especially critical. Hospitals, for example, carry an
array of drugs and blood supplies that might be
needed on short notice.

• However, many of these items have a limited shelf

life, so carrying large quantities would mean having
to dispose of unused, costly supplies.
• The different kinds of inventories include the
following:
1. Raw materials and purchased parts.
2. Partially completed goods, called work-in-process
(WIP).
3. Finished-goods inventories (manufacturing firms) or
merchandise (retail stores).
4. Tools and supplies.
5. Maintenance and repairs (MRO) inventory.
6. Goods-in-transit to warehouses, distributors, or
customers (pipeline inventory).
 Functions of Inventory
1. To meet anticipated customer demand: These
inventories are referred to as anticipation stocks
because they are held to satisfy expected (i.e.,
average ) demand.
2. 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.
3. 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.
4. To reduce the risk of stockouts: Delayed
deliveries and unexpected increases in demand
increase the risk of shortages. The risk of shortages
can be reduced by holding safety stocks, which are
stocks in excess of expected demand to compensate
for variabilities in demand and lead time.
5. To take advantage of order cycles: To minimize
purchasing and inventory costs, a firm often buys
in quantities that exceed immediate
requirements.
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.
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.
7. 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-
inprocess inventory. (pipeline inventories)
8. To take advantage of quantity discounts:
Suppliers may give discounts on large orders.
Inventory Management:
• Inventory management has two main concerns.
One is the level of customer service, that is, to have
the right goods, in sufficient quantities, in the right
place, at the right time. The other is the costs of
ordering and carrying inventories.
• The overall objective of inventory management is to
achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds.
• Managers have a number of performance measures
they can use to judge the effectiveness of inventory
management.
• The most obvious, of course, is customer satisfaction,
which they might measure by the number and
quantity of backorders and/or customer complaints.
• A widely used measure is inventory turnover , which
is the ratio of annual cost of goods sold to average
inventory investment.
 Requirements for Effective Inventory
Management
1. A system to keep track of the inventory on hand and
on order.
2. A reliable forecast of demand that includes an
indication of possible forecast error.
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs,
ordering costs, and shortage costs.
5. A classification system for inventory items.
 Inventory Counting Systems
1. Periodic system:
• A physical count of items in inventory is made at
periodic, fixed intervals.
• Many small retailers use this approach.
• An advantage of this type of system is that orders
for many items occur at the same time, which can
result in economies in processing and shipping
orders.
2. Perpetual inventory system (also known as a
continuous review system)
• To 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.
• Moreover, a physical count of inventories must still
be performed periodically to verify records because
of possible errors, pilferage, spoilage, and other
factors that can reduce the effective amount of
inventory.
• Perpetual systems range from very simple to very
sophisticated.
 Two-bin system
 Universal product code (UPC) , or bar code
A typical grocery product code is illustrated here:

• The zero on the left of the bar code identifies this as a grocery item,
the first five numbers (14800) indicate the manufacturer (Mott's),
and the last five numbers (23208) indicate the specific item. Items
in small packages, such as candy and gum, use a six-digit number.
3. Point-of-sale (POS) systems;
electronically record actual sales.
4. Radio frequency identification (RFID) tags are also
used to keep track of inventory in certain
applications.
 Lead time and costs
• Lead time: Time interval between ordering
and receiving the order
• 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 (carrying) costs: cost to carry an item
in inventory for a length of time, usually a year
• Ordering costs: Costs of ordering and receiving
inventory
• Shortage costs: Costs when demand exceeds
supply
• Setup costs: The costs involved in preparing
equipment for a job when a firm produces its
own inventory instead of ordering it from a
supplier.
 Classification System
A-B-C approach:
• 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.
• It would be unrealistic to devote equal attention to
each of these items. Instead, a more reasonable
approach would be to allocate control efforts
according to the relative importance of various items
in inventory.
• Typically, three classes of items are used: A (very
important), B (moderately important), and C (least
important).
• With three classes of items, A items generally
account for about 10 to 20 percent of the number of
items in inventory but about 60 to 70 percent of the
annual dollar value.
• A items should receive close attention through
frequent reviews of amounts on hand and control
over withdrawals, where possible, to make sure that
customer service levels are attained.
• At the other end of the scale, C items might account
for about 50 to 60 percent of the number of items
but only about 10 to 15 percent of the dollar value of
an inventory.
• The C items should receive only loose control (two-
bin system, bulk orders), and the B items should have
controls that lie between the two extremes.
1. For each item, multiply annual volume by unit price to get the
annual dollar value.
2. Arrange annual dollar values in descending order.
3. The few (10 to 15 percent) with the highest annual dollar value
are A items. The most (about 50 percent) with the lowest annual
dollar value are C items. Those in between (about 35 percent) are
B items.
• for inventory record accuracy: (+/-)0.2 percent for A
items, (+/-)1 percent for B items, and (+/-) 5 percent
for C items.
• A items are counted frequently, B items are counted
less frequently, and C items are counted the least
frequently.
• Inventory that is intended to meet expected demand
is known as cycle stock ,
• while inventory that is held to reduce the probability
of experiencing a stockout (i.e., running out of stock)
due to demand and/or lead time variability is known
as safety stock .
 HOW MUCH TO ORDER ?
1. The basic economic order quantity model (EOQ).
2. The economic production quantity model(EPQ).
3. The quantity discount model.
 Basic Economic Order Quantity (EOQ) Model

Assumptions in the EOQ model:

1. Only one product is involved.
2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year so that
the demand rate is reasonably constant.
4. Lead time is known and constant.
5. Each order is received in a single delivery.
6. There are no quantity discounts.
• The optimal order quantity reflects a balance between
carrying costs and ordering costs: As order size varies, one
type of cost will increase while the other decreases.
• Thus, the ideal solution is an order size that causes
neither a few very large orders nor many small
orders, but one that lies somewhere between. The
exact amount to order will depend on the relative
magnitudes of carrying and ordering costs.
• The average inventory is simply half of the order
quantity: The amount on hand decreases steadily
from Q units to 0, for an average of ( Q 0)/2, or Q /2.
• Using the symbol H to represent the average annual
carrying cost per unit, the total annual carrying cost
is
• Annual ordering cost is a function of the number of
orders per year and the ordering cost per order:
• The total annual cost (TC) associated with carrying
and ordering inventory when Q units are ordered
each time is:
 Economic Production Quantity (EPQ)

• The batch mode is widely used in production.

• The reason for this is that in certain instances, the
capacity to produce a part exceeds the part's usage
or demand rate.
• The assumptions of the EPQ model are similar to
those of the EOQ model. The assumptions are:
 Only one product is involved.
 2. Annual demand is known.
 3. The usage rate is constant
 Usage occurs continually, but production occurs
periodically.
 The production rate is constant when production is
occurring.
 Lead time is known and constant.
 There are no quantity discounts.
• Because the company makes the product itself, there
are no ordering costs as such.
 Quantity Discounts
• Quantity discounts are price reductions for larger
orders offered to customers to induce them to buy in
large quantities.
• Example, a Chicago surgical supply company
publishes the price list shown in Table for boxes of
gauze strips.
• Analysis of quantity discount problems differs slightly,
depending on whether holding costs are independent of unit
price (i.e., constant), or whether they are a percentage of unit
price. The following table illustrates the two ways, using 20
percent to illustrate holding costs that are a percentage of
unit price.
When carrying costs are constant, all
curves have their minimum points at
the same quantity.

When carrying costs are stated as a

percentage of unit price, the minimum
points do not line up.
• The procedure for determining the overall EOQ
differs slightly, depending on which of these two
cases is relevant. For carrying costs that are constant,
the procedure is as follows:
1. Compute the common minimum point.
2. Only one of the unit prices will have the minimum
point in its feasible range since the ranges do not
overlap. Identify that range.
a) If the feasible minimum point is on the lowest price
range (i.e., the lowest cost curve), that is the optimal
order quantity.
b). If the feasible minimum point is in any other range,
compute the total cost for the feasible minimum
point and for the price breaks of all lower unit costs.
Compare the total costs; the quantity (minimum
point or price break) that yields the lowest total cost
is the optimal order quantity.
• When carrying costs are expressed as a percentage of
price, determine the best purchase quantity with the
following procedure:
1. Beginning with the lowest unit price, compute the
minimum points for each price range until you find a
feasible minimum point (i.e., until a minimum point falls
in the quantity range for its price).
2. If the minimum point for the lowest unit price is
feasible, it is the optimal order quantity. If the minimum
point is not feasible in the lowest price range, compare
the total cost at the price break for all lower price
ranges with the total cost of the feasible minimum
point. The quantity that yields the lowest total cost is
the optimum.
Example
• Surge Electric uses 4,000 toggle switches a year.
Switches are priced as follows: 1 to 499, 90 cents
each; 500 to 999, 85 cents each; and 1,000 or more,
80 cents each. It costs approximately $30 to prepare
an order and receive it, and carrying costs are 40
percent of purchase price per unit on an annual
basis. Determine the optimal order quantity and the
total annual cost.
 REORDER POINT (ROP)
• EOQ models answer the question of how much to
order, but not the question of when to order.
• Reorder point (ROP): When the quantity on hand of
an item drops to this amount, the item is reordered.
• The goal in ordering is to place an order when the
amount of inventory on hand is sufficient to satisfy
demand during the time it takes to receive that order
(i.e., lead time).