37 Purpose of inventory and inventory cost

Sudhanshu Joshi

1. Introduction:

Inventory management, in the context of an industry, typically refers to the act of managing the material resources of an organization that can help the organization earn revenue in the future. Operations Manager is responsible for the managing part.

For example, a retail store that sells multiple goods (packed food items, groceries, clothes, and electronics goods, etc.) does not usually store all the goods in the store. In other words, a part of the entire stock of goods is kept at a warehouse. The sum of the goods in the store and at the warehouse at any particular point in time is known as the inventory.

The Inventory control system is maintained by every firm to manage its inventories efficiently. Inventory is the stock of products that a company manufactures for sale and the components or raw materials that make up the product. Hence, an inventory comprises of the buffer of raw material, work-in-process inventories and finished goods.

Organizations that are specifically into the production of goods or products heavily depend on a well-managed inventory for a number of reasons. The bottom-line is that an organization heavily into goods and products cannot really survive without a good inventory management system.

2. Significance of Inventory Management

Reasons for having a good inventory management system:

a) Meeting demands steadily: Demands for specific goods and services will not be the same throughout the For example, the sale of air-conditioners usually peaks during the summer and goes down during the winter. A well planned inventory of goods will enable an enterprise to fulfill the demands- and it is well known that the key to earning revenue is the optimum capitalization of demands.
b) Continuity of operations: Sound inventory management will enable an enterprise to run its operations For example, if an organization manufactures goods that are heavily dependent on raw materials, then the enterprise needs a good inventory of raw materials so that the operations are unhindered.
c) Economy of operations: A well managed inventory management system enables an enterprise to cut For example, when the festive season is round the corner and the enterprise foresees a surge in demand for goods, it can procure goods in bulk and store them for the season. The main benefits of this exercise are that the enterprise can keep up with the demand and when it buys in bulk, and it will be eligible for discounts too.

3.Basic Inventory Control Systems

3. 1 Fixed –Order Quantity Model

3.2 Fixed- time Period Model

3.1 Fixed-Order Quantity Model: A method that only allows for a specific amount of a given item to be ordered at one time. This type of rule helps to limit reorder mistakes, conserve storage space, and prevent unnecessary expenditures that would tie up funds that could be better utilized elsewhere. The fixed order quantity may be linked to an automatic reorder point where a specific quantity of a product is ordered when stock on hand reaches a predetermined level.

A fixed-order quantity system is one of the most important in inventory management. For that reason we need to look at how to compute the two variables that define it: the order quantity Q and the reorder point ROP. Before we do that, however, we need to look at the assumptions this system makes. Most importantly, the system assumes that all the variables occur at a constant rate and their values are known with certainty. For example, the system assumes that the demand, D, occurs at a constant rate and that there is no variability in demand. Also, the lead time, L, is constant, the holding cost, H, is known and fixed, as are stock out cost, S, and unit price, C. Although these assumptions are not realistic the model is highly robust and provides excellent results despite these assumptions.

3.1.1. Features of Fixed-order Quantity Model

Order Quantity = Constant
When to place an order = When inventory position drops to a re-order level.
Record keeping = each time a withdrawal or addition is made
Size of inventory= Less than fixed-time period model

3.2 Fixed –Order Quantity Model

The first decision in the fixed-order quantity model is to select the order quantity Q. Recall that there are a number of inventory costs, most notably inventory holding cost and ordering cost. We want to select the “best” order quantity that minimizes these costs—the EOQ mentioned previously. This is computed by looking at the total annual inventory cost and finding the order quantity that minimizes it. Consider that the total annual cost is comprised of annual purchase cost, annual ordering cost, and annual holding cost, and looks as follows:

Total cost = Purchase cost + Ordering cost + Holding cost
TC = DC + (D/Q) S + (Q/2) H

where

TC = Total cost
D = Annual demand
C = Unit cost
Q = Order quantity
S = Ordering cost
H = Holding cost

The first term in the equation, DC, is the annual purchase cost for items. It is comprised of annual demand (D) times the unit cost of each item (C). The second term (D/Q) S is the annual ordering cost. It is computed as the number of orders placed per year (D/Q), times the cost of each order, S. Finally, the third term is annual holding cost where (Q/2) is the average inventory held. Remember that our maximum inventory is Q units when the order is received. When inventory is depleted we have zero. Therefore on average we have Q/2 units in inventory. H is the annual holding cost per unit of inventory

The objective is to pick an order quantity that minimizes the sum of both the holding and ordering costs, which is the minimum point on the total cost curve. To compute this we use calculus and end up with the following classic computation of the “best” or optimal order quantity, the EOQ:

When to Order?

The EOQ answers the question of how much to order, but we still need to determine when to order. Assume that the demand rate (D) and lead time (L) are constant and known with certainty. In that case the ROP would simply be enough inventory to ensure that demand is covered during the length of the lead time. In this simple case, the ROP would be computed as

ROP = demand during lead time
ROP = D L

Let’s assume that lead time L for a product is one week and the demand, d, is 250 units per week. The ROP would be

Reorder Point = ROP = D x L = 1 week x 250 = 250 units

This means that every time inventory reaches 250 units an order is placed for the economic order quantity Q.

Unfortunately, D and L are rarely fixed, and demand is often higher than expected. As a result we often have to carry a bit more inventory to address this uncertainty. This is called safety stock or buffer stock and is inventory we carry in addition to the demand during lead time. Safety stock is added to the ROP calculation and is computed as follows:

ROP = demand during lead time + safety stock
ROP = D L + SS

Safety stock is computed based on the service level a company wants to maintain, which is simply the chance that we will not run out of stock. This is set by the company based on the level of service it wants to provide for a particular product and customer base. Higher service levels mean higher levels of inventory. Another factor that is used to compute safety stock is the variability of demand. The higher the variability and the higher the service level the higher the safety stock, or the amount added to the final computation of the ROP

4.Selective Inventory Control –Selective inventory control means that the method of inventory control varies from item to item and the differentiation should be on a selective basis.

Types of Inventory

1 ABC Inventory Control System
2 Three-Bin System
3 Just-in-Time (JIT) System
4 Outsourcing Inventory System
5 Computerized Inventory Control System
6 Fixed Order Quantity
7 Fixed Period Ordering

5.1 ABC Analysis

In materials management, the ABC analysis (or Selective Inventory Control) is

an inventory categorization technique.

ABC analysis divides an inventory into three categories-

“A items” with very tight control and accurate records;
“B items” with less tightly controlled and good records; and
“C items” with the simplest controls possible and minimal records.

The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls. The ABC analysis suggests that inventories of an organization are not of equal value. Thus, the inventory is grouped into three categories (A, B, and C) in order of their estimated importance. ‘A’ items are very important for an organization. Because of the high value of these ‘A’ items, frequent value analysis is required. In addition to that, an organization needs to choose an appropriate order pattern (e.g. ‘Just- in- time’) to avoid excess capacity. ‘B’ items are important, but of course less important than ‘A’ items and more important than ‘C’ items. Therefore, ‘B’ items are intergroup items. ‘C’ items are marginally important.

5.1.1 Advantages of ABC Analysis

By controlling the inventory of ‘A’ Category items, the total inventory costs can be considerably reduced. There are no fixed threshold for each class, different proportion can be applied based on objective and criteria. ABC Analysis is similar to the Pareto principle in that the ‘A’ items will typically account for a large proportion of the overall value but a small percentage of number of items.

5.1.2 Limitations of ABC Analysis

To be effective, it should be carried out with standardization and codification.
Importance to item is given on its annual consumption value and not on its criticality for the production.
Periodical Review is necessary to take into account the changes in prices and consumption.

5.2 X-Y-Z Analysis

XYZ analysis is one of the basic supply chain techniques, often used to determine the inventory valuation inside Stores. It’s also strategic as it intends to enable the Inventory manager in exercising maximum control over the highest stocked item , in terms of stock value A system of categorization, with similarities to Pareto analysis, the method usually categorizes inventory into three bands with each band having a different management control “scoring” an inventory item is that of annual stock value of said item (qty in stock X cost of item) with the result then ranked and then scored (X, Y or Z). Bandings may be specific to the industry but typically follow a 70%, 90%, 100% banding in that X class items represent 70% of the stock value (although they may account for 20% number wise), Y class items fall between 70% and 90% of the annual stock value with C class the remaining. In practical terms the complex high cost materials typically fall into the X class items, with the consumable, low cost (and typically fast moving) classed as X class.

Not all stock is equally valuable and therefore doesn’t require the same management focus. The results of the XYZ analysis provide information that helps evaluate how each inventory part should be monitored and controlled. These controls are typically:a) X class items which are critically important and require close monitoring and tight control – while this may account for large value these will typically comprise a small percentage of the overall inventory

b) Y class are of lower criticality requiring standard controls and periodic reviews of
c) Z class require the least controls, are sometimes issues as “free stock” or forward

5.2.1 Features of X-Y-Z Analysis

Based on value of inventory of materials actually held in stores at a given time.
Actual inventory value of items in stores instead of their estimated annual consumption value.

5.3 V-E-D Analysis

VED Analysis attempts to classify the items used into three broad categories, namely Vital, Essential, and Desirable. The analysis classifies items on the basis of their criticality for the industry or company.

a). Vital: Vital category items are those items without which the production activities or any other activity of the company, would come to a halt, or at least be drastically affected.

b) Essential: Essential items are those items whose stock – out cost is very high for the

c) Desirable: Desirable items are those items whose stock-out or shortage causes only a minor disruption for a short duration in the production The cost incurred is very nominal.

5.3.1 Features of V-E-D Analysis

Usually applied for spare parts on the basis of criticality.
Classification is on the basis of ‘V’ Stands for Vital, ‘E’ for essential, ‘D’ for desirable.

VED Analysis is very useful to categorize items of spare parts and components. In fact, in the inventory control of spare parts and components it is advisable, for the organization to use a combination of ABC and VED Analysis. Such control system would be found to be more effective and meaningful.

Suggested Readings:

(a) Piasecki (2009): Inventory Management Explained: A focus on Forecasting, Lot sizing, Safety Stock and Ordering Ops Publishing.
(b) Muller (2011): Essentials of Inventory AMACOM.
(c) Silver and Pyke (2016): Inventory and Production Management in Supply Chains. CRC
(d) Waller and Esper (2014): The Definition Guide to Inventory Management: Principles and Strategies for the Efficient Flow of Inventory across the Supply Pearson FT Press.
(e) Piasecki (2003): Inventory Accuracy: People, Processes & Technology. OPS Publishing
(f) Subramanian (2014): Inventory Management: Principles and Excel Books
(g) Waters (2003): Inventory Control and Wiley

Point to Ponder:

Inventory management, in the context of an industry, typically refers to the act of managing the material resources of an organization that can help the organization earn revenue in the future. Operations Manager is responsible for the managing part.
Organizations that are specifically into the production of goods or products heavily depend on a well-managed inventory for a number of reasons. The bottom-line is that an organization heavily into goods and products cannot really survive without a good inventory management system.
Demands for specific goods and services will not be the same throughout the season..
Sound inventory management will enable an enterprise to run its operations smoothly.
A well managed inventory management system enables an enterprise to cut costs.
This is a specialized skill. An enterprise must be able to project demands for specific goods and products at a specific time of the year. The enterprise must design its inventory system based on the demands.
An inventory must have the mechanism of monitoring the amount of stock of goods at any point in time. The enterprise must be able to exactly find out the amount of inventory at any particular point in time.
The warehouse must be able to keep the stock in good condition. Wasted materials amount to lost revenue opportunities.