INVENTORY MODELS

One of the basic functions of management is to employ capital efficiently so as to yield the maximum returns. This is known as Return on Capital Employed (ROIC). This can be done in either of two ways or by both, i.e. Increasing fixed asset productivity Increasing current asset productivity

The importance of materials management / inventory control arises from the fact that materials account for 60 to 65 percent of the sales value of a product, that is to say, from every rupee of the sales revenue, 65 paisa are spent on materials. Hence, small change in material costs can result in large sums of money saved or lost. Inventory control should, therefore, be considered as a function of prime importance for our industrial economy.

Sales Revenue Spent

20% Materials 15% 65% Wages & Salaries

Overheads

By careful financial analysis, it is shown that a 5% reduction in material costs will result in increased profits equivalent to a 36% increase in sales. Inventory control provides tools and techniques, to reduce/control the materials cost substantially.

 Inventory of resources is held to provide desirable services to customers and to achieve sales turnover target. Investment in large inventories adversely affects the organizations cash flow and working capital as investment in inventory represents substantial portion of total capital investment in any business. It is therefore essential to balance the advantage of having inventory of resources and the cost of maintaining it so as to determine an optimal level of inventory of each resources so that the total inventory cost is minimum.

DEFINITION OF INVENTORY The word inventory means a physical stock of material or goods or commodities or other economic resources that are stored or reserved or kept in stock or in hand for smooth and efficient running of future affairs of an organization at the minimum cost of funds or capital blocked in the form of materials or goods (Inventories).

Forms of Inventory
Type of organization Manufacturer Types of inventories held Raw materials; semi-finished goods; finished goods; spare parts etc. Number of beds; stock of drugs; specialized personnel etc. Cash reserves; tellers etc. Seating capacity; spare parts; specialized maintenance crew etc.

Hospital
Bank Airline company

DEFINITION INVENTORY CONTROL

Inventory control systems appear complicated, however, there are only a few basic questions to answer for an efficient control of inventory and the most important of these are:
1. What items should be stocked?
Criticality Availability Movement

2. When should an order be placed to replenish inventory?

Periodic review system Fixed order quantity system Optional replenishment system

DEFINITION INVENTORY CONTROL

Inventory control systems appear complicated, however, there are only a few basic questions to answer for an efficient control of inventory and the most important of these are:
3. How much should be ordered in each replenishment?
Demand pattern Price of an item, discount option, total budget, warehouse space Lead time

Classification of Inventories
Inventories which play direct role during manufacture (or which can be identified on the product) is labelled as direct inventories Inventories which are needed for manufacturing, but not as a part of production (or cannot be identified on the product) are labelled as indirect inventories.

Reasons for carrying inventory

1. 2. 3. 4. 5. 6. Improve customer service Reduce costs Maintenance of operational capability Irregular supply and demand Quantity discounts Avoiding stock-outs (shortages)

 Direct Inventories
1. Raw material inventories
Bulk purchase of materials to save the investment, To meet the changes in production rate, To plan for buffer stock or safety stock to serve against the delay in delivery of inventory against orders placed and also against seasonal fluctuations.

2. Work-in -process inventories

Provide economical lot production, Cater to the variety of products, Replacement of wastages, To maintain uniform production even if sales varies.

3. Finished goods inventories

To ensure the adequate supply to the customers To allow stabilization of the production level and To help sales promotion programme

4. Spare parts inventories

To provide after sales service to the customer To utilize the product fully and economically by the customer.

5. Scrap or waste inventory

 Indirect Inventories
Anticipation (Seasonal) inventory
When there is an indication that the demand for companys product is going to be increased in the coming season, a large stock of material is stored in anticipation. Examples: Fashion items, agricultural products, childrens toys, etc.

Lot size inventory or Cycle inventories

It is the inventory necessary to meet the average demand during the successive replenishments. The amount of such inventory depends upon production lot size, economical shipment quantities, warehouse space available, replenishment lead time, price-quantity discounts, inventory-carrying cost

 Decoupling inventories
If various manufacturing processes (stages) operate successively, then in the event of the breakdown of one, the whole system could get affected. Thus stocking points of inventory could act as buffer to take care of such eventualities. Decoupling inventories could classified into four groups: 1. Raw materials and components 2. Work-in-process inventory 3. Finished goods inventory 4. Spare parts inventory
Decouple 1 (RM Store) Decouple 3 (FG Store)

Decouple 2

Supplier

Manuf. Stage 1

Manuf. Stage 2

Distributor

 Safety inventory
A specific level of extra inventory is maintained for protection against uncertainties of demand and supply (lead time). The demand and lead time both are random variables with known probability distribution. The level of buffer stock is determined by trade-off between protection against demand and supply uncertainties and the level of investment in additional stock.

Transportation Inventories
Since movement of inventory cannot be instantaneous, optimal inventory level is required for shipment of inventory to distribution centres and customers from production centres. Such an inventory is called process inventory, as it consists of materials actually being worked on or moving between work centres. Hence for satisfying demand without delay, it is essential to keep extra stock of inventory at various work places to meet the demand while the supply is in transit. The amount of pipeline inventory depends on the time required for shipment and the nature of the demand.

Factors Involved in Inventory Problem Analysis

A number of factors must be considered in the analysis of inventory problems:
1. 2. 3. 4. 5. Relevant inventory costs Demand for inventory items Replenishment lead time Length of the planning period Constraints on the inventory system

 Inventory Sub-systems
Replenishment pattern
In a manufacturing system, the inventory of raw material may be required either to keep in warehouse for future need or to be used for processing immediately on arrival. The replenishment of such items may be instantaneous, constant, or gradual depending on lead time.

Inventory System Performance

The performance of an inventory system is related to the inventory costs. These costs are often not reflected in a firms balance sheet. Therefore, the system performance is sometimes measured in relation to inventory turnover.

 Inventory Sub-systems
Operating constraints
The stock level of various items in the inventory is governed by various constraints such as limited warehouse space, limited budget available for inventory, customer service level etc.

Operating decision rules

Two types of managerial decisions need to be made to determine efficient inventory policy.
1. 2. Order quantity Time to order for replenishment

 Decisions regarding the size and timing of replenishment orders are influenced by four factors:
1. 2. 3. 4. The forecast of demand for the item Replenishment lead time Inventory related costs Management policy

 Decisions on the size and timing of replenishment orders for an item can be made by adopting following basic inventory control policies or systems:
1. Continuous Review Systems
1. (s,Q) Policy (Fixed-order quantity policy) 2. (s, S) Policy (S is a pre-determined inventory level)

2. Periodic Review Systems

1. (T, S) Policy (T is a regular interval of time) 2. (T, s, S) Policy

Inventory Cost Components

The costs that are affected (increase or decrease) by the firms decision to maintain a particular level of inventory is called relevant costs and they play an important role in the study of an inventory system. Purchase cost: This cost consists of the actual price paid for the procurement of the items.
Purchase cost = (Price per unit) x (Demand per unit time)

Carrying (Holding) Cost

Carrying (Holding) cost: It is the expenses incurred for carrying the items in the warehouse. Carrying cost can be determined by two different ways as given below:
1. Carrying cost = (Cost of carrying one unit of an item in the inventory for a year) x (Average number of units of an item carried in the inventory for a year) 2. Carrying cost = (Cost of carrying one rupees worth inventory for a year) x (Rupee value of units carried)

Ordering Cost
Ordering (Set-up) cost: Ordering cost includes all costs that do not vary with the size of the order but are incurred each time an order is placed. Ordering cost is independent of the size of the order (or production), rather it varies with the number of orders placed during a period of time.
1. Ordering cost = (Cost per order or per set-up) x (Number of orders or set-ups placed in the planning period)

Shortage (Stock-out) Cost

The shortage of items occurs when items cannot be supplied on demand. Shortages can be viewed in two different ways:
1. The supply of items is awaited by the customers, i.e. the items are back ordered. 2. Customers are not ready to wait. Shortage cost = (Cost of being short one unit of an item) x (Average number of units short)
Average number of units short = = (Minimum shortage + Maximum shortage) x Period of shortage 2

Total Inventory Cost

Total Inventory cost = Purchase cost + Ordering cost + Carrying cost + Shortage cost
Demand
The size of demand is referred to the number of the item required in each period (cycle or season). The pattern of demand is the manner in which inventory items are required by the customers.

COSTS ASSOCIATED WITH INVENTORY

Inventory Carrying Cost (Holding Cost)
Rent for the building in which the stock is maintained if it is a rented building. It includes the cost of equipment, if any, and cost of racks and any special facilities used in the stores. Interest on the money locked in the form of inventory or on the money invested in purchasing the inventory. The cost of stationery used for maintaining the inventory. The wages of personnel working in the stores. Cost of depreciation, insurance. Cost of deterioration due to evaporation, spoilage of material etc. Cost of obsolescence due to change in requirement of material or changed in process or change in design and item stored as a result of becomes old stock and become useless. Cost of theft and pilferage i.e. indenting for the material in excess of requirement.

Factors affecting the inventory level

Inventory models can be classified according to the following factors:

1. Inventory related costs

Inventory related costs are classified as

a) Purchase (or production) cost

It is the cost at which an item is purchased, or if an item is produced, it is the direct manufacturing cost.

b) Ordering (or set up) cost (Co)

The cost incurred in replenishing the inventory is known as Ordering Cost. It includes all the costs relating to administration (such as salaries of the persons working for purchasing, telephone calls, computer costs, postage, etc.), transportation, receiving and inspection of goods, processing payments, etc. If a firm produces its own goods instead of purchasing the same from an outside source, then it is the cost of resetting the equipment for production. This cost is expressed as the cost per order or per set up.

c) Carrying (or holding) cost (Ch)

The cost associated with maintaining the inventory level is known as Holding Cost. It is directly proportional to the quantity to be kept in stock and the time for which an item is held in stock. It includes the cost of money, handling cost, maintenance cost, depreciation, insurance, warehouse rent, taxes, etc. This cost may be expressed either as cost per unit of item held per unit of time or as a percentage of average rupee value of inventory held.

Shortage (or stock out) cost (Cs) It is the cost, which arises due to running out of stock (i.e., when an item can not be supplied on the customer's demand). It includes the cost of production stoppage, loss of goodwill, loss of profitability, special orders at higher price, overtime/idle time payments, expediting, loss of opportunity to sell, etc.

Factors affecting the inventory level

2. Demand
It is an effective desire which is related with a particular time, price, and quantity. The demand pattern of a commodity may be either deterministic or probabilistic. In case of deterministic, it is assumed that the quantities needed in future are known with certainty. This can be fixed (static) or can vary (dynamic) from time to time. To the contrary, in case of probabilistic, the demand over a certain period of time is uncertain, but its pattern can be described by a known probability distribution.

Factors affecting the inventory level

3. Ordering cycle
An ordering cycle is defined as the time period between two successive placement of orders. The order may be placed on the basis of following two types of inventory review systems: a) Continuous review: In this case, record of the inventory level is updated continuously until a specified point (known as reorder point) is reached, at this point a new order is placed. Sometimes, this is referred to as the twobin system.

Factors affecting the inventory level

Periodic review : In this case, the orders are placed at equally spaced intervals of time. The quantity ordered each time depends on the available inventory level at the time of review.

Factors affecting the inventory level

4. Lead time or delivery lag
The time gap between the moment of placing an order and actually receiving the material is referred to as lead time. The lead time can be deterministic, constant or variable, or probabilistic. If there is no such gap, then we say that lead time is zero. If the lead time exists (i.e., it is not zero), then it is required to place an order in advance by an amount of time equal to the lead time.

Factors affecting the inventory level

5. Buffer (or safety) stock
Normally, demand and lead time are uncertain and cannot be predetermined completely. So to absorb the variation in demand and supply, some extra stock is kept. This extra stock is known as buffer stock.

6. Available space
Generally, an inventory system involves more than one commodity. The number of items held in inventory affect the situation when these items compete for limited floor space or limited total capital.

ECONOMIC ORDER QUANTITY

Points to be remembered
Inventory cost increases with the quantity purchased.
If we purchase more items per order (or produce more items per set up), the ordering cost (or set up cost) per item decreases, the stock-out situation reduces, but the inventorycarrying cost increases.
If discount is allowed on quantity purchased the material cost also reduces.

If we purchase less items per order (or produce less items per set up) ordering cost per item (or set up cost per item) increases, stock-out position may increase which increases stock out costs, but the inventory-carrying cost decreases.
Quantity discounts may not be available.

Inventory Control Systems

There are various methods of controlling inventory.
p-System or Fixed Period System, q-System or Fixed quantity system, These are also known as perpetual inventory control Systems pq-System, ABC Analysis ED Analysis XYZ Analysis FNSD analysis Economic Order Quantity.

 p-System or Fixed Period System In this system inventory is replenished at fixed intervals, say for example every first of the month. The quantity ordered depends on rate of consumption in that period. For example if 20 units are consumed in the first period, order is placed for 20 pieces. Here period of ordering is constant and the quantity ordered per order will differ. Hence it is known as fixed period system.

 q-System or Fixed Quantity System Unlike the p-system, here the quantity ordered per order is constant but the period of placing order will differ. This system is also known as Two-Bin System. A bin means a container. There will be two containers of same capacity in which the material is stored. When the material in the first bin is completely consumed, then order is placed for the quantity consumed (i.e. capacity of the bin). The time required to consume all the material in the bin depends on the rate of demand.

 pq-System (Optional Replenishment System) Unlike the p-system, here the quantity ordered per order is constant but the period of placing order will differ. This system is also known as Two-Bin System. A bin means a container. There will be two containers of same capacity in which the material is stored. When the material in the first bin is completely consumed, then order is placed for the quantity consumed (i.e. capacity of the bin). The time required to consume all the material in the bin depends on the rate of demand.