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Inventory
Definition
 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
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inventory planning and control techniques3
 Types of Inventory

Work in
process

Vendors Raw Work in Finished Customer

Materials process goods
Work in
process

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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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Reasons To Hold Inventory
 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:- Carrying costs:-
 Quotation or tendering  Warehousing or storage

 Requisitioning  Handling

 Order placing  Clerical and staff

 Transportation  Insurance

 Receiving, inspecting and  Interest

storing  Deterioration,shrinkage,
 Quality control
evaporation and
 Clerical and staff obsolescence
Stock-out cost  Taxes

 Loss of sale  Cost of capital

 Failure to meet delivery

commitments
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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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Functions of Inventory
Management
-Track inventory
–How much to order
–When to order

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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
A
annual rupees usage, represent 80% of total
annual rupees usage.

B
• Next 15% of items reflect 15% of annual
rupees
• Next 70% accounts only for 5% usage
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.
Therefore V items has to be stocked more
• Raw materials on market demand
and D Items has to be less stocked
• Spare parts on performance of plant and

machinery.
• V – Vital, E – Essential, D – Desirable
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
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 Method
Assumptions:-
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 600 300 200 150 120 100 75 60 50

I* Q/2
Annual ordering cost 37.5 75 112.5 150 187.5 225 300 375 450
O*C/Q

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

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 Certainty case of the inventory cycle

Q
level order
Inventory

quantity

Average inventory =
Q/2

0 T T T T
1 2 Time 3 4

1. Here the negative slope from Q to T1

represents the inventory being used up
2. T1, T2, T3, T4 represents the replenishment
points
3. The inventory varies between 0 and Q
Graphical method to find EOQ

l c os t
C Q/2
a
Tot ost
=
c
Cost in RS.

ry ing
r
Ca

Ordering c
ost = DS/Q

0 EOQ
Order quantity
Extension of basic EOQ model

 This model can be extended to include

quantity discounts, were simple calculation
for quantity discount is added.

 Non zero
Non zerolead
leadtime
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

Reorder
point
0 T1 - n T1 T2 - n T2 T3 - n T3 T4 - n T4

Time
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.
 Probabilistic inventory model
contd…
 But in some cases even the safety stock
becomes ineffective to combat stock out. Like:-

Reorder point

Safety stock

T1 T2 T3 T4 T5 T6
Lead
Placeme time
nt of
Stock
order out
A Review
So we have dealt with

1. EOQ model
2. Its extension
3. Probabilistic model

4. And now we will be dealing with special

inventory models
Special inventory model

 Non – Instantaneous replenishment

 Quantity Discount

 One – period decision

Special inventory model

Non – Instantaneous replenishment

Capacity 10 units

A B C D

Thus the inventory is replenished gradually than in lots

Particularly in situation were manufacturers use continues

production process
e.g. FACT makes Ammonium on a continual basis
Special inventory model
Discount Quantities
 If discount increases with the order quantity,
then the price of inventory is no more constant

Hence a new approach is needed to find the

best lot size

Total Annual holding Annual Annual cost of

cost = cost + ordering cost + materials
Special inventory model
One period decisions
The newsboy problem
 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.

Applicable to fashion goods, seasonal goods and

due to change in technology
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
Beneficial for projects like oil drilling were the
an additional
benefit inventory
is acquired of 1000
only after a longtelevision
time but per
oncemonth. The cost
oil is struck the of holding inventory
additional expanse isiscovered.
spread overtime.
• Inflows = no: of units × probability × present

value
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
In combined.
effect the responsibility cannot be kept
• Production
on one headlooks after
since the workmanagement
inventory in progress
• Logistics plays
is a aintegrated
major role effort
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
THANK YOU