Inventory Management

Inventory management is the formulation and administration of plans and policies to

efficiently and satisfactorily meet production and merchandising requirements and minimize
costs relative to inventories.

Objective of Inventory Management

To maintain inventory at a level that best balances the estimates of actual savings, the
cost of carrying additional inventory, and the efficiency of inventory control.
Firms should always avoid a situation of over-investment or under-investment in
inventories. The major dangers of over investment are:
 unnecessary tie-up of the firm's funds and loss of profit,
 excessive carrying costs, and
 risk of liquidity.
The consequences of underinvestment in inventories are:
 production hold-ups
 failure to meet delivery commitments. Inadequate raw materials and work-in-process
inventories will result in frequent production interruptions.

There are three general motives for holding inventories:

1. Transactions motive emphasizes the need to maintain inventories to facilitate smooth
production and sales operations. For uninterrupted and proper running of any firm it is
necessary to have an appropriate level of inventory.
2. Precautionary motive necessitates holding of inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors.
3. Speculative motive influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.

Inventory Management Techniques

1. Inventory Planing
It is the determination of the quality and quantity and location of inventory, as well as
the time of ordering, in order to meet future business requirements.
 Econimic Order Quantity (EOQ) Model
 Reorder Point
 Just-in-Time (JIT)
The Just-in-Time (JIT) system is used to minimize inventory investment. The
philosophy is that materials should arrive at exactly the time they are needed for production.
Ideally, the firm would have only work-in-process inventory. Because its objective is to
minimize inventory investment, a JIT system uses no, or very little, safety stocks.

2. Inventory Control
It is the regulation of inventory within predetermined level; adequate stocks should be
available to meet business requirements, but the investment in inventory should minimum.
 Fixed Order Quantity System: an order for a fixed quantity is placed when the
inventory level reaches the reorder point.
 Fixed Reorder Cycle System (periodic review or replacement): orders are made after a
review of inventory levels has been done at regular intervals.
 Optional Replacement System
 ABC Classifiacation System: inventories are classified for selectibe control
o A items: high value items requiring highest possible control
o B items: medium cost items requiring normal control
 o C items: low cost items requiring the simplest possible control

3. Modern Inventory Management

It is often applied in the context of automated manufacturing
 Materials Requirement Planning (MRP): designed to plan and control raw materials
used in production. The demand for materials, which is assumed to be dependent on
some factors, is programmed into a computer.
 Manufacturing Resource Planning (MRP-II): closed loop system that integrates all
facets of a business, including inventories, production, sales, and cash flows.
 Enterprise Resource Planning (ERP): integrates the information systems of the whole
enterprise. All organizational operations are connected and the organization itself is
connected with its customers and suppliers.

The Economic Order Quantity (EOQ) Model

One of the most common techniques for determining the optimal order size for
inventory items is the economic order quantity (EOQ) model. The EOQ model considers
various costs of inventory and then determines what order sixe minimizes total inventory
cost. EOQ assumes that the relevant costs of inventory can be divided into order costs and
carrying costs.
 Ordering cost: (peso/order)
o requisitioning
o order placing
o transportation
o receiving, inspecting and storing
o quality control
o clerical and staff
 Carrying cost: (peso/unit/year)
o warehousing
o handling
o clerical and staff
o insurance
o deterioration, shrinkage, evaporation and obsolescence
o opportunity cost
o taxes and cos of capital

Order costs decrease as the size of the order increases. Carrying costs, however, increase
with incresases in the order size. The EOQ model analyzes the trade-off between order costs and
carrying costs to determine the order quantity that minimizes the total inventory cost.

Assumption of EOQ model:

 demand occurs at a constant rate throughout the year
 lead time on the receipt of the orders is constant
 the entire quantity ordered is received at one time
 the unit costs of the items ordered are constant; thus, there can be no quantity
discounts
 there are no limitations on the size of the inventory

Formula:
where:
EOQ= 2od
EOQ= order size (units)
c o= ordering cost per order (peso)
d= annual demand in units (units)
c= carrying cost per unit per year (peso)
Average inventory= EOQ/2
Total order cost= (d/EOQ)x ordering cost per order
Total carrying cost= average inventory x carrying cost per unit per year
Total inventory cost= total order cost + total carrying cost

Example:
XYZ Company has been buying product A in lots of 1,250 units which represents a
three months supply. The cost per unit is P220. the order cost is P900 per order; and the
annual inventory carrying cost per one unit is P25. Assume that the units will be required
evenly throughout the year, compute the EOQ.
Solution:

EOQ= 2x 1,250x 4x 900

25
= 600 units

Order Size
700 units 600 units 500 units
Ordering cost 6,428.57 7,500.00 9,000.00
Carrying cost 8,750.00 7,500.00 6,250.00
Total cost 15,178.5 15,000.00 15,250.00
7

Note: The order size using the EOQ model would provide the lowest total inventory cost. We can know that the
order size (EOQ) will provide the lowest total inventory cost if the transaction cost is equal to the carrying cost.

When applied to manufacturing operations, the EOQ formula may be used to compute
the Economic Lot Size (ELS).
Formula:

2sd where:
ELS=
EOQ= order size (units)
c
s= cost per set-up (peso)
d= annual demand in units (units)
c= carrying cost per unit per year (peso)

Re-order Point
We have now solved the problem of “how much to order” by determining the
economic order quantity, we have yet to seek the answer to the second problem, “when to
order”. This is a problem of determining the re-order point.
The re-order point is that inventory level at which an order should be placed to
replenish the inventory.
To determine the re-order point, we should know:
 lead time,
 average usage
 economic orders quantity
Under such a situation, re-order point is simply that inventory level which will be
maintained for consumption during the lead-time. That is:
 Reorder point = lead time in days x daily usage

Lead-time
It is the period between the time the order is placed and the order is received. By
certainty we mean that usage and lead-time do not fluctuate.

Safety stock
The demand for material may fluctuate from day to day or from week to week.
Similarly, the actual delivery time may be different from the normal lead-time. If the actual
usage increases or the delivery of inventory is delayed, the firm can face a problem of stock-
out, which can prove to be costly for the firm. Therefore, in order to guard against the stock-
out, the firm may maintain a safety-stock (some minimum or buffer inventory as cushion
against expected increased usage and/or delay in delivery time).

Total safety stock= safety stock (time) + safety stock (increase in demand/usage)
Safety stock (time)= (maximum lead time- normal lead time) x average daily usage
Safety stock (demand/usage)= (maximum daily usage/demand- average daily usage/demand)
x
normal lead time
Normal lead time usage= normal lead time x average daily usage
Re-order point (no safety stock)= normal lead time usage
Re-order point (with safety stock)= normal lead time usage x safety stock or
maximum lead time x average daily usage

Re-order point illustrated:

ave. daily usage= 5 units
normal lead time= 10 days
maximum lead time= 15 days

maximum lead time (15 days)

safety stock-time
normal lead time (10 days) (25 units)
re-order point- no safety
stock (50 units)
re-order point- with safety
stock (75 units)