Unit 4

Inventory management
 Contents
• Concept
• Importance
• Classification of inventory systems
• EOQ model
 CONCEPT
It refers to the process of ordering, storing, using, and selling a company's inventory. This includes
raw materials, components, and finished products, as well as the warehousing and processing of
these items. There are different methods of inventory management, each with its pros and cons,
depending on a company's needs.
• Inventory management is the entire process of managing inventories from raw materials to
finished products.
• Inventory management tries to efficiently streamline inventories to avoid both gluts and
shortages.
• Four major inventory management methods include just-in-time management (JIT), materials
requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory (DSI).
 CONCEPT
• A company's inventory is one of its most valuable assets. In retail, manufacturing, food services, and other
inventory-intensive sectors, a company's inputs (such as raw materials) and finished products are the core of
its business. A shortage of inventory when and where it's needed can be extremely detrimental.
• At the same time, inventory can be thought of as a liability (if not in an accounting sense). A large inventory
carries the risk of spoilage, theft, damage, or shifts in demand. Inventory must be insured, and if it is not used
up or sold in time it may have to be disposed of at clearance prices—or simply destroyed.
• For these reasons, inventory management is important for businesses of any size. Knowing when to restock,
what quantities to purchase or produce, and when to sell and at what price can easily become complex
decisions. Small businesses will often keep track of stock manually and determine the reorder points and
quantities using spreadsheet (Excel) formulas. Larger businesses may use specialized
enterprise resource planning (ERP) software. The largest corporations use highly customized
software as a service (SaaS) applications. Companies are also calling on artificial intelligence to optimize
these processes.
 Benefits of inventory
management
• Saves Money:
Understanding stock trends means you see how much of and where you have
something in stock so you’re better able to use the stock you have. This also allows
you to keep less stock at each location (store, warehouse), as you’re able to pull from
anywhere to fulfill orders — all of this decreases costs tied up in inventory and
decreases the amount of stock that goes unsold before it’s obsolete.
• Improves Cash Flow:
With proper inventory management, you spend money on inventory that sells, so
cash is always moving through the business.
• Satisfies Customers:
One element of developing loyal customers is ensuring they receive the items they
want without waiting
 Challenges of inventory
management
• Getting Accurate Stock Details:
If you don’t have accurate stock details,there’s no way to know when to refill stock or
which stock moves well.
• Poor Processes:
Outdated or manual processes can make work error-prone and slow down operations.
• Changing Customer Demand:
Customer tastes and needs change constantly. If your system can’t track trends, how
will you know when their preferences change and why?
• Using Warehouse Space Well:
Staff wastes time if like products are hard to locate. Mastering inventory management
can help eliminate this challenge.
 Important terms
• ABC Analysis:
This method works by identifying the most and least popular types of stock.
• Batch Tracking:
This method groups similar items to track expiration dates and trace defective items.
• Bulk Shipments:
This method considers unpacked materials that suppliers load directly into ships or trucks. It involves buying, storing and shipping
inventory in bulk.
• Consignment:
When practicing consignment inventory management, your business won’t pay its supplier until a given product is sold. That supplier
also retains ownership of the inventory until your company sells it.
• Cross-Docking:
Using this method, you’ll unload items directly from a supplier truck to the delivery truck. Warehousing is essentially eliminated.
• Demand Forecasting:
This form of predictive analytics helps predict customer demand.
• Dropshipping:
In the practice of dropshipping, the supplier ships items directly from its warehouse to the customer.
• Economic Order Quantity (EOQ):
This formula shows exactly how much inventory a company should order to reduce holding and other costs.
• FIFO and LIFO:
First in, first out (FIFO) means you move the oldest stock first. Last in, first out (LIFO) considers that prices
always rise, so the most recently-purchased inventory is the most expensive and thus sold first.
• Just-In-Time Inventory (JIT):
Companies use this method in an effort to maintain the lowest stock levels possible before a refill.
• Lean Manufacturing:
This methodology focuses on removing waste or any item that does not provide value to the customer from
the manufacturing system.
• Materials Requirements Planning (MRP):
This system handles planning, scheduling and inventory control for manufacturing.
• Minimum Order Quantity:
A company that relies on minimum order quantity will order minimum amounts of inventory from
wholesalers in each order to keep costs low.
• This method combines lean management and Six Sigma practices to remove waste and raise efficiency
• Reorder Point Formula:
Businesses use this formula to find the minimum amount of stock they should have before
reordering, then manage their inventory accordingly.
• Perpetual Inventory Management:
This technique entails recording stock sales and usage in real-time. Read “
The Definitive Guide to Perpetual Inventory” to learn more about this practice.
• Safety Stock:
An inventory management ethos that prioritizes safety stock will ensure there’s always extra
stock set aside in case the company can’t replenish those items.
• Six Sigma:
This is a data-based method for removing waste from businesses as it relates to inventory.
• Lean Six Sigma:
 CATEGORIES OF INVENTORY
• Raw Materials
• The raw materials are the basic components that are transformed into finished
goods. They are the essential items required at the start of the production process,
without which the final product cannot be made.

• Regularly monitoring your raw materials helps in forecasting needs, negotiating

• Example: For instance, a chocolate factory might have raw cocoa, sugar, and milk as
part of its raw material inventory.
 CATEGORIES OF INVENTORY

• 2. Work-in-Progress (WIP)
• WIP inventory pertains to products that are in the process of being manufactured but are
not yet complete. These items have commenced the manufacturing phase but haven't
reached the final stage.

• WIP inventory provides insights into the efficiency of the production process. By tracking
the amount of WIP inventory, businesses can identify bottlenecks or inefficiencies in their
manufacturing line.

• Example: Consider a car manufacturing plant producing 100 cars, with 30 of them
currently in assembly. These 30 cars represent the WIP inventory.
 CATEGORIES OF INVENTORY

• 3. Finished Goods
• The finished goods are the products that are fully manufactured, ready for sale, and need no further
processing. They are the end result of the production process, awaiting distribution to retailers or
direct consumers.

• This inventory is vital for meeting consumer demands. By analyzing sales trends and seasonal
variations, businesses can predict how much finished stock they should have on hand at any given
time.

• Example: Elegant Footwear might have a stock of 5,000 pairs of shoes ready to be shipped to retailers.
 CATEGORIES OF INVENTORY
• 4. MRO (Maintenance, Repair, and Operations) Inventory
• MRO inventory refers to the items used in the production process but are not part
of the final product. They assist in ensuring the smooth operation and maintenance
of the production line, ensuring continuity and efficiency.

• The efficient management of MRO inventory ensures that production is never

• Example: A bakery, Bread & Beyond, might have an MRO inventory that includes
oven mitts, baking trays, and cleaning supplies.
 CATEGORIES OF INVENTORY

• 5. Safety Stock
• The safety stock serves as a buffer against unexpected spikes in demand or disruptions in supply.
It's a contingency measure to prevent stockouts and ensure uninterrupted supply to customers.

• Example: Natural Beauty Cosmetics might keep an extra 2,000 units of their best-selling lipstick
shade as safety stock to ensure they can meet sudden demand surges.

• 6. Consignment Inventory
• Consignment inventory allows businesses to extend their product reach by placing items in retail
spaces without committing to a sale. This strategy helps gauge customer interest and market
demand, as the products remain the property of the supplier until they're sold.
 CATEGORIES OF INVENTORY

• Example: A local artist places their handmade jewelry in City Boutique without an upfront
sale. Only when a customer purchases a piece does the artist receive payment and the
boutique takes a commission.

• 7. Cycle Stock
• Cycle stock is the primary inventory that businesses maintain to cater to their day-to-day
customer demands. This portion of inventory is frequently replenished and "cycled"
through, ensuring that products are always available for regular sales.

• Example: A grocery store like Daily Fresh Mart replenishes its stock of fresh fruits every
week, ensuring that customers always find fresh produce available.
 Inventory management methods
• 1. Just-in-Time Management (JIT)
• This manufacturing and inventory management model originated in Japan in the 1960s and 1970s.
Toyota Motor (TM) is credited with contributing the most to its development.2 JIT allows companies
to save significant amounts of money and reduce waste by purchasing and keeping on hand only the
inventory they need to produce and sell products within a certain time frame. This approach reduces
storage and insurance costs, as well as the cost of liquidating or discarding excess inventory.
• JIT inventory management can be risky. If demand unexpectedly spikes, the manufacturer may not be
able to source the inventory it needs to meet that demand, damaging its reputation with customers
and driving business to competitors. Even the smallest delays can be disruptive; if a key input does
not arrive "just in time," a bottleneck can result.
Inventory management methods
• 2. Materials Requirement Planning (MRP)
• This inventory management method is sales-forecast dependent, meaning
that manufacturers rely on detailed sales records to anticipate their inventory
needs and communicate those needs to suppliers in a timely manner.3 For
example, a ski manufacturer using an MRP inventory system might ensure that
materials such as plastic, fiberglass, wood, and aluminum are in stock based
on forecasted orders. Inability to accurately forecast sales and plan inventory
acquisitions will result in the manufacturer's inability to fulfill orders.
Inventory management methods
• 3. Economic Order Quantity (EOQ)
• This model is used in inventory management by calculating the number of units a
company should add to its inventory with each batch order to reduce the total costs of
its inventory while assuming constant consumer demand. The costs of inventory in the
model include holding and setup costs.
• The EOQ model seeks to ensure that the right amount of inventory is ordered per batch
so a company does not have to make orders too frequently and there is not an excess of
inventory sitting on hand. It assumes that there is a trade-off between inventory
holding costs and inventory setup costs, and total inventory costs are minimized when
both setup costs and holding costs are minimized.4
 Inventory management methods
• 4. Days Sales of Inventory (DSI)
• This financial ratio indicates the average time in days that a company takes to turn its
inventory, including goods that are a work in progress, into sales. DSI is also known
as the average age of inventory, days inventory outstanding (DIO), days in inventory
(DII), days sales in inventory, or days inventory and is interpreted in multiple ways.
• Indicating the liquidity of the inventory, the figure represents how many days a
company's current stock of inventory will last. Generally, a lower DSI is preferred as it
indicates a shorter duration to clear off the inventory, though the average DSI varies
from one industry to another.
 ABC ANALYSIS
ABC analysis refers to the inventory management technique used to identify items that
constitute a significant part of the overall inventory value and categorize them into critical,
important, and moderately important. This allows managers and decision-makers to prioritize
their inventories and other materials according to the immediate needs of their business.
The basic premise of ABC analysis is that every single item in an inventory doesn’t have
equal value and demand – some items cost much more than others. In contrast, some items
are used more frequently, and the remaining are a mix of both. Therefore, categorizing them
according to these parameters based on inventory ABC analysis gives businesses a
clearer view of their standpoint.
GRAPHICAL REPRESENTATION
 BENEFITS OF ABC ANALYSIS
• Increased Inventory Optimization: The analysis identifies the products that are in demand. A company
can then use its precious warehouse space to adequately stock those goods and maintain lower stock levels
for Class B or C items.
• Improved Inventory Forecasting: Monitoring and collecting data about products that have high customer
demand can increase the accuracy of sales forecasting. Managers can use this information to set inventory
levels and prices to increase overall revenue for the company.
• Better Pricing: A surge in sales for a specific item implies demand is increasing and a price increase may
be reasonable, which improves profitability.
• Informed Supplier Negotiations: Since companies earn 70% to 80% of their revenue on Class A items, it
makes sense to negotiate better terms with suppliers for those items. If the supplier will not agree to lower
costs, try negotiating post-purchase services, down payment reductions, free shipping or other cost savings.
• Strategic Resource Allocation: ABC analysis is a way to continuously evaluate resource allocation to
ensure that Class A items align with customer demand. When demand lowers, reclassify the item to make
better use of personnel, time and space for the new Class A products.
• Better Customer Service: Service levels depend on many factors, like quantity sold, item cost and
profit margins. Once you determine the most profitable items, offer higher service levels for those items.
• Better Product Life Cycle Management: Insights into where a product is in its life cycle (launch,
growth, maturity or decline) are critical for forecasting demand and stocking inventory levels
appropriately.
• Control Over High-Cost Items: Class A inventory is closely tied to a company’s success. Prioritize
monitoring demand and maintaining healthy stock levels, so there’s always enough of the key products
on hand.
• Sensible Stock Turnover Rate: Maintain the stock turnover rate at appropriate levels through
methodical inventory control and data capture.
• Reduced Storage Expenses: By carrying the correct proportion of stock based on A, B or C classes,
you can reduce the inventory carrying costs that come with holding excess inventory.
• Simplified Supply Chain Management: Use an ABC analysis of inventory data to determine if it’s time
to consolidate suppliers or shift to a single source to reduce carrying costs and simplify operations.
 CHALLENGES
• Parameter Instability: ABC analysis often results in managers assigning up to 50% of items to a new category every quarter or
year. Often, companies are not aware of the changes until there is a problem with demand, and the need to reassess may take up
valuable time and jeopardize customer satisfaction.
• Limited Pattern Consideration: The standard ABC method will not account for factors like new product introductions or product
seasonality. For example, a new product may have low sales volume because it has no buying history. ABC analysis has a somewhat
static perspective on demand and will generate inventory inefficiencies whenever demand is shifting or unclear.
• Low Information Extraction: ABC class information may not provide all the statistical data or detail needed to make informed,
strategic management decisions.
• High Resource Consumption: Giving disproportionate weight to trivial issues is known as bikeshedding, which can be an
unfortunate consequence of ABC analysis. Since ABC analysis is easy to grasp, staff may inject their opinions or request their own
variants making ABC analysis a resource-consuming process rather than a time-saving tool.
• Value Blindness: ABC analysis ascribes product importance based on revenue or frequency of use, but some items may not hold
to this paradigm. For example, a retail display item may rarely sell but may attract a lot of customers (who will buy other products)
based on its novelty. In aerospace, a specific part for a plane may not be used often and have little market value, but it may be a
fundamental safety function.
• System Incompatibility: ABC inventory analysis conflicts with traditional costing systems and is out of compliance with generally
accepted accounting principles (GAAP) requirements. If you must run multiple costing systems, labor costs will rise alongside
inefficiency.
 CHALLENGES
• Undersupply or Oversupply Issues: One ABC analysis disadvantage is it looks at dollar-based values, rather than
the volume that cycles through inventory, so there is a risk of running out of Class B or C items. The opposite can
occur, too. You may have excess low-class items that accumulate in inventory if you reorder them without regular
reviews.
• Loss Risk: Just because B and C items do not have as high a value as Class A products does not mean they no
value. One of the limitations of ABC analysis is that excess stocks are always in jeopardy of obsolescence or damage.
Therefore, the inventory that habitually goes uncounted or unmonitored may be subject to theft.
• Mandatory Standardization: The ABC method is only successful if every item is subject to the standardization of
materials, which includes how they are named, stored, and consistently rated and monitored.
• Arbitrary Categorization: Without preset boundaries or agreed-upon standards for each category, classifying
goods depends on the manager's professional judgment. So this can be a relatively subjective process.
• Business Limitations: ABC analysis is not useful for companies that have an equable annual consumption value of
inventory items by type. For instance, a company that sells the same version of an item like candy, nails or socks,
may not be able to sort stock based on the Pareto Principle.
• High Resource Consumption: Companies with a significant number of inventory items will have to hire additional
staff or buy special equipment to control inventory using ABC categorization.
 E.O.Q
• Economic order quantity (EOQ) is the ideal quantity of units a company should purchase to meet
demand while minimizing inventory costs such as holding costs, shortage costs, and order costs.
This production-scheduling model was developed in 1913 by Ford W. Harris and has been refined
over time. The economic order quantity formula assumes that demand, ordering, and holding
costs all remain constant.
• The economic order quantity (EOQ) is a company's optimal order quantity that meets demand
while minimizing its total costs related to ordering, receiving, and holding inventory.
• The EOQ formula is best applied in situations where demand, ordering, and holding costs remain
constant over time.
• One of the important limitations of the economic order quantity is that it assumes the demand
for the company’s products is constant over time.
CALCULATION
GRAPHICAL REPRESENTATION
 BENEFITS
1. Reduced inventory costs
•
• Having an excess inventory can quickly increase storage costs. Inventory costs can also rise as a result of how you order,
what gets damaged, and which products never sell. If you're constantly re-ordering products with low velocity, EOQ can
help you figure out how much to order in a given time frame.
2. Reduce stockouts
•
• EOQ can help you understand how much and how frequently you need to reorder. You can avoid stock outs by calculating
how much inventory you need based on how much you sell in a given period of time. You might be surprised to learn that
ordering in smaller quantities is more cost-effective for your company, or that the opposite is true — calculating EOQ can
help you determine this.
3. Increasing overall effectiveness
• Overall, calculating EOQ can assist you in making better decisions regarding inventory storage and management. The
truth is that many e-commerce businesses place orders based on a "gut feeling" of how much product is required, rather
than ordering how much product is required. Calculating EOQ is an efficient way to better quantify how much you require
based on key cost variables
 BENEFITS
Improved Order Fulfillment: When you need a specific item or something for a
customer order, optimal EOQ ensures that the product is on hand, allowing you to
complete the order on time and keep the customer satisfied. This should improve
customer satisfaction and possibly lead to increased sales.
•
Less Waste: Better order schedules should reduce obsolete inventory, especially
for businesses that keep perishable inventory, which can result in dead stock.
•
Reduced Storage Costs: When your ordering corresponds to your demand, you
should have fewer products to store. This can result in lower real estate, utility,
security, insurance, and other costs.
 CHALLENGES
1. Bad data
A company must have the right data to make accurate calculations. EOQ assumes that there is a consistent demand for products and that you can replenish
them immediately. It also takes into account fixed costs for:
• Inventory item
• Order fees
• Holding costs
• This makes accounting for changes in consumer demand or seasonality difficult, if not impossible, for businesses. You'll have the wrong amount of
inventory if you don't have accurate, real-time data on holding or order costs, which can quickly lead to a stockout. To determine the proper amount of
inventory, you must estimate needs based on historical demand. If you're using spreadsheets and don't have any tracking in place, this can be time-
consuming. Software for Inventory management, on the other hand, can compile this data in just a few clicks. so you can apply the right data to your EOQ
formula.
2. Seasonality and Changing demand
• The EOQ model is a straightforward model for products that have consistent demand all year. This, however, is not always the case. Newly launched
products may have a higher initial demand that fades over time. Products with seasonal demand, where sales fluctuate throughout the year, may render
EOQ calculations invalid.
• You can't just measure EOQ at the start of the year and expect it to be accurate. As a result of inconsistent reordering, this could result in stockouts or
excess inventory.
3. Supply constraints
• Inventory shortages are another limitation of the EOQ model. Some businesses that are new to using EOQ may be conservative in their reordering,
resulting in smaller orders and your store being understocked.
 MRP IN INVENTORY
MANAGEMENT
• Material requirements planning (MRP) is a software-based integrated inventory and supply
management system designed for businesses.
• Companies use MRP to estimate quantities of raw materials, maintain inventory levels, and schedule
production and deliveries.
• Material requirements planning (MRP) is the earliest computer-based inventory management system.
• MRP helps develop a production plan for finished goods by defining inventory requirements for
components and raw materials.
• MRP assures that materials and components will be available when needed, minimizes inventory
levels, reduces customer lead times, and improves customer satisfaction.
• MRP relies on data accuracy, has a high cost to implement, and maintains a strict production
schedule.
 MRP
• Material requirements planning was the earliest of the integrated information technology (IT)
systems that aimed to improve productivity for businesses by using computers and software
technology.
• The first MRP systems of inventory management evolved in the 1940s and 1950s, using mainframe
computers to extrapolate information from a bill of materials for a specific finished product into a
production and purchasing plan. MRP systems expanded to include information feedback loops
so that production managers could change and update the system inputs as needed.
• The next generation of MRP, manufacturing resources planning (MRP II), also incorporated
marketing, finance, accounting, engineering, and human resources aspects into the planning
process. A concept that expands on MRP is enterprise resources planning (ERP), developed in the
1990s, which uses computer technology to link various functional areas across an entire business
 MRP
• Pros • Cons
• Materials and components are available when • Heavy reliance on input data accuracy
needed
• Minimized inventory levels and associated costs • Expensive to implement
• Reduced customer lead times
• Lack of flexibility in the production schedule
• Increased manufacturing efficiency
• Tendency to hold more inventory than
• Increased labor productivity needed

• Less capable than an overall ERP system