Production Planning

& Control

Chapter 6
Inventory Management

chapter6 1
 Inventory Management

™Inventory is a list for goods and materials, or those

goods and materials themselves, held available in stock by a
business.
™Inventory are held in order to manage and hide from the
customer the fact that manufacture/supply delay is longer
than delivery delay, and also to ease the effect of
imperfections in the manufacturing process that lower
production efficiencies if production capacity stands idle for
lack of materials.

chapter6 2
 Inventory Management

inventory
™Definition 1
™A company's merchandise, raw materials, and
finished and unfinished products which have not
yet been sold.
™These are considered liquid assets, since they can
be converted into cash quite easily.
™There are various means of valuing these assets,
but to be conservative the lowest value is usually
used in financial statements.
chapter6 3
 Inventory Management

inventory
™Definition 2
™The securities bought by a broker or dealer in order to
resell them.
™For the period that the broker or dealer holds the
securities in inventory, he/she is bearing the risk related to
the securities, which may change in price.
™Stocks of goods held by businesses for further processing
or for sale.
™Inventory -- Merchandise that is purchased and/or
produced and stored for eventual sale.
chapter6 4
 Inventory Management

™Yet another definition of inventories include following

category items
™Production inventories:Raw material,parts,which is
required for the final product in the production process
™These are divided into two categories special type &
standard items like screw etc.
™MRO Industries:Maintenance operations & repair
which are consumed in production process.
™In process Inventories:Semi Finished products found at
various stages in production operation
™Finished goods Inventories:Completed products ready
for sale chapter6 5
 Objectives of Inventories

wBuffer stock is held in individual workstations against

the possibility that the upstream workstation may be a little
delayed in providing the next item for processing. Whilst
some processes carry very large buffer stocks, Toyota
moved to one (or a few items) and has now moved to
eliminate this stock type.
wSafety stock is held against process or machine failure in
the hope/belief that the failure can be repaired before the
stock runs out. This type of stock can be eliminated by
programmes like Total Productive Maintenance
wOverproduction is held because the forecast and the
actual sales did not match. Making to order and JIT
eliminates this stock type.
chapter6 6
 Objectives of Inventories

wLot delay stock is held because a part of the process is

designed to work on a batch basis whilst only processing
items individually. Therefore each item of the lot must wait
for the whole lot to be processed before moving to the next
workstation. This can be eliminated by single piece working
or a lot size of one.
wDemand fluctuation stock is held where production
capacity is unable to flex with demand. Therefore a stock is
built in times of lower utilisation to be supplied to
customers when demand exceeds production capacity. This
can be eliminated by increasing the flexibility and capacity
of a production line or reduced by moving to item level load
balancing. chapter6 7
 Objectives of Inventories

wLine balance stock is held because different sub-

processes in a line work at different rates. Therefore stock
will accumulate after a fast sub-process or before a large lot
size sub-process. Line balancing will eliminate this stock
type.
wChangeover stock is held after a sub-process that has a
long setup or change-over time. This stock is then used
while that change-over is happening. This stock can be
eliminated by tools like SMED.

chapter6 8
 Why Do We Want to Hold
Inventory?
„ Improve customer service
„ Reduce certain costs such as
– ordering costs
– stock out costs
– acquisition costs
– start-up quality costs
„ Contribute to the efficient and effective
operation of the production system
chapter6 9
 Why We Do Not Want to Hold
Inventory
„ Certain costs increase such as
– carrying costs
– cost of customer responsiveness
– cost of coordinating production
– cost of diluted return on investment
– reduced-capacity costs
– large-lot quality cost
– cost of production problems

chapter6 10
 Two Fundamental Inventory
Decisions
„ How much to order of each material when
orders are placed with either outside
suppliers or production departments within
organizations
„ When to place the orders

chapter6 11
 Independent Demand Inventory
Systems
„ Demand for an item carried in inventory is
independent of the demand for any other
item in inventory
„ Finished goods inventory is an example
„ Demands are estimated from forecasts
and/or customer orders

chapter6 12
 Dependent Demand Inventory
Systems
„ Items whose demand depends on the
demands for other items
„ For example, the demand for raw materials
and components can be calculated from the
demand for finished goods
„ Therefore the systems used to manage these
inventories are different from those used to
manage independent demand items
chapter6 13
 Inventory Costs
„ Costs associated with ordering too much
(represented by carrying costs)
„ Costs associated with ordering too little
(represented by ordering costs)
„ These costs are opposing costs, i.e., as one
increases the other decreases
„ . . . more

chapter6 14
 Inventory Costs
„ The sum of the two costs is the total stocking cost
(TSC)
„ When plotted against order quantity, the TSC
decreases to a minimum cost and then increases
„ This cost behavior is the basis for answering the
first fundamental question: how much to order
„ It is known as the economic order quantity (EOQ)

chapter6 15
 Inventory Costs

wInventories cost money.

wThe cost factor must be considered while taking any
decision regarding inventories.Each of these comprises
several elements as listed below:
wOrdering Cost
Cost of placing order
Preparing a PO
Processing payment
Receiving & inspecting the material
wCarrying Cost
Cost connected directly with material
Financial cost
wCapital cost chapter6 16
 Inventory Costs

wStorage Space Costs:Rent on building,Taxes ,Insurance

Depreciation on building,Cost of maintenance & repair
wInventory Service Cost:Taxes on inventory,labor costs
Clerical expenses
wHandling Equipment Cost:Fuel Expenses,Depreciation
equipment
wInventory risk cost:Insurance on inventory,Obsolescence
of inventory
wOut of stock cost: back ordering,lost sales
wCapacity cost:
Overtime payments when capacity is too small
Layoffs & idle time when capacity is too large
chapter6 17
 Inventory Management & Control

Because of High cost involved in inventories,there proper

management and control assume considerable importance.
™Inventory management involves the development and
administration of policies,systems,and procedures which
will minimize total costs relative to inventory decisions.
™Viewed in that perspective inventory management is
broad in scope and affects great number of activities In a
companies organization.
™Because of this inventory management stresses the need
of integrated information
™Inventory control ,on the other hand ,pertaining to
administration of essential policies,systems & procedures
chapter6 18
 Benefits of Inventory
Management & Control
Proper management & control will result in following
benefits to an organization
™Inventory Control ensures an adequate supply of
materials ,stores.
™Minimizes shortages & avoids costly interruptions in
operations.
™It facilitates purchasing economics
™Eliminates duplication of ordering
™Permits better utilization of stock
™Provides check against loss of material
™It facilitates cost accounting by providing means of
allocating material cost to product
Chapter6 19 19
 Benefits of Inventory
Management & Control

™It enables management to make cost and consumption

comparison
™It provides means for the location and disposition of
inactive and obsolete items in store.
™Perpetual inventory values provide a consistent and
reliable basis for preparing financial statement
™It provides better utilization of available stocks by
facilitating inter departmental transfer.

Chapter6 20 20
 Process of Inventory
Management & Control

Four steps are involved

1.Determination of optimum inventory levels
2.Determination of degree of control that is
required for best results
3.Planning & design of the inventory control
system
4.Planning of the inventory control organization

Chapter6 21 21
 Optimum inventory levels

There exists for every inventory situation a theoretical

optimum inventory level. This is the average inventory
needed to provide a given fill rate without the added
problems created by:
™ Economic order quantity considerations
™ Minimum pallet or carton quantities
™ Larger than needed purchases to take advantage of
discounts
™ Other "real-world" issues that interfere with optimizing
inventory turns

Chapter6 22 22
 Optimum inventory levels

™This theoretical optimum quantity is, however, driven

by a series of elements that are fundamental and unique to
each and every SKU in the inventory. They are:
™The historical pattern of demand for the item, which in
turn determines the forecast for the item and the mean
average deviation (which is the measurement of the
inherent variability of the item).
™The lead time and order frequency associated with the
routine reordering of the item.
™It would be handy to be able to determine this quantity,
either for a given item, or for an entire group of items. It
would provide a base point against which to measure our
actual inventory. Chapter6 23
 Optimum inventory levels
™It so happens that the reorder target is determined by the
sum of the two times regardless of which is greater.
™As the inventory replenishment process takes place,
however, the relationship of the two items has a big
influence.
™ Shorter order frequencies play a major roll in lowering
the TOI. For example, you could have two items with
identical forecasts and MAD’s, one with a lead-time of
one week and an order frequency of every three weeks,
and another item with the reverse.
™Both will have the same reorder target, but the one with
the one-week order frequency will have a significantly
lower TOI than the other. Chapter6 24
Planning & design of Inventory
System
™The process to determine the TOI is to plot out the
classical "saw tooth" graphs that result from simulating the
reordering process. ".
™ In general the process is similar to the graph shown in
Exhibit A below. The vertical axis is the amount of
inventory that is on hand at any point in time, and the
horizontal axis is the passage of time.

chapter6 Chapter6 25 25
Planning & design of Inventory
System
™The interpretation of this saw tooth graph is that the
inventory starts to decease with time as the product is sold.
At some point (determined by the order frequency) a
reorder is triggered (that is the difference between the
reorder target and the net available on hand).
™Then, after the lead-time has passed, the product arrives
and is put in stock. The saw tooth rises up to the peak only
to start down again. If you plot these graphs for any
variety of items, the process will always come back to the
characteristic saw tooth shown below.
™The quantity that is never penetrated by the saw tooth is
the safety stock.
™ Chapter6 26
Planning & design of Inventory
System
™In the real world the safety stock will be penetrated
whenever the demand for the item exceeds the forecast
(that is what the safety stock is for).
™Conversely, there will be an equal number of times that
the saw tooth does not get down to the safety stock
because the demand was less than the forecast.
™ Consequently on the average the safety stock will be a
layer of inventory that on the average will always be part
of the TOI.
™The other part of the TOI is the average of the height of
the saw tooth. In other words, the TOI will be made up of
the safety stock plus half the height of the saw tooth.
Chapter6 27
 Planning & design of Inventory
System
™This assertion is based on the fact that on the average half
of the saw tooth quantity of stock will be around at any
time.
™At times there will be the full amount of the height, and
other times it will be right at the bottom, but on the average
it will be half the amount. In our example above the safety
stock is 20 units, and half of the saw tooth is 10 units,
making the TOI 30 for that particular SKU.
™By plotting out the TOI for innumerable SKU’s , develop
a general relationship that appears to be universal. It relates
the ratio of the lead-time (LT) of the item over the order
frequency (OF), to the percent of the "base quantity"
portion of the reorder target calculation.
Chapter6 28
Planning & design of Inventory
System
™(The base quantity is the first part of the reorder target
equation, and is simply the forecast times the sum of the lead
time and order frequency in months.) This relationship is
displayed in Exhibit B.
™

Chapter6 29
Fixed Order Quantity Systems
„ Behavior of Economic Order Quantity
(EOQ) Systems
„ Determining Order Quantities
„ Determining Order Points

chapter6 30
 Behavior of EOQ Systems
„ As demand for the inventoried item occurs, the
inventory level drops
„ When the inventory level drops to a critical point,
the order point, the ordering process is triggered
„ The amount ordered each time an order is placed
is fixed or constant
„ When the ordered quantity is received, the
inventory level increases
„ . . . more

chapter6 31
 Inventory Control Techniques
Several techniques of inventory control are in use and
it depends on the convenience of the firm to adopt
any of these The techniques most commonly used are
listed as follows:
™Always Better Control(ABC) Classification
™High medium low Classification
™Vital,essential,desirable Classification
™Scare,difficult,easy to procure
™Fast moving,non moving,slow moving
™Economic Order Quantity
™Max- minimum System
™Materials requirement planning
™Just-in time Chapter6 32
 ABC Analysis
™ABC Analysis
™Commonly used in practice
™Classify items by revenue or value
™Combination of usage, sales price, etc.
™what is different between the classes?
™A Items
Very few high impact items are included
Expect many exceptions to be made
™B Items
Automated control w/ management by exception
Rules can be used for A (but usually too many
Chapter6 33
exceptions)
 ABC Analysis
™C Items :Control systems should be as
simple as possible
™Require the most managerial attention and
review
™Many moderate impact items (sometimes
most)
™Many if not most of the items that make up
minor impact
™Reduce wasted management time and
attention
™Group into commonChapter6
regions, suppliers, end 34
users
 ABC Analysis

™The Pareto principle (also known as the 80-20 rule, the

law of the vital few and the principle of factor sparsity)
states that, for many events, 80% of the effects comes from
20% of the causes. Business management thinker Joseph M.
Juran suggested the principle, who observed that 80% of
income in Italy went to 20% of the population.
™It is a common rule of thumb in business; e.g., "80% of
your sales comes from 20% of your clients."
™The Pareto principle is only tangentially related to Pareto
efficiency
™Pareto developed both concepts in the context of the
distribution of income and wealth among the population.
Chapter6 35
 Behavior of EOQ Systems
„ An application of this type system is the
two-bin system
„ A perpetual inventory accounting system is
usually associated with this type of system

chapter6 36
 Determining Order Quantities
„ Basic EOQ
„ EOQ for Production Lots
„ EOQ with Quantity Discounts

chapter6 37
 Model I: Basic EOQ
„ Typical assumptions made
– annual demand (D), carrying cost (C) and
ordering cost (S) can be estimated
– average inventory level is the fixed order
quantity (Q) divided by 2 which implies
» no safety stock
» orders are received all at once
» demand occurs at a uniform rate
» no inventory when an order arrives
– . . . more

chapter6 38
 Model I: Basic EOQ
„ Assumptions (continued)
– Stock out, customer responsiveness, and other costs are
inconsequential
– acquisition cost is fixed, i.e., no quantity discounts
„ Annual carrying cost = average inventory level X
carrying cost = (Q/2)C
„ Annual ordering cost = average number of orders
per year X ordering cost = (D/Q)S
„ . . . more

chapter6 39
 Model I: Basic EOQ
„ Total annual stocking cost (TSC) = annual
carrying cost + annual ordering cost =
(Q/2)C + (D/Q)S
„ The order quantity where the TSC is at a
minimum (EOQ) can be found using
calculus (take the first derivative, set it
equal to zero and solve for Q)

EOQ= 2DS/ C
chapter6 40
 Model II: EOQ for Production Lots
„ Used to determine the order size, production
lot, if an item is produced at one stage of
production, stored in inventory, and then
sent to the next stage or the customer
„ Differs from Model I because orders are
assumed to be supplied or produced at a
uniform rate (p) rate rather than the order
being received all at once
„ . . . more

chapter6 41
Model II: EOQ for Production Lots

„ It is also assumed that the supply rate, p, is

greater than the demand rate, d
„ The change in maximum inventory level
requires modification of the TSC equation
„ TSC = (Q/2)[(p-d)/p]C + (D/Q)S
„ The optimization results in
2D S ⎡ p ⎤
EOQ =
C ⎢⎣ p − d ⎥⎦

chapter6 42
Model III: EOQ with Quantity
Discounts
„ Under quantity discounts, a supplier offers a lower
unit price if larger quantities are ordered at one
time
„ This is presented as a price or discount schedule,
i.e., a certain unit price over a certain order
quantity range
„ This means this model differs from Model I
because the acquisition cost (ac) may vary with
the quantity ordered, i.e., it is not necessarily
constant
„ . . . more
chapter6 43
 Model III: EOQ with Quantity
Discounts
„ Under this condition, acquisition cost
becomes an incremental cost and must be
considered in the determination of the EOQ
„ The total annual material costs (TMC) =
Total annual stocking costs (TSC) + annual
acquisition cost
TSC = (Q/2)C + (D/Q)S + (D)ac
„ . . . more

chapter6 44
 Model III: EOQ with Quantity Discounts

To find the EOQ, the following procedure is

used:

1. Compute the EOQ using the lowest

acquisition cost (ac). If the resulting EOQ is
feasible, i.e., that quantity can be purchased
at the acquisition cost used, it is optimal.
Otherwise, go on to Step 2
chapter6 45
 Model III: EOQ with Quantity Discounts

2. Using the EOQ from Step 1 and the discount

schedule, find the acquisition cost that should have
been used and compute a new EOQ. This new
EOQ should be feasible.
3. Compute the TMC for the EOQ found in Step 2
4. Compute the TMC for all quantities greater than
Step 2’s EOQ where a discount is offered. Select
the quantity with the lowest TMC

chapter6 46
Determining Order Points
„ Basis for Setting the Order Point
„ DDLT Distributions
„ Setting Order Points

chapter6 47
 Basis for Setting the Order Point

„ In the fixed order quantity system, the

ordering process is triggered when the
inventory level drops to a critical point, the
order point
„ This starts the lead time for the item.
„ Lead time is the time to complete all
activities associated with placing, filling
and receiving the order.
„ . . . more

chapter6 48
 Basis for Setting the Order Point

„ During the lead time, customers continue to

draw down the inventory
„ It is during this period that the inventory is
vulnerable to stock out (run out of
inventory)
„ Customer service level is the probability
that a stock out will not occur during the
lead time
„ . . . more

chapter6 49
Basis for Setting the Order Point
„ Thus, the order point is set based on
– the demand during lead time (DDLT) and
– the desired customer service level
„ Order point (OP) = Expected demand
during lead time (EDDLT) + Safety stock
(SS)
„ The amount of safety stock needed is based
on the degree of uncertainty in the DDLT
and the customer service level desired
chapter6 50
 DDLT Distributions
„ If there is variability in the DDLT, the
DDLT is expressed as a distribution
– discrete
– continuous
„ In a discrete DDLT distribution, values
(demands) can only be integers
„ A continuous DDLT distribution is
appropriate when the demand is very high
chapter6 51
 Setting Order Point
for a Discrete DDLT Distribution

„ Assume a probability distribution of actual

DDLTs is given or can be developed from a
frequency distribution
„ Starting with the lowest DDLT, accumulate
the probabilities. These are the service
levels for DDLTs
„ Select the DDLT that will provide the
desired customer level as the order point
chapter6 52
 Setting Order Point
for a Continuous DDLT Distribution
„ Assume that the lead time (LT) is constant
„ Assume that the demand per day is normally
distributed with the mean (d ) and the standard
deviation (σd )
„ The DDLT distribution is developed by
“adding” together the daily demand
distributions across the lead time
„ . . . more

chapter6 53
Some Realities of Inventory Planning

„ ABC Classification
„ EOQ and Uncertainty
„ Dynamics of Inventory Planning

chapter6 54
 ABC Classification

„ Start with the inventoried items ranked by

dollar value in inventory in descending
order
„ Plot the cumulative dollar value in
inventory versus the cumulative items in
inventory
„ . . . more

chapter6 55
 ABC Classification
„ Typical observations
– A small percentage of the items (Class A) make
up a large percentage of the inventory value
– A large percentage of the items (Class C) make
up a small percentage of the inventory value
„ These classifications determine how much
attention should be given to controlling the
inventory of different items

chapter6 56
 EOQ and Uncertainty
„ The TSC and TMC curves are relatively
flat, therefore moving left or right of the
optimal order quantity on the order quantity
axis has little effect on the costs
„ Estimation errors of the values of parameter
used to compute an EOQ usually do not
have a significant impact on total costs
„ . . . more

chapter6 57
 EOQ and Uncertainty

„ Many costs are not directly incorporated in

the EOQ and EOP formulas, but could be
important factors
„ Emergency procedures to replenish
inventories quickly should be established

chapter6 58
Dynamics of Inventory Planning
„ Continually review ordering practices and
decisions
„ Modify to fit the firm’s demand and supply
patterns
„ Constraints, such as storage capacity and
available funds, can impact inventory
planning
„ Computers and information technology are
used extensively in inventory planning
chapter6 59
Wrap-Up: World-Class Practice
„ Inventory cycle is the central focus of
independent demand inventory systems
„ Production planning and control systems are
changing to support lean inventory
strategies
„ Information systems electronically link
supply chain

chapter6 60
 Just In Time

„ Just In Time (business), an inventory strategy that reduces

in-process inventory
„ Just-in-time compilation, a technique for improving the
performance of byte code-compiled programming
systems
„ Just in Time (Code Lyoko episode), an episode of the
French animated television series Code Lyoko
„ Jit (Corvette), An abbreviation for "Jawvette", also
known as a Corvette.
„ "Just in Time," a 1956 popular song composed by Jule
Styne with lyrics written by Betty Comden and Adolph
Green, best known in a recording by Tony Bennett
chapter6 61
Measurement of effectiveness in
inventory Control
The following are some performance indicator of inventory
management
1.Overall Inventory turnover = Cost of capital sold
ratio Average Inventory at cost

Annual consumption of Raw

2 Raw material Inventory = material
turnover ratio Average Raw material Inventory

3 Out of Stock Index = Number of times out of stock

Number of times Requisitioned

4 Spares part Index = Value of spares part inventory

chapter6 Value of capital Equipment
62
 Solved Examples
Problem1
An auto Industry Purchases Spark plug at the rate of
Rs 25 per piece. The annual consumption of
spark plug is 18,000 no’s .If the ordering cost is
Rs 250 per order and carrying cost is 25% p.a,
a)What would be EOQ?
b)If the supplier of spark plug offers discount of 5%
for order quantity of 3000 no’s per order do you
accept the discount offer?

chapter6 63
 Solved Examples
Solution1 a
Calculation of EOQ:
Annual demand(D) = 18,000 nos.
Unit price P = Rs 25/
Ordering Cost per order C0 = Rs 250/
Carrying Charges CI = 25%

EOQ= 2DCO = 2*18000*250

PCI 25*0.25
=1200 nos.
chapter6 64
 Solved Examples
Solution1 b
Decision regarding discount offer for Q=3000
1) EOQ option:
Total cost of material plus
= DP+D/Q*CO+Q/2P*C1
Cost on material per annum
=1800*25+(18000/1200)*250
+ (1200/2*25*20/100)
=4,50,000+3750+3750
Total Cost TC =4,57,500
EOQ

chapter6 65
 Solved Examples
Solution1 b
Decision regarding discount offer for Q=3000
1) Discount option:
Discount offered for order qty Q1 of 3000 nos. =5% of unit price
New price after discountp1=0.95*25=23.75

(Total Cost of material

= DP+D/Q1*CO+Q1/2P*C1
Plus cost of materials
TC Discount ) =1800*23.75+(18000/3000)*250
+ (3000/2*23.75*0.25)
=4,27,500+1500+8906.25
Tc discount =4,37,906.25
Decision rule : if TC(discount) <=Tc(EOQ)- Accept order
if TC(discount) >Tc(EOQ)- Reject Discount order
Hence order is acceptable chapter6 66
 Production Planning
& Control

End Of

Chapter 6

chapter6 67