Chapter 11 – Inventory Management
Inventory: An idle material or product
Many of the items a company carries in inventory relate to the kind of business it engages in.
Inventory Management: planning, coordinating, and controlling activities related to the flow of inventory into,
through, and out of an organization
Inventory system: is the set of policies and controls that monitor levels of inventory and determines what
levels should be maintained, when stock should be replenished, and how large orders should be
Importance of Inventories
- Inventories are a vital part of business. Not only are they necessary for operations, but they also
contribute to customer satisfaction.
- A typical company probably has 30% of its current assets and as much as 90% of its working capital
invested in inventories.
- One widely used measure of managerial performance relates to return on investment (ROI), which is
profit after taxes divided by total assets.
- Inventories may represent a significant portion of total assets, but a reduction of inventories can result in
a significant increase in ROI
Functions of Inventory
1. To meet expected sales or usage
2. To wait while being transported
3. To protect against stock outs
4. To take advantage of economic lot size and quantity discount
5. To smooth seasonal production requirements
6. To decouple operations
7. To hedge against price increases
Objectives of Inventory Control
Inadequate control of inventories can result in both under and overstocking of items.
- Inventory management has two main concerns, one is the level of customer service and the other is the
costs of ordering and holding inventories
- The overall objective of inventory management is to achieve satisfactory levels of customer service
while keeping inventory costs within reasons boundaries - Managers measure performance through customer satisfaction, but also through inventory turnover:
ratio of annual cost of goods sold to average inventory investment.
REQUIRMENTS FOR EFFECTIVE INVENTORY MANAGEMENT
Two basic functions concerning investories; to establish a system to safely store and use inventories, to
accuractely keep track of levels of inventories; these require the following;
1. A system to safely store and use inventories
2. A system t keep track of inventories, and replenishment models
3. Reliable forecasts of demands and knowledge of lead times
4. Reasonable estimates of inventory holding, ordering, and shortage costs
5. 5. A-B-C classification
Inventory Counting and Replenishment Models
Periodic Counting: Physical count of items in inventory made at period intervals (e.g. weekly, monthly)
- Fixed order interval model: periodically checking shelves and stockroom to determine quantities on
hand. Then estimating how much of it will be demanded prior to the next delivery.
- Advantage - orders from the same supplier can be issued at the same time, resulting in economies in
prices and shipping
- Disadvantage – possibility of stock out between reviews.
Perpetual tracking: System that keeps track of removals from and additions to inventory continuously, thus
providing current levels of each item
- Fixed order-quantity or reorder point model: An order of a fixed size, usually equal to the economic
order quantity, is placed when the amount on hand drops to or below a minimum quantity called the
- Advantages - shortages are avoided, can determine an optimal order quantity and use it for every order
- Disadvantage – added costs of continual record keeping, and possibly frequent orders
Two-bin System: two containers of inventory, reorder when the first is empty (with a reorder card at the
bottom), use the second bin until order arrives
- Advantages – no need to record each withdrawal from inventory or keep track of inventory on hand
- Disadvantages – the reorder card may not be turned in
Bar Codes: a number assigned to an item or location, made of a group of vertical batrs of different thickness
that are readable by a scanner. (5 different types)
Demand Forecasts and Lead-Time Information
Purchase lead time: Time interval between ordering and receiving the order Manufacturing lead time: the time it will take for a batch of a product to be manufactured.
Managers need to know the extent to which demand and lead time might vary. The greater the potential
variability, the greater the need for additional safety stock to reduce the risk of a shortage between deliveries.
Thus, there is a crucial link between forecasting and inventory management.
Point-Of-Sale (POS) System: Software for electronically recording sales and updating inventory levels at the
time and location of sale
Three basic costs are associated with inventories; holding, ordering, and shortage costs
Holding or Carrying Costs: costs to keep an item in inventory. (warehousing costs – heat, cooling, light,
opportunity costs, insurance, spoilage, breakage, etc)
- Stated as a % of unit cost or as a $ of amount per unit
Ordering Cost: Cost of determining order quantity and preparing purchase orders the fixed cost portion of
receiving, inspection, and material handling, and paying the invoice. Not including Purchasing Costs – the cost
of goods acquired from suppliers, including freight
- Expressed as a fixed dollar amount per order, regardless of order size
Setup: Time spent preparing equipment for the job by adjusting the machine, changing cutting tools, etc
- expressed as a fixed charge per production run, regardless of the size of the run
Shortage Cost: Cost resulting when demand exceeds the supply of inventory on hand, often unrealized profit
per unit (opportunity cost of not making a sale, customer goodwill, late charges, and expediting costs)
A-B-C Classification: Grouping inventory items to three classes according to some measure of importance, and
allocating control efforts accordingly.
An application of the A-B-C concept is to judge cycle counting: Regular physical count of the items in
inventory on a cyclic schedule
The key questions concerning cycle counting for management are;
1.How much accuracy is needed
2. What counting cycle should be sued
3. Who should do it FIXED ORDER QUALITITY/REORDER POINT MODEL: DETERMING ECONOMIC ORDER
In this model, the fixed order quantity is determined and used for an item in inventory when the amount on hand
drop to or below the reorder point (quantity). The order quantity u