Inventory Management PDF

CHAPTER SIX: INVENTORY MANAGEMENT 1. INTRODUCTION In a modern competitive world, the major problem and primary responsibility of an organization, whether it is a public sector, private sector or government department (business or industry) is to optimize the use of resources. For the survival a...

CHAPTER SIX: INVENTORY MANAGEMENT 1. INTRODUCTION In a modern competitive world, the major problem and primary responsibility of an organization, whether it is a public sector, private sector or government department (business or industry) is to optimize the use of resources. For the survival and growth of an organization, it is highly essential that all the pervasive efforts are made to minimize and control the total costs, to achieve higher operational efficiency and profitability. Inventory management is the branch of business management that covers the planning and control of the inventory. Inventory management is the process of monitoring and controlling inventory level and ensuring adequate replenishment in order to meet customer demand. Determining the appropriate inventory level is crucial since inventory ties up money and affects performance. Having too much inventory reduces the working capital and impacts the company’s liquidity. On the contrary, having too little inventory leads to stock outs and missed sales which leads to less profit. It becomes clear that management attention should be focused on keeping inventory level somewhere in between, striving for increased customer satisfaction and minimum stock outs while keeping inventory costs as low as possible. This chapter discusses inventory control policies for effective material management in an organization. 2. DEFINITION OF INVENTORY Inventory generally refers to the materials in stock. It is also called the idle resource of an enterprise. Inventories represent those items which are either stocked for sale or they are in the process of manufacturing or they are in the form of materials, which are yet to be utilized. Inventories serve several functions in an organization. The main function of inventories is to reduce the interdependency of various stages of the production and delivery system. Consider three subsystems of an organization representing the supplier, production, and the market. These three subsystems are rigidly connected with each other, without any inventories, as shown in Figure 6.1. The interval between receiving the purchased parts and transforming them into final products varies from industries to industries depending upon the cycle time of manufacture. It is, therefore, necessary to hold inventories of various kinds to act as a buffer between supply and demand for efficient operation of the system. Thus, an effective control on inventory is a must for smooth and efficient running of the production cycle with least interruptions. Inventory can be defined as “an idle stock of physical goods that contain economic value, and are held in various forms by an organization in its custody awaiting packing, processing, transformation, use or sale in a future point of time”. (Press to learn more) 3. FUNCTIONS OF INVENTORY The main functions of inventory within organization are: - To meet anticipated customer demand. These inventories are referred to as anticipation stocks because they are held to satisfy planned or expected demand. - To smooth production requirements. Firms that experience seasonal patterns in demand often build up inventories during off-season to meet overly high requirements during certain seasonal periods. Companies that process fresh fruits and vegetable deal with seasonal inventories - To decouple operations. The buffers permit other operations to continue temporarily while the problem is resolved. Firms have used buffers of raw materials to insulate production from disruptions in deliveries from suppliers, and finished goods inventory to buffer sales operations from manufacturing disruptions. - To protect against stock-outs. Delayed deliveries and unexpected increases in demand increase the risk of shortages. The risk of shortages can be reduced by holding safety stocks, which are stocks in excess of anticipated demand. - To take advantage of order cycles. Inventory storage enables a firm to buy and produce in economic lot sizes without having to try to match purchases or production with demand requirements in short run. - To hedge against price increase. The ability to store extra goods also allows a firm to take advantage of price discounts for large orders. - To permit operations. Production operations take a certain amount of time means that there will generally be some work-in-process inventory. 4. TYPES OF INVENTORY All organizations will carry some inventory or stock of goods at any one time. This can range from items such as stationery to machinery parts or raw materials. Generally inventory is classified by its location or type. (press to learn more) 4.1. Inventory Classified by Location Inventory can be classified by location are classified as raw materials, semi-finished goods, finished goods, and work-in-process (WIP). 1- Raw Materials Purchased items or extracted materials that are converted via the manufacturing process into components and/or products. These are Iron ore for steel, grain for flour, wood for furniture, raw cotton yarn for cloth and materials used to make the components of the finished product. 2- Semi-finished Goods Semi-finished goods are items that have been stored uncompleted, awaiting final operations that will adapt them to different uses or customer specifications. Semi-finished goods are made under the instruction of a shop order, using the components issued by a picking order, and stored in the warehouse when finished. Semi-finished goods are not sold to the customers. 3- Finished Goods A finished good is a product sold as a completed item or repair part, i.e., any item subject to a customer order or sales forecast. Finished goods are stored in the warehouse before they are shipped. 4- Work-In-Process (WIP) Products in various stages of completion throughout the plant, including all material from raw material that has been released for initial processing up to completely processed material waiting for inspection and acceptance as finished goods. These materials are waiting between operations in the factory. 5- Maintenance, Repair, and Operational Supplies (MRO) Items used in support of general operations and maintenance such as maintenance supplies, spare parts, and consumables used in the manufacturing process and supporting operations. These items are used in production but do not become part of the product. 4.2. Inventory Classified by Type The type of inventory can also be used to provide a method of identifying why inventory is being held and so suggest policies for reducing its level. Inventory types include the following. 1- Buffer/Safety This is used to compensate for the uncertainties inherent in the timing or rate of supply and demand between two operational stages. Safety stock is often used to compensate for uncertainties in the timing of supplies from suppliers. It is also used to compensate for uncertainties in supply between operational stages in a process, due to factors such as equipment breakdowns. 2- Cycle If there is a requirement to produce multiple products from one operation in batches, there is also a need to produce enough to keep a supply while other batches are being produced. This is an example of how differences between the timing of supply and demand can lead to high levels of work- in-progress inventory. 3- De-Coupling This permits stages in the manufacturing process to be managed and their performance to be measured independently, to run at their own speed and not match the rate of processing by departments at different points in the process. 4- Anticipation This includes producing to stock to anticipate an increase in demand due to seasonal factors. Speculative policies, such as buying in bulk to take advantage of price discounts, may also increase inventory levels. Accurate forecasting can help ensure anticipated inventory reflects any increase in demand. Bulk-buying policies will need to take into account the full cost of storing inventory. 5- Pipeline/Movement This is the inventory needed to compensate for the lack of stock while material is being transported between stages, for example the distribution time from a warehouse to a retail outlet. Thus pipeline inventory may be the result of delays in the supply chain between customer and supplier. If an alternative supplier can be found then pipeline inventory can be reduced. 5. IMPORTANCE OF KEEPING INVENTORIES Keeping stock is a crucial issue for any organization since it enable it to achieve the following: -To stabilize production: The demand for an item fluctuates because of the number of factors, e.g., seasonality, production schedule etc. The inventories (raw materials and components) should be made available to the production as per the demand failing which results in stock out and the production stoppage takes place for want of materials. Hence, the inventory is kept to take care of this fluctuation so that the production is smooth. - To take advantage of price discounts: Usually the manufacturers offer discount for bulk buying and to gain this price advantage the materials are bought in bulk even though it is not required immediately. Thus, inventory is maintained to gain economy in purchasing. - To meet the demand during the replenishment period: The lead time for procurement of materials depends upon many factors like location of the source, demand supply condition, etc. So inventory is maintained to meet the demand during the procurement (replenishment) period. - To prevent loss of orders (sales): In this competitive scenario, one has to meet the delivery schedules at 100 per cent service level, means they cannot afford to miss the delivery schedule which may result in loss of sales. To avoid the organizations have to maintain inventory. - To keep pace with changing market conditions: The organizations have to anticipate the changing market sentiments and they have to stock materials in anticipation of non-availability of materials or sudden increase in prices. - Sometimes the organizations have to stock materials due to other reasons like suppliers minimum quantity condition, seasonal availability of materials or sudden increase in prices. 6. FACTORS AFFECTING THE LEVEL OF INVENTORY The level of inventory should be appropriate. The appropriateness of the amount of inventory depends upon a number of factors. Some significant factors affecting the level of inventory are explained as follows: - Nature of business: The level of inventory will depend upon the nature of business whether it is a retail business, wholesale business, manufacturing business or trading business. - Inventory turnover: Inventory turnover refers to the amount of inventory which gets sold and the frequency of its sale. It has a direct impact on the amount of inventory held by a business concern. - Nature of type of product: The product sold by the business may be a perishable product or a durable product. Accordingly, the inventory has to be maintained. - Economies of production: The scale on which the production is done also affects the amount of inventory held. A business may work on large scale in order to get the economies of production. - Inventory costs: More the amount of inventory is held by the business, more will be the operating cost of holding inventory. There has to be a trade-off between the inventory held and the total cost of inventory which comprises of purchase cost, ordering cost and holding cost. - Financial position: Sometimes, the credit terms of the supplier are rigid and credit period is very short. Then, according the financial situation of the business the inventory has to be held. - Period of operating cycle: If the operating cycle period is long, then the money realization from the sale of inventory will also take a long duration. Thus, the inventory managed should be in line with the working capital requirement and the period of operating cycle. - Attitude of management: The attitude and philosophy of top management may support zero inventory concept or believe in maintaining huge inventory level. Accordingly, the inventory policy will be designed for the business. 7. RESULTS OF INADEQUATE CONTROL OF INVENTORY Inadequate control of inventories can result into two categories: 1. Under stocking results in missed deliveries, lost sales, dissatisfied customers and production bottlenecks. 2. Overstocking unnecessarily ties up funds that might be more productive Therefore, any organization should identify the main concerns of inventory management in order to overcome the results of inadequate control of inventories. The main two concerns are: First, level of customer service to have the right goods, in sufficient quantities, in the right place, and at the right time. And the second is the cost of ordering and carrying inventories. 8. INVENTORY COST The three basic cots of inventory are:(press to learn more) - Holding or Carrying Cost: is the costs to carry an item in inventory for a length of time usually a year. Cost includes interest, insurance, taxes, depreciation, obsolescence, deterioration, spoilage, pilferage, breakage, etc. - Ordering Cost: is cost of ordering and receiving inventory. These include determining how much is needed, preparing invoices, inspecting goods upon arrival for quality and quantity, and moving the goods to temporary storage. - Storage Cost: is cost resulting when demand exceeds the supply of inventory on hand. These costs can include the opportunity cost of not making a sale, loss of customer goodwill, late charges, and similar costs. 9. WHAT IS INVENTORY MANAGEMENT? Inventory management is the practice overseeing and controlling of the ordering, storage and use of components that a company uses in the production of the items it sells. A component of supply chain management, inventory management supervises the flow of goods from manufacturers to warehouses and from these facilities to point of sale. Inventory control means efficient management of capital invested in raw materials and supplies, work- in – progress and finished goods. 10. OBJECTIVES OF INVENTORY MANAGEMENT The objective of inventory management is to maintain inventory at an appropriate level to avoid excess or shortage of inventory. Inventory management systems reduce the cost of carrying inventory and ensure that the supply of raw material and finished goods remains continuous throughout the business operations. The objectives specifically may be divided into two categories mentioned below: A- Operating objectives: They are related to the operating activities of the business like purchase, production, sales etc. They include: - To ensure continuous supply of materials. - To ensure uninterrupted production process. - To minimize the risks and losses incurred due to shortage of inventory. - To ensure better customer services. - Avoiding of stock out danger. B. Financial Objectives: They include: - To minimize the capital investment in the inventory. - To minimize inventory costs. - Economy in purchase. C. Apart from the above objectives, inventory management also emphasize to bring down the adverse impacts of holding excess inventory. Holding excess inventory lead to the following consequences: - Unnecessary investment of funds and reduction in profit. - Increase in holding costs. - Loss of liquidity. - Deterioration in inventory. 11. REQUIREMENTS FOR EFFECTIVE INVENTORY MANAGEMENT To be effective, management must have the following: - A system to keep track of the inventory on the hand on order. - A reliable forecast of demand that includes an indication of possible forecast error. - Knowledge of lead times and lead time variability. - Reasonable estimates of inventory holding costs, ordering costs, and shortage costs. - A classification system for inventory items. 12. INVENTORY CONTROL TECHNIQUES In any organization, depending on the type of business, inventory is maintained. When the number of items in inventory is large and then large amount of money is needed to create such inventory, it becomes the concern of the management to have a proper control over its ordering, procurement, maintenance and consumption. The control can be for order quality and order frequency. The main techniques of inventory control are: (1) ABC analysis, (2) HML analysis, (3) VED analysis, (4) FSN analysis, (5) SDE analysis, (6) GOLF analysis and (7) SOS analysis. 1. ABC analysis: The most widely used method of inventory control is known as ABC analysis. In this technique, the total inventory is categorized into three sub-heads and then proper exercise is exercised for each sub-heads. In this analysis, the classification of existing inventory is based on annual consumption and the annual value of the items. Hence we obtain the quantity of inventory item consumed during the year and multiply it by unit cost to obtain annual usage cost. The items are then arranged in the descending order of such annual usage cost. The analysis is carried out by drawing a graph based on the cumulative number of items and cumulative usage of consumption cost. Classification is done as follows: Once ABC classification has been achieved, the policy control can be formulated as follows: A- Item: Very tight control, the items being of high value. The control need be exercised at higher level of authority. B- Item: Moderate control, the items being of moderate value. The control need be exercised at middle level of authority. C- Item: The items being of low value, the control can be exercised at gross root level of authority, i.e., by respective user department managers. 2. HML analysis: In this analysis, the classification of existing inventory is based on unit price of the items. They are classified as high price, medium price and low cost items. 3. VED analysis: In this analysis, the classification of existing inventory is based on criticality of the items. They are classified as vital, essential and desirable items. It is mainly used in spare parts inventory. 4. FSN analysis: In this analysis, the classification of existing inventory is based consumption of the items. They are classified as fast moving, slow moving and non-moving items. 5. SDE analysis: In this analysis, the classification of existing inventory is based on the items. 6. GOLF analysis: In this analysis, the classification of existing inventory is based sources of the items. They are classified as Government supply, ordinarily available, local availability and foreign source of supply items. 7. SOS analysis: In this analysis, the classification of existing inventory is based nature of supply of items. They are classified as seasonal and off- seasonal items. For effective inventory control, combination of the techniques of ABC with VED or ABC with HML or VED with HML analysis is practically used. 13. INVENTORY MODELS ECONOMIC ORDER QUANTITY (EOQ) Inventory models deal with idle resources like men, machines, money and materials. These models are concerned with two decisions: how much to order (purchase or produce) and when to order so as to minimize the total cost. For the first decision, how much to order, there are two basic costs are considered namely, inventory carrying costs and the ordering or acquisition costs. As the quantity ordered is increased, the inventory carrying cost increases while the ordering cost decreases. The ‘order quantity’ means the quantity produced or procured during one production cycle. Economic order quantity is calculated by balancing the two costs. Economic Order Quantity (EOQ) is that size of order which minimizes total costs of carrying and cost of ordering. i.e., Minimum Total Cost occurs when Inventory Carrying Cost = Ordering Cost Economic order Three (3) Order Size 1- The economic order quantity model. 2- The economic order quantity model with non-instantaneous delivery. 3- The quantity discount model. Inventory Cycles begins with the receipt of an order of Q units, which are withdrawn at instant rate over time. When the quantity on the hand is just sufficient to satisfy demand during lead time, an order for Q units is submitted to the supplier. Developing EOQ Mathematical Model Assumption of the Basic EOQ Model - Only one product is involved. - Annual demand requirements are known. - Demand is spread evenly throughout the year so that the demand rate is reasonably constant. - Lead time does not vary. - Each order is received in a single delivery. - There are quantity discounts. Holding Cost (H) or carrying cost relate to having items in storage. Cost includes interest, insurance, tax, depreciation Obsolesce, deterioration, spoilage, breakage. Warehouse cost (heat, light, security and rent. In EOQ Model Holding Cost is Express in terms of unit, So: Total holding Cost = Number of unit x quantity Ordering Costs are the costs of ordering and receiving inventory. They are the cost that varies with the actual placement of an order such as shipping cost, preparing invoices, inspecting goods upon arrivals. The ordering Cost express as fixed dollars per order regardless of order size. By merging the two Graphs we can notice that the minimum Inventory Cost is at the intersection point. Total Cost = Holding Cost + Ordering Cost EXAMPLE OF ORDERING COST FACTORS - Processing and inspecting incoming inventory - Developing and sending purchase orders - Bill paying - Inventory inquiries - Utilities, phone bills, and so on, for the purchasing department - Salaries and wages for the purchasing department employees - Supplies such as forms and paper for the purchasing department EXAMPLES OF CARRYING COST FACTORS - Cost of capital - Taxes - Insurance - Spoilage - Theft - Obsolescence - Supplies such as forms and paper for the warehouse - Utilities and building costs for the warehouse - Salaries and wages for warehouse employees Determinants of Reorder point quantity (when we have to reorder?) - Rate of demand - The lead time - The extent of demand - The degree of stock out risk acceptable to management ROP (Reorder Point) = Daily Demand X Lead Time ROP = d x L (Note that Demand is on daily basis) Example: SaveMart needs 1000 coffee makers per year. The cost of each coffee maker is $78. Ordering cost is $100 per order. Carrying cost is $20 of per unit cost. Lead time is 5 days. Save Mart is open 360 days/yr. a- What is EOQ Model? b- How many times per year does the store reorder? c- What is the length of order cycle? d- What is the total annual cost if the EOQ quantity is ordered? Answer: EOQ = √ [ (2 x S x D) / H] = EOQ = √ [ (2 x 100 x 1000) / 2] = 100 units Number of orders = 1000 /100 = 10 times Cycle Length = 100 / 1000 = 0.1 per year = 36 days Total Annual Inventory Cost = [(100/2) × 20] × [(1000/100) × 100] = 2000 EOQ with Non instantaneous Replenishment (EPQ) When a firm is both a producer and a user or deliveries are spread over time, inventories tend to build up gradually instead of instantaneously. If usage production (or delivery) rates are equal, there will be no inventory buildup since all output will be used immediately and the issue of lot size doesn’t come up. In the more typical case, the production or delivery rate exceeds the usage rate. In the production case, production occurs over only a portion of each cycle because the production rate is greater than the usage rate, and usage occurs over the entire cycle. Where P is Production or Delivery Rate U is usage rate Example: A toy manufacturer uses 48,000 rubber wheels per year for its popular dump truck. The firm makes its own wheels, which it can produce at a rate of 800 per day. The toy trucks are assembled uniformly over entire year. Carrying cost is $ 1 per wheel a year. Setup cost of production run of wheels is $45. The firm operates 240 days per year. Determine the:- - Optimal Run Size. - Minimum total annual cost for carrying and setup. - Cycle time for the optimum run size. - Run time. Answer D = 48,000 wheels per year S= $ 45 H= $ 1 per wheel per year P = 800 wheels per day U = 48,000 wheel per 240 days or 200 wheels per day Answer Qp = √ [ (2 x 48000 x 45) / 1] × [ 800/(800-200) = 2400 Wheels EOQ with Quantity Discount Quantity Discounts are price reductions for large orders offered to customers to induce them to buy in large quantities. If quantity discounts are offered, the customer must weigh the potential benefits of reduced purchase price and fewer orders that will result from buying in large quantities against the increase in carrying costs caused by higher average inventories TC = carrying cost + Ordering cost + Purchasing Cost EXAMPLE: The maintenance department of a large hospital uses about 180 cases of liquid cleanser annually. Ordering costs are $25, carrying costs are $5 per case a year, and the new schedule indicates that orders of less than 45 cases will cost $2.0 per case, 45 to 69 will cost $1.7 per case, and more than 70 cases will cost $1.4 per case. Determine the optimal order quantity and total cost. Answer We can note that at some range from 45 to 70 units annual cost will be appropriate even the EOQ state other range due to discount effect.