Inventory management involves balancing the costs of holding inventory with the costs of stockouts. Key considerations include classifying inventory using ABC analysis, ensuring accurate records through cycle counting, and determining optimal order quantities using economic order quantity models to minimize total costs. The economic order quantity model balances ordering costs and holding costs to find the point where total costs are minimized.
2. Learning objectives
• Identify and describe classification systems,
particularly ABC analysis
• Understand the importance of record accuracy
• Explain cycle counting
• Discuss the impact of independent and
dependent demand on inventory
• Identify the costs involved in inventory holding
• Define the term ‘inventory’
• List reasons for holding inventory
3. Learning objectives (cont.)
• Discuss the main requirements for effective inventory
management
• Describe and use basic economic order quantity models
• Understand periodic and perpetual review systems
• Describe and use the quantity discount model and
reorder point model
• Appreciate the need for buffer stock in inventory
management
• Appreciate the need for keeping inventory
• Explain the importance of service levels in inventory
management.
4. 8.1 Introduction
• Inventory = stockpile or store of goods
• Type of business determines inventory
type
• Inventory: one of the most expensive
assets
• Good indicator – number of times
inventory is turned.
5. 8.2 The nature and importance of
holding inventory
• ROI
• Larger the reduction in holding inventory,
the higher the ROI
• Manufacturing organisations hold:
– Raw materials
– WIP
– Finished goods
– Replacement parts
6. 8.2 The nature and importance of
holding inventory (cont.)
COMMON REASONS FOR KEEPING
INVENTORY
Decouple production process
There is an insecure supply of raw materials
To distance organisation from uncertain demand
To facilitate wide variety of products
To take advantage of supplier discounts
To avoid price increases
Items are in transit
To smooth production requirements
To prevent stock-outs occurring
To take advantage of ordering cycles
7. 8.2 The nature and importance of
holding inventory (cont.)
• Objective function of inventory control
– Satisfaction of customers
– Management of inventory costs
Two types of stockholding
Overstocking – too much inventory – large
funds tied up
Understocking – too little inventory – late
deliveries
8. 8.2 The nature and importance of
holding inventory (cont.)
• Inventory types:
– Inventory of raw materials – not yet
transformed into finished goods
– WIP inventory – in process but not completed
– Maintenance, repair and operating inventory –
machine parts etc.
– Finished goods inventory – goods that are
ready for delivery
9. 8.2 The nature and importance of
holding inventory (cont.)
• Control and turnover of inventory
• Lower the turnover the poorer the
performance of the inventory control function
10. 8.2 The nature and importance of
holding inventory (cont.)
11. 8.2 The nature and importance of
holding inventory (cont.)
Average world wide trends:-
ITR = 3 or 4 times
Lean manufacturing as much as 30 times!
12. 8.2 The nature and importance of
holding inventory (cont.)
If we assume the following:-
R250,000 of average inventory = FGI
R250,000 of average inventory = RMI
R500,000 of average inventory = WIP
R2,000,000 labour and overhead costs to transform raw materials
to finished goods
R2,500,000 = Purchasing materials cost
R750,000 – cost of carrying FGI
R2,000,000 labour and overhead costs to transform raw materials
to finished goods
Calculate TWIP,TRM & TFGI
13. 8.2 The nature and importance of
holding inventory (cont.)
ASSUMPTIONS
R250,000 = FGI
R250,000 = RMI
R500,000 = WIP
R2,500,000 = Purchasing
materials cost
R750,000 – cost of carrying FGI
R2,000,000 labour and overhead
costs to transform raw materials
to finished goods
14. 8.2 The nature and importance of
holding inventory (cont.)
ASSUMPTIONS
R250,000 = FGI
R250,000 = RMI
R500,000 = WIP
R2,500,000 = Purchasing
materials cost
R750,000 – cost of carrying FGI
R2,000,000 labour and overhead
costs to transform raw materials
to finished goods
15. 8.2 The nature and importance of
holding inventory (cont.)
ASSUMPTIONS
R250,000 = FGI
R250,000 = RMI
R500,000 = WIP
R2,500,000 = Purchasing
materials cost
R750,000 – cost of carrying FGI
R2,000,000 labour and overhead
costs to transform raw materials
to finished goods
16. 8.2 The nature and importance of
holding inventory (cont.)
ASSUMPTIONS
R250,000 = FGI
R250,000 = RMI
R500,000 = WIP
R2,500,000 = Purchasing
materials cost
R750,000 – cost of carrying FGI
R2,000,000 labour and overhead
costs to transform raw materials
to finished goods
17. 8.2 The nature and importance of
holding inventory (cont.)
• Methods utilised to reduce stocks
• Reduction in line and store stock
• A two-bin system
• SILS (Supplier in-line sequencing) – all needed
parts delivered to operative
• Kanbans – cards or similar for each operating
station to communicate demand
• Milk runs – daily trips by suppliers
• Supplier sub-assembly of components on the
organisation premises
18. 8.3 Requirements for effective
inventory management
• Two basic functions:
• Keeping track of the entire inventory
• Deciding how much to order and when
19. 8.3 Requirements for effective
inventory management (cont.)
• Counting systems for inventory:
• Periodic counting system – daily, weekly, monthly
inventory counts
– Small retail outlets
– Results determine next order quantity
• Perpetual counting system:
– System updated every time an item is removed
• Batch perpetual system
• Online perpetual system
• Barcode systems
20. 8.3 Requirements for effective inventory
management (cont.)
• Forecasting demand and information regarding lead
time
• Costs incurred when inventory is carried out:
• Holding cost – cost incurred for the actual storage
of inventory over a specific time period
• Ordering cost - cost associated with ordering and
receipt of goods such as suppliers, forms and
clerical support
• Shortage cost – Cost incurred when demand
exceeds supply
21. 8.3 Requirements for effective inventory
management (cont.)
• HOLDING COST
• Cost of insurance against theft/fire damage
• Cost of interest for loans to build warehouse and stock it
• Cost of depreciation of goods held in inventory
• Obsolescence costs due to newer/better products coming
into market
• Opportunity costs because money is tied up in stock and
can, therefore not be used for other, more profitable items
• Usually expressed as a % of the selling price of product
22. 8.3 Requirements for effective inventory
management (cont.)
• HOLDING COST
TV sells for R5000.
Holding cost is 4% of
selling price per annum.
How much will it cost
organisation to hold 1 TV
in stock for 1 year?
23. 8.3 Requirements for effective inventory
management (cont.)
• ORDERING COST
• Set up costs – cost of setting machinery for
manufacturing
• Labour cost
• Lost time for production
• Operations manager must ensure all procedures and
processes running efficiently to reduce ordering costs
24. 8.3 Requirements for effective inventory
management (cont.)
• SHORTAGE COST
– Cost of losing a sale due to unavailability of a product
– The loss of goodwill of the customer
– The cost of lost production
– Downtime cost of lost production
– Estimation of these costs is difficult
25. 8.3 Requirements for effective
inventory management (cont.)
• Classification systems for inventory
• ABC analysis
• Pareto principle: 80/20
Critical few; trivial many
Use management effort to control critical
few i.e. top 20% in value!
Don’t always use monetary value of
inventory item
• H. Ford Dickie , developed ABC in 1951
• Class discussion
(see Table 8.2 on page 202 of the textbook)
26. 8.3 Requirements for effective
inventory management (cont.)
• Need for accurate inventory records
• Usually accuracy is between 1 & 3%
27. 8.3 Requirements for effective
inventory management (cont.)
• Cycle counting – confirm accuracy of inventory
records by continuous audit
• Counted on a continuous rather than batch
basis
• Rules most often used:
– Count after a busy period
– Count when the balance shows zero stock
– Use ABC analysis to determine frequency of count
– Count when inventory records show a positive balance
but a stock out occurs
28. 8.3 Requirements for effective
inventory management (cont.)
• Cycle counting – CLASS EXERCISE
CLASS INVENTORY POLICY ITEMS TO BE
HOLDING COUNTED/DAY
A
B
C
29. 8.3 Requirements for effective
inventory management (cont.)
• Cycle counting – CLASS EXERCISE
CLASS INVENTORY POLICY ITEMS TO BE
HOLDING COUNTED/DAY
20
A WORKING
2750
DAYS
60
B WORKING
3500
DAYS
120
C WORKING
5000
DAYS
30. 8.3 Requirements for effective
inventory management (cont.)
ADVANTAGES OF CYCLE COUNTING
Ensures accuracy of inventory records
Enhances detection of errors and ensures remedial action
taken timeously
No need to close plant to facilitate cycle counting
Only trained warehouse personnel should do counts – this
minimises errors
31. 8.3 Requirements for effective
inventory management (cont.)
• How to control service inventory
• Pilferage
• Inventory shrinkage
• Measures:
• Bar coding shipments
• Magnetic tags
• Staff selection
32. 8.3 Requirements for effective
inventory management (cont.)
• Advantages and
disadvantages of holding
inventory
• see Table 8.5 on page 206
33. 8.4 Economic order quantity
models
• Used to decide how much to order
• There are 3 models:
• The basic EOQ model
• The economic production quantity model
• The quantity discount model
34. BASIC EOQ MODEL
• Developed by FW Harris at Westinghouse
in 1915
• This same model and a number of
variations are still used throughout industry
today
• A number of assumptions have to be made
35. BASIC EOQ MODEL
Assumptions
• No stock outs should happen if orders for inventory are
placed at correct time
• There is a known and constant lead time that never varies
• Only two types of variable cost will incur: set up cost (cost
of placing order) and holding cost
• All demand is independent, constant, known and never
varies
• No discounts for quantity will be given
• The entire inventory will be received at once and complete
• There will be only one product involved and no interaction
will take place with other products
36. 8.4 Economic order quantity models
Q = order size in units
H = holding cost
D = annual demand
Q = order size
S = cost per order
Q0 = Optimal order quantity
38. EOQ – Basic Model
• Most limiting factor of the
basic EOQ model is
assumption that demand will
always be constant
• Therefore more flexible
continuous (Q or fixed order)
system is used
39. EOQ – Continuous Model
• Mistake many managers make is to ignore
inventory quantities that are already on
order
• This system monitors inventory on hand on
a continuous basis after each inventory
transaction
• When inventory reaches reorder point
(RoP) an order for a fixed quantity is
placed.
40. Continuous Model
R=m+s R = reorder point
s = zσ m = mean demand over
a specific lead time
s = safety inventory
Z = no of std dev for a
given service level
Σ = std dev of demand
over leadtime
41. BASIC EOQ MODEL
####
D Annual Demand Quantity of the Product 1,000 Costs with EOQ
P Purchase Cost per Unit 1.00 Average Annual Purchase Cost: 1,000.00
C Fixed Cost per Order 20.00 Average Annual Fixed Order Cost: 50.00
H Annual Holding Cost per Unit 0.25 Average Annual Holding Cost: 50.00
(warehouse space, refrig., ins., etc.) Total: 1,100.00
EOQ Economic Order Quantity 400.00 Try different order quantities: 500.00
(optimal order quantity)
450.00
Costs by Order Quantity 400.00
Inventory Level
350.00
300.00
250.00
Holding Cost
200.00
Ordering Cost
Total Cost 150.00
100.00
50.00
0.00
Since the demand will be satisfied with the unit purchase cost any way, it is discarded from the model. The cost in consideration is reduced to
2 types: Holding Cost and Ordering Cost. The tradoff between these costs is optimized at the minimum point of the Total Cost Curve, i.e. EOQ.
EOQ is the level of the inventory where ordering cost and carrying cost remains equal.
