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Course Notes Operations Management Inventory Management

13: Inventory Management

Charles E. Oyibo

Introduction

An inventory is a stock or store of goods.

A typical manufacturing firm carries different kinds of inventories, including the following:

Functions of Inventory

  1. To meet anticipated demand. These inventories are called anticipation stock because they are held to satisfy expected (i.e. average) demand.
  2. To smooth production requirements. These inventories are called seasonal inventories because they are usually built up during off-season periods to meet overly high requirements during certain seasonal periods.
  3. To decouple components of the production-distribution system. Manufacturing firms use inventories as buffers between successive operations to maintain continuity of production that would otherwise be disrupted by events such as breakdowns of equipment and accidents that cause a portion of the operation to shut down temporarily. (Considering the cost and space inventories require, the task of the discerning company is to find and eliminate sources of disruptions so as to reduce the need for decoupling operations).
  4. To protect against stockouts. Delayed deliveries and unexpected increase in deman increases risks of shortages. The risk of shortages can be reduced by holding safety stocks, which are stocks in excess of average demand to compensate for variabilities in demand and lead time.
  5. To take advantage of order cycles. Inventory storage enable a firm to buy and produce in economic lot sizes without having to try to match purchases or production with demand requirements in the short run. This results in periodic orders or order cycles. The resulting stock is known as cycle stock. Order cycle might also be based on practical (rather than economic) reasons.
  6. To hedge against price increases or to take advantage of quantity discounts. A firm that envisages an increase in the price of its raw materials might make a larger-than-normal purchase to avoid having to pay a higher price in the future.
  7. To permit operations. Since production operations take a certain amount of time (i.e. they are not instantaneous), there will generally be some work-in-progress inventory. Also, intermediate stocking of goods--raw materials, semifinished items, and finished goods at production sites, as well as goods stored in warehouses--leads to pipeline inventories thoughout a production-distribution system.

Objectives of Inventory Control

Inadequate control of inventories can lead to both under- and overstocking of items. Understocking can result in missed deliveries, lost sales, dissatisfied customers, and production bottlenecks. Overstocking unnecessarily ties up funds that might be more productive elsewhere.

Inventory management has two main concerns: (1) the level of customer service, that is, to have the right goods, in sufficient quantities, in the right place, at the right time; and (2) the cost of ordering and carrying inventories. The overall objective is to achieve satisfactory levels of customer services while keeping inventory costs within reasonable bounds. To this end, the operations manager must make two fundamental decisions: the timing and size of orders (that is, when to order and how much to order).

Two measures of effectiveness of inventory management are: inventory turnover and days of inventory on hand.

Requirements for Effective Inventory Management

Management has two basic functions concerning inventory. One is to establish a system of keeping track of items in inventory, and the order is to make decisions about how much and when to order. To be effective, management must have the following:

  1. A system to keep track of inventory on hand an on order.
  2. A reliable forecast of demand that includes an indication of possible forecast error.
  3. Knowledge of lead times and lead time variability.
  4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
  5. A classification system for inventory items.

We know explore these requirements more extensively.

Inventory Counting Systems

Inventory counting systems can be periodic or perpetual. Under a periodic system, a physical count of items in inventory is made at periodic intervals in order to determine how much to order of each item; a perpetual inventory system (also, continual system) keeps track of removals from inventory on a continuous basis, so the system can provide information on the current level of inventory for each item. When the amount on hand reaches a predetermined minimum, a fixed quantity, Q, is ordered. A simple perpetual system is the two-bin system in which two containers are used for inventory, with items being drawn from the first until its contents are exhausted at which time an order is placed.

Perpetual systems can either be batch or on-line. In a batch system, inventory records are collected periodically and entered into the system. In on-line systems, the transactions are recorded in real-time. Universal Product Code (UCP) scanners represent a major change in the inventory system of stores that use them. Radio frequency identification (RFID) is a relatively new automatic identification and data capture (AIDA) technology that allow for non-contact, non-line-of-sight reading. RFID has established itself in a wide range of markets including livestock identification and automated vehicle identification (AVI) systems.

Demand Forecasts and Lead-time Information

It is essential to have reliable estimates of the amount and timing of demand and, also, how long it will take for orders to be delivered. Additionally, managers need to know the extent to which demand and lead time (the time between submitting an order and receiving it) might vary. Point-of-sale (POS) systems provide a method for electronically tracking sales to enable managers make necessary changes to restocking decisions.

Cost Information

Three basic costs are associated with inventories: holding, transaction (ordering), and shortage costs.

Holding or carrying costs relate to physically having items in storage. Costs include interest, insurance, taxes (in some states), depreciation, obsolescence, terioration, spoilage, pilferage, breakage, and warehousing costs (rent, heat, light, security). They also include opportunity costs associated with having funds which could be used elsewhere tied in inventory. (Note that it is the variable portion of these costs that is pertinent).

Ordering costs are the costs of ordering and receiving inventory. These costs vary with the actual placement of an order and include determining how much is needed, preparing invoices, shipping costs, inspecting goods upon arrival for quantity and quality, and moving the goods to temporary storage. When a firm produces its own inventory rather than ordering from a supplier, the costs of machine setup are analogous to ordering costs.

Shortage costs result when deman 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. Also, if the shortage costs occurs in an item carried for internal use (e.g. to supply to an assemble line), the cost of lost production or downtime is considered a shortage cost.

Classification System

Items held in inventory are generally not of equal importance in terms of money invested, profit potential, sales or usage volume, or stockout penalty, and hence, it would be unrealistic to devote equal attention to each of these items. A more reasonable approach woulf be to allocate control efforts according to the relative importance of various items in inventory.

The A-B-C approach classified inventory according to some measure of importance, usually annual dollar usage, and then allocates control efforts accordingly. A items (A=very important) should receive close attention, to make sure taht customer service levels are attained. C items (C=least important) should receive only loose control, and the B items (B=moderately important) should have controls that lie between the two extremes.

How Much to Order: Economic Order Quantity Models

EOQ models identify the optimal order quantity by minimizing the sum of certain annual costs that vary with order size. Three order size models are describes here:

  1. The basic economic order quantity model.
  2. The economic production quantity model.
  3. The quantity discount model.

Basic Economic Order Quantity EOQ Model

The basic EOQ model is used to identify the order size that will minimize the sum of the annual costs of holding inventory and ordering inventory

 

 

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Page Last Updated: Wednesday December 8, 2004 6:16 PM