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Definition of Inventory.
Inventories are materials that business institutions carry either for sales or to provide
input to other process or the finished goods products. They are raw materials , semi
finished products , finished goods , spares , machines , equipments. Inventory carries
substantial manufacturing cost , between 20-30 % Of total assets , 4-10 % of
production cost.
In the present competitive business environment inventory management and control
is one of the important function of management being led by very efficient and
effective personnel . Varieties of inventories in the production processes poses a
bigger challenge now-a-days to the management for competitive pricing of the
finished product thereby improving their profit portfolio.

Types of Inventory.
1) Production Inventories.

Raw materials, spare parts, components which enter to production process for making finished goods.
These may consist of two general types : A ) special items supplied as per company specifications. B) Standard
industrial items directly purchased from market.

2) MRO Inventories.
Maintenance, Repair, operating machineries which are consumed in the production process but don’t become
a part of the finished goods. ( Lubricants, oi l, soap, machine repair parts.).

3) In-process inventories.
Semi-finished products found at various stages in the production process.

4) Finished goods inventories.

Finished products (Completed products) ready for shipment to customers.

Cost of Inventory or Inventory Cost.

Inventories cost money . It includes ordering cost, carrying cost, stock-out cost, capacity cost.
1)Ordering Cost.
A) For ordering on vendor following costs incurred.
- preparing purchase order.
- Processing payments to be made.
- Inspecting and receipts of materials.
B) order from plant.
- Machine set up/ tear down.
- start up scrap generated from getting production run started.
2) Carrying Cost.
A) Costs Directly connected with materials.
1) Obsolescence 2) Deterioration 3) Pilferage.
B) Financial costs.
1) Taxes 2) Insurance 3) storage 4) Interest on borrowed capital

Carrying cost. Contd.

C) Capital Cost.
1)Money invested in inventory purchase 2) Interest on money invested 3) Interest on money invested on
land and building for storage 4) Opportunity cost for money invested.
D) Storage space cost.
1) Rent on building if hired 2 ) Depreciation on building 3) Cost of maintenance and repair 4) Utility
charges like heat , light , air conditioning etc. 5) Salaries of security and maintenance staff.
E) Service cost.
1) Taxes on inventory 2) Labour cost in handling and maintenance . 3) Clerical expense in store keeping.
4) Administrative over heads.
F) Handling Equipments cost.
1) Taxes and insurance of equipments 2) Depreciation on on equipments 3) Fuel expenses 4) Cost of
maintenance and repairs.
G) Inventory Risk Cost.
1) Obsolescence of inventory 2) Insurance on inventory 3) Physical deterioration 4) losses from Pilferage.
3) Stock out cost a) Back ordering b) Expediting Cost c) Lost sales d) Loss of customer.

Other cost of inventory . Contd.

Stock out cost contd. :- It is the cost incurred because of zero stock situation.
Capacity Cost:- 1) If the inventory arrives but there is no storage space to unload and store , over time paid to
logistics for waiting . (Cost due to inadequate storage capacity)
2) If capacity is high but inventory is less , lay-offs and Idle time cost to be borne by the organization. ( cost
due due to Large capacity cost).

These cost factors must be considered while taking decisions regarding planning and procuring inventories.


• 1) Minimize the Inventory cost.

• 2) Availability of inventory at right time and right quantity.
• 3) Eliminate the possibility stock out condition.
• 4) Avoidance of excess stock.
• 5) Maintaining the quality of inventory.
• 6) Reduce wastage of inventory.
• 7) Managing pool of good vendors/suppliers.
• 8) Optimum utilization of machines and man power.
• 9) Controlling the finished good cost.
• 10) Meeting the customer demands and increase satisfactions level.

Basis of Inventory management Decisions.

Because of high cost involved in inventories , their proper management & control has considerable importance
for any business organization. The Inventory management involves
“The development and administration of policies , systems , and procedures which minimizes total cost of
inventory, maintain production schedule, improve customer service requirements.” Viewed in this
prospective inventory management is in broad scope of many functional areas of the organization like
production, operation, maintenance, construction, finance, purchase , stores, risk management and all
other users who are indirectly involved in production like health care, IT,HR, Environment etc”.
Factors Influencing the Inventory management and Control”.
Type of Product:- High unit value items in the inventory system requires higher degree of control . Its
procurements, store keeping, usage are keenly monitored and safeguard their wastage , loss etc.
Short supply materials, Government rationed items significantly influence the management practice
proper stock is maintained.
Standard items and customer-specific made items for manufacturing units needs entirely different types
management practices.
Type of Manufacturing:- Type of manufacturing also influences inventory management practices.
For continuous manufacture the rate of production is a key factor. The economic advantage of
manufacture is the uninterrupted operation of machines and assembly lines in the plant.

It is a major offence for inventory control personnel if the plant is shutdown for the lack of required inventory.

On the other hand intermittent manufacture permits greater flexibility in the management and control of
Volume of production:-
Volume of production also influence management decisions and practices. Ex. For bulb manufacturing unit ,
millions of brass bases are required each month . Even though large volume of inventory of brass bases
are required by Bulb Manufacturing unit , its management and control is relatively easy. Because only one
or two nos of inventories are required to be controlled.
On the other hand for manufacture of a large locomotives, involves planning and control of thousands of
items of inventory. Hence needs very efficient and stringent management procedures and practices to
inventory problem.
Nature of Inventory. Inventories like Electronics items, pharmaceuticals items, paints and other liquid items,
perishable items needs different types of inventory management practices for its effective usage in the
production processes.

Various Methods of Inventory Management.

There are various methods of inventory management . The methods vary from business to business depending
upon their type of product, services and management practices. Following are the general methods which
results in effective inventory management and control.

1) Efficient procurement policies and procedures.

2) Classification of inventories.
3) Proper stock keeping in warehouses.
4) Unique codification of items for quick identification and necessary actions.
5) Use of FIFO – First in First out concept for inventory use.
6) Regular Auditing and stock reviews.
7) Computerisation of inventory management function.
8) Regular interaction with vendors for quality and timely supply.

Inventory Systems.
An inventory system provides the organizational structure , operating policies for maintaining and controlling
goods to be inventoried. The system is also responsible for ordering and receipts of goods , timing the
order placements, keeping track of order supply status.
There are two approaches to inventory system. 1) Fixed order quantity system 2) fixed time period system.
These are called multiperiod inventory systems. This is to ensure that an item is available to ongoing
production process through out the year. The items are ordered multiple times in a year where the logic in
the system dictates the actual quantity ordered and timing of the order.

Fixed Order quantity System or “Q” system.

In this system the material is ordered whenever the stock in hand reaches the reorder point. A fixed quantity of
the material is ordered which is called the EOQ or (Economic Order Quantity ). Between reorder point to
actual receipt of items in store is called lead time. During this lead time the material is consumed from
buffer stock called lead time consumption. When the actual stock reaches at minimum level the new
ordered stock reaches ( Equal to EOQ) and stock value reaches maximum level.
Advantages of “Q” system.
1) Each material can be procured in most economical quantity.
2) Purchase action taken automatically when ever reorder point arrives.

Disadvantages of “Q” System.

1) The orders are raised at irregular intervals , inconvenient to suppliers.
2) The items grouping not possible because reorder point occurs irregularly.
3) Sometimes the EOQ quantity is smaller than the supplier minimum order quantity. In this situation good
discount can be lost.
4) It assumes stable usage and definite lead time. In case it changes significantly , a new order quantity and
new reorder point should be fixed, which is quite cumbersome.
Fixed Period order or “P” system.
In this system the stock position of each item is reviewed on regular interval. When the stock level of a given
item is insufficient to sustain the production process until the next scheduled review , the order is placed for
replenishing the stock. The frequency of reviews varies from organization to organization . It also varies from
item to item , specific production schedule, market condition and so forth. Order quantities , like wise , vary for
different materials.
Advantages of “P” system.
1) The ordering and inventory cost are low . Since number of orders are less , ordering cost is reduced
though follow up work for each delivery may be required.
2) The suppliers will also offer attractive discounts as sales volume is comparatively high and guaranteed.

Advantages of “P” system.

3) The system works well for materials having irregular and seasonal usage and whose purchases must be
planned in advance on the basis of sales estimates.

Disadvantages of “P” system.

This system has certain limitations.
1) It compels a periodic review of all items which itself is in-efficient. Even though usage rate changes the
item is not ordered till succeeding review.
2) The system demands for an inflexible order quantities in the interest of administrative efficiency, even
though there is EOQ for each item depending upon its price structure , its rate of usage and internal
holding cost.
3) The purchasing works tends to be at peak during and around the review dates only.
Comparison of “P” and “Q” system.
Point of Difference. “Q” System. “P” system.
1) Initiation of order. Stock on hand reaches to Based on Fixed review period.
Reorder point.
2) Period of order. When stock level reaches to After a predetermined period.
reorder point.

Comparison of “P” and “Q” system.

Point of Difference. “Q” System. “P” system.
3) Record Keeping. Perpetual , whenever stock Only at review period.
is withdrawn.
4) Order Quantity. Constant as EOQ. Quantity order vary each time
order is placed.
5) Size of Inventory. Less than “P” system. Larger than “Q” system.
6) Time to maintain. Higher due to perpetual
record keeping. Less due to only at review period.
Where “Q” system is used:-
Where all aspects of the business situation is known in certainty. Demand is known and constant and uniform
throughout the period.
Lead Time is constant. Price per unit of product is stable.
Where “P” system is used.
Where vendors visit customers place on regular basis and take orders for their complete line of products.
When buyers want to combine orders to save transportation costs.
To facilitate planning their inventory count , to meet the request of distributors.


EOQ or Q (Optimum Quantity ) is the purchase order quantity at which total cost of ordering and carrying is the
least or minimum.
The ordering cost decreases as the order quantity increases . Because
1) Number of orders in a time period (Say in one financial year ) is less , hence manpower involvement is less.
2) Processing cost ie computer time, stationery use, other overheads are also less.

The carrying cost or Holding cost increases if the order quantity increases. Beause
1) Requires more storing area.
2) Taxes, insurance, cost increases.
3) Capital cost , inventory service cost , handling cost , risk cost etc increases.
In the graphical representation a point where carrying cost curve and ordering cost curve meet , represent the
least cost . The quantity at this point is called the Economic order quantity.
1) Demand of the inventory is constant and uniform throughout the period.
2) Lead time ( Time from ordering to receipt ) constant.
3) Price for unit of product is constant.

EOQ , Assumptions . contd.

4) Inventory holding cost is based on average inventory.
5) Ordering cost is constant.
6) All demands of the inventory will be satisfied ( NO Backorder is allowed).
Calculation of EOQ.
In any inventory model the first step is to develop a functional relationship between the variables of interest
and measure of effectiveness. In this case the concern is for cost, hence the following equation is formulated.
Total cost of inventory cost = Annual purchase cost + Annual ordering cost + Annual holding cost.
( One inventory only ) .
TC = DC + ( D/Q) S + ( Q/2 ) H.
Where T C = Total Annual cost of inventory.
D = Annual Demand
C = Purchase cost per unit.
Q = Quantity to be ordered ( Economic order quantity ).
S = Ordering cost for an order.
H = Holding or Storage cost per unit of average inventory. ( Normally holding cost ia taken as
percentage of the cost of the item , such as H = iC , where i is the percent carrying cost).

In the graph the point where the two curves of ordering cost and holding cost is intersected is the minimum of
all costs.
Hence it can be written at this point ( D/Q) S = ( Q/2 )H.
Q (EOQ) = Square root (2 DS/H).
When more complex cost equations are involved , this single algebraic approach is not sufficient. Different
calculus must be used.
EOQ technique is vey much useful for knowing how much quantity is to be ordered.
It is applicable for single inventory item. It can be for group of items with similar holding cost and procurement
Limitations of EOQ system. (Fixed order quantity System ).
1) Not applicable for erratic demand pattern of inventory.
2) It ‘s accuracy depends upon the accuracy of ordering cost, carrying cost which are cumbersome to
calculate. Sometimes carting cost is linked to opportunity cost of capital invested.
3) Needs experienced and skilled cost accountants , which is costly calculations.
4) Sime times require human common sense. May be long term order is less costly, joint orders may be
favourable for suppliers ,hence price preferences may be obtained.
5) EOQ ordering must be tempered with judgement. Like for less self life items, critically required items may
over-ride EOQ sometimes.

Reorder Level :-
In the fixed quantity inventory system the EOQ is calculated on the basis of constant demand and lead time and
no safety stock is necessary. The Reorder level is simply
R = dL
d = Average daily demand (Constant).
L = Lead time in days (Constant).

Numericals 1:-
An auto industry purchases spark plugs at the rate of Rs.25/- per piece. The annual consumption of spark plug
is 18,000 nos . If the ordering cost is Rs.250/- per order and carrying cost is 25% P.A. what would be the EOQ ?
If the supplier of spark plugs offers a 5% discount for order quantity of 3000 no’s per order , do you accept the
discount offer ?

Solution 1 :-
a) Calculation of EOQ:-
Annual Demand (D) = 18,000 nos.
Unit Price (C ) = Rs.25/-
Ordering cost per order (S) = Rs.250/-
Carrying cost (as %) (O) = 25%
EOQ = Square root 2 DS/ C.i.
= Square root ( 2X18000X250 ) / 25X0.25
= 90,00,000/6.25 = 1200 units
b) Decision Regarding discount offer Q = 3000
With EOQ = 1200 units the total cost of inventory is
TC1 = ( 18000 X 25 ) +{ ( 18000/1200 ) x250 ) + (1200/2 X ( 25 x 25/100) }.
= 4,50,000 + 3750 + 3750
= 4,57,500/-
With discounted qty = 3000 having 5% discount total cost of inventory is
New price after discount = 25 x 0.95 = Rs.23.75.
TC2 = ( 18000 x 23.75) +{ ( 18000/3000 ) x 250 ) } + { ( 3000/2) X (23.75 x 25/100) }

TC2 = 4,27,500 + 15,00 + 8906.25

Decision Rule if TC (Discount) is less than or equal to TC(EOQ) accept discount offer.
If TC (Discount ) is greater than TC (EOQ) reject the discount offer.
Since total cost on discount (Rs.4,37,906 /) - is less than total cost on EOQ ( Rs.4,57,500/- ) the discount offer
on order of 3000 units is acceptable.

Numerical 2.
Find the Economic order quantity , reorder point and total annual inventory cost , given the following .
Annual Demand = 1000 units.
ordering cost = Rs.5/- per order.
Holding cost = Rs. 1.25 per unit per year.
Lead time = 5 days.

Cost per unit = Rs.12.50/- .

Assume no of days in a year = 365 days.

Solution 2.
The Economic order quantity EOQ = Square root of ( 2X D x S)/ H.
= Square root of ( 2 X 1000 X 5 ) / 1.25 = 89.4 units.
The Reorder level = dL = ( 1000/ 365 ) X 5 = 13.7 units.

Result and conclusion. The inventory policy is , when the inventory level drops to 14 units (Rounded off
reorder level ) , place an order for 89 units (Rounded off EOQ ).

Total Annual inventory cost TC = DC + ( D/Q )S + (Q/2 )H. = ( 1000 X12.50 ) + { (1000/89) X 5 ) } + ( 89/2 ) X1.25
= Rs.12611.81/- .
he cost per unit of inventory is taken as purchase price.

This EOQ for fixed quantity at reorder level and

Different order quantity in fixed time interval are
called multiperiod Inventory system. Because inventory is ordered multiple time for a particular
time period ie may in one financial year. Most of the manufacturing/processing industries follow this system
except for few spare part inventory which are very costly and having less demand.

In contrast when inventory order is placed only once for a whole time period may be for one financial year, for
particular season, particular event is called single period inventory system.

Example of single period inventory.

A manufacturer of woollen garments procure all wools and other inventories for a particular winter season
once t a time , since demand for woollen garments are known in conformity. Of course they keep some margin
of safety stock to take care of fluctuations in demand.

A retailer keeps inventory of particular types of T-shirts designed for a specific event like world cup matches,
Olympic , by ordering once at a time till that event occurs ie a single order for the T-shirts for that event only.

A retailer selling fashion items makes a single order for the entire season. This is because of long lead time and
limited life of the products. They also take care the lost profit due to sales not made or discounted sales after
the season.

Inventory Management under uncertainty.

In certain situations , the product demand is not constant but varies from day to day. Hence safety stock is
maintained to provide some level of protection against stock outs . The uncertainty is because of some of the
reasons as
1) Uncertain raw material availability. 2) Lead time variations 3) Seasonal unpredictability.
Safety stock :- It is defined as the quantity of inventory carried in addition to the expected demand. For
example – Against average demand of 100 units suppose 120 units are kept , then 20 units is called safety
stock. Reorder level is also increased by safety stock.
Safety stock is determined based on many criteria with experience.
- Say Keeping safety stock for certain weeks demand.
- Probability of stock out (say 5% chances) if demand exceeds 500 units . This is called keeping safety stock
with probability of stock out approach.
Reorder level = ( Average daily demand X lead time ) + safety stock.
Uncertainties of demand is also managed through replenishment policies . A) Continuous review and
replenishment . Because of continuous review , the orders are placed studying the variability in demand , time
between two orders may vary. B) Periodic review and replenishment. After each certain period a review of
inventory is taken and order is placed accordingly to accommodate the anticipated fluctuations in demand.
Time between two orders is fixed , quantity may change.

Uncertainties demand situation is also managed by arranging alternative source of procurements (alternative
vendors) by rate contracts or empanelment.
Inventory Analysis and classifications.
In order to have better control and management of inventory it is very much essential to analyse the inventory
And classify them . There are following inventory classifications.
ABC analysis and classifications.- Based on annual consumption value.
“A” class items constitute 20% of total no of items but consumption value accounts 80%.
“B” class items constitute 30% of total no of items but consumption value accounts 15%.
“C” class items constitute 50% of total no of items but consumption value accounts 5% only.
It is obvious that “A” class items are extremely important and deserves highest control and most frequent
“B” class items are important but needs moderate control on it.
“C” class items are least important and have low priority on control.
XYZ analysis and classifications. This analysis is based on inventory stock value of the items.
“X” categories items are 10% in nos. but constitute 70% of total inventory value.
“Y” categories items are 20% in nos. but constitute 20% of total inventory value.
“Z” categories items are 70% in nos. but constitute 10% pf total inventory value.

“X” categories items are even less in nos. but needs more control and review to reduce inventory cost.

FSN analysis and classification . FSN stands for fast , slow and non-moving . Here the classification in done
based on pattern of issues from stores and is useful to control obsolescence. Fast consumption items are also
called active items. Slow moving items generate surplus which needs examined, for consumption else where .
Non-moving items are examined further and their disposal is considered.

VED analysis and classification. VED analysis is done to determine the criticality of an item and its effect on
production and services. V stands for vital , E stands for essential, D stands for desirable. Normally sufficient
inventory is maintained for V category items, for D items minimum item is maintained. This is specially used for
spare parts.

SDE analysis and classification. The SDE analysis is based on upon the availability of items an is very useful in
the context of scarcity of supply. The “S” refers to “SCACRE” items ,generally imported and which are of short
supply. “D” refers to difficult items which are available indigenously but are difficult to procure. Items which are
coming from distant places and vendors are difficulty to come by. “E” refers to items which are easily available.
The SDE analysis is done based on problems faced in procurement , this is also vital to lead time analysis.