8 Inventory Management Notes

Inventory Management

Basics of Inventory Management

• Inventory: Stock of any item or resource used in an organization.

  • Types:

    • Raw Materials (Raw M)

    • Semi-finished goods (Work In Progress - WIP)

    • Finished goods

Purpose of Inventory

• Meet Customer Demands: Immediate fulfillment from stock.

• Smooth Production Requirements: Buffer stock to ensure continuous production.

• Protect Against Stock Outs: Addressing uncertainty in demand or supply.

• Take Advantage of Economic Lot Size: Fixed cost spreading and quantity discounts.

• Hedge Against Price Increase: Bulk purchasing.

Inventory-Related Costs

• Acquisition Cost: Purchase or variable production costs.

• Holding Cost: Storage and capital costs associated with maintaining inventory.

• Shortage Cost: Lost sales and customer dissatisfaction due to stock outs.

• Setup/Ordering Cost: Fixed cost per setup or order, regardless of quantity.

Key Terminology

• On-Hand Inventory: Physical stock available.

• Backorders: Received orders not shipped due to stock outs.

• Inventory Position: On-hand inventory - backorders + scheduled receipts.

• SKU (Stock Keeping Unit): Uniquely identifiable item.

• Lot Size: Quantity ordered or produced each time.

• Cycle Stock: Regular inventory to meet expected demand during the order cycle.

• Cycle Service Level: Probability of not running out during an order cycle.

ABC Analysis

• Purpose: Classify SKUs based on dollar usage.

• Classes:

  • A: Top 20% of items (highest dollar volume).

  • B: Next 30% of items.

  • C: Remaining 50% of items (lowest dollar volume).

• Control Strategy: Frequent reviews for A-class items, less frequent reviews for B & C.

  • Example: Home theater systems and computers categorized as A due to high monthly dollar usage.

Physical Inventory

• Cycle Counting: Frequent, partial counting of inventory.

• Procedures:

  • Set rules for item selection (e.g., A items weekly, B items bi-weekly).

  • Count and update records regularly.

Inventory Control

• Continuous Review System (Q System): Inventory monitored continuously.

• Fixed quantity ordered when inventory drops to the reorder point (R).

Economic Order Quantity (EOQ)

• Goal: Minimize total inventory cost (ordering and holding costs).

• EOQ Assumptions:

  • Constant demand.

  • Constant lead time.

  • No stock outs allowed.

• EOQ Formula: EOQ = \sqrt{\frac{2DS}{H}}

  • Where:

    • D = Demand per year

    • S = Ordering cost per order

    • H = Holding cost per unit per year

• Example:

  • Demand = 1,000 units/year, Ordering cost = $10/order, Holding cost = $2.50/unit/year. Calculate EOQ.

Time Between Orders (TBO)

• TBO Formula:
  TBO = \frac{EOQ}{Demand \ Rate}

• Interpretation: Average time interval between successive orders.

Continuous Review System: Decision Variables

• Order Quantity: Use EOQ.

• Reorder Point (R): Based on demand during lead time.

• Service Level: Set reorder point to meet desired service level (e.g., 95%).

• When Demand is Uncertain:

  • Demand during lead time (DDLT) assumed normally distributed.

  • Reorder point incorporates safety stock to maintain service level.

    • Example: Daily demand = 60 units, lead time = 6 days. Compute R to maintain a 95% service level.