You are on page 1of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management Objectives At the end of this topic, you will

be able to: explain the definition and analogy of inventory; explain the purpose of the inventory; identify types of inventory; describe inventory cost structures; and differentiate between dependent and independent demand inventory.

Abstract Inventory management must be designed to meet the dictates of the marketplace and support the companys strategic plan. The inventory management system provides information to efficiently manage the flow of materials, effectively utilize people and equipment, coordinate internal activities, and communicate with customers. Inventory management does not make decisions or manage operations; they provide the information to managers who make more accurate and timely decisions to manage their operations. In this topic, we will begin with the definition and analogy of inventory. To understand the importance of inventory management, we have to understand the purpose of inventory, the types of inventory and cost structure of inventory. The last part of this topic, which is, the understanding and differentiation of nature of inventory dependent and independent demand can assist us to decide on the method, approach or the model of the inventory management to be adopted. 1.1 Introduction Inventory is the supply of raw material, partially finished goods and finished goods that an organization maintains to meet its operational needs. As such, it represents a sizable investment and a potential source of waste if not properly managed. If organization keeps too much inventory, it will waste money in storage costs and lose money if the inventory is damaged, stolen or become obsolete. On the other hand, with too little inventory, it may run out of stock, causing production to stop or be delayed. In this case, the organization suffers losses due to time wasted, underutilized labor and machinery, and a drop in customer service image.

UNITAR 2005

Page 1 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

Inventory management is among the most important operation management responsibilities because inventory requires a great deal of capital and affects the delivery of goods to customer. Inventory management has an impact on all business function, particularly operation, marketing, accounting and finance. Therefore, it is extremely important to make sure that the inventories are managed in a logical and consistent manner. 1.2 Definition and Analogy of Inventory Inventory can be defined as a company's merchandise, raw materials, and finished and unfinished products that have not yet been sold. An inventory system is the set of policies and controls that monitor levels of inventory and determine what levels should be maintained, when stock should be replenished, and how large orders should be. By convention, manufacturing inventory generally refers to items that contribute to or become part of a firms product output. Manufacturing is the transformation of raw materials into finished goods for sale, or intermediate processes involving the production or finishing of semi-manufactures. Manufacturing organizations usually divide their "goods for sale" inventory into: materials and components scheduled for use in making a product (Materials and Components or Raw Materials) materials and components that have begun their transformation to finished goods (Work in Process, or WIP) finished goods that are ready for sale to customers.
Work in Process Generally describes inventory that is currently being processed in an operation, or inventories that has been processed through one operation and are awaiting another operation. WIP is actually an inventory account that represents the value of materials, labor, and overhead that has been issued to manufacturing but has not yet produced a stockable item. Depending on how your accounting and inventory systems are set up, it may also include components picked for production usage or finished products awaiting final inspection.

UNITAR 2005

Page 2 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

For example, a canned food manufacturer's materials inventory includes the foods to be canned, empty cans and their lids (or coils of steel or aluminum for constructing those components), labels, and anything else (solder, glue & etc.) that will form part of a finished can. The firm's work in process includes those materials from the time of release to the work floor until they become complete and ready for sale to wholesale or retail customers. Its finished good inventory consists of all the cans of food in its warehouse that it has manufactured and wishes to sell to food distributors (wholesalers), to grocery stores (retailers), and even perhaps to consumers through arrangements like factory stores and outlet centers. In service sector, inventory generally refers to the tangible goods to be sold and the supplies necessary to administer. Inventory stocks are located at various points in the production process, with flow connecting one stock points to another. The rate at which a stock can be replenished is the supply capacity, and the rate of stock depletion is demand. Inventory acts as a buffer between the different demand and supply rates. Inventory can be analogized by the water tank flow supply rate and demand rate as shown below:

A Water Tank Analogy for Inventory

UNITAR 2005

Page 3 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

The above illustration shows that the level of water in the tank corresponds to inventory. The rate of flow into the tank is analogous to supply capacity, and the rate of flow out corresponds to demand. The water level is thus a buffer between supply and demand is called inventory. If demand exceeds supply, the water level will drop until the demand and supply rates come back into balance or until the water is depleted. Likewise, if supply exceeds demand, the water level will rise. The basic purpose of inventory analysis in manufacturing and stock keeping service is to specify: a) When items should be ordered; and b) How large the order should be made. Many firms are tending to enter into longer-term relationships with vendors to supply their needs for perhaps the entire year. This changes the when and how many order to when and how many to deliver. 1.3 Purpose of Inventory The primary purpose of inventories is to uncouple the various phases of operations. Raw materials inventory uncouples a manufacturer from its suppliers; work in progress inventory uncouples the various stages of manufacturing from each other; and finished goods inventory uncouples a manufacturer from its customer. Within the overall uncoupling purpose, there are five main reasons to carry inventory, which are explained in details below.
Reason 1. To maintain independence of operations Description A supply of material at a work center allows that center flexibility in operation. For example, because there are costs for making each new production setup, this inventory allows the management to reduce the number of setups. Independence of workstations is desirable on assembly lines as well. The time that it takes to do identical operations will naturally vary from one unit to the next unit. Therefore, it is desirable to have a cushion of several parts within the workstation so that shorter performance times can compensate for longer performance times. This way the average output can

UNITAR 2005

Page 4 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management


be fairly stable. 2. To meet variation in product demand or supply If the demand for the product is known precisely, it may be possible to produce the product to exactly meet the demand. Usually, however, demand is not completely known, and safety or buffer stock must be maintained to absorb the variation. 3. To provide a safeguard for variation in raw material When materials are ordered from a vendor, delay can occur for a variety of reasons: 4. To take ad vantage of economic purchase order size a normal variation in shipping time; a shortage of material at the vendors plant causing backlogs; an unexpected strike at the vendors plant or at one of the shipping companies; a lost order; or a shipment of incorrect or defective material. There are costs to place an order: labor, phone calls, typing, postage, and so on. Therefore, the large each order is, the fewer the orders that need to be written. Also, shipping costs favor large orderslarger shipment lowers the per-unit cost. 5. To provide for transit Transit inventories consist of materials that are on their way from one point to another. These inventories are affected by plant location decisions and by the choice of carrier. Sometimes the inventory in transit is called pipeline inventory because it is in the distribution pipeline.

For each of preceding reasons, be aware that inventory is costly and large amounts are generally undesirable. Long cycle times are caused by large amounts of inventory and are undesirable as well.
Assembly lines A process in which the job of making a product is divided into many smaller jobs. Each worker assembles the same part on every item made. The workers stay in the same place while the items pass by on a moving belt or track.

Buffer stock A quantity of goods or articles kept in store to safeguard against unforeseen shortages or demands.

UNITAR 2005

Page 5 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

1.4 Types of Inventory Generally, inventory can be divided into four categories, as explained in the table below.
Type of Inventory 1. Raw material inventory Description Raw materials are inventories that have not been processed. To protect against the uncertainties of supply, raw materials inventories act as buffers to ensure a continuous supply to the production line. It is often held for the reasons of future price increase or potential supply problems. Another reason for maintaining raw materials may be seasonal availability of supply such as in the case of fruits or vegetables for canning. Regardless of the reason of maintaining a raw material inventory, the cost of holding the inventory should always be compared to the saving realized. 2. Work-in-Process (WIP) Inventory WIP Inventories are components or raw materials that have undergone some changes but are not completed products. WIP is often maintained between manufacturing operations within a plant to avoid a shutdown if a critical piece of equipment were to break down. It also helps in equalizing process flow since not all manufacturing operation produce at the same rate. The stockpiling of WIP permits maximum economies of production without work stoppage. 3. Finished Goods Inventory (FGI) FGI is completed product awaiting shipment. FGI can be used as a mean to improve customer service level by reducing the likelihood of a stock out due to unanticipated increase in demand. 4. Maintenance / Repair / Operating Inventory (MRO) MRO are inventories devoted supplies that to are maintenance/repair/operating

necessary to keep machine and process productive. They exist because the needs and timing of maintenance and repair of some equipment are unknown. Although the demand for MRO inventories is often a function of maintenance schedules, other unscheduled MRO demand must be anticipated.

UNITAR 2005

Page 6 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

Stockpiling Accumulating and storing a reserve supply.

1.5 Inventory Cost Structure Using economic criteria can solve many inventory decision problems. One of the most important prerequisites, however, is an understanding of the inventory cost structure. Inventory cost structures incorporate the following five types of cost:
4 Types of Inventory Cost Structure Item cost refers to the cost of buying or producing the individual inventory items. It is usually expressed as a cost per unit multiplied by the quantity produced or procured. Sometimes, item cost is discounted if the quantities of purchase are large enough at one time. The ordering cost is associated with ordering a batch or lot of items. Ordering cost does not depend on the number of items ordered; it is assigned to the batch or lot size. The ordering costs include all the details, such as counting items, calculating order quantities, typing the Purchase Order (PO), expediting the order, transportation costs, and so on. These costs are also associated with maintaining the system needed to track orders. When the items are produced within the firm, there are also costs associated with placing an order that are independent of the number of items produced. These costs are called set-up cost, or are also called production change cost. Set-up costs include paperwork costs plus the costs required to set up the production equipment for a run. Set-up costs can amount to thousands of dollars, leading to significant economies for large runs. If there were no cost or loss of time in changing from one product to another, many small lots would be produced. This would reduce inventory levels, with a resulting savings in cost. Set-up cost is often considered fixed when, in fact, changing the way operations are designed and managed can reduce it. The carrying, or holding cost, is associated with keeping items in inventory for a period of time. The carrying cost is typically charged as a percentage of dollar value per unit time. For example, a 15 % annual holding cost means that it will cost 15 cents to hold $1 of inventory for a year. In practice, carrying costs typically range from 15 % to 30% per year. The carrying cost usually consists of three components:

Item Cost

Ordering Cost

Set-up Cost

Carrying Cost

UNITAR 2005

Page 7 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management


Component Cost of capital Description When items are carried in inventory, the capital invested is not available for other purpose. This represents a cost of foregone opportunities for other investments, which is assigned to inventory as an opportunity cost. This cost includes variable space cost, insurance, and taxes. In some cases, a part of the storage cost is fixed, for example, when a warehouse is owned and cannot be used for other purposes. Such fixed costs should not be included in the cost of inventory storage. Likewise, taxes and insurance should be included only if they vary with the inventory level. Obsolescence costs should be assigned to items that have high risk of becoming obsolete; the higher the risk, the higher the cost. Perishable products should be charged with deterioration costs when the item deteriorates over time, for example, food and blood. Many products have an expiration date printed on them and become obsolete at that time. The costs of loss include pilferage and breakage costs associated with holding items in inventory.

Cost of storage

Cost of obsolescence, deterioration and loss

Shortage Cost

When the stock of an item is depleted, an order for that item must either wait until the stock is replenished or be canceled. Consequently, there will be some loss of future business. This opportunity loss is counted as a shortage cost. There is a trade-off between carrying stock to satisfy demand and the costs resulting from stock out. This balance is sometimes difficult to obtain, because it may not be possible to estimate lost profit, the effects of lost customers, or lateness penalties. Frequently, the assumed shortage cost is little more than a guess, although it is usually possible to specify a range of such cost. As a conclusion, the stock out condition will affect to the current and future company profit.

Given the above costs, it is easy to see why inventory management is a cross-functional problem. Marketing may be particularly interested in minimizing the shortage costs associated with lost sales. Accounting and finance may be interested in minimizing the amount of inventory that needs to be financed. Operations may want a sufficient level of inventory to assure smooth scheduling and production control. Since these objectives may be at odds, it is important that the total cost minimization approach need to be studied and analyzed. The approach is inherently cross-functional in nature and does what is the best for the entire firm.

UNITAR 2005

Page 8 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

To achieve this objective, it has to establish the correct quantity to order from vendors or the size of lots submitted to the firms productive facilities involves a search for the minimum total cost resulting from the combined effects of five individual cost. Of course, the timing of these orders is a critical factor that may impact inventory cost. 1.6 Nature of Inventory In inventory management, it is important to understand the differences between dependent and independent demand. Table below shows the differences between the two:
Dependent Demand A demand directly related to or derived from the demand for other items or end products. Dependent demands are therefore calculated, and need not and should not be forecast. Dependence demand is related to the demand for another item and is not independently determined by market. It can also be explained by the need for any one item is a direct result of the need for some other item, usually a higherlevel item of which is part. When products are built up from parts and assemblies, the demand for these components is dependent on the demand for the final product. In concept, dependent demand is a relatively straightforward computational problem. Needed quantities of a dependent demand item are simply computed, based on the number needed in each higher-level item in which it is used. For example, if automobile company plans on producing 500 cars per day, then obviously it will need 2,000 wheels and tires. The number of wheels and tires needed is dependent on the production levels and is not derived separately. The demand for car, on the other hand, is dependent it comes from sources external to the automobile firm and is not a part of other products; it is unrelated to the demand for other products. Dependent demand can exhibit a fixed pattern of the demand usage. The fixed pattern is a lumpy, on-again, off again pattern. A quantity of parts is required when a lot is required when a lot is made; then no parts are required until the next lot is made. Independent Demand A demand that is unrelated to demand for other products. Demand for finished goods, parts required for destructive testing and service parts requirements are examples of independent demand. Independence demand is influenced by market condition outside the control of operation. It is therefore independence of operation. Finish goods and spare parts for replacement usually have independence demand inventories. For example, a workstation may produce many parts that are unrelated but meet some external demand requirement. Independent demand is subject to market forces or uncertain, it cannot exhibit the fixed pattern of the demand usage over time series.

UNITAR 2005

Page 9 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

Demand patterns for both, independent and dependent demand, are shown in the figures below.

Different demand patterns call for different approaches to inventory management. For independent demand, a replenishment philosophy is appropriate. As the stock is used, it is replenished in order to have goods or products on hand for the customers. As inventory begin to run out, an order is triggered for more goods or product and inventory is replenished. For dependent demand, a requirements philosophy is used. The amount of stock ordered is based on requirement for higher-level items. As one begins to run out, additional raw material or work-in-process (WIP) inventory is not ordered. More material is ordered only as required by the need for other higher level or end products. The two different types of nature of demand lead to generate sets of model or solution for the purpose of inventory. Details will be discussed in subsequent topics.

UNITAR 2005

Page 10 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

Summary In this topic, you have learnt: Inventory can be either raw materials, finished items already available for sale, or goods in the process of being manufactured. Inventory is recorded as an asset on a company's balance sheet. High inventory is not a good sign because there is a cost associated with storing the extra inventory. There are five reasons to carry inventory, which are: o o o o o To maintain independence of operations; To meet variation in product or supply; To provide a safeguard for variation in raw material; To take advantage of economic purchase order size; and To provide for transit.

In general, there are four categories of inventory, which are: o o o Raw material inventory; Work-in-process inventory (WIP); Finished goods inventory (FGI); and

o Maintenance/repair/operating inventory (MRO).


There are five types of inventory cost structures, which are: o o o o o Item cost; Ordering cost; Set-up (Production Change) cost; Carrying (Holding) cost; and Shortage cost.

Independent demand is the demand for the final-end product or demand not related to other items.

Dependent demand is derived demand items for component parts, sub-assemblies, raw material etc.

UNITAR 2005

Page 11 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management

Additional Readings: Basics of Inventory Management http://www.uky.edu/~dsianita/300/inventory.html#purpose http://www.muhlenberg.edu/depts/abe/business/miller/oispp/inventory.ppt Good Inventory Management: It Will Improve Your Bottom Line http://www.somr.com/InventoryArticle.html Useful articles for Inventory Management http://www.invatol.com/index.html

UNITAR 2005

Page 12 of 13

Course Name: Inventory Management Topic 1: Introduction To Inventory Management CROSSWORD PUZZLE TOPIC 1: INTRODUCTION TO INVENTORY MANAGEMENT
1 2 3

4 8 9 10 12 13

11

14

15

16

17 18

UNITAR 2005

P E L I N E

DOWN 1 Transit inventories are affected by _____ location decisions and choice of carrier. 3 _____ cost refers to the cost of buying or producing the individual

Page 13 of 13

P P I L T WA S T E N M T C A F P R I A N C I I S T H S Y S E D E M A N

A M E R C H A C I C O N O D U C T M N E P T N L C A E N T E M C E E D I N V E

S N D I S E A S N O N A T A L

C I O N S P I S T E N N T

O R Y R U E

ACROSS 2 Transit inventory is also called as _____ inventory. 4 if organization keeps too much inventory, it will _____ money in storage costs and lose money if the inventory is damanged, stolen or become obsolete. 8 Inventory can be defined as a company's _____, raw materials, and finished and unfinished products that have not yet been sold. 13 Set-up cost are also called _____ change cost. 14 Cost of _____ represents a cost of foregone opportunities for other investments. 15 An inventory _____ is a set of policies and controls that monitor levels of inventory and determine what levels

should be maintained, when stock should be replenished, and how large orders should be. 16 Type in True / False for the following statement. There are four categories of inventory, which are, raw material inventory, W IP inventory, FGI and MRO. 17 The rate of stock depletion is _____. 18 _____ is the supply of raw material, partly finished goods that an organization maintains to meet its operational needs.

inventory items. 5 W ork-in-process is an inventory _____ that represents the value of materials, labor, and overhead that has been issued to manufacturing but has not yet produced a stockable item. 6 _____ / repair / operating inventory (MRO) are inventories devoted to maintenance/repair/operating supplies that are necessary to keep machine and process productive. 7 One of the reasons for maintaining raw materials is the _____ availability of supply such as in the case of fruits for canning. 9 The rate at which a stock can be replenished is the supply _____. 10 W IP inventories are components or raw materials that have undergone some changes but are not _____ products. 11 Inventory should be managed in logical and _____ manner. 12 _____ goods inventory (FGI) is completed product awaiting shipment.

You might also like