Inventory Management | Sahithyan's Notes

Inventory is the stock of any item or resource used in an organization: raw materials, work-in-process, finished products.

An inventory system is the set of policies and controls that monitor inventory levels, decide what levels to maintain, when to replenish, and how large orders should be.

Purpose of Holding Inventory

Maintain independence of operations.
Meet variations in product demand.
Allow flexibility in production scheduling.
Safeguard against variation in raw material delivery time.
Take advantage of economic purchase-order size and discounts.
Take advantage of currency fluctuations.
Manage inventory cost.

Inventory Costs

Ordering Costs

Cost incurred to place an order. Denoted as $C_o$ .

Setup Costs

Cost of arranging specific equipment setups (production change).

Holding Costs

Cost of storage, handling, insurance, and similar, per unit per year. Denoted as $C_h$ .

Shortage Costs

Cost of lost sales, emergency procurement, and similar.

Economic Order Quantity

The most favorable quantity to order each time fresh supplies are required.

Q = \sqrt{\frac{2 D C_o}{C_h}}

Here: $Q$ is the economic order quantity, $D$ is annual demand, $C_o$ is cost of ordering per order, and $C_h$ is annual cost of holding per unit.

EOQ balances only ordering cost and holding cost. Setup cost and shortage cost are excluded by assumption.

Assumptions:

Production or sales can be forecasted perfectly.
Demand is evenly distributed over the period.
Lead time is constant.
Cost of materials remains constant.
Holding and ordering cost per unit remain constant during the year.

Stock Levels

Threshold quantities of inventory that trigger and bound replenishment decisions such as when to place an order, and how much stock is too little or too much to hold.

Objectives: avoid holding unnecessary stock (which raises holding cost and loses profit), and avoid stock outs (which interrupt production).

Lead Time

Time between placing an order and receiving it. Lead time varies, so the re-order and stock-level formulas below use its maximum ( $t_{\text{max}}$ ), average ( $t_{\text{avg}}$ ), or minimum value ( $t_{\text{min}}$ ).

Consumption Rate

Quantity of stock used per unit time. It varies, so the re-order and stock-level formulas below use its maximum ( $c_{\text{max}}$ ), average ( $c_{\text{avg}}$ ), or minimum value ( $c_{\text{min}}$ ).

Re-Order Level

Level at which the storekeeper initiates a purchase requisition. Fixed between the maximum and minimum stock levels. $R$ is the re-order level.

R = c_{\text{max}} \times t_{\text{max}}

Maximum Stock Level

Level above which stock should not rise, so that capital is not blocked unnecessarily in stores. $M$ is the maximum stock level.

M = R + Q - (c_{\text{min}} \times t_{\text{min}})

Minimum Stock Level

Safety or buffer stock. Stock should not fall below this level. $S$ is the minimum stock level.

S = R - (c_{\text{avg}} \times t_{\text{avg}})

ABC Analysis

Inventory management technique that categorizes items by their importance to the business into Class A (most important), Class B, and Class C (least important). Helps direct attention and resources to the items that matter most.

Advantages:

Better inventory optimization and forecasting for high-demand items.
Informed supplier negotiations for Class A items.
Control over high-cost critical items.
Reduced storage expense.

Disadvantages:

Parameter instability from frequent reassignment.
Ignores new products and seasonal variation.
High resource consumption on trivial items.
Focuses on monetary value and may overlook operationally critical low-value items.
Relies on subjective judgment.
May conflict with traditional costing systems and GAAP.

Just in Time

JIT inventory management holds stock for production only when needed, aiming to minimize inventory and eliminate waste. Adopted as a cost-cutting strategy.

Advantages:

Lower holding and storage costs.
Less waste.
Better cash flow.
Higher quality control.
Stronger supplier relationships.
Faster response to demand changes.

Disadvantages:

Heavy reliance on reliable suppliers.
Higher risk of stockouts and production disruption.
Frequent transportation.
Less buffer for emergencies.
Accurate demand forecasting required.
Costly to set up.

Inventory Valuation

FIFO
Issues are priced at the cost of the oldest stock on hand.
WAC
Weighted average cost. Issues are priced at the average cost of all stock on hand, recomputed after each purchase.