Inventory Management

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 ($C_o$)
  Cost incurred to place an order.
• Setup costs
  Cost of arranging specific equipment setups (production change).
• Holding costs ($C_h$)
  Cost of storage, handling, insurance, and similar, per unit per year.
• Shortage costs
  Cost of lost sales, emergency procurement, and similar.

Stock levels

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

Average lead time is the average time from placing an order to receiving it.

• Re-order level
  Level at which the storekeeper initiates a purchase requisition. Fixed between the maximum and minimum stock levels.

  $$\text{Re-order level} = \text{Maximum consumption per unit time} \times \text{Maximum lead time}$$

  Or:

  $$\text{Re-order level} = \text{Minimum stock level} + (\text{Average consumption per unit time} \times \text{Average lead time})$$

• Maximum stock level
  Level above which stock should not rise, so that capital is not blocked unnecessarily in stores.

  $$\text{MSL} = \text{Re-order level} + \text{Re-order quantity (EOQ)} - (\text{Minimum consumption per unit time} \times \text{Minimum lead time})$$

• Minimum stock level
  Safety or buffer stock. Stock should not fall below this level.

  $$\text{Minimum stock level} = \text{Re-order level} - (\text{Average consumption per unit time} \times \text{Average lead time})$$

Economic order quantity

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

Where $D$ is annual demand, $C_o$ is cost of ordering per order, and $C_h$ is annual cost of holding per unit.

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.

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 revenue and ignores engagement value, 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
  Reduced holding cost and storage requirement, less waste, improved cash flow and production efficiency, better quality control, improved supplier relationships, faster response to demand changes.
• Disadvantages
  High dependence on reliable suppliers, higher risk of stockouts, production disrupted easily, higher transportation frequency, less protection against emergencies, requires accurate demand forecasting and good coordination systems, expensive to implement initially.

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.