UNIT 4INVENTORY ANALYSIS AND

CONTROL

INTRODUCTIONINTRODUCTION

Definition:

Scientific method of finding out how much stock should be maintained in order to meet the production demands and be able to provide right type of material at right time, in right quantities and at competitive prices.

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Introduction (Cont’d)

• Inventory is actually money, which is available in the shape of materials (raw materials, in-process and finished products), equipment, storage space, work-time etc.

Input MaterialManagement department

Inventory(money)

Goods in storesWork-in-progressFinished products

Equipment etc.

OutputProductiondepartment

Basic inventory model3

Introduction (Cont’d)

• Inventory control is concerned with achieving an optimum balance between two competing objectives.

1) Minimizing the investment in inventory.

2) Maximizing the service levels to customer’s and it’s operating departments.

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Why We Want to Hold Inventories?

• Improve customer service.

• Reduce certain costs such as– ordering costs– stock out costs– acquisition costs– start-up quality costs

• Contribute to the efficient and effective operation of the production system.

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Inventory Classifications

• Finished Inventories– Essential in produce-to-stock positioning strategies– Necessary in level aggregate capacity plans– Products can be displayed to customers

• Work-in-Process Inventories– Necessary in process-focused production– May reduce material-handling & production costs

• Raw (Material) Inventories– Suppliers may produce/ship materials in batches– Quantity discounts

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• Certain costs increase such as– carrying costs– cost of customer responsiveness– cost of coordinating production– cost of diluted return on investment– reduced-capacity costs– large-lot quality cost– cost of production problems

Why We Do Not Want to Hold Inventories?

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Two Fundamental Inventory Decisions

• How much to order of each material?

• When to place the orders?

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COSTS IN INVENTORY

Inventory costs may vary from 28 to 32% of the total cost. Apart from material costs, several other costs are also involved in inventory. These are given as below:

• Ordering Costs

• Holding Costs/ Carrying Costs

• Stock Out Costs9

• Stationary

• Clerical and processing, salaries/rentals

• Postage

• Processing of bills

• Staff work in expedition /receiving/ inspection and documentation

Ordering Costs

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Holding/Carrying Costs

• Storage space (rent/depreciation)• Property tax on warehousing• Insurance• Deterioration/Obsolescence• Material handling and maintenance, equipment• Stock taking, security and documentation• Capital blocked (interest/opportunity cost)• Quality control

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• Loss of business/ profit/ market/ advise

• Additional expenditure due to urgency of purchases

a) telegraph / telephone charges

b) purchase at premium

c) air transport charges

• Loss of labor hours

Stock out Costs

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Objectives of Inventory1. To ensure that the supply of raw material & finished goods will remain continuous so that production process is not halted and demands of customers are duly met.2. To minimize carrying cost of inventory.3. To keep investment in inventory at optimum level.4. To reduce the losses of theft, obsolescence & wastage etc.5. To make arrangement for sale of slow moving items.6. To minimize inventory ordering costs.

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FUNCTIONS OF INVENTORY

• To meet anticipated demand.

• To smoothen production requirements.

• To decouple operations.

SUPPLY PROCESS

PRODUCTS

DEMAND

INVENTORY

PRODUCTS

DEMAND

DEMANDPROCESS

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Functions Of Inventory (Cont’d)

• To protect against stock-outs.

• To take advantage of order cycles.

• To permit operations.

• To take advantage of quantity discounts.

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Economic Order Quantity

Economic Order QuantityDefinition of EOQHow to use the EOQ model in a

business organizationHow the EOQ model work

The Definition of EOQ

EOQ, or Economic Order Quantity, is defined as the optimal quantity of orders that minimizes total variable costs required to order and hold inventory.

Assumptions in EOQ• The ordering cost is constant.

• The rate of demand is known, and spread evenly throughout the year.

• The lead time is fixed.

• The purchase price of the item is constant i.e. no discount is available

• The replenishment is made instantaneously, the whole batch is delivered at once.

• Only one product is involved.

• EOQ is the quantity to order, so that ordering cost + carrying cost finds its minimum. (A common misunderstanding is that the formula tries to find when these are equal.)

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How to use EOQ in your organization

How much inventory should we order each month?

The EOQ tool can be used to model the amount of inventory that we should order each month.

How EOQ Works

&

The Principles Behind EOQ: The Total Cost Curve(Relationship between Cost and Quantity)

• B – Reorder point• L – Lead time• R – Requisition time

• P – Inventory procurement time

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EOQ Formula Derivation

D = Annual demand (units)C = Cost per unit ($)Q = Order quantity (units)S = Cost per order ($)I = Holding cost (%)H = Holding cost ($) = I x C

Number of Orders = D / QOrdering costs = S x (D / Q)

Average inventory units = Q / 2 $ = (Q / 2) x C

Cost to carry average inventory = (Q / 2) x I x C = (Q /2) x H

Total cost = (Q/2) x I x C + S x (D/Q) inv carry cost order cost

Take the 1st derivative:

d(TC)/d(Q) = (I x C) / 2 - (D x S) / Q²

To optimize: set d(TC)/d(Q) = 0

DS/ Q² = IC / 2

Q²/DS = 2 / IC

Q²= (DS x 2 )/ IC

Q = sqrt (2DS / IC)

H

SDEOQ

2

D = Annual demand (units)S = Cost per order (Rs) C = Cost per unit (Rs) I = Holding cost (%)H = Holding cost (Rs) = I x C

Economic Order Quantity

EOQ Model Equations

LdROP

Dd

NT

Q

DN

H

SDQ

Days/Year Working

Days/Year WorkingOrdersBetween Time Expected

Orders ofNumber Expected

QuantityOrder Optimal

*

2*

LdROP

Dd

NT

Q

DN

H

SDQ

Days/Year Working

Days/Year WorkingOrdersBetween Time Expected

Orders ofNumber Expected

QuantityOrder Optimal

*

2*

D = Demand per year

S = Setup (order) cost per order

H = Holding (carrying) cost

d = Demand per day

L = Lead time in days

Inventory Costs• Ordering cost -- salaries and expenses of processing

an order, regardless of the order quantity• Holding cost -- usually a percentage of the value of

the item assessed for keeping an item in inventory (including finance costs, insurance, security costs, taxes, warehouse overhead, and other related variable expenses)

• Backorder cost -- costs associated with being out of stock when an item is demanded (including lost goodwill)

• Purchase cost -- the actual price of the items• Other costs

3 basic inventory elements

1.1. Carrying cost, Carrying cost, Cc

• Include facility operating costs, record keeping, interest, etc.

2.2. Ordering cost, Ordering cost, Co

• Include purchase orders, shipping, handling, inspection, etc.

3.3. Shortage (stock out) cost, Shortage (stock out) cost, Cs

• Sometimes penalties involved; if customer is internal, work delays could result

Inventory Models

• Simple EOQ model

• EOQ model with stock outs allowed

• Inventory models under risk

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THE SIMPLE EOQ MODEL

Demand rate

0 TimeLead time

Lead time

Order Placed

Order Placed

Order Received

Order Received

Inve

nto

ry L

eve

l

Reorder point, R

Order qty, Q

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EOQ Model with stock out allowed

• In the EOQ model wth shortages, the assumption that shortages cannot exist is relaxed.

• Assumed that unmet demand can be backordered with all demand eventually satisfied.

Shortage = S/Q

On hand = (Q-S)/Q

Shortage

½*base* height = ½ * (Q-S) * (Q-S)/Q = ½ * (Q-S)2 /Q

Area = ½ * (S/Q) * S = ½ * S2 /Q

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Inventory model under risk

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Fluctuating Demand in every cycleSafety stocks can be defined as the difference between the reorder level and average lead time…

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ABC Analysis

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The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control.

Policies based on ABC analysis:•A ITEMS: very tight control and accurate records•B ITEMS: less tightly controlled and good records•C ITEMS: simplest controls possible and minimal records

ABC ANALYSIS(ABC = Always Better Control)

This is based on cost criteria. It helps to exercise selective control when confronted with large number of items it rationalizes the number of orders, number of items & reduce the inventory.

About 10 % of materials consume 70 % of resources

About 20 % of materials consume 20 % of resources

About 70 % of materials consume 10 % of resources

‘A’ ITEMSSmall in number, but consume large amount of resourcesMust have:

•Tight control•Rigid estimate of requirements•Strict & closer watch•Low safety stocks•Managed by top management

‘B’ ITEMIntermediateMust have:

•Moderate control•Purchase based on rigid requirements•Reasonably strict watch & control•Moderate safety stocks•Managed by middle level management

‘C’ ITEMSLarger in number, but consume lesser amount of resourcesMust have:

•Ordinary control measures•Purchase based on usage estimates•High safety stocks ABC analysis does not stress on items those are less costly but may be vital

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CUMMULATIVE CUMMULATIVE COST COST [Rs.]

ANNUAL COST ANNUAL COST [Rs.]

ITEMITEM COST %COST %ITEM %ITEM %

70 %70 %

20 %20 %

10 %10 %

10 %10 %

20 %20 %

70 %70 %

ABC

ANALYSIS

WORK

SHEET

INTRODUCTION :Materials Requirement Planning (MRP) is both

an inventory control and a scheduling technique.

It consists of a series of steps which start by determining what finished products are needed to meet the demand by time periods and are completed with a schedule of the finished product components needed at each assembly level for each time period.

MATERIAL REQUIREMENTS PLANNING

WHERE TO USE MRP :MRP is the most useful scheduling technique for many

industries engaged in fabricating and assembling products like automobiles, tractor-trailer equipments, Rail coaches, etc., It is especially suitable for situations where one or all of the following conditions exists :

a) The final product is complex and made up of several levels of assemblies.b) The final product is expensive.c) The lead times for components and raw materials are relatively long.d) The manufacturing cycle is long for the finished product.e) Consolidation of requirements for several products is desirable so that economic lot sizes are applicable.

Inputs of MRP

The three inputs of MRP are,The master production schedule and other order dataThe bill of material file, which defines the product structureThe inventory record file

MRP STRUCTURE

THE STEPS IN MATERIAL REQUIREMENT PLANNING

STEP 1 : Determine the Gross Requirement.

STEP 2 : Determine the Net Requirements.

Net Requirements = Gross requirements – Available Inventory.

STEP 3 : Develop the Master Schedule.

STEP 4 : Explode the Bill of Materials.

STEP 5 : Screen for ABC items.

STEP 6 : Determine net requirements for an item.

STEP 7 : Adjust requirements by Scrap or Shrinkage factor.

STEP 8 : Schedule planned orders.

STEP 9 : Explode the next level.

STEP 10 : Aggregate Demands and Determine Order Quantity.

STEP 11 : Write and place the planned orders.

Manufacturing resource planning (MRP II) is defined as a method for the effective planning of all resources of a manufacturing company. Ideally, it addresses operational planning in units, financial planning, and has a simulation capability to answer "what-if" questions and extension of closed-loop MRP.

This is not exclusively a software function, but a marriage of people skills, dedication to database accuracy, and computer resources. It is a total company management concept for using human resources more productively.

Manufacturing Resource Planning (MRP II)

Manufacturing Resource Planning System(MRPS)

BENEFITS OF MRP IIMRP II systems can provide:

•Better control of inventories•Improved scheduling•Productive relationships with suppliers

For design / engineering:•Improved design control•Better quality and quality control

For financial and costing:•Reduced working capital for inventory•Improved cash flow through quicker deliveries•Accurate inventory records

Operating Cycle

It was earlier referred to that working capital is also known as revolving capital. That is, a circular path of conversion/re-conversion takes place.

The operating cycles refers to the length of time necessary to complete the following cycle of events:

1.Convert cash into Inventory2.Convert inventory into receivables3.Convert receivable into cash