Topic1-Intoduction to Inventory Managment-290212_022300

8/2/2019 Topic1-Intoduction to Inventory Managment-290212_022300

1/13

Course Name: Inventory ManagementTopic 1: Introduction To Inventory Management

UNITAR 2005 Page 1 of 13

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.


2/13



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 andcontrols 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 orRaw 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 processedin an operation, or inventories that has been processed throughone operation and are awaiting another operation. WIP isactually an inventory account that represents the value ofmaterials, labor, and overhead that has been issued tomanufacturing but has not yet produced a stockable item.Depending on how your accounting and inventory systems areset up, it may also include components picked for productionusage or finished products awaiting final inspection.


3/13



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


4/13



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 todemand. 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 Description

1. To maintain independence of operations 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


5/13



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 exactlymeet 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, delaycan occur for a variety of reasons:

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.

4. To take ad vantage of economic purchase

order size

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 orders-

larger 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 generallyundesirable. Long cycle times are caused by large amounts of inventory and are undesirable aswell.

Assembly lines

A process in which the job of making a product is divided intomany smaller jobs. Each worker assembles the same part onevery item made. The workers stay in the same place while theitems pass by on a moving belt or track.

Buffer stock

A quantity of goods or articles kept in store to safeguarda ainst unforeseen shorta es or demands.


6/13



1.4 Types of Inventory

Generally, inventory can be divided into fourcategories, as explained in the table below.Type of Inventory Description

1. Raw material inventory 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 to

maintenance/repair/operating supplies that arenecessary 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.


7/13



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 inventoryitems. It is usually expressed as a cost per unit multiplied by the quantityproduced or procured. Sometimes, item cost is discounted if the quantities ofpurchase 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 isassigned to the batch or lot size. The ordering costs include all the details,such as counting items, calculating order quantities, typing the PurchaseOrder (PO), expediting the order, transportation costs, and so on. Thesecosts are also associated with maintaining the system needed to trackorders.

When the items are produced within the firm, there are also costs associatedwith placing an order that are independent of the number of items produced.These costs are called set-up cost, or are also called production changecost. Set-up costs include paperwork costs plus the costs required to set upthe production equipment for a run.

Set-up costs can amount to thousands of dollars, leading to significanteconomies for large runs. If there were no cost or loss of time in changingfrom one product to another, many small lots would be produced. This wouldreduce inventory levels, with a resulting savings in cost. Set-up cost is oftenconsidered fixed when, in fact, changing the way operations are designedand managed can reduce it.

The carrying, or holding cost, is associated with keeping items in inventoryfor a period of time. The carrying cost is typically charged as a percentage ofdollar value per unit time. For example, a 15 % annual holding cost meansthat 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:

Stockpiling

Accumulating and storing a reserve supply.

Item Cost

Ordering Cost

Set-up Cost

Carrying Cost


8/13



Component Description

Cost of capital When items are carried in inventory, the

capital invested is not available for otherpurpose. This represents a cost offoregone opportunities for otherinvestments, which is assigned to inventoryas an opportunity cost.

Cost of storage This cost includes variable space cost,insurance, and taxes. In some cases, apart of the storage cost is fixed, forexample, when a warehouse is owned andcannot be used for other purposes. Suchfixed costs should not be included in thecost of inventory storage. Likewise, taxesand insurance should be included only ifthey vary with the inventory level.

Cost of obsolescence,deterioration and loss

Obsolescence costs should be assigned toitems that have high risk of becomingobsolete; the higher the risk, the higher thecost. Perishable products should becharged with deterioration costs when theitem deteriorates over time, for example,food and blood. Many products have anexpiration date printed on them andbecome obsolete at that time. The costs ofloss include pilferage and breakage costsassociated with holding items in inventory.

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

Shortage Cost


9/13



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 costresulting from the combined effects of five individual cost. Of course, the timing of these orders is

a critical factor that may impact inventory cost.

1.6Nature 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 Independent Demand

A demand directly related to or derived fromthe 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 demandfor another item and is not independentlydetermined by market. It can also be explainedby the need for any one item is a direct result ofthe need for some other item, usually a higher-level item of which is part. When products arebuilt up from parts and assemblies, the demandfor these components is dependent on thedemand for the final product.

In concept, dependent demand is a relativelystraightforward computational problem. Needed

quantities of a dependent demand item aresimply computed, based on the number neededin each higher-level item in which it is used. Forexample, if automobile company plans onproducing 500 cars per day, then obviously itwill need 2,000 wheels and tires. The number ofwheels and tires needed is dependent on theproduction levels and is not derived separately.The demand for car, on the other hand, isdependent it comes from sources external tothe automobile firm and is not a part of otherproducts; it is unrelated to the demand for otherproducts.

Dependent demand can exhibit a fixed patternof the demand usage. The fixed pattern is alumpy, on-again, off again pattern. A quantity ofparts is required when a lot is required when alot is made; then no parts are required until thenext lot is made.

A demand that is unrelated to demand for otherproducts. Demand for finished goods, parts

required for destructive testing and service partsrequirements are examples of independentdemand.

Independence demand is influenced by marketcondition outside the control of operation. It istherefore independence of operation. Finishgoods and spare parts for replacement usuallyhave independence demand inventories. Forexample, a workstation may produce manyparts that are unrelated but meet some externaldemand requirement.

Independent demand is subject to market forcesor uncertain, it cannot exhibit the fixed pattern of

the demand usage over time series.


10/13



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 thepurpose of inventory. Details will be discussed in subsequent topics.


11/13



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

To maintain independence of operations;o To meet variation in product or supply;

o To provide a safeguard for variation in raw material;

o To take advantage of economic purchase order size; and

o To provide for transit.

In general, there are four categories of inventory, which are:

o Raw material inventory;

o Work-in-process inventory (WIP);

o Finished goods inventory (FGI); and

o Maintenance/repair/operating inventory (MRO).

There are five types of inventory cost structures, which are:

o Item cost;

o Ordering cost;

o Set-up (Production Change) cost;

o Carrying (Holding) cost; and

o 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.


12/13



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


13/13



CROSSWORD PUZZLETOPIC 1: INTRODUCTION TO INVENTORY MANAGEMENT

PPIPELINE

LT

WASTEAMS

NMERCHANDISE

TCCIA

ACONCS

FPRODUCTIONO

IAMNENN

NCPTNSA

IILCAPITAL

STENS

HSYSTEMCTRUE

EEEE

DEMANDN

INVENTORY

1 2 3

4 5 6 7

8

9

10 11

12 13

14

15 16

17

18

ACROSS2 Transit inventory is also

called as _____ inventory.4 if organization keeps too

much inven tory, it will_____ money in storagecosts and lose money ifthe inventory isdamanged, stolen orbecome obsolete.

8 Inventory can be definedas a company's _____,raw materials, andfinished and unfinishedproducts that have not yetbeen sold.

13 Set-up cost are alsocalled _____ changecost.

14 Cost of _____ representsa cost of foregoneopportunities for otherinvestments.

15An inventory _____ is aset of policies andcontrols that monitorlevels of inventory anddetermine what levels

should be maintained,when stock should bereplenished, and howlarge orders should be.

16 Type in True / False forthe following statement.There are four categoriesof inventory, which are,raw material inventory,WIP inventory, FGI andMRO.

17 The rate of stockdepletion is _____.

18_____ is the supply ofraw material, partlyfinished goods that anorganization maintains tomeet its operationalneeds.

DOWN1 Transit inventories are

affected by _____ locationdecisions and choice ofcarrier.

3_____ cost refers to thecost of buying orproducing the individual

inventory items.5 Work-in-process is an

inventory _____ thatrepresents the value ofmaterials, labor, andoverhead that has beenissued to manufacturingbut has not yet produceda stockable item.

6_____ / repair / operatinginventory (MRO) areinventories devoted tomaintenance/repair/oper-ating supplies that are

necessary to keepmachine and processproductive.

7 One of the reasons formaintaining raw materialsis the _____ availability ofsupply such as in the caseof fruits for canning.

9 The rate at which a stockcan be replenished is thesupply _____.

10 WIP inventories arecomponents or rawmaterials that haveundergone some

changes but are not_____ products.

11 Inventory should bemanaged in logical and

_____ manner.12_____ goods inventory

(FGI) is completedproduct awaitingshipment.

Topic1-Intoduction to Inventory Managment-290212_022300

Documents

Transcript of Topic1-Intoduction to Inventory Managment-290212_022300