Inventory management is one of the important functions under operation system. Basically inventory is the stock of any item or resources that used by organization to create different types of outputs. Inventory refers stock of raw materials finished products component parts supplies and work in process etc. Mainly two direct and indirect costs are associated with inventory. Direct cost refer holding cost and ordering cost whereas indirect cost is related with stock out cost so operational manger should maintained the stock neither more nor less which is known as inventory management. An effective inventory system is the set of policies and controls that monitor levels of inventory and determines what levels should be maintained when stock should be replenished and how large orders should be. An organization holds a number of items at a time ranging from small administrative items like pin pencil paper nail screw to large items like machines and equipment vehicles furniture the raw materials and final product depending upon the nature of the organization final product. A university has inventory of pen paper marker supplies of operation furniture educational equipment and many more small and large items. Super market stocks fresh food packaged food canned food household supplies cosmetic and miscellaneous items. Thus the stock of various items held by manufacturing or service sector is the inventory.

Nature and importance of Inventories 

Inventories are a vital part of business. Not only are they necessary for operations but they also contribute to customer satisfaction. To get a sense of the significance of inventories consider the following: some very large firms have tremendous amounts of inventory. For example general motors was at one point reported to have as much as $40 billion worth of materials parts cars and trucks in its supply chain A;though the amounts and dollar values of inventories carried  by different types of firms very widely a typical firm probably has about 30 percent of its current assets and perhaps as much as 90 percent of its  working capital invested in inventory. One widely used measure of managerial performance relates to return on investment (ROI) which is profit after taxes divided by reduction of inventories can result in a significant increase in ROI. Furthermore the ratio of inventories to sales in the manufacturing wholesale and retail sectors is one measure that is used to gauge the health of the US economy.

 Inventory decisions in service organization can be especially critical. Hospitals for example carry an array of drugs and blood supplies that might be needed on short notice. Being out of stock on some of these could imperil the well being of a patient. However many of these items have a limited shelf life. so carrying large quantities would mean having to dispose of unused costly supplies . On site  repair services for computers printers copies and fax machines also have to carefully consider which parts to bring to the site to avoid having to make an extra trip to obtain parts. the same goes for home repair services such as electricians appliance repairers and plumbers.

The major source of revenues for retail and wholesale businesses is the sale of merchandise (ie inventory) In fact in terms of dollars the inventory of goods held for sale is one of the largest assets of a merchandising business. Retails stores that sell clothing wrestle with decisions about which styles to carry and how much of each to stock knowing full well that fast selling items will mean greater profits having to heavily discount goods that didnt sell.

The different kinds of inventories include the following:

  • Raw materials and purchased parts.
  • Partially completed goods called work in process(WIP)
  • Finished goods inventories ( manufacturing firms) or merchandise (retail stores)
  • Replacement parts tools and supplies
  • Goods in transit to warehouse or customers (pipeline inventory)

Both manufacturing and service organizations have to take into consideration the space requirements of inventory. In some cases space limitations may pose restrictions on inventory storage capability. thereby adding another dimension to inventory decisions.

To understand why firms have inventories at all you need to be aware of the various functions of inventory.

Functions of Inventory

Inventories serve a number of functions. Among the most important are the following:

To meet anticipated customer demand

To smooth production requirements

To decouple operations

To protect against stockouts

To take advantage of order cycles

To hedge against price increases

To permit operations

To take advantage of quantity discounts

  1.  To meet anticipated customer demand. A customer can be a person who walks in off the street to buy a new stereo system a mechanic who requests a tool at a tool crib or a manufacturing operation. These inventories are referred to as anticipation stocks because they are held to satisfy expected ie average demand.
  2. To smooth production requirements. Firms that experience seasonal patterns in demand often build up inventories during preseason periods to meet overly high requirements during seasonal periods. These inventories are aptly named seasonal inventories. Companies that process fresh fruits and vegetables deal with seasonal inventories. Companies that process fresh fruits and vegetables deal with seasonal inventories. so do stores that sell greeting cards skis snowmobiles or Christmas trees.
  3. To decouple operations. Historically manufacturing firms have used inventories as buffers between successive operations to maintain continuity of production that would otherwise be disrupted by events such as breakdowns of equipment and accidents that cause a portion of the operation to shut down temporarily. The buffers permit other operations to continue temporarily while the problem is resolved. Similarly firms have used buffers of raw materials to insulate production from disruptions in deliveries from suppliers and finished goods inventory to buffer sales operations from manufacturing disruptions. More recently companies have taken a closer look at buffer inventories, recognizing the cost and space they require and realizing that finding and eliminating sources of disruptions can greatly decrease the need for decoupling operations.
         Inventory buffers are also important in supply chains. Careful analysis can reveal both points where buffers would be most useful and points where they would merely increase costs without adding value.

     4. To Protect against stockouts. Delayed deliveries and unexpected increases in demand increase the risk of shortages, Delays can occur because of weather conditions supplier stockouts deliveries of wrong materials quality problems and so on. The risk of shortage can be reduced  by holdings safety stocks which are stocks in excess of average demand to compensate for variabilities in demand and lead time.

5. To take advantage of order cycles. To minimize purchasing and inventory costs a firm often buys in quantities that exceed immediate requirements. This necessitates storing some or all of the purchased amount for later use. similarly, it is usually economical to produce in large rather than small quantities. Again the excess output must be stored for later use. Thus inventory storage enables a firm to buy and produce in economic lot sizes without having to try to match purchases or production with demand requirements in the short run. This results in periodic orders, or order cycles. the resulting stock n known as cycle stock. Order cycles are not always based on economic lot sizes. In some instances, it is practical or economical to group orders and or to order at fixed intervals.

6. To hedge against price increases. Occasionally a firm suspect that a substantial price increase is about to occur and purchase larger than normal amounts to beat the increase. The ability to store extra goods also allows a firm to take advantage of price discounts for larger orders.

7.To permit operations. The fact that production operations take a certain amount of time(ie they are not instantaneous) means that there will generally be some work in process inventory. In addition, intemediate stocking of goods including raw materials, semi finished items and finished goods at production sutes as well as goods stored in warehouses leads to pipeline inventories throughout a production  distribution system. Littles law can be useful in quantifying pipeline inventory. It states that the average amount of inventory in a system is equal to the product of the average rate at which inventory units leave the system(i.e the average demand rate) and the average time a unit is in the system. Thus if a unit is in the system for an average of 10 days and the demand rate is 5 units per day the average inventory is 50 units 5 unit/day X10 days = 50 units.

8. To take advantage of quantity discounts. Suppliers may given discounts on large orders. To minimize the cost usually firms purchase the quantities more than the forecasted demand. It is most of the time economical to buy in lot and also product in lot size. Thus the purchased materials and the finished goods have to be stored.

Types of inventories

To accommodate the function of inventory firms maintain following types of inventories.

1. Raw material and purchased parts: the raw material are that inventory which needs to be purchased for obtaining finished product. Raw material for nebico biscuits are flour ghee sugar etc.

2. Work in progress: partially completed goods called work in progress. These are the stocks which are not yet completed. In garment factories the clothes cut but not stitched are the work in process inventory.

3. Finished goods inventories: The goods or service which finished to complete but not yet distributed in the market have to be stored untill they go to the market. Hence the final product are called finished good inventory.

Types of inventories

Raw materials and purchased parts

Work in progress

Finished goods inventories

Anticipated inventory

Buffer stock or safety stock

Decoupling inventory


4. Anticipated inventory: this is the fundamental use of maintaining the inventory of items. It is to satisfy the demand of customer ie to ensure that no customer is disappointed by not getting the desired items at any point of time. Enough inventories of items should exist to meet the expected or anticipated demand of customer.

5. Buffer stock or safety stock: to protect against fluctuation of demand and abrupt increase in the time taken by the suppliers to supply the items, some stock known as the safety or buffer stock is maintained in excess of the anticipation inventory.

6. Decoupling inventory: Inputs are passed numbers of stages before made outputs at operation system. Sometimes uneven flow of materials unequal capacity of operation units repair and maintenances machine breakdowns and others reasons inventory are seen at process which inventories are known as decoupling inventory. For example a garment items are often passed some basic stages before made finished goods wool processing then knitting then dying or coloring Finishing and packaging. If there is some disturbance seen in dying department may inventories will be seen at knitting department which inventory can see as inventory decoupling.

7.MRO: Mro are inventories devoted to maintenance repair operating supplies necessary to keep machinery and process productive.

Inventory costs 

In making any decision that affects inventory size the following costs must be considered.

Inventory costs

Holding costs . ordering cost or setup cost. Stock out cost or back log cost. Total inventory cost.

1. Holding cists: carrying / holding cost relate to physically having item in storage. It includes the cost of maintaining the inventory warehouse and protecting the inventory. Such costs are interest insurance taxes depreciation obsolescence deterioration spoilage breakage and warehouse costs (heat light rent security).

2. Ordering cost or set up cost: ordering costs are the costs of ordering and receiving inventory. It includes cost of placing an order setup cost, cost of postage telephone made to vender fax email labour cost involved in purchasing and accounting receiving cost. Ordering cost is generally expressed as a fixed cost amount per order size.

3. Stock out cost or back log cost: shortage cost or stock out cost results when demand exceeds the supply of inventory on hand. These costs can include the opportunity cost of not making a sale loss of customer Goodwill late customer loyalty switching cost and similar costs . The shortage costs are difficult to measure and often they are subjectively estimated.

4. Total inventory cost: if unit price of an item depends on the quantity purchase ie price discounts are available, then we should formulate an inventory policy which takes into consideration the purchase cost of the items held in stock also. The total inventory cost ( TC) is the given by:

Total inventory cost = purchase cost + ordering cost + carrying cost + shortage cost.

Objective of inventory management

The overall objective of inventory management is to achieve satisfactory levels of customer service while keeping inventory costs within reasonable limits. In this context a decision maker must make two fundamental decisions the timing of the order and size of orders(ie when to order and how much to order)

The performance of inventory management can be measured in the following terms:

1. Customer satisfaction: This is measured by the number and quantity of backorders and or customer complaints. If the customers complaints are less then the customer satisfaction is high and vice versa.

2. Inventory turnover: this is the ratio of annual cost of goods sold to average inventory investment. It is a widely used measure. The turnover ratio indicates how many times a year the inventory is sold. The higher the ratio the better because that implies more efficient use of inventory. It can be used to compare companies in the same industry.

3. Days of inventory on hand: the expected number of days of sales that can be supplied from existing inventory. A balance is desirable a higher number of days might imply excess inventory, while a lower number might imply a risk of running out of stock.

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