Inventory Control Techniques in Operations Management

Inven­tory con­trol tech­niques are the spe­cific meth­ods an organ­i­sa­tion uses to keep stock under con­trol: to decide which items deserve close atten­tion, how much to order, when to order and how to check that records match real­ity. They turn the broad goal of inven­tory man­age­ment, the right stock at min­i­mum cost, into prac­ti­cal rules for thou­sands of indi­vid­ual items.

They mat­ter because items are not equally impor­tant. A store hold­ing 5,000 items will have some that are very costly and some that are cheap, some that move fast and some that hardly move, some that halt pro­duc­tion if miss­ing and some that nobody would miss for a week. Treat­ing them all the same wastes man­age­ment time on triv­ial items and leaves crit­i­cal ones under-con­trolled. Tech­niques such as ABC, VED, FSN, EOQ and the reorder point solve this by match­ing the level of con­trol to the item.

Need and objec­tives

Why tech­niques are needed

Uncon­trolled stock cre­ates famil­iar prob­lems: too much stock raises car­ry­ing cost, too lit­tle causes short­ages, impor­tant items run out, money is blocked in unnec­es­sary items, stor­age space is wasted and records become dif­fi­cult to man­age.

Objec­tives

The main objec­tive is to main­tain opti­mum inven­tory with proper con­trol at min­i­mum cost. In prac­tice this means to:

• clas­sify stock and pri­ori­tise impor­tant items;
• keep enough stock for pro­duc­tion and sales, but not too much;
• reduce invest­ment in inven­tory and use cap­i­tal bet­ter;
• improve avail­abil­ity and sup­port smooth pro­duc­tion;
• keep con­trol over thou­sands of items with lim­ited staff.

Inven­tory con­trol is more than count­ing

Con­trol means decid­ing which items need strict, mod­er­ate or sim­ple con­trol, when to reorder, how much to reorder and which items are crit­i­cal to oper­a­tions. Dif­fer­ent tech­niques answer dif­fer­ent parts of that ques­tion.

Overview of the main tech­niques

The first five are called selec­tive inven­tory con­trol tech­niques because they decide how much atten­tion each item gets.

ABC analy­sis

ABC analy­sis is a selec­tive con­trol tech­nique that clas­si­fies items into A, B and C classes accord­ing to their annual con­sump­tion value (annual usage quan­tity mul­ti­plied by unit cost). It applies the Pareto prin­ci­ple: a small num­ber of items usu­ally accounts for most of the money. The idea was pop­u­larised in indus­try by H. F. Dickie at Gen­eral Elec­tric. Typ­i­cal, not fixed, pro­por­tions are:

Steps in ABC analy­sis

1. List all items with their annual usage and unit cost.
2. Mul­ti­ply to get annual usage value for each item.
3. Rank items in descend­ing order of annual usage value.
4. Cal­cu­late cumu­la­tive value and cumu­la­tive per­cent­age of value and of items.
5. Draw the cut-off lines to form classes A, B and C.

Worked exam­ple: ABC clas­si­fi­ca­tion

Sup­pose the stores of an engi­neer­ing work­shop hold ten items with the fol­low­ing annual data.

Total annual value:

$$7{,}00{,}000 + 5{,}00{,}000 + 2{,}40{,}000 + 2{,}00{,}000 + 1{,}60{,}000 + 60{,}000 + 50{,}000 + 40{,}000 + 30{,}000 + 20{,}000 = 20{,}00{,}000$$

Share of P1: $\displaystyle \frac{7{,}00{,}000}{20{,}00{,}000} \times 100 = 35\%$. Pro­ceed­ing the same way and cumu­lat­ing gives the table above. The result:

• Class A = P1, P2: 2 items (20% of items) and ₹12,00,000 (60% of value).
• Class B = P3, P4, P5: 3 items (30% of items) and ₹6,00,000 (30% of value).
• Class C = P6 to P10: 5 items (50% of items) and ₹2,00,000 (10% of value).

Man­age­ment should there­fore watch motors and con­trol pan­els most closely, for exam­ple with EOQ-based order­ing, weekly review and tight stock records, while bolts and cable ties can be bought in bulk and checked occa­sion­ally.

Advan­tages of ABC analy­sis

• bet­ter con­trol over costly items;
• improved use of man­age­ment time;
• reduced inven­tory invest­ment;
• bet­ter pur­chas­ing deci­sions and sim­pler record con­trol;
• espe­cially use­ful in large organ­i­sa­tions with many items.

Lim­i­ta­tions of ABC analy­sis

• It con­sid­ers only value, not crit­i­cal­ity: a cheap part can stop a whole machine if unavail­able.
• Classes change as prices and usage change, so the analy­sis must be repeated peri­od­i­cally.
• It needs accu­rate usage and cost data.

So ABC is help­ful but should not be the only con­trol method.

VED analy­sis

VED clas­si­fies items by crit­i­cal­ity, and is widely used for spare parts, main­te­nance stores and hos­pi­tal med­i­cines.

• Vital: oper­a­tions stop com­pletely if these are unavail­able (oxy­gen cylin­ders in a hos­pi­tal, a crit­i­cal machine spare). They must never be out of stock.
• Essen­tial: impor­tant, but a short absence can be man­aged for a lim­ited time.
• Desir­able: use­ful but not imme­di­ately crit­i­cal.

Com­bin­ing ABC with VED

Because ABC asks "which items cost more?" and VED asks "which items are more crit­i­cal?", many firms use both together in a nine-cell matrix. An item can be low cost but vital, and such an item still needs top-pri­or­ity avail­abil­ity.

FSN analy­sis

FSN clas­si­fies items by rate of move­ment out of stores, usu­ally judged by issue fre­quency or the time since the last issue.

• Fast mov­ing: issued fre­quently; need reg­u­lar replen­ish­ment.
• Slow mov­ing: issued occa­sion­ally; need peri­odic review.
• Non-mov­ing: not issued for a long time; can­di­dates for dis­posal as obso­lete or sur­plus stock.

FSN helps iden­tify dead stock, free stor­age space and release money locked in idle items. ABC focuses on money impor­tance, FSN on move­ment, so an item may be low value but fast mov­ing, or high value but slow mov­ing.

HML and SDE analy­sis

HML analy­sis

HML clas­si­fies items as High, Medium or Low cost by unit price. It helps man­age­ment review expen­sive units care­fully and con­trol pur­chase deci­sions. It dif­fers from ABC, which uses annual usage value rather than unit price: in the exam­ple above the con­trol panel has the high­est unit price (H), while bear­ings are only medium in price but still class B because of their vol­ume.

SDE analy­sis

SDE clas­si­fies items by ease of pro­cure­ment:

• Scarce: hard to obtain, often imported or sin­gle-source; need advance plan­ning and higher stock.
• Dif­fi­cult: avail­able, but not eas­ily or quickly.
• Easy: read­ily avail­able in the local mar­ket.

SDE helps firms plan for sup­ply risk.

EOQ, reorder point and safety stock

Eco­nomic Order Quan­tity

EOQ is the order size that min­imises the total of annual order­ing cost and car­ry­ing cost. Order­ing too often raises order­ing cost; order­ing too much at once raises stor­age cost. The for­mula, due to F. W. Har­ris, is:

$$\displaystyle EOQ = \sqrt{\frac{2DS}{H}}$$

For the bear­ings (P3) in the exam­ple, sup­pose order­ing cost $S$ is ₹150 per order and car­ry­ing cost is 20% of the ₹60 unit cost, so $H$ is ₹12 per bear­ing per year. With $D = 4{,}000$:

$$\displaystyle EOQ = \sqrt{\frac{2 \times 4{,}000 \times 150}{12}} = \sqrt{1{,}00{,}000} \approx 316 \text{ bearings}$$

Safety stock

Safety stock is extra inven­tory kept as a safety mar­gin against sud­den demand increases, sup­plier delay, longer pro­duc­tion times or urgent orders. Com­pa­nies may also hold it in dis­tri­b­u­tion cen­tres to pre­pare for future demand. It reduces the risk of stock-out.

Reorder point

The reorder point tells the store when to order, before stock reaches zero:

$$ROP = (\text{daily demand} \times \text{lead time}) + \text{safety stock}$$

If the work­shop uses 16 bear­ings a day (4,000 over 250 work­ing days), the lead time is 6 days and safety stock is 30, then:

$$ROP = (16 \times 6) + 30 = 96 + 30 = 126 \text{ bearings}$$

So when­ever bear­ing stock falls to 126, an order for about 316 bear­ings is placed. The reorder point pre­vents short­age, makes order­ing sys­tem­atic, matches stock to lead time and reduces emer­gency pur­chases.

Two-bin sys­tem

A sim­ple phys­i­cal ver­sion of the reorder point, com­mon for C items: stock is kept in two bins, and when the first bin is empty the sec­ond (hold­ing reorder-level stock) is opened and a new order is placed.

Record-based con­trols

Per­pet­ual inven­tory sys­tem

Stock records (bin cards and stores ledger, or soft­ware) are updated every time mate­r­ial is received or issued, so the bal­ance is always known. It reduces record errors, sup­ports stock con­trol, improves deci­sions and detects short­ages early.

Peri­odic review sys­tem

Stock is checked at fixed inter­vals and topped up to a tar­get level. It suits many small items ordered from the same sup­plier.

Stock ver­i­fi­ca­tion

Phys­i­cal check­ing of whether actual stock matches recorded stock, either at year-end or con­tin­u­ously on a rotat­ing basis (con­tin­u­ous stock-tak­ing). It detects loss, dam­age, theft, record­ing errors and obso­lete mate­ri­als.

Com­bin­ing tech­niques in prac­tice

Clas­si­fi­ca­tion is use­ful because costly items need finan­cial con­trol, crit­i­cal items need avail­abil­ity con­trol, slow-mov­ing items need dis­posal review and hard-to-buy items need advance plan­ning. Real organ­i­sa­tions there­fore com­bine meth­ods:

• ABC for value;
• VED for crit­i­cal­ity;
• FSN for move­ment;
• EOQ for order size;
• reorder point for tim­ing.

A hos­pi­tal stor­ing oxy­gen cylin­ders, injec­tions, cot­ton, gloves and expen­sive imported equip­ment may use VED for crit­i­cal med­ical items, ABC for costly items and reorder points for daily con­sum­ables. A fac­tory may use ABC for spare parts; a retail store may use EOQ for reg­u­lar stock order­ing. These tech­niques apply in fac­to­ries, hos­pi­tals, schools, retail stores, ware­houses and main­te­nance depart­ments.

Advan­tages and lim­i­ta­tions

Inven­tory man­age­ment is the full sys­tem of plan­ning and con­trol­ling stock; inven­tory con­trol tech­niques are the tools inside that sys­tem.

Key terms

Selec­tive inven­tory con­trol

Apply­ing dif­fer­ent lev­els of con­trol to dif­fer­ent classes of items.

ABC analy­sis

Clas­si­fi­ca­tion of items by annual con­sump­tion value into high, medium and low value classes.

Annual con­sump­tion value

Annual usage quan­tity mul­ti­plied by unit cost.

VED analy­sis

Clas­si­fi­ca­tion by crit­i­cal­ity into vital, essen­tial and desir­able items.

FSN analy­sis

Clas­si­fi­ca­tion by rate of move­ment into fast, slow and non-mov­ing items.

HML analy­sis

Clas­si­fi­ca­tion by unit price into high, medium and low cost items.

SDE analy­sis

Clas­si­fi­ca­tion by pro­cure­ment dif­fi­culty into scarce, dif­fi­cult and easy items.

Reorder point

Stock level that trig­gers a new order: lead time demand plus safety stock.

Per­pet­ual inven­tory

A record sys­tem updated after every receipt and issue.

Com­mon ques­tions

What is the basis of ABC analy­sis?

Annual con­sump­tion value, that is annual usage mul­ti­plied by unit cost. It is not unit price alone, which is the basis of HML analy­sis.

How is ABC dif­fer­ent from VED?

ABC clas­si­fies by money value; VED clas­si­fies by how crit­i­cal the item is. A cheap item can be vital, so the two are often com­bined.

Why is ABC called selec­tive inven­tory con­trol?

Because it selects a small group of high-value items for strict con­trol and allows sim­pler con­trol for the many low-value items.

Which tech­nique iden­ti­fies dead stock?

FSN analy­sis, through its non-mov­ing cat­e­gory.

What does EOQ tell that the reorder point does not?

EOQ tells how much to order; the reorder point tells when to order. They are used together.

Which tech­nique suits a hos­pi­tal phar­macy?

VED for life-sav­ing drugs, usu­ally com­bined with ABC for cost con­trol and reorder points for rou­tine con­sum­ables.

Ref­er­ences

1. Dickie, H. F. (1951) "ABC inven­tory analy­sis shoots for dol­lars, not pen­nies". Fac­tory Man­age­ment and Main­te­nance, 109(7), 92–94.
2. Har­ris, F. W. (1913) "How Many Parts to Make at Once". Fac­tory, The Mag­a­zine of Man­age­ment, 10(2), 135–136.
3. Chary, S. N. Pro­duc­tion and Oper­a­tions Man­age­ment. McGraw-Hill Edu­ca­tion (India).
4. Pan­neer­sel­vam, R. Pro­duc­tion and Oper­a­tions Man­age­ment. PHI Learn­ing.
5. Steven­son, W. J. Oper­a­tions Man­age­ment. McGraw-Hill Edu­ca­tion.

Related read­ing

• Inven­tory Man­age­ment in Oper­a­tions Man­age­ment
• EOQ in Oper­a­tions Man­age­ment (Eco­nomic Order Quan­tity)
• MRP in Oper­a­tions Man­age­ment (Mate­r­ial Require­ments Plan­ning)