Inventory Management in Operations Management

Inven­tory is the stock of mate­ri­als and goods an organ­i­sa­tion keeps for use in pro­duc­tion or for sale: raw mate­ri­als, work-in-progress, fin­ished goods and main­te­nance sup­plies. Inven­tory man­age­ment is the plan­ning, con­trol­ling and main­tain­ing of that stock at the proper level, decid­ing what items to keep, how much to keep, when to reorder and how much to order, so that work con­tin­ues smoothly with­out lock­ing up exces­sive money.

The topic mat­ters because inven­tory is usu­ally one of the largest cur­rent assets on a man­u­fac­tur­er's or retail­er's bal­ance sheet. Too lit­tle stock stops pro­duc­tion and loses sales; too much stock raises stor­age cost, blocks work­ing cap­i­tal and risks spoilage. The aim is not max­i­mum stock but opti­mum stock: the right quan­tity, at the right time, at min­i­mum total cost.

A sim­ple way to under­stand inven­tory man­age­ment

Think of a gro­cery shop. If it keeps too lit­tle rice, sugar and oil, cus­tomers leave empty-handed and sales are lost. If it keeps too much of every­thing, money is blocked, the store­room is crowded and some items spoil. The shop­keeper must keep enough, but not too much. A note­book man­u­fac­turer faces the same prob­lem with paper: too lit­tle and the machines stop; too much and ware­house cost rises and the paper may be dam­aged by mois­ture. Decid­ing how much paper to keep, when to order more and how much safety stock to hold is inven­tory man­age­ment.

Inven­tory ver­sus inven­tory man­age­ment

Inven­tory is the stock itself. Inven­tory man­age­ment is the process of con­trol­ling that stock prop­erly.

Types of inven­tory

Raw mate­ri­als

Basic mate­ri­als that have not yet been processed: steel for a machine com­pany, flour for a bak­ery, wood for a fur­ni­ture maker.

Work-in-progress (WIP)

Items that have entered pro­duc­tion but are not com­plete, such as a half-assem­bled chair on the shop floor.

Fin­ished goods

Com­pleted prod­ucts ready for sale, such as packed bis­cuit boxes await­ing dis­patch. They are held so cus­tomers can be served quickly.

Spare parts and con­sum­ables (MRO)

Main­te­nance, repair and oper­at­ing sup­plies that keep oper­a­tions run­ning: lubri­cants, machine belts, nuts and bolts, clean­ing mate­ri­als.

Inven­tory by pur­pose

Text­books also clas­sify stock by the rea­son it is held:

Why organ­i­sa­tions hold inven­tory

• To sup­port con­tin­u­ous pro­duc­tion: if raw mate­ri­als are miss­ing, machines stop, work­ers are idle and orders are delayed.
• To meet cus­tomer demand: fin­ished goods let cus­tomers be served imme­di­ately.
• To han­dle uncer­tainty: demand may rise sud­denly and sup­ply may be delayed; stock acts as pro­tec­tion.
• To cover lead time: sup­pli­ers take time to deliver, and stock is needed in the mean­time.
• To gain from bulk buy­ing: larger pur­chases may earn quan­tity dis­counts and lower trans­port cost per unit.
• To smooth pro­duc­tion: a firm can pro­duce at a steady rate while demand fluc­tu­ates.

In short, inven­tory exists because busi­ness con­di­tions are never per­fectly smooth.

Objec­tives and impor­tance

The main objec­tive is to main­tain the right quan­tity of stock at the right time with min­i­mum total cost, bal­anc­ing avail­abil­ity against the cost of hold­ing stock. Spe­cific objec­tives are to:

• ensure mate­r­ial avail­abil­ity for smooth pro­duc­tion;
• avoid both short­age and excess stock;
• min­imise total inven­tory cost (order­ing, car­ry­ing and short­age costs);
• improve cus­tomer ser­vice;
• make good use of work­ing cap­i­tal and stor­age space;
• pre­vent wastage, pil­fer­age and obso­les­cence;
• sup­port pro­duc­tion plan­ning and improve prof­itabil­ity.

Poor inven­tory man­age­ment shows up quickly: pro­duc­tion stops, goods are unavail­able, stor­age cost rises and losses mount. That is why inven­tory man­age­ment is one of the cen­tral func­tions of oper­a­tions, closely linked with pro­duc­tion plan­ning and con­trol (PPC), pur­chas­ing and stores.

Advan­tages of hold­ing inven­tory and dan­gers at both extremes

Advan­tages of hold­ing inven­tory

• Greater avail­abil­ity of mate­ri­als and prod­ucts when needed;
• smooth pro­duc­tion with­out inter­rup­tion;
• bet­ter cus­tomer ser­vice through quick deliv­ery;
• pro­tec­tion against delay when a sup­plier is late;
• flex­i­bil­ity to respond to changes in demand.

Both extremes are harm­ful, which is why inven­tory man­age­ment aims for bal­ance.

Inven­tory-related costs

Order­ing cost

The cost of plac­ing and receiv­ing one order: paper­work, com­mu­ni­ca­tion, fol­low-up, trans­port arrange­ment, receiv­ing and inspec­tion. Total order­ing cost rises with the num­ber of orders. In a fac­tory mak­ing its own parts, the equiv­a­lent is set-up cost.

Car­ry­ing (hold­ing) cost

The expense of stor­ing inven­tory for a spec­i­fied period, usu­ally a year: ware­house rent, insur­ance, secu­rity, inter­est on cap­i­tal, dete­ri­o­ra­tion and obso­les­cence. It is often expressed as a per­cent­age of the item's value, for exam­ple 20% per year. Total car­ry­ing cost rises with the aver­age stock held.

Short­age (stock-out) cost

The cost of not hav­ing stock when needed: lost sales, pro­duc­tion stop­page, lost cus­tomer good­will, urgent trans­port and emer­gency pur­chases at higher prices.

Pur­chase cost

The price paid for the items them­selves. It becomes rel­e­vant when quan­tity dis­counts are offered.

Order­ing cost and car­ry­ing cost pull in oppo­site direc­tions: order­ing more at a time reduces orders but raises aver­age stock. The Eco­nomic Order Quan­tity (EOQ) model finds the bal­ance.

Key plan­ning con­cepts

Lead time

The time between plac­ing an order and receiv­ing the mate­r­ial. If bolts ordered today arrive after 5 days, lead time is 5 days.

Safety stock

Extra stock kept as pro­tec­tion against uncer­tainty in demand or lead time. A com­pany that keeps a suf­fi­cient safety mar­gin of extra inven­tory is said to hold safety stock; it is backup stock that should nor­mally not be used.

Reorder point (reorder level)

A busi­ness should not wait until stock reaches zero. It orders when stock falls to the reorder point:

$$\text{Reorder point} = \text{Lead time demand} + \text{Safety stock} = (d \times L) + SS$$

where $d$ is demand per day and $L$ is lead time in days.

Order cycle

The time between two suc­ces­sive orders. If orders go out on the 1st of every month, the order cycle is one month.

Aver­age inven­tory

With steady use, stock falls from its high­est level to its low­est in a straight line, so aver­age inven­tory is half the order quan­tity plus any safety stock: $\displaystyle \frac{Q}{2} + SS$.

Worked exam­ple: reorder point and annual inven­tory cost

Sup­pose a sta­tionery whole­saler sells a pop­u­lar note­book. The data are:

Step 1: annual demand and num­ber of orders

$$\displaystyle D = 40 \times 300 = 12{,}000 \text{ notebooks}, \qquad \text{Orders per year} = \frac{12{,}000}{800} = 15$$

Step 2: order cycle

$$\displaystyle \text{Order cycle} = \frac{300}{15} = 20 \text{ working days}$$

Step 3: reorder point

$$ROP = (40 \times 5) + 60 = 200 + 60 = 260 \text{ notebooks}$$

When stock falls to 260, an order for 800 is placed. Over the next 5 days, 200 note­books are sold and the new lot arrives just as stock reaches the safety level of 60.

Step 4: aver­age inven­tory and car­ry­ing cost

$$\displaystyle \text{Average inventory} = \frac{800}{2} + 60 = 460 \text{ notebooks}$$

$$H = 20\% \text{ of } ext{₹}50 = ext{₹}10 \text{ per notebook per year}$$

$$\text{Annual carrying cost} = 460 \times ext{₹}10 = ext{₹}4{,}600$$

Step 5: order­ing cost and total cost

$$\text{Annual ordering cost} = 15 \times ext{₹}300 = ext{₹}4{,}500$$

$$\text{Total relevant inventory cost} = ext{₹}4{,}600 + ext{₹}4{,}500 = ext{₹}9{,}100$$

Step 6: what if the order size changes?

Order­ing too lit­tle too often and order­ing too much at once both cost more. The EOQ for these data is $\displaystyle \sqrt{\frac{2 \times 12{,}000 \times 300}{10}} = \sqrt{7{,}20{,}000} \approx 849$ note­books, so 800 is close to the eco­nom­i­cal size.

Fac­tors affect­ing inven­tory lev­els

• Demand rate and its vari­abil­ity;
• lead time and sup­plier reli­a­bil­ity;
• item cost and the cost of cap­i­tal;
• stor­age capac­ity avail­able;
• per­isha­bil­ity and shelf life of the item;
• quan­tity dis­counts and price trends;
• nature of pro­duc­tion (con­tin­u­ous or batch) and the desired ser­vice level.

Inven­tory man­age­ment across sec­tors

Man­u­fac­tur­ing

Man­ages raw mate­ri­als, work-in-progress, fin­ished goods and spare parts.

Retail

Mainly man­ages goods bought for resale, often thou­sands of prod­uct lines.

Ser­vice organ­i­sa­tions

Hos­pi­tals, col­leges and banks man­age med­i­cines, sta­tionery, spare equip­ment and main­te­nance stock. Inven­tory is rel­e­vant almost every­where, not only in fac­to­ries.

Links with pro­duc­tion, cus­tomer ser­vice and cost

Pro­duc­tion: well-man­aged stock keeps mate­ri­als avail­able and flow smooth; badly man­aged stock stops machines, wastes labour and breaks sched­ules. Cus­tomer ser­vice: if fin­ished goods are unavail­able, sales are lost, cus­tomers switch to com­peti­tors and brand trust falls. Cost con­trol: poor man­age­ment raises stor­age, dam­age, cap­i­tal and short­age costs; good man­age­ment low­ers them and improves effi­ciency.

Inven­tory con­trol tech­niques

With hun­dreds or thou­sands of items, sim­ply keep­ing stock is not enough. Firms use tech­niques such as ABC analy­sis (clas­si­fi­ca­tion by annual value), EOQ (how much to order), reorder point (when to order), safety stock plan­ning, VED and FSN analy­sis, per­pet­ual inven­tory records, peri­odic review sys­tems and, for depen­dent demand items, MRP. Just-in-time (JIT) sys­tems go fur­ther and try to cut inven­tory to the min­i­mum by syn­chro­nis­ing sup­ply with use.

Com­mon prob­lems and a good inven­tory sys­tem

Com­mon prob­lems

Inac­cu­rate stock records, sud­den demand change, delayed sup­ply, poor stor­age, over-order­ing, under-order­ing, obso­lete stock, dupli­cate stock under dif­fer­ent codes, and poor coor­di­na­tion between depart­ments.

Qual­i­ties of a good inven­tory sys­tem

• shows cur­rent stock clearly and accu­rately;
• sup­ports timely order­ing;
• pre­vents both short­age and excess stock;
• is easy to update;
• con­nects with pur­chase and stores;
• helps man­age­ment make deci­sions quickly.

Stores man­age­ment and inven­tory man­age­ment

Key terms

Inven­tory

Stock of raw mate­ri­als, work-in-progress, fin­ished goods and sup­plies held for pro­duc­tion or sale.

Inven­tory man­age­ment

Plan­ning and con­trol­ling stock at an opti­mum level to meet demand at min­i­mum total cost.

Lead time

Time between plac­ing an order and receiv­ing the goods.

Safety stock

Extra stock held as a buffer against uncer­tain demand or sup­ply.

Reorder point

Stock level at which a new order is placed; lead time demand plus safety stock.

Order cycle

Time between two suc­ces­sive orders.

Order­ing cost

Cost of plac­ing and receiv­ing one order.

Car­ry­ing cost

Cost of hold­ing one unit in stock for a period, usu­ally a year.

Short­age cost

Cost aris­ing from not hav­ing stock when it is needed.

Com­mon ques­tions

What is the main objec­tive of inven­tory man­age­ment?

To main­tain opti­mum stock, enough to meet demand and keep pro­duc­tion run­ning, at the low­est total cost of order­ing, car­ry­ing and short­ages.

What are the types of inven­tory in a man­u­fac­tur­ing firm?

Raw mate­ri­als, work-in-progress, fin­ished goods, and spare parts and con­sum­ables (MRO).

How is the reorder point cal­cu­lated?

Mul­ti­ply daily demand by lead time in days and add safety stock. With 40 units a day, a 5-day lead time and 60 units of safety stock, the reorder point is 260 units.

Why is excess inven­tory harm­ful?

It raises car­ry­ing cost, blocks work­ing cap­i­tal, occu­pies space and increases the risk of spoilage and obso­les­cence.

What is the dif­fer­ence between car­ry­ing cost and order­ing cost?

Car­ry­ing cost rises when more stock is held on aver­age; order­ing cost rises when more orders are placed. Larger order sizes lower order­ing cost but raise car­ry­ing cost.

Which fac­tors decide how much inven­tory to keep?

Demand rate, lead time, sup­plier reli­a­bil­ity, item cost, stor­age capac­ity, per­isha­bil­ity, dis­counts and the ser­vice level the firm wants.

Ref­er­ences

1. Steven­son, W. J. Oper­a­tions Man­age­ment. McGraw-Hill Edu­ca­tion.
2. Heizer, J., Ren­der, B. and Mun­son, C. Oper­a­tions Man­age­ment: Sus­tain­abil­ity and Sup­ply Chain Man­age­ment. Pear­son.
3. Chary, S. N. Pro­duc­tion and Oper­a­tions Man­age­ment. McGraw-Hill Edu­ca­tion (India).
4. Chopra, S. and Meindl, P. Sup­ply Chain Man­age­ment: Strat­egy, Plan­ning, and Oper­a­tion. Pear­son.
5. Har­ris, F. W. (1913) "How Many Parts to Make at Once". Fac­tory, The Mag­a­zine of Man­age­ment, 10(2), 135–136.

Related read­ing

• Stores Man­age­ment in Oper­a­tions Man­age­ment
• Inven­tory Con­trol Tech­niques in Oper­a­tions Man­age­ment
• EOQ in Oper­a­tions Man­age­ment (Eco­nomic Order Quan­tity)