ARTICLES

Less inventory

 means more money freed up for debt reduction or other uses. Lower carrying costs reduce pressure on the bottom line and result in more profits. Lower, better-managed inventories enable improved patient service through fewer stockouts and partial fills.

What Is Inventory?

Inventory or stock (in standard terms) is considered to be the central theme in managing materials. The inventory turnover ratio (ITR) is a barometer of the performance of the materials management function. It is necessary to have physical stock in the system to take care of the anticipated demand because the non-availability of materials when needed will lead to delays in production or projects or services delivered. However, keeping inventory is not accessible because the organization has opportunity costs of “carrying” or “holding” inventory. Thus, the paradox is that we need inventory, but it is not desirable to have inventory. It is this paradoxical situation that makes inventory management a challenging problem area in materials management. It also makes a high inventory turnover ratio as a desirable performance indicator.

Types of Inventories

These include the following:

(a) Raw materials inventory as input to the manufacturing system.

(b) Bought-out parts (BOP) inventory which directly goes to the assembly of the product as it is.

(c) Work-in-progress (WIP) or work-in-process inventory or pipeline inventory.

(d) Finished goods inventory for supporting the distribution to the customers.

(e) Maintenance, repair, and operating (MRO) supplies. These include spare parts, indirect materials, and all other sundry items required for production/service systems.

Why Do We Need Inventories?

Some of the reasons for having inventories in the production/service system are as follows:

1.    Time lag between placing orders and getting supplies:

 at the point of consumption whenever we place a replenishment order; there is a time lag between placing the order and getting the materials at the point of use. This is called “replenishment lead time.” In most cases, the lead time is nonzero, and at times it is quite high. This necessitates holding inventory to take care of demand during the lead times.

2.    Variability of lead times:

In most cases, particularly in the Indian supply environment, there is some degree of variability in lead times because the supply environment is perhaps a “just-in-case” (JIC) type. Inventory has to be maintained as a shield to cope with the supply uncertainty. Inventory is the premium an organization pays for operating in a just-in-case supply environment. If there was no such uncertainty and if demand and supply are deterministic, then in a just-in-time (JIT)-type environment, no or low inventory will be required. The greater the amount of supply uncertainty, the greater the amount of additional inventory required.

3.    Demand variability:

If either we are unable to estimate the demand correctly or if there are uncertainties in demand, additional inventory will be required to act as a shield to absorb the demand variability. The greater the demand variability, the greater the amount of additional inventory required.

4.    Seasonal inventory:

 If the demand is cyclic or seasonal, then sometimes building inventory in the lean period to meet the peak period demand is employed as a strategy in aggregate production planning. This strategy results in inventory in some parts of the year.

5.    Pipeline inventory

 This is the inventory due to the distribution of a product or a commodity over long distances so that the “goods in transit” become substantially important. This constitutes the pipeline inventory. In the context of production processes, this is called in-process inventory or work in progress (WIP) which is also inventory in terms of idle resources blocked in the nonproductive form. This can be reduced by making the supply chain move faster.

6.    Other factors

 Sometimes inventory is maintained to take care of other situational parameters such as inflationary pressures, shortage of materials in the markets, and quantity discounts to encourage bulk purchasing or simply the desire to spend the budget allocated for materials before the end of the financial year resulting in large and at times unnecessary purchases which eventually become dead stock.

Just-in-Time or Zero-Inventory Essentials:

Just-in-time (JIT) is one of the most talked about topics in materials planning primarily due to its tremendous success in the context of Japanese companies. JIT or zero-inventory system is an idealized concept of inventory management wherein we are able to supply whatever material is required, wherever required, and whenever required just in time with 100 % supply assurances without keeping any inventory on hand.

Obviously, from the resource management point of view, nothing can be better than this, as there are no inventories, no shortages, and no replenishment orders placed. However, this concept necessitates that the suppliers (vendors) are local and are 100 % dependable; orders splitting with small orders without additional transportation costs is feasible, i.e., frequent deliveries are economically viable, and the requirements are firmly known. This also calls for a single vendor base and having a long-term relationship with the vendor, who has to be a quality vendor. This also requires that the vendor has sufficient capacity to supply anytime without passing on the costs of overcapacity to the buyer. The supply of oxygen to the human body is perhaps the perfect example of a JIT/zero-inventory system.

Functions of Inventory: A Mechanical Analogy

The role of inventory is to decouple the two subsystems so that a subsystem is not directly coupled to another subsystem. This means that even if supply disruptions take place, raw materials inventory will enable production operations to go on up to a limit. A similar decoupling function is provided by in-process inventory to decouple one department or a machine from the other. The finished goods inventory decouples the production subsystem from the distribution/sales subsystem. The spare inventory decouples the maintenance subsystem from the production subsystem.

What Is an Inventory Problem?

The inventory problem when we need to decide about

(a) when to initiate a purchase order [when to buy]

(b) how much to buy [determine the lot size]. In solving these twin problems of decision making, we need to develop a model of inventory. A rational scientific approach to decision making calls for developing an inventory model which links up the objective function with the decision variables (e.g., lot size and reorder point) and various inventory-related cost parameters as well as situational variables such as demand, uncertainty of demand, lead time, uncertainty of lead time, constraints (if any), and any other relevant data such as quantity discounts or inflationary trend.

The three costs are as follows:

(a) Inventory carrying costs or holding cost – This is the estimated or imputed cost of holding or carrying a unit of material in the form of inventory for a unit period of time. This is a function of the price of the material held in stock per unit and a fraction of carrying charge expressed as a fraction or percentage of unit price/unit time. The carrying cost is expressed as `per unit/unit time. For example, if the material cost is `1,000 per unit and if the fraction of carrying charge is 0.25 per year, then the unit carrying cost is `250 per unit/year. The fraction of carrying charge is contingent upon a number of situational parameters which will be detailed out in the next section, but the cost of capital blocked in the nonproductive form (which inventories are perceived to be) is the most dominant component. This in turn requires a method of estimating these costs.

(b) Cost of shortage or stockout – This is the estimated or imputed opportunity cost incurred if we do not have materials in stock when the demand arises. This depends upon the consequences of such a situation to arise. If we lost a customer, then it will be the opportunity cost of lost sales. If the demand remains backlogged (or back-ordered), then this will be the penalty cost (if any), loss of goodwill, cost of production or project delays, etc. Estimating the shortage cost is relatively more difficult than the carrying cost, but an approximate estimate is better than ignoring such costs altogether.

(c) Ordering costs – Ordering or replenishment costs are the costs of efforts put in and expenses incurred when a purchase order is initiated for procurement or replenishment of inventories. The ordering cost is quite dependent on the purchase procedures and the extent of bureaucracy and paperwork involved in the processing of a purchase order. This includes administrative efforts expanded in paper flow, progress chasing, inspection, and other costs which will be detailed out in the next section. However, for the sake of simplification, inmany inventory models, the ordering cost is assumed to be independent of the order size and is expressed as `per order. Though it may not be strictly true, yet many inventory models are developed assuming this as an approximation of reality.

Inventory Policies:

1. Economic Order Quantity (EOQ)-Reorder Point (ROP) Policy:

Under this policy, the inventory status is continuously monitored. Whenever the inventory level falls to a predetermined level called as reorder point (ROP), a replenishment order of fixed quantity called economic order quantity (EOQ) is placed. Thus EOQ (Q) and ROP (R) are the two decision variable involved in solving the problem of how much to buy and when to buy.Figure 2.2 shows the graphical operation of the (Q, R) policy. Such inventory model must have (Q, R) as decision variables.

Since this policy requires that the inventory levels be continuously monitored, it calls for keeping a constant watch at stock levels, while in a computerized inventory control, it is easy; in manual systems its administrative costs of operation could be more. To ease this situation, a very ingenious method of manual monitoring of this policy has been evolved and is in practice for long and is called the “two-bin” policy. Under the two-bin policy, total stock is kept in two bins. The second bin keeps the stock required during the lead time, and the first bin contains the Q minus the stock in the second bin. The consumption is met from the first bin until it gets totally consumed. The moment it happens, the reorder point is deemed to have been reached, and a replenishment order of size (Q) is placed. During the replenishment period, the demand is met from the second bin.

 Of course, with the computerization of inventory records, the stock status can be continuously monitored easily without the two-bin policy, because in the two-bin policy one has to keep two storage units for each item. EOQ policy is perhaps the most talked about policy in inventory control literature and is the oldest scientific model of inventory control.

2. Periodic Review Inventory Policy:

The stock status is periodically reviewed under this policy after a fixed time interval (T). When the review period is reached, Under this policy, S, the maximum stock level and the time interval between two reviews (T) are the two decision variables for optimization. Therefore, it is also called as (S, T) policy. Operation of this policy is relatively easy because status of inventory is taken only after a fixed time interval. However, this policy is quite sensitive to the consumption during the review cycle. If stock on hand is high, the order quantity for the next period is low and vice versa. However, under this policy, an order has to be mandatorily placed even if the stock levels are quite high at the review period due to which the order size is a small quantity. In order to simplify the model, one may specify one of the decision variables it`s called (Sp, T) policy if S is prescribed and T is the only decision variable. If T is prescribed, then it is called (S, Tp) policy with S as a decision variable.

3. Optional Replenishment Policy:

This is a variant of periodic review inventory policy wherein there are two levels of inventory identified as S (the maximum level) and s (the minimum level). The stock levels are periodically examined at fixed time interval T. However, if the stock levels are more than the minimum level (s) at the time of review, the replenishment decision is deferred to the next review cycle, and no order is placed because the current stock is deemed to be adequate for the time being until the next review cycle. If, at the time of review, the stock level (X) is less than or equal to (s), then the order quantity Q is determined so that it raises the stock level to S. Thus under this policy.

This policy is also called as minimum-maximum stock level policy or (s, S) policy. Here the decision variables are s, S, and T. This is also called as optional replenishment policy because there is an option of skipping the replenishment decision to the next review period if the current inventory on hand is more than the minimum level prescribed. Thus, intuitively, this would appear to be better than (S, T) policy provided (s, S) and T are optimized.

There may be other variants of these three basic policies, but the most common policies are only these. The inventory model to be developed depends upon the choice of inventory policy. Hence, we have to first decide the inventory policy to be employed before we develop an inventory model for optimal choice of the decision variables.

All data is summarized and collected from ''Basic Concepts in Inventory Management''.