INVENTORY MANAGEMENT

Purchase cost This cost, denoted by C is the actual price per unit paid for the procurement of items, and is
independent of the size of the quantity ordered or manufactured. It is given by
Purchase cost, C = (Price per unit) × (Demand per unit time) = C.D
When quantity discounts are there, Purchase cost becomes variable and depends on size of the order. In this case,
Purchase cost = Price per unit when order size is Q × Demand per unit time = C (Q) . D
Carrying (holding) cost is inventory cost incurred for carrying items in warehouse. It is calculated as:
Carrying(holding) cost = Cost of carrying one unit × Average number of units of an item carried in the inventory.
Annual Carrying or holding Cost is Ch = r x C
Ordering (set-up) cost is the inventory cost incurred each time an order is placed for procuring items from the
vendors. It is calculated as follows:
Ordering cost = (Cost per order/per set-up) × (Number of orders/set-ups placed in the given period)
Shortage (or stock out) cost - occurs when inventory items cannot be supplied due to delay in delivery or demand
becomes more than the expected demand. It is calculated as follows:
Shortage cost = (Cost of being short one unit of an item) × (Average number of units short)
Where, Average no of units short = (Minimum shortage + Maximum Shortage) / 2 x (Period of shortage).
Total inventory cost (TC) or TVC = Purchase cost + Ordering cost + Carrying cost + Shortage cost
Note : The above formula is used when price or quantity discounts are offered.
However, if price discounts are not offered, the purchase cost per unit of an item remains constant and is
independent of the quantity purchased. In this case, TC is calculated as follows:
Total inventory cost (TC) = Ordering cost + Carrying cost + Shortage cost
EOQ, denoted by Q* is an order quantity that minimizes the total average inventory cost.
Replenishment Order Size Decisions and Concept of EOQ
The size of an order(s) affects inventory level to be maintained at various stocking points. Large order size for an item
may reduce (i) the frequency of orders to procure inventory items, and (ii) the total ordering cost.
But, large order size for an item will, however, increase the cycle stock inventory and carrying cost for excess
inventory. Any decision on replenishment order size (or batch size for production) should facilitate economical trade-
off between relevant inventory costs, viz., ordering, carrying and shortage costs. Such replenishment order is
referred as, economic order (or lot size) quantity, EOQ denoted by the parameter Q*.
EOQ denoted by Q* is the optimal replenishment order size (or lot size) of inventory item (or items) that
achieves the optimum total (or variable) inventory cost during the given period of time.

C = purchase (or manufacturing) cost of an item, expressed in Rs per unit.

Co denotes the ordering (or set-up) cost per order.
r = cost of carrying one rupee’s worth of inventory, in terms of percent of rupee value of
inventory.
Ch = C x r = cost of carrying one unit of an item in the inventory
Cs = shortage cost per unit per time (Rs per unit time)
D = annual requirement (demand) of an item i.e. ANNUAL DEMAND of a product/item.
Q = order quantity (units) per order placed.
ROL = reorder level (or point) at which an order is placed
LT = replenishment lead time (delivery time or period)
N or n = number of orders per time period
t = reorder cycle time (time period), i.e. time between successive orders to replenish
inventory stock
tp = production period (time) , rp = production rate (quantity per unit time) at which quantity Q
is added to inventory , TC = total inventory cost (in Rs), TVC = total variable inventory cost
(in Rs).
SINGLE ITEM INVENTORY CONTROL MODELS WITHOUT SHORTAGES

Model 1(a) : EOQ Model with Constant Rate of Demand

The following assumptions(INPUTS) are made in this model:
The inventory system involves one type of item or product,
The demand is known and constant and is resupplied instantaneously,
The inventory is replenished in single delivery for each order,
Lead Time L(LT) is constant and known, so inventory increases by Q units as soon as an order is placed,
Shortages are not allowed, means there is always enough inventory on hand to meet the demand,
Purchase price and reorder costs do not vary with the quantity ordered ( No QUANTITY DISCOUNTS),
Annual Carrying Cost and Ordering Cost per order are known and constant,
Each item is independent and money cannot be saved by substituting by other items into a single order.

Order quantity Q is number of units of a product that are produced/ordered at one time to replenish inventory.
Q = Consumption of stock in one inventory cycle. Therefore, Q= D. t
Where D denotes the annual demand, and t denotes the Reorder cycle time. So, t = Q/D.

Figure showing the trade-off between inventory carrying cost and ordering cost.
As shown in Fig., the total variable inventory
cost is minimum at a value of Q, which
appears to be at the point where inventory
carrying and ordering costs are equal. That
is,

Formula for Q* is known as the Wilson

or Harris lot size formula.
Q1. The prod. department of a company requires 3,600 kg of raw material for manufacturing a particular item per
year. The cost of placing an order is Rs 36 and cost of carrying inventory is 25 per cent of the investment in the
inventories. The price is Rs 10 per kg. Help the purchase manager to determine an ordering policy for raw material.

SOLUTION- We have D = 3600 kg per year; Co = Rs 36 per order,

Ch = 25% of the price/unit of raw material = Rs 10 × 0.25 = Rs 2.50 per kg per year.

Q2. Mohan is a confectioner. He buys plastic boxes in bulk. His annual requirement is 1200
boxes and each box costs him Rs 30. He has estimated that his ordering costs are Rs 10 per
order and his carrying costs are 20 percent. How many boxes should he order at a time so as
to minimize his expenses?

SOLUTION : To compute EOQ?

D = 1200, carrying cost Ch = 30 x (20/100) = Rs 6, Ordering cost C 0 = 10
EOQ =  (2 D. C0 / Ch) =  (2 X 1200 X 10 / 6) = 2010 = 20 X 3.16 = 63 BOXES
Q2b) If the suppler sells the boxes only in lots of 25, should we buy 50 or 75?
SOLUTION : We should now calculate the ordering and carrying costs in both cases.
The cost of the inventory can be ignored as it remains the same.
Case 1 : Q = 50
Ordering cost = (1200 x 10) / 50 = 240 and Carrying cost = (50 x 30 x 0.2) / 2= 150
Total cost = Ordering cost + Carrying cost = 390
Case 2: Q =75
Ordering cost = (1200 x 10) / 75 = 160 and Carrying cost = (75 x 30 x 0.2) / 2= 225
Total cost = Ordering cost + Carrying cost = 160 + 225 = 385
As the total cost of buying lots of 75 is lesser, we should buy in lots of 75.

Q2 C) The supplier offers 2% discount if the purchases are in quantities of 300 at a time. Should we accept
the discount?

SOLUTION : We should now calculate the totals costs including the cost of inventory as the offer of a 2%
discount will result in a reduction of cost of acquisition.

Case 1 : Q = 75
Ordering cost = (1200 x 10) / 75 = 160 and Carrying cost = (75x30x0.2) / 2= 225
Inventory cost = 1200 x 30 = 36000
Total cost = Ordering + Carrying + Inventory Costs = 160 + 225 + 36000 = 36385
Case 2: Q = 300 (2% disc on cost per unit)
Ordering cost = (1200 x 10) / 300 = 40 and
Carrying cost = (300x30x0.98x0.2) / 2= 882
Inventory cost = 1200 x 30 x 0.98 = 35280
Total cost = Ordering + Carrying + Inventory Costs = 36202
We should accept the discount as the total cost is less.

Model 1(b) : EOQ Model with Different Rates of Demand

This inventory system has same assumptions as Model I(a) except that the demand is
constant and varies from period to period. The objective is to determine the order size in each
reorder cycle (or period) that will minimize the total inventory cost. The total demand, D is
specified over the planning period, T.
Q3. A company that operates for 50 weeks in a year is concerned about its stocks of copper cable.
This costs Rs 240 a meter and there is a demand for 8,000 meters a week. Each replenishment
costs Rs 1,050 for administration and Rs 1,650 for delivery, while holding costs are estimated at
25 per cent of value held a year. Assuming no shortages are allowed, what is the optimal
inventory policy for the company?
How would this analysis differ if the company wanted to maximize its profits rather than minimize
cost? What is the gross profit if the company sells the cable for Rs 360 a meter?
It may be noted that in comparison of total inventory cost in excess of Rs 9,63,60,000 per year, the total
variable inventory cost is only Rs 3,60,000 or 0.36 per cent. If the company desired to maximize profit
rather than minimize cost, the analysis used would remain exactly the same. In such a case, the selling
price (SP) per unit is defined in such a way that gross profit per unit time becomes

The maximum profit with respect to Q can be obtained by solving this equation.
If company sells the cable for Rs 360 a meter, its revenue is Rs 360 × 4,00,000 = Rs 14,40,00,000 a
year. The total inventory cost of Rs 9,63,60,000 is subtracted from this revenue to get a gross
profit of Rs 4,76,40,000 a year.
Q4. Each unit of an item costs Rs 40. Annual holding costs are 18 per cent of unit cost of the item
due to miscellaneous charges: 1 per cent for insurance, 2 per cent allowances for obsolescence,
Rs 2 for building overheads, Rs 1.50 for damage and loss, and Rs 4 miscellaneous costs.
Annual demand for item is constant at 1,000 units. Placing each order costs the company Rs 100.
(a) Calculate EOQ and the total costs associated with stocking the item.
(b) If supplier of item will deliver batches of 250 units, how are the stock holding costs affected?
(c) If the supplier relaxes his order size requirement, but the company has limited warehouse
space and can stock a maximum of 100 units at any time, what would be the optimal ordering
policy and associated costs?
Q5. A chemical company is trying to find the optimal batch size for the reorder of concentrated
sulphuric acid. The management accountant has supplied the following information:
i(i) The purchase price of H2SO4 is Rs 150 per gallon.
(ii) The clerical and data processing costs are Rs 500 per order.
All the goods are transported by rail. Each time the special line to the factory is opened the
company is charged Rs 2,000. A charge of Rs 20 gallon is also made. The company uses 40,000
gallons per year. Maintenance costs of stock are Rs 400 per gallon per year.
Each gallon requires 0.5 sq ft of storage space. If warehouse space is not used, it can be rented
out to another company @Rs 200 per sq ft per annum. Available warehouse space is 1,000 sq ft,
overhead costs being Rs 5000 per annum. Assume that all free warehouse space can be rented
out.

a) Calculate the economic reorder size.

b) Calculate the minimum total annual cost of holding and reordering stock.
ASSIGNMENT
1. A manufacturer has to supply his customer with 600 units of his product per year. Shortages are not
allowed and the storage cost amounts to Rs 0.60 per unit per year. The set-up cost per run is Rs 80.00.
Find the optimum run size and the minimum average yearly cost.
2. A manufacturer has to supply his customer with 24,000 units of his product per year. This demand is
fixed and known. Since the unit used by the customer is an assembly-line operation and the customer has
no storage space for the units, the manufacturer must ship a day’s supply each day. If the manufacturer
fails to supply the required units, he will lose the account and probably his business. Hence, the cost of
shortage is assumed to be infinite, and, consequently, none will be tolerated. The inventory holding cost
amounts to 0.10 per unit per month, and the set-up cost per run is Rs 350. Find the optimum lot size and
the length of optimum production run.
3. The production of a particular item is instantaneous. The cost of one item is Re 1 per month and the set-
up cost is Rs 25. If the demand is 200 units per month, find the optimum quantity to be produced per set-
up and hence determine the total cost of storage and set-up per month.
4. A certain item costs Rs 235 per tonne. The monthly requirement is 5 tonnes and each time the stock is
replenished there is a set-up cost of Rs 1,000. The cost of carrying inventory has been estimated at 10 per
cent of the value of the stock per year. What is the optimal order quantity?
5. An aircraft company uses rivets at a constant rate of 2,500 per year. Each unit costs Rs 30. The company
personnel estimate that it costs Rs 130 to place an order, and that the carrying cost of inventory is 10 per
cent per year. How frequently should orders be placed? Also determine the optimum size of each order?
Problem: A large automobile manufacturing plant produces multiple models of cars.
The plant operates three shifts a day, each lasting 8 hours. In a given month, the plant
produces 5,000 sedans and 3,000 SUVs. The plant employs 500 workers, with an
average hourly wage of $20. Additionally, the plant uses specialized machinery, which
runs 24/7 and costs $50 per hour to operate. Over the month, the plant consumed
10,000 units of electricity, costing $6,000. Office space and other overhead costs
amount to $30,000 per month. Calculate the total factor productivity of the plant for
the given month.

Solution:

1. Calculate Labor Costs: Total Labor Cost = Number of Workers * Average

Wage * Total Hours Worked Total Labor Cost = 500 workers * $20/hour * (3
shifts/day * 30 days * 8 hours/shift) Total Labor Cost = $500,000
2. Calculate Machinery Costs: Total Machinery Cost = Machinery Cost per Hour
* Total Hours Operated Total Machinery Cost = $50/hour * (3 shifts/day * 30
days * 24 hours/day) Total Machinery Cost = $108,000
3. Calculate Energy Costs: Total Energy Cost = Cost per Unit of Electricity *
Total Units Consumed Total Energy Cost = $6,000
4. Calculate Overhead Costs: Total Overhead Cost = $30,000
5. Calculate Total Input Cost: Total Input Cost = Total Labor Cost + Total
Machinery Cost + Total Energy Cost + Total Overhead Cost Total Input Cost =
$500,000 + $108,000 + $6,000 + $30,000 Total Input Cost = $644,000
6. Calculate Total Output: Total Output = Total Sedans Produced + Total SUVs
Produced Total Output = 5,000 sedans + 3,000 SUVs Total Output = 8,000
7. Calculate Total Factor Productivity: Total Factor Productivity = Total Output
/ Total Input Cost Total Factor Productivity = 8,000 / $644,000 Total Factor
Productivity ≈ 0.0124 cars per dollar

So, the total factor productivity of the automobile manufacturing plant for the given
month is approximately 0.0124 cars per dollar. This metric provides insight into the
plant's efficiency in utilizing its resources to produce cars.