Introduction To Inventory


In today’s competitive world the major task of business organizations or industrial enterprises is to increase the productivity with the limited capital resources. It has been found that material account for nearly two third of the total cost of production.  Therefore for a balanced growth and an efficient running of an enterprise it is necessary that the material costs, material supply and utilization are so controlled that they lead to maximization of production, reduction in the cost of production and distribution leading to maximization of margin of profits.

The firms’ intent upon earning profits has three major objectives:

  1. Maximum customer service.
  2. Minimum inventory investment.
  3. Efficient plant operation.

These objectives are basically in conflict with each other. Maximum customer service can be provided only if inventories are raised to a high level and the plant is kept flexible by frequently altering the production levels and varying production schedules to meet the customers changing demand. The second and third objective suffers in meeting with the first. For achieving maximum plant efficiency large inventories have to be kept. Inventory control is therefore of prime importance for efficient and profitable business operation.

Materials Management in general and inventory control in particular are of great importance to the manufacturing industry because materials are vital input to the production system. Since materials in general contribute more than 50% to the cost of production, their availability in right quantity and quality at proper time at a reasonable cost (procurement as well as storage) require a careful and specific attention furthermore there has to be an organized and efficient way of storage, unkeep issues and utilization of the material resource. In the context inventory control assumes a great importance.

In the beginning inventory control was an intuitive process based on experience and judgment but later it developed into a more scientific activity, particularly since the start of 20th century. The concepts of selective inventory control, economic lot sizes and the EOQ came into being. Techniques were then developed with overall production schedule in background resulting in the concept of aggregate inventory management. However these techniques could not cope with the dynamic nature of inventory management in the context of modern manufacturing environment.

These techniques had to work without proper means of huge inventory data processing and were based on some short cut approximation methods with assumptions, which were not appropriate in real life situations in manufacturing industry. But with the availability of computer capable of handling information in large volumes at high speed the individual manufacturing inventory items requirement can now be pin pointed in terms of both quantity and timing.

As such the traditional inventory control techniques have been rendered obsolete in dynamic manufacturing environments. New techniques like ‘Material Requirement Planning’ and ‘ Just in Time’ inventory control have emerged as more appropriate and effective. JIT techniques are a recent development, which originated in and is widely applied in Japan. It still in trial or investigation stage in other countries. Material Requirement Planning called MRP in short is the inventory control technique, which is widely used in almost all industrial advanced countries.

Present study reviews various inventory control techniques in an engineering industry,  which is manufacturing transformers. MRP, which is based on Master Production Schedule and implemented with the help of EDP on computer, has been found to be quite successful in present day manufacturing environment and is highly systematic. It saves a good amount of time, money and space as well as operational difficulties. In this work it is endeavored to develop a comprehensive set of recommendations duly supported by appropriate PPC information/data for implementing MRP.

Relevant production data and information on store, purchase and inventory control has been collected and processed to work out a requisite frame work for developing and needed MRP system which, with suitable modification and alternative/additional data can be extended to other sections of production system also. Inventory serves many functions. People associated with each function would prefer an inventory policy that first satisfied their pet function. Efficient Inventory Management is therefore the one, which develops policies for keeping inventory at the optimum level so that need of each function is satisfied and the inventory cost is minimized.



The dictionary meaning of inventory is ‘stock of goods’. An inventory may be defined as a stock of goods or services, which are held for the purpose of future production or sale. The goods or services may be a consumptive or non-consumptive type. Inventories form an alternative to the production or purchase in future. Thus inventory on one side is stock of goods and services but on the other hand it is locked capital.

Inventory serves as a cushion between the production and consumption of goods necessitated by the technological demands of production and transportation and customer needs. Inventories can be categorized into several types. These are generally classified as Raw Material and Supplies Inventories, Production Inventories, and MRO Inventories, In Process Inventories, Finished Inventories, Material in transit inventory and Dealer stock.




Inventories are generally justifiable and there are obvious economic reasons for their existence. Since there are several costs associated with the inventories, an effective inventory management boils down essentially to setting a balance between the opposing cost factors. Inventory control means controlling the inventories in the organization. It is a technique of maintaining stock items at desired levels, whether they may be a raw material, goods in process or finished products.



The primary objectives of inventory control are:

  1. To minimize idle time caused by shortage of raw materials, spares etc.
  2. To keep down capital investment in inventories, inventory carrying costs and obsolescence losses.

The two objectives are in conflict with each other and the efficiency of inventory management lies in balancing them to arrive at optimum overall results.



Following are the main benefits of inventory control:

  1. Ensures adequate supply of materials to Production.
  2. Minimizes stock outs and shortages.
  3. Ensures economy in purchase.
  4. Reduces the possibility of excess items being stocked. Thus saving capital from being unnecessarily locked up.
  5. Eliminates duplication in ordering.
  6. Keeps inventory carrying costs at lowest level.
  7. Permits better utilization of available stock.
  8. Provides a check against losses of material through pilferage, spoilage etc
  9. Facilitates proper accounting of material.
  10. Locates and disposes inactive or obsolete items of store.
  11. Enables the management to make cost and consumption comparisons between operation and periods.
  12. Perpetual inventory values provide a reliable basis for preparing financial statements.
  13. Simplifies procedures for paper work and record keeping.
  14. Increase profitability.



There are both internal and external factors, which influence decisions on inventory in an organization. The external factors arise from market conditions, credit availability and government regulations. Market conditions can be viewed from two angles. Firstly there is the dynamic nature of prices and availability. To combat this we adopt efficient forecasting and planning techniques. Secondly there is the finite time lag between the placing of an order and obtaining the materials, known as lead-time, which is defined as the period that elapses between recognition of a need and its fulfillment. Inventory level increases with increase in lead-time. It is comprised of administrative lead-time, manufacturing lead-time, transporting lead-time and inspection lead-time.

Generally there is variation in demand rate and lead-time. In order to compensate for uncertainties in either lead-time or demand rate, additional stocks may be carried to reduce the risk of stock out during the lead-time interval. This additional stock is known as safety stock or buffer stock, which is held in excess of expected demand. There is direct relationship between safety stock and service level.



The problem of balancing the costs of less than adequate inventories versus more than adequate inventories is a complex one due to numerous costs involved. The major tangible costs associated with inventories are ordering costs or set up costs, carrying costs, purchase cost, understock costs and overstocking cost.


The various costs associated with the stock can be classified into following groups:


Inventory carrying costs represent the expenses of holding the stocks of goods. These include opportunity costs of funds invested in inventories, insurance, taxes, storage and cost of deterioration and obsolescence. These carry cost move in that proportion to the size of inventory.


These costs are in the form of procurement expenses which are incurred as and when we have to place purchase order. These include costs incurred in the following activities: requisitioning, purchase ordering, transporting, receiving, inspecting, and storing.

The ordering cost increase in proportion to the number of order placed.


These costs arise when there is equal to the storage in production facilities. It may be in the shape of lost sales or lost good will.



In inventory control, basic thing is that the controller should be able to identify the various items of inventory in an unambiguous manner. Codification is the strategy adopted to achieve this. Codes can be made of letters or numerals or both. Numbers of digits usually range from seven to fourteen. The digits are split into group of the digits signify classification based on material, type of product and availability.

There are seven type of codification system in use at present. Some important ones are:

  1. Alphabetical systems
  2. Mnemonic systems
  3. Visual coding systems
  4. Numerical system
  5. Decimal system
  6. Alfa Numerical system
  7. Kodak systems



To optimize the number of stock items and to reduce inventory, standardization and simplification measures are essential. Uniform standards for similar items are adopted. Unnecessary variety is reduced, most economical sizes; grades, shapes, colors and parts are standardized. Indian standard codes can be referred to for this purpose.


In the beginning inventory control was an intuitive process but later it developed into a more scientific ones, particularly since the start of 20th century. The concept of economic lot size and EOQ came into use. Then came the concept of aggregate inventory management to control the overall inventory level, in consonance with production schedules. The following techniques are categorized under traditional method of inventory control.

  1. Selective Inventory control technique
  2. Mathematical Models for inventory control.
  3. Aggregate Inventory Management.



The selective inventory control techniques classify the stock items on the basis of their consumption value, criticality, availability and cost. Highly critical components or high consumption value items are put under higher degree of control. Lesser control is exercised over majority of items, which have low consumption value and are not critical. The selective inventory control techniques are useful for multi item inventories. They help the manager to effectively apply his energy to problem areas, thus resulting in optimal use of efforts. Following are some of the selective inventory control techniques currently in use.


S. No.




ABC Classification

Annual Consumption Value

Purchase Management, Inspection, Stores management, Inventory control, Traffic and material handling

HML classification

(high, medium, low)

Unit Price of Material

To control Purchase

XYZ classification

Value of Items in Storage

To review inventories and their use

VED classification

(Vital, Essential, Desirable)

Criticality of the items

Inventory control of spare parts

FSN classification

(Fast, Slow, Non moving)

Consumption Pattern of items

To control obsolescence and to determine stock level of consumption.


Of the above classification methods ABC classification is the most important and is widely used. The items are classified on the basis of annual consumption value. 10% of the items contributing about 70% value of consumption are called A items. 20 % of items contributing about 20% of consumption values are called B class items and remaining 70% items contributing remaining 10 % value are called C class items. Careful attention is paid to the control of A items, Control on B items is moderate and control on C items is comparatively relaxed.


The solution of inventory problem with mathematical models is to find appropriate levels of holding inventory, ordering sequence and the quantities that have to be ordered so that the total cost incurred is minimized. The demand and supply conditions that act within and without impose constraints on the decision-making process. The demand can be fully known, partially known or completely unknown. These three situations are termed as demand being certain, demand being risky and demand being uncertain respectively. On supply side there are two distinct possibilities:

  1. The supply being static if only a single supply is possible during the entire consumption period.
  2. Supply being dynamic if more than one supply can be obtained during the consumption period.

These states of nature of demand and supply conditions can be combined to form six different practical situations, namely:

    1. Supply station-demand certain
    2. Supply station-demand risky
    3. Supply station-demand uncertain
    4. Supply dynamic-demand certain
    5. Supply dynamic-demand risky
    6. Supply dynamic-demand uncertain



With supply station only a single supply is possible during entire consumption period. Obtaining Newspapers to be sold in particular time, ice cream for one-day fair, purchase of high fashion items. Replacement orders are either not possible or extremely expensive. For demand certain situation simply order has to be placed taking lead-time and shelf life into consideration. For demand risky situation, the level of risk can be expressed in terms of probability distribution based on past expressed in terms of probability distribution based on past experience. For demand uncertain situation decision-maker has to use subjective probabilities and improve the solution based on past experience. Static inventory models although practical and of interest are not widely applicable as dynamic models.


Economic Ordering Quantities:

Important assumptions in EOQ models are listed below:

  1. Demand and lead-time are known and constant.
  2. Replenishment is instantaneous at the expiry of the lead-time.
  3. Item cost doesn’t vary quantity order i.e. there are no quantity discounts.
  4. Ordering and carrying cost expressions include all relevant costs and these are constants.
  5. Uniform demand in small increments.

Many mathematical models for inventory control were developed by researchers. Mathematical models based on concept of EOQ techniques provide the total minimum inventory cost by balancing inventory carrying and ordering costs. Total cost of stocking inventory is the sum of purchase costs, cost of ordering and cost of carrying inventory i.e.

T.C. = CoD/Q + Cc Q/2 + PD

Where, T.C. = Total cost

Co = Ordering cost

D = Demand in units on annual basis

Cc = Cost to carry a unit inventory in stock for a given period.

P = Unit purchase cost.

Q= Lot size and Q/2 is average inventory.

Differentiating the total cost with reference to Q gives the slope of T.C. curve. Setting the first derivative equal to zero, identifies the point where T.C. is minimum. Thus Qo = sqrt 2CoD/Cc is obtained. This is known as economic ordering quantity equation. It is often referred to as Wilson Formulas. It is classical mathematical inventory model. Some simple extensions of the classical model are in use after relaxing some assumptions. The following are the general models in use.



Here the basic equation is transformed as under:

Qo = sqrt (2 CoD/Cc) * sqrt (Cc+Cs)/Cs

Cs is the shortage cost.


In this the basic equation becomes

Qo = sqrt (2CoD/KCc)

K is unit cost.


ERL = sqrt(2CoD/Cc(1-d/p))

Where ERL is economic run length,

P is production per day and d is demand per day.

Ratio 1-d/p represents that portion of production, which goes into inventory.



In simple inventory management models both demand and supply lead times have been assumed constant. But variability in demand and supply lead-time is a reality. The effect of demand and supply lead time variation is taken care of by carrying larger inventories called buffer stocks or safety stock.

EOQ models answer the question of how to order but these don’t address the question of when to order. The later is the function of the reorders point models, which identify the reorders, point (ROP) in terms of quantity. The reorder point occurs when the quantity on hand drops to pre-specified amount. That amount generally includes expected demand during lead-time and an extra cushion of stock, which serves to reduce the probability of experiencing a stock out during lead-time. There are four determinants of the reorder point quantity:

  1. The rate of demand.
  2. The length of lead-time.
  3. The extent of demand and lead-time variability.
  4. The degree of stock out risk acceptable to the management.

According to above determinants the reorder models have been worked out.


When both demand and lead-time are constant than there is no risk of a stock out created by increased demand and lead-time longer than expected. In such case ROP is equal to the product of usage rate and lead-time.


Under normal circumstances one or other or both demand rate and lead-time tend to exhibit some variability. In order to compensate for uncertainties, in either demand rate or lead-time, additional stocks are carried to reduce the risk of a stock out during lead-time interval. This additional stock is known as buffer stock or safety stock.

ROP = Expected demand during lead-time + Safety stock.

Because it costs money to hold a safety stock, Manager must weigh the cost of carrying safety stock against the reduction in safety out risk. The service level increases as the risk of stock out decreases. So the safety stock is kept by keeping in mind the service level. The amount of safety stock will depend on the following factors:

  • Average demand rate and average lead-time.
  • Demand and lead time variability.
  • The desired service level.


With inventory models attempts have been made to isolate variable and parameter to understand the behavior of inventories under a wide variety of condition and various degrees of models completely. Managerial inventory system attempt to apply models in operating situation in a practical way to deal with the total inventory control problem. The following are the common inventory systems.


Here fixed quantity is ordered when the ordered point is reached.


Inventory is reviewed periodically and the variable quantity order is issued so that quantity on hand and quantity on order go up to a specified level.


Stock levels are periodically reviewed but orders are placed only when inventories fall to a predetermined level.



Almost every traditional technique discussed earlier deals with one item. For taking important decisions management should know about the total system rather than individual items. The need for giving aggregate evaluation of inventory to the management was therefore felt.

Aggregate inventory is a concept and set of techniques used for manipulating and controlling the inventories in toto. The overall inventory investment level becomes subject to direct management control through certain policy variables such as carrying costs and services level. Under conventional approach to aggregate inventory management, the two inventory categories most susceptible to control by means of varying a policy variable is lot size inventory and safety stock.



The standard EOQ equation is EOQ = sqrt ( 2CoD/Cc)

Shows the total lot size of inventory can be increased if lower value of carrying cost is used and reduced if larger value is employed. In aggregate lot size inventory, carrying cost is considered a management policy variable to control the cycle stock of lot size inventory.



It is a technique developed for handling EOQ’s in a aggregate and dealing with the problem of constraint of EOQ equation. It provides a means to calculate directly the proper lot size for a family of items to meet some constraints. It is a two-phase technique. In the first phase trial economic lot sizes are calculated for each item in the chosen group using standard EOQ equation and using reasonable inventory carrying cost. The total set up hours required for these EOQ ‘s are then compared with total set up hours required for present lot sizes. Then limit order quantities are calculated with the help of formulas A & B

Limit formula A = Ccb = Cca = ( Hb/ha)2

Limit formula B = M = Ha/Hb

Where Hb  = Total set up hours for present quantities.

Ha  = Total set up hours for trial order quantities.

Cca  = Inventory carrying cost for trial order quantities.

Ccb  = Inventory carrying cost used for limit order quantities.

The result is usually to reduce the total inventory very substantially with no change in set up hours (operating conditions). In the second phase a series of alternatives are presented for the family of items, showing the effect of lot size inventory when more orders are placed or more time is spent on setting up machines. The number of alternative is varied to suit any desired condition.



The better-desired service to the customer, the higher the finished good inventory must be kept in a business. A balance has to be a struck between customer service and inventory investment. The reserve stock required for each service level is calculated from annual forecast figures, order quantity, means absolute deviation and unit cost of item. A curve is then plotted showing reserve stock inventory required for various levels of services. The curve shows the rapid increase in reserve stock as the required level of customer service is increased. Using such a curve, a reasonable level of customer service can be selected and required reserve stock can be determined to attain that service level.

The service ratio corresponding to point selected is then used to calculate reserve stocks for each item in the family. The service versus investment curve for a group of items is then drawn and the inventory investment required for entire product line is shown in relation to the customer service. Using these curves the management can see the service versus investment alternatives that are available and they can determine the reasonable level of inventory.



Due to heavy information processing constraint, the conventional methods of inventory control suffered from imperfection. These represented the best that could be done under the circumstances. Some unrealistic assumptions, short cut approximations were made to make these techniques workable. With the availability of computer capable of handling information in volumes at a very high speed, this constraint has been removed. With the help of computer the need of individual manufacturing inventory item can be pin pointed in terms of both quantity and timing. All the old techniques, which were based on short cut approximation method, can no longer deliver goods. The relevance and applicability of the conventional inventory management concepts to manufacturing inventory is discussed below:

  1. The concept of stock replenishment doesn’t fit into manufacturing inventory. It is in conflict with basic management objectives of low inventory and high return on investment. Stock replenishment systems are based on the principle of having inventory items in stock at all the time so as to make them a valuable at the time of need. It is intended to compensate for the inability to determine the precise quantity and time of need in the short-term future. But in manufacturing, the inventory item should be available at the time of need rather than to carry it just so that it would be available when and if needed. Through the use of computer aided modern methods it is possible to pin point the quantity and timing of need of an item. So the stock replenishment techniques are not suitable in a manufacturing environment now a day.
  2. Reorder point techniques forecast demand during replenishment lead-time and attempt to provide some safety stock to compensate for fluctuation in demand. These techniques are not able to determine specific timing of future demand environment and misinterpret the observed demand behavior. These techniques result in unnecessarily high overall inventory level and inventory imbalance.
  3. Since EOQ is determined solely on the basis of ordering cost, unit cost, carrying cost, and annual usage it is totally insensitive to the timing of actual, discrete demand arising during the period, that the EOQ is intended to cover. After precisely determining and positioning future requirements for an inventory item along a time axis, it can be seen that EOQ calculations do not balance the quantity and timing of actual requirements. Let us take a demand for ten week period as



The EOQ of this item may turn out to be 50. It will be more than for first 3-week requirement but is less than 9th week requirement. 10 pieces are to carry unnecessarily for six weeks without meeting the 9th week demand. EOQ would be still 50 if the ten-week demand is altered as under:

20-0-40-0-0-0-0-0-0-0   OR   20-0-0-0-0-0-0-0-0-40

In the first case it doesn’t meet first three weeks requirement and in the second case 30 items are unnecessarily carried for nine weeks that too without meeting the requirement of tenth weeks.

The derivation of EOQ formula is based on the assumption of gradual inventory depletion at a steady rate which allows carrying cost to calculate for an average inventory of one half of the ordering quantity. In manufacturing environment this assumption is highly unrealistic.

Inventory control problem in EO models have been assumed as basically mathematical problem. But in actual practice it is a problem of massive data processing. With the invent of computer data processing has become easy.

  1. Safety stock serves to compensate for fluctuations in demand. In stock replenishment systems safety stock is calculated on every inventory item and the sum of safety stock for all items represent a good portion of inventory. But in material requirement planning systems safety stock is not calculated on individual items, as their demand is certain it is only calculated for end items whose demand can show variability.
  2. For order point system future demand is forecast based on past history of demand. These forecasts are used to replenish the stock levels. These forecasts are generally erroneous. In MRP system, past demand for component is irrelevant. The ordering philosophy is based on actual requirements generated from master production schedule.


Statistical forecasting where order point depends on addresses only the problem of individual item demand magnitude but for the purpose of manufacturing, component inventory represents matched sets. When components are forecast and ordered, independently of each other their inventories will tend not to match assembly requirements and cumulative service level will significantly lower then the service level of parts taken individually. This is a group of components at needed at one time for making an assembly.



Material Requirement Planning and Just in Time techniques have taken care of most of the drawbacks, which were being experienced with traditional inventory control techniques for managing inventories in manufacturing environments. These techniques termed as modern inventory control techniques are primarily meant for manufacturing environment. JIT philosophy is of recent origin and is being widely applied in Japan. Under these techniques component parts are manufactured only when required by down steam work center, thus right amount of parts are made at the right time and the inventory is kept to virtually near zero. JIT techniques are being considered and tried in other industrialized countries too now.

The success of JIT techniques in Japan is due to unique physical and philosophical characteristics typical of Japanese production system/culture. These include the ability to virtually freeze master production schedules, to cross train the highly skilled and very disciplined Japanese workers, to utilize high degree of automation and robotics and to profit from close proximity and reliability of material and parts suppliers.

These characteristics enable Japanese firms to reduce system variability to the extent that demand can be estimated very accurately and production parameters such as machine processing times and utilization approach very stable levels. These factors are not exhibited in manufacturing systems in other countries. JIT techniques are at trial stage in industrially advanced countries and have not found their way in developing countries, as yet. MRP items are widely used for controlling manufacturing inventories in industrially advanced countries.



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