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Managing Your Inventory

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There are various notions about inventory. One school of thought contends that having inventory is inevitable since the costs of not having inventory when customers want them outweigh the costs of carrying them. The other school of thought strongly believes that inventory is the root of all production evils. In other words, the presence of inventory means the firm is hiding behind inventory levels certain production inefficiencies.

This module focuses on the first school of thought. If inventories cannot be totally eliminated and stockless production is an ideal situation, then inventories must at least be managed.

What is inventory?

Inventory by definition refers to the stock of any item or resource used in an organization that can be in the following forms:

•  Raw materials

•  Work-in-process

•  Finished goods

•  Component parts

•  Supplies

Inventories exist to allow companies to meet customer requirements. It also exists normally to smoothen the flow of goods through the production process especially for dependent work centers. Its main reason for existence is the protection against uncertainties of suppliers. The presence of inventory also allows for a realistic and maximum utilization of equipment and manpower.

What are the costs of holding inventory?

There are two cost categories associated with inventory – (1) the cost to carry inventory, and (2) the cost of not carrying inventory.

The cost to carry inventory includes the unit materials cost; the cost of ordering them or reordering them; and the carrying or holding costs.

•  When firms produce as well the materials that they need for production, the reorder cost is being substituted by the cost to set up the machine or perform change over activities.

•  The carrying or holding costs generally include the costs of storage, fire and theft insurance, and warehouse administration.

•  The intangible cost related with carrying inventory is the opportunity loss associated with investments in inventories which could otherwise have been spent for more profitable ventures.

The costs of not carrying inventory primarily relate to the loss of customer goodwill and lost revenues in case shortages or stock outs occur, not to mention the possibility of such incident being relayed to potential customers.

What is inventory management?

Inventory management deals with inventory planning and control. Inventory planning seeks to answer two basic questions:

•  When to Order -This question is related to the concept of the reorder point . This is a system whereby any regularly used material is re-ordered when the inventory drops to a certain level. This level is usually a function of the lead time, daily demand, and safety stock.

•  How Much to Order - The quantity to be ordered is determined through the Economic Order Quantity.

There are two basic inventory planning systems - (1) the f ixed-order quantity model, and (2) fixed-time period model.

The inventory policy of firms employing the Fixed-Order Quantity Model will be to order a standard quantity when the reorder point has been reached regardless of when this occurs. This is event-triggered and depends on the demand for the items. This model is applicable for:

•  More expensive items

•  More important / critical items

The Fixed-Time Period Model is the other inventory planning system where inventory policy is to order materials or parts at a designated time period regardless of whether the reorder point has been reached. This is time-triggered and involves no physical count of inventory items. This is applicable under the following conditions:

•  Less expensive and less critical items

•  Vendors / buyers can get fresh orders if they make regular / routine visits to customers

•  Vendors / buyers will combine orders to reduce ordering and transportation costs

Since the system is time triggered, it must have a larger average inventory to protect against stockout during the review period. 

How can inventories be controlled?

Inventory Control systems are designed to monitor the levels of inventory and to design systems and procedures for effective inventory management. In establishing systems to manage inventory, there are two important decision areas – (1) classification of inventories and (2) accuracy of inventory records.

The inventory control strategies include the following:

•  ABC Analysis – this is a technique that classifies the company's inventories according to three classifications on the basis of annual dollar volume .

The annual dollar volume is computed as follows:

ADV = annual demand of each inventory item x cost per unit

On the basis of the ADV, the inventory items may be classified as follows:



Class A

The ADV is high normally representing about 15% of your total inventory items but account for about 75 – 80% of the total inventory costs.

Class B

The ADV is moderately high representing about 30% of items but 15 – 25% of value.

Class C

The ADV is low representing about 55% of items but only 5% of value.

This classification implies that Class A items should have stricter physical inventory control measures, more accurate forecasting, and should have more supplier involvement.

Cycle Counting

Cycle counting involves a continuing audit of inventory items. This utilizes the classification of inventory items from the ABC analysis. There are three important procedures in cycle counting:

•  Count the inventory items.

•  Verify the records.

•  Document the inaccuracies.

•  Trace the causes of the inaccuracies.

•  Take remedial actions.

The cycle counting is done on a regular but unannounced basis. The frequency of cycle counting depends on the classification of the inventory items, as follows:


Frequency of Cycle Counting

Class A

Once a month

Class B

Once a quarter

Class C

Once every six months

5S Adoption 

The 5S system is a Japanese system on practical housekeeping technique and involves five pillars:

Japanese Word

English Translation




An ACTION to sort the items and classify them as to whether they are needed or unneeded. The unneeded items are discarded, eliminated or disposed while the needed items are managed and stored properly.



An ACTION to put each needed item in their proper location and making sure that it is in good order. This involves the use of labels, signages, storage and record keeping systems to make the storage and retrieval of these items easier.



An ACTION to clean your workplace thoroughly making sure that it is neat and tidy.



A CONDITION where high standard of good housekeeping is maintained so that there is no dust and rust anywhere and that the employees are committed to the first 3S's.



A CONDITION where all members practice the above 4S's spontaneously and willingly as a way of life and has become a company culture.



•  Lee J. Krajewski and Larry P. Ritzman, Chapter Chapter 13 – Inventory Management, Operations Management: Strategy and Analysis , 5 th edition, 1999, pages 543-580.

•  Donald Waters, Chapter 18 – Independent Demand Inventory Items, Operations Management: Producing Goods and Services , 1996, pages 606-642.

•  Richard B. Chase and Nicholas J. Aquilano. Chapter 14 – Inventory Systems for Independent Demand, Production and Operations Management: Manufacturing and Services , 7 th edition, 1995, pages 544-585.


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