2.1 WHAT IS INVENTORY?
Inventory is a total list of all materials and items held by a business during the ordinary cause of business (Accounting Explained, 2013). It includes work in progress, raw materials and production output that is held by the business. Inventory is also referred to as stock. In inventory management, Inventory Turnover Ratio (ITR) is the measure of how the stock performs in terms of procurement and sale of finished products.
Inventory needs to be regulated. This is because inventory is a necessity and its availability or unavailability determines the rate of production of a firm in order to meet the anticipated demand. This means that unavailability of stock causes delays in production and its availability translates towards the quick production of goods and services. However, keeping inventory incurs expenses to the organization due to holding and carrying charges. This makes inventory a necessity that is not desirable to the firm and thus requires to be regulated. According to Vrat (2014), most people have come to agree that stock is a necessary evil.
2.2 TYPES OF INVENTORIES
There are several types of inventories classified according to their nature and purpose. They are as follows:
Raw materials inventory; these are the materials that a firm makes use to produce its final product. They have to undergo a cycle in order for them to become ready and offered to consumers.
Work-in-progress inventory (WIP); all the materials that have already started to be processed but are yet to be complete and usable by the consumers. They are products that are unfinished.
Finished goods inventory; these are the goods that are ready to be sold to the consumers. In other words, they are ready for use by the customers but have not yet been sold.
Maintenance, operating and repairs (MRO) supplies; these are inventories that are used to suffice the existing stock. They include spare parts and materials used to help in repairs.
Bought-out-parts; they are the inventories that go directly to the assembling of materials as they are (Vrat, 2014)
2.3 WHY INVENTORY IS IMPORTANT
It is crucial to hold inventory in a firm during the normal cause of business. The aim of this is to have better performance of the firm. The following are the reasons:
First, to reduce downtime of the firm when there is need to replenish the existing stock. A firm aim at reducing the lead time by holding onto stock in order to have it ready when it is needed. Taking time to acquire new stock from the source may take important time from the firm and lower the production.
Dealing with uncertainty: An organization needs to maintain a constant supply of inventory to deal with uncertainty in demand. There needs to be a minimal lead time in the production process so as to cater for the needs of the consumers. Most firms hold inventory for "just in case (JIC)" scenario, to deal with uncertain demand.
Seasonal demand inventory is a case where a firm holds onto stock during the lean period. This inventory is used to cater for the rise in demand during the peak. This mostly happens in a seasonal demand environment. Other factors that cause a company to hold inventory are inflation cases, anticipated raw materials shortage and for demand variability in the industry.
2.4 JUST-IN-TIME ESSENTIALS
Also known as zero-inventory. JIT is the scenario where a firm does not hold on to any idle stock. This is commonly used in a market where the suppliers are reliable and ready to supply. This is a very efficient method of inventory management but only in a case of reliability on the vendors. The markets that have mostly relied on this method are Japan and India.
2.6 INVENTORY PROBLEM
Inventory problem is a case in inventory management decision making on (a.) how much stock to buy (b.) and when to buy this stock (Vrat, 2014) (the period to buy). For us to solve this and arrive into an optimal decision, we need to come up with a scientific method that has both decision variables and objective functions. The following are costs associated with inventory:
Carrying costs or holding costs; holding costs are the costs incurred for possessing the inventory. They include (but not limited to) storage rent and insurance paid for the stock. Carrying costs on the other hand are the costs incurred in the procurement process including transportation, communication charges et cetera. . Holding costs are usually directly proportionate to the size of the order at hand. Ordering Costs; these are costs incurred during the procurement process mostly paperwork. Cost of shortage or stock out are costs associated with increased demand and limited stock. The loss is usually depicted on decreased sales of the firms products.
2.8 INVENTORY MODEL
These are the scientific models that have been developed with the aim of solving the inventory problem. As we have seen above, the inventory problem is the decision building process of when and what amount of stock to procure. We need a model that combines these decision variables with situational parameters. This means that we include the three types of costs described above as C1, C2 and C3 and two of these costs are kept under control and solved.
2.9 INVENTORY POLICIES
EOQ being an inventory policy it helps us implement an inventory model. An inventory model is a method that tries to represent an inventory problem in order to reach decision making on the two forms above. Like other inventory policies, EOQ ends up giving an inventory graph as a time function. The graph depicts how the inventory status changes with time and when to procure.
ECONOMIC ORDER QUANTITY (EOQ)-REORDER POINT (ROP) POLICY
Here, EOQ (Q) and ROP (R) are used as decision variables to determine on when and how much to purchase. Inventory is continuously monitored and whenever it falls to a certain predetermined level (ROP) a replenishment order (EOQ) is placed. (See the graph below)
In this graph, when the inventory falls below ROP, EOQ is placed. Q represents the Order Quantity.
Monitoring of this model can be done by computerized inventory control or the traditional manual continuous checkup. The computerized system is easy and has few cost overheads compared to the manual two-bin method.
THE EOQ FORMULA AND ASSUMPTIONS
There are three assumptions associated with the calculation of EOQ as stated below:
Planned shortages are negligent
A known constant demand rate per unit is existent
Quantity order (Q) to replenish the stock arrives when it is desired and all at once when the inventory level drops to ROP
These assumptions are used in the EOQ formula below;
EOQ=2(annual number used in units)*(order cost)/(annual carrying cost per unit) which is further deducted as below:
Q*= Optimal order quantity
Q= Order quantity
D= Annual demand quantity
K= per order fixed cost
h= Holding cost per unit (annual)
The annual usage is usually the forecasted amount. Order cost is translated as the amount needed in order for the placement of an order and this includes all the costs associated with it. The procurement usually occurs at an optimal point A as in the graph below since carrying costs increase as costs rise.
INVENTORY MONITORING APPROACHES
Choi (et al, 2013) states that there are three methods of monitoring inventory using EOQ. These are stated as follows:
Fixed Quantity: In this approach, a constant size is placed with an allowance of varying time between the placements of orders. When an inventory level falls to the reorder point level, a replenishment is placed. This method causes total control due to its vigorous monitoring of the inventory that is usually required.
Fixed period system: This method maintains a fixed time between placement of orders. However, the sizes of the orders could vary. Unlike the fixed quantity method, it does not require thorough scrutiny since there are specified periods to place the orders. In a case of high demand that is not expected, the inventory is depleted and it has to wait for the review time to re-stock. This means that the amount ordered after depletion will be higher than usual.
The Hybrid EOQ system: This system allows for variation between both the order size and the time for placement. It allows an order to be placed only if the size of the order sufficiently justifies its placement.
M. Viliathal, R. Uthayakumar (2011), A New Study of an EOQ Model for Deteriorating Items Shortages under Inflation and Time Discounting (Vol. 2), retrieved on 22nd December 2017 from https://www.slideshare.net/DivyeshSolanki4/a-new-study-of-an-eoq-model
S. Agarwal (2014), Economic Order Quantity Model: A Review (Journal), retrieved on 22nd December 2017 from https://www.researchgate.net/publication/270895433_ECONOMIC_ORDER_QUANTITY_MODEL_A_REVIEWT. Choi et al (2013), Handbook of EOQ Inventory Problems, (Vol. 1) pgs. 6-40
Vrat, P. (2014), Materials Management: An Integrated Approach, (Ch. 2, pgs. 21-36)
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