Inventory is working capital and therefore the control of inventories is an important aspect of operations management. The basic questions in the management of inventory are:
1. How much inventory to keep; and
Before getting at a mathematical treatment of the above question, let us understand the function of inventory.
1. There are inventories for normal consumption requirements. Therefore, depending upon the average consumption rates and average lead times for procurement/manufacture of the material, inventories are kept at the appropriate times.
2. A production process, however continuous it may be, is bound to have some interruptions; it may also have imbalances in the consumption and production rates of the materials at different stages. These interruptions and imbalances make it necessary to keep stocks of inventory between the different stages of the operations.
Inventory is needed for the definite consumption demand of materials, and to take care of the uncertainly involved in the usage or availability of the materials. The latter aspect is sometimes considered as the decoupling function of the inventory. It means that the various dependent operational stages in any production/operations process can act independent of each other to some extent, if an inventory of materials is maintained at the different stages of production. The inventory ensures that one stage of production does not suffer because of the non-functioning or malfunctioning of the previous stage of production over which the former is dependent. The inventory taking care of the first aspect of normal consumption is called the normal inventory and the inventory taking care of the second aspect of uncertainty is called the safety stock or buffer stock of inventory.
There are various other categories of inventories mentioned in the literature such as the ‘anticipation inventory’, ‘transit inventory’ or the ‘pipeline inventory’. But these are basically modified versions of the concepts described above.
To answer, the ‘how much’ and ‘when’ questions of inventory, let us first concentrate on the normal inventory. As this inventory corresponds to the normal consumption rates of the material, we should procure the inventory as and when it is required for production. Let us examine whether procuring a material as and when it is required requires the incorporation of other cost economies. Therefore we shall consider the relevant costs associated with the normal inventory keeping.
The relevant costs for the ‘how much’ and ‘when’ decisions of normal inventory keeping are:
Cost of Capital: Since inventory is equivalent to locked-up working capital, the cost of capital is an important relevant cost. This is opportunity cost of investing in inventory. Of course, as mentioned, a form cannot always take the spot opportunity cost as the cost of capital. Similarly it cannot take the interest paid on the borrowed working capital as the cost of capital. The cost of capital has to be arrived at by giving suitable weightages to the different considerations about the use and procurement of the funds.
Space Cost: Inventory keeping space and therefore, the ‘how much’ and ‘when’ questions of inventory keeping are related to the space requirements. This cost may be the rent paid for the space.
Material handling Costs: The inventory needs to be moved within the warehouse and the factory, and costs associated with the internal movement of the inventory are included in this category.
Obsolescence, Spoilage or Deterioration Cost: If inventory is procured in a large quantity, there is always a risk of the item becoming obsolete due to a change in product design, or the item getting spoilt because of the natural ageing process. The latter is particularly true of many sensitive chemicals and drugs which have limited shelf-life. Such costs have, definitely a relation to basic questions of ‘how much’ and ‘when’.
Insurance Costs: There is always a risk of fire, theft or pilferage of materials. These costs should, therefore be estimated. A firm might have taken insurance against such mishaps and the insurance premiums paid are relevant costs for our decision.
Costs of general Administration: Inventory keeping will involve the use of various staff. With large inventories, the costs of general administration might go up.
Inventory Procurement Cost: In addition to the general administration, whenever an order for procurement is to be placed to an external agency supplying the materials, there is a cost associated with activities such as tendering, evaluation of bids, placing purchase order, follow up of the purchase order, receipt and inspection of materials etc. Every time a purchase order is placed, these costs are incurred as against general administration costs which are incurred for the entire materials procurement activity.