CHAPTER 12 INVENTORY MANAGEMENT

1. Importance of Inventory and its Types

Inventory is any stored resource used to satisfy need. Cash in a bank, blood supply in a hospital, water in a reservoir, and

finished products in a warehouse are good examples of inventory. The objective of inventory management is to strike a

balance between inventory investment and customer service.

Inventory is one of the most expensive assets of many companies, representing as much as 50 percent of total invested

capital. The importance of inventory in the economy of the United States can be seen from the following table:

U.S. GDP and Inventories

Types of Inventory:

(1) Raw material inventory: This inventory has been purchased but not processed.

(2) Work-in-process inventory: This inventory includes components or raw materials that have undergone some change but

are not completed. WIP exists because of the time it takes for a product to be made (called cycle time). Reducing cycle

time reduces inventory.

(3) Maintenance/repair/operating supply (MRO) inventory: This inventory is devoted to maintenance/repair/operating

supplies necessary to keep machinery and processes productive. They exist because the need and timing for

maintenance and repair of some equipment are unknown.

(4) Finished-goods inventory: This inventory includes completed product waiting shipment. Finished goods may be

inventoried because future customer demands are unknown.

2. Managing Inventory

In practice, it is not uncommon that an operations manager is in charge of hundreds of different inventory items. ABC

analysis is used to divides on-hand inventory into three classifications according to the annual dollar volume.

oClass A – high annual dollar volume

oClass B – medium annual dollar volume

oClass C – low annual dollar volume

The idea is to establish inventory policies that focus resources on the few critical inventory parts and not the many trivial

ones. It is not realistic to monitor inexpensive items with the same intensity as very expensive items.

Procedure of ABC analysis

2

Step 1: Determine annual usage/sales for each item

Step 2: Determine the percentage of the total usage/sale by item

Step 3: Rank the items from highest to lowest percentage

Step 4: Classify the items into ABC categories

▶ Class A: 15% of item accounts for 70% – 80% of sales.

▶ Class B: 30% of items accounts for 15% – 25% of sales

▶ Class C: 55% of items accounts for 5% of sales

Item

Percent of

Number of

Items Stocked

Annual Volume

(unit)

 Unit Cost = Annual Dollar

Volume

Percent of

Annual Dollar

Volume

Clas

s

#10286 17.5% 1,000 $90.00 $90,000 38.8% 72

%

A

#11526 500 154.00 77,000 33.2% A

#12760

33.9%

1,550 17.00 26,350 11.3% 23

%

B

#10867 350 42.86 15,001 6.4% B

#10500 1,000 12.50 12,500 5.4% B

#12572

48.6%

600 14.17 8,502 3.7%

5%

C

#14075 2,000 .60 1,200 0.5% C

#01036 100 8.50 850 0.4% C

#01307 1,200 0.42 504 0.2% C

#10572 250 0.60 150 0.1% C

8,550 $232,057 100.0%

A graphic representation of ABC analysis can be shown as below:

Other criteria than annual dollar volume may be used

oHigh shortage or holding cost

oAnticipated engineering changes

oDelivery problems

oQuality problems

Policies employed may include

oMore emphasis on supplier development for A items

oTighter physical inventory control for A items

oMore care in forecasting A items

Example 12.1: Omega Corporation is a small manufacturer of computer connectors in

Raleigh, North Carolina. The materials which go into a connector are summarized

below:

Material Annual usage Unit cost ($)

A-2 3,870 0.25

3

B-7 1,550 0.66

C-1 990 7.01

D-9 2,150 12.30

E-4 775 8.90

F-6 7,000 0.13

G-5 1,285 5.74

H-3 1,900 15.06

Perform an ABC analysis on the eight inventory items carried by LLB.

[Solution]

Step 1: calculate the annual dollar volume

Step 2, 3 & 4: Determine the percentage, Rank the items from highest to lowest percentage & Classify the items into ABC