Inventory Management: Types, Costs, Models & Control Systems

What is Inventory?

Inventory refers to raw materials, work-in-progress (WIP), finished goods, and supplies held by an organization to support production, sales, or operations. It acts as a buffer between supply and demand, ensuring smooth business operations.

Why is Inventory Important?

• Prevents stockouts (running out of goods).
• Reduces production delays (e.g., Daraz’s warehouse stock ensures fast order fulfillment).
• Balances supply and demand (e.g., NTC manages spare parts inventory for telecom networks).
• Supports just-in-case (JIC) and just-in-time (JIT) strategies (e.g., Toyota’s lean inventory system).

Types of Inventory

Inventory is classified based on function, stage of production, and usage. Below is a comparison table:

Inventory Costs: The Trade-off Triangle

Managing inventory involves three key costs that must be balanced:

graph TD
    A["Total Inventory Cost"] --> B["Holding/Carrying Cost"]
    A --> C["Ordering/Setup Cost"]
    A --> D["Stockout/Shortage Cost"]
    B --> B1["Storage cost (warehouse rent)"]
    B --> B2["Insurance & taxes"]
    B --> B3["Obsolescence (expired/spoiled goods)"]
    B --> B4["Capital cost (opportunity cost of tied-up money)"]
    C --> C1["Order placement cost (labor, phone calls)"]
    C --> C2["Setup cost (machine adjustments for production)"]
    D --> D1["Lost sales (customer dissatisfaction)"]
    D --> D2["Production delays (e.g., Daraz order cancellation)"]
    D --> D3["Rush ordering (higher transport costs)"]

Worked Example: Nabil Bank’s Loan Processing Inventory

Nabil Bank holds application forms, customer data, and loan documents as inventory. If they overstock forms, they incur holding costs (storage, waste). If they understock, they face stockout costs (lost business, delays).

• Holding Cost (50% of inventory value/year):
  • If 10,000 forms cost ₹50 each → ₹500,000 inventory value.
  • Annual holding cost = ₹250,000 (50%).
• Ordering Cost (₹500 per order):
  • If they order 5 times a year → ₹2,500.
• Stockout Cost (₹100 per missed loan due to no forms):
  • If 200 loans are lost → ₹20,000.

Total Cost = ₹250,000 (holding) + ₹2,500 (ordering) + ₹20,000 (stockout) = ₹272,500. Nabil Bank must find the optimal order quantity to minimize this total cost.

ABC Inventory Classification

Not all items require the same level of control. The ABC analysis categorizes inventory into three groups based on annual consumption value:

pie
    title ABC Inventory Classification
    "A Items (15% items, 70% value)" : 70
    "B Items (30% items, 20% value)" : 20
    "C Items (55% items, 10% value)" : 10

Why ABC Analysis Matters:

• Daraz focuses on A items (e.g., smartphones) with daily stock checks.
• C items (e.g., tape, labels) are ordered in bulk every 6 months.

Inventory Control Systems

Two main approaches exist: Periodic and Perpetual.

1. Periodic Inventory System

• How it works: Stock is reviewed at fixed intervals (e.g., monthly).
• Pros:
  • Simple to implement.
  • Lower record-keeping costs.
• Cons:
  • Risk of stockouts between reviews.
  • Less accurate demand tracking.
• Example: NTC checks its spare parts inventory every quarter.

flowchart TD
    A["Start"] --> B["Review Inventory (e.g., monthly)"]
    B --> C["Check if Stock ≤ Reorder Level"]
    C -->|"Yes"| D["Place Order"]
    C -->|"No"| E["Continue Operations"]
    D --> F["Receive New Stock"]
    F --> B

2. Perpetual Inventory System

• How it works: Real-time tracking using barcodes, RFID, or ERP software (e.g., SAP, Odoo).
• Pros:
  • Immediate stock visibility (e.g., Daraz’s warehouse uses RFID tags).
  • Reduces stockouts and overstocking.
• Cons:
  • Higher initial cost (technology, training).
  • Requires accurate data entry.
• Example: Khalti tracks digital wallet transactions in real-time to manage "inventory" of available funds.

flowchart TD
    A["Start"] --> B["Scan/Record Sale (Barcode/RFID)"]
    B --> C["Update Inventory Database"]
    C --> D["Check if Stock ≤ Reorder Point"]
    D -->|"Yes"| E["Auto-Generate PO"]
    D -->|"No"| F["Continue"]
    E --> G["Supplier Delivers"]
    G --> B

Quantitative Inventory Models

1. Economic Order Quantity (EOQ) Model

The EOQ model determines the optimal order quantity that minimizes total inventory costs (holding + ordering).

Formula: $$EOQ=\sqrt{\frac{2DS}{H}}$$

• $D$ = Annual demand (units)
• $S$ = Ordering cost per order
• $H$ = Holding cost per unit per year

Worked Example: Himalayan Java’s Coffee Beans

• Annual demand (D) = 10,000 kg
• Ordering cost (S) = ₹500 per order
• Holding cost (H) = 20% of ₹100/kg = ₹20/kg/year

$$EOQ=\sqrt{\frac{2\times 10,000\times 500}{20}}=\sqrt{5,000,000}=2,236\text{ kg}$$

Interpretation:

• Himalayan Java should order 2,236 kg every time to minimize costs.
• Number of orders per year = $D/EOQ=10,000/2,236\approx 4.47$ → 5 orders/year.

Total Cost Calculation:

2. Reorder Point (ROP) Model

The ROP determines when to order based on lead time (time between ordering and receiving stock).

Formula: $$ROP=\text{Average Daily Demand}\times \text{Lead Time}+\text{Safety Stock}$$

Worked Example: NTC’s SIM Card Inventory

• Daily demand = 5,000 SIMs
• Lead time = 5 days
• Safety stock = 2,000 SIMs (to prevent stockouts)

$$ROP=5,000\times 5+2,000=25,000+2,000=27,000\text{ SIMs}$$

Interpretation:

• NTC should reorder when stock drops to 27,000 SIMs.
• If demand increases, safety stock must rise.

Inventory Management Techniques

1. Just-in-Time (JIT) Inventory

• Concept: Inventory arrives just as it is needed (no storage).
• Pros:
  • Reduces holding costs.
  • Improves cash flow (money not tied in stock).
• Cons:
  • High risk of stockouts.
  • Requires reliable suppliers.
• Example: Toyota’s lean manufacturing uses JIT to minimize car parts inventory.

2. Safety Stock

• Purpose: Extra inventory to prevent stockouts due to demand/supply uncertainty.
• Calculation: $$\text{Safety Stock}=\text{Max Daily Demand}\times \text{Lead Time}-\text{Average Daily Demand}\times \text{Lead Time}$$
• Example: Pathao keeps extra bike spare parts (e.g., tires, batteries) to avoid ride disruptions.

3. Economic Production Quantity (EPQ)

• For companies that produce goods in batches (e.g., Himalayan Cycles).
• Formula: $$EPQ=\sqrt{\frac{2DS}{H}\times \frac{P}{P-D}}$$
  • $P$ = Production rate (units/day)
  • $D$ = Demand rate (units/day)

Inventory Management in Nepal: Case Study – Daraz

Daraz, Nepal’s largest e-commerce platform, uses advanced inventory techniques to manage 100,000+ products:

Key Metrics:

• Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
  • Daraz aims for 8–12 turns/year (higher = better efficiency).
• Stockout Rate = <1% (due to AI demand forecasting).

In the Real World

1. Khalti (Digital Wallet)

   • Idea Used: Perpetual Inventory System
   • How: Khalti tracks available balance in real-time (like inventory). If a user spends ₹500, the "inventory" (balance) drops instantly, triggering alerts for low funds (like a reorder point).

2. Nabil Bank (Loan Processing)

   • Idea Used: ABC Analysis + Safety Stock
   • How: Nabil Bank classifies loan applications as:
     • A (High-value loans, e.g., ₹5M+) → Strict verification (like A inventory).
     • C (Small loans, e.g., ₹50K) → Automated processing (like C inventory).
   • Safety Stock: Extra loan officers during peak season (like safety stock for forms).

3. NTC (Telecom Infrastructure)

   • Idea Used: EOQ + Reorder Point
   • How: NTC orders fiber optic cables in bulk (EOQ) but keeps emergency stock (ROP) to avoid network downtime during monsoons.

Exam Tip

What Examiners Look For

1. Definitions with Examples
   • Always link theory to Nepali companies (e.g., "Like Daraz’s RFID system, perpetual inventory uses real-time tracking").
2. Calculations
   • EOQ, ROP, and safety stock are high-scoring. Show step-by-step math (like the Himalayan Java example).
3. Pros/Cons Tables
   • Compare periodic vs. perpetual, JIT vs. safety stock in a structured table.
4. Real-World Applications
   • 1 mark per relevant example (e.g., "NTC uses safety stock to prevent telecom failures").
5. Diagrams
   • Draw flowcharts for inventory systems (e.g., perpetual vs. periodic).
   • Use pie charts for ABC analysis.

Common Mistakes to Avoid

• Ignoring units in EOQ (e.g., forgetting to square root).
• Mixing up holding vs. ordering costs.
• Not explaining assumptions (e.g., "We assume demand is constant").
• Overcomplicating answers – stick to bullet points + formulas + examples.

Final Checklist for Full Marks

✅ Define inventory and its types (with Nepali examples). ✅ Explain ABC analysis with a pie chart. ✅ Derive EOQ and ROP with a worked example (use real numbers). ✅ Compare periodic vs. perpetual systems in a table. ✅ Discuss JIT, safety stock, and EPQ with one Nepali case study. ✅ Link to real-world apps (Khalti, Daraz, NTC, Nabil Bank). ✅ Draw a flowchart for an inventory control system.