Inventory Management: Types, Costs, Models & Control Systems

Core Concepts & Definitions

What is Inventory?

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

mindmap
  root((Inventory))
    Raw Materials
    Work-in-Progress (WIP)
    Finished Goods
    Maintenance/Repair/Operating (MRO) Supplies
    Transit Inventory

Why is inventory important?

• Balances supply and demand (avoids stockouts or overstocking).
• Supports production schedules (just-in-time vs. bulk ordering).
• Reduces lead time risks (delays in supplier deliveries).
• Enhances customer satisfaction (faster order fulfillment).

Types of Inventory (with Real-World Examples)

1. ABC Analysis (Classification by Value)

ABC analysis categorizes inventory into three classes based on annual consumption value:

• A-items: High-value, low-quantity (e.g., iPhone chips at Ncell’s warehouse).
• B-items: Moderate value (e.g., Daraz’s mid-range electronics).
• C-items: Low-value, high-quantity (e.g., Khalti’s plastic cards).

Worked Example (Nepal Context): Nabil Bank classifies its ATM ink ribbons as A-items (high cost, critical for operations). It uses just-in-time (JIT) ordering to avoid overstocking while ensuring zero stockouts during peak hours (e.g., salary days).

2. VED Analysis (Classification by Criticality)

VED categorizes items based on urgency and importance:

• Vital (V): Essential for operations (e.g., NTC’s fiber optic cables).
• Essential (E): Important but not critical (e.g., Pathao’s bike spare parts).
• Desirable (D): Nice to have (e.g., Himalayan Java’s premium coffee beans).

Comparison Table: ABC vs. VED

Inventory Costs: The Trade-Off Triangle

Three key costs determine optimal inventory levels:

1. Holding (Carrying) Costs

   • Storage, insurance, obsolescence, spoilage, capital tied up.
   • Example: Daraz spends 15-20% of item value annually on warehouse rent and security for high-value electronics.

2. Ordering Costs

   • Purchase orders, transportation, receiving, inspection.
   • Example: Nabil Bank incurs Rs. 5,000 per order for ATM components from Singapore.

3. Stockout Costs

   • Lost sales, rush orders, customer dissatisfaction, production delays.
   • Example: NTC faces Rs. 50,000/hour downtime if fiber optic spares are unavailable.

Real-World Trade-Off: Khalti’s Inventory Strategy

• High holding costs: Stores minimal physical cash (Rs. 50,000/day max) due to theft risk.
• Low ordering costs: Uses automated teller machines (ATMs) for cash replenishment.
• Zero stockout costs: Partners with Nabil Bank for real-time fund transfers.

Quantitative Inventory Models

1. Economic Order Quantity (EOQ) Model

Assumptions:

• Demand is constant and known.
• Lead time is fixed.
• Ordering and holding costs are constant.
• No stockouts or quantity discounts.

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

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

Worked Example: Daraz’s Order for Smartphones

• Annual demand (D): 5,000 units
• Ordering cost (S): Rs. 2,000 per order
• Holding cost (H): Rs. 100 per unit/year $$EOQ=\sqrt{\frac{2\times 5000\times 2000}{100}}=\sqrt{200,000}=447\text{ units}$$ Interpretation: Daraz should order 447 smartphones at a time to minimize total inventory costs.

2. Reorder Point (ROP) Model

Determines when to order based on: $$ROP=\text{Average Daily Demand}\times \text{Lead Time}+\text{Safety Stock}$$

Worked Example: NTC’s Fiber Optic Cables

• Daily demand: 5 units
• Lead time: 10 days
• Safety stock: 10 units (to cover delays) $$ROP=5\times 10+10=60\text{ units}$$ Action: Order when stock drops to 60 units.

3. ABC-EOQ Integration (Practical Approach)

Combine ABC analysis with EOQ for different inventory classes:

Qualitative Inventory Techniques

1. Just-in-Time (JIT) Inventory

• Goal: Receive goods only as needed (minimizes holding costs).
• Example: Toyota’s Nepal plant uses JIT for car parts from Japan, reducing warehouse space by 60%.

Advantages: ✅ Low holding costs ✅ Reduced waste ✅ High responsiveness

Disadvantages: ❌ Vulnerable to supply chain disruptions (e.g., COVID-19 port delays) ❌ Requires high supplier reliability

2. Safety Stock

Extra inventory held to prevent stockouts due to:

• Demand uncertainty (e.g., Diwali season at Daraz).
• Supply delays (e.g., monsoon disrupting road transport).

Formula: $$\text{Safety Stock}=Z\times \sigma \times \sqrt{L}$$

• $Z$ = Safety factor (from Z-table)
• $\sigma$ = Standard deviation of demand
• $L$ = Lead time

Worked Example: Nabil Bank’s ATM Cash

• Daily demand (μ): 10,000 notes
• Standard deviation (σ): 2,000 notes
• Lead time (L): 3 days
• Desired service level: 95% ($Z=1.65$) $$\text{Safety Stock}=1.65\times 2000\times \sqrt{3}=9,350\text{ notes}$$ Total stock to hold: $10,000\times 3+9,350=39,350$ notes.

Inventory Control Systems

1. Periodic Review System

• Fixed time intervals (e.g., monthly checks).
• Example: Himalayan Java reviews coffee bean stock every 15 days.

Pros: ✅ Simple to implement ✅ Good for C-items

Cons: ❌ Risk of stockouts between reviews

2. Perpetual (Continuous) Review System

• Real-time tracking (e.g., RFID tags at Daraz warehouses).
• Example: Ncell uses barcode scanners to track iPhone stock.

Pros: ✅ Minimizes stockouts ✅ Better for A-items

Cons: ❌ High technology cost

Comparison Table: Periodic vs. Perpetual

## In the Real World

1. Daraz (Nepal’s Amazon)

   • Uses ABC-EOQ for electronics (A-items ordered via EOQ, C-items in bulk).
   • Perpetual inventory system with RFID in warehouses to track stock in real time.
   • Safety stock for Diwali season (demand spikes by 300%).

2. Nabil Bank (ATM Cash Management)

   • JIT replenishment for cash (orders from RBI based on daily withdrawals).
   • Safety stock formula to cover 99% service level (minimizes stockouts).
   • Periodic review for low-value supplies (e.g., printer paper).

3. NTC (Fiber Optic Network)

   • VED analysis: Fiber cables = Vital (V), backup generators = Essential (E).
   • ROP model for spares (orders when stock hits 60 units).
   • Dual sourcing for critical items (e.g., cables from China and India).

## Exam Tip

How to Score Full Marks in TU Exams for Inventory Management

1. Define terms precisely:

   • "EOQ is a model that determines the optimal order quantity to minimize total inventory costs, assuming constant demand and fixed ordering/holding costs."
   • "Safety stock is the extra inventory held to mitigate uncertainties in demand or lead time."

2. Use formulas correctly:

   • Always label variables in EOQ/ROP (e.g., $D=5000$, $S=2000$).
   • Show step-by-step calculations (e.g., EOQ worked example).

3. Compare models in tables:

   • Examiners love ABC vs. VED, Periodic vs. Perpetual, or EOQ vs. JIT tables.

4. Relate to Nepal:

   • Daraz (ABC-EOQ), Nabil Bank (JIT), NTC (VED-ROP) are high-scoring examples.
   • Use real numbers (e.g., "NTC holds 60 units of safety stock for fiber cables").

5. Diagrams = Easy Marks:

   • Draw EOQ cost curve, JIT flow, or ABC classification pie chart.
   • Label every part (e.g., "Minimum total cost at EOQ = 447 units").

6. Case Study Approach:

   • "How would you manage inventory for a Nepali e-commerce firm like Daraz?"
     • Step 1: ABC analysis (A=electronics, C=packaging).
     • Step 2: EOQ for A-items, bulk for C-items.
     • Step 3: Perpetual review with RFID.

Avoid: ❌ Vague answers ("Inventory is important" → 0 marks). ❌ Skipping assumptions (EOQ assumes no discounts → critical for full marks). ❌ Forgetting units (always state units in calculations, e.g., units/year).