Unit 07 — Inventory Management

Definition. Inventory is the stock of any item or resource used in an organisation — raw materials, work-in-process, finished goods, and maintenance/repair/operating (MRO) supplies. Inventory management is the set of policies that decide what to stock, how much, and when to reorder.

The four types of inventory

• Raw materials — inputs purchased but not yet processed.
• Work-in-process (WIP) — partly completed units inside the process.
• Finished goods — completed units awaiting sale or shipment.
• MRO supplies — maintenance, repair and operating items that support production without entering the product.

Why firms hold inventory — the functions

• Meet anticipated demand — serve customers immediately rather than making them wait.
• Decouple stages of production so a stoppage at one does not halt the next.
• Buffer against uncertainty in demand and in supplier lead time (safety stock).
• Smooth production against seasonal or fluctuating demand.
• Obtain quantity discounts and lower ordering/transport cost per unit.
• Hedge against price increases or expected shortages.
• Cover transit — pipeline stock in transport is inventory too.

Role of inventory in the supply chain

• Inventory exists at every stage — supplier, manufacturer, distributor, retailer — and is the buffer between them.
• It is the main lever on the trade-off between responsiveness and efficiency: more inventory means faster service and higher cost.
• Poor coordination produces the bullwhip effect — small demand variations at the retail end amplify into large swings upstream.

Why inventory planning, ordering, storage and control matter (the FMCG question)

• Planning — ensures sufficient stock for high, fluctuating consumer demand; avoids stockouts causing lost sales and dissatisfaction; optimises working capital by balancing investment against turnover.
• Ordering — determines when and how much to order for smooth production and distribution; reduces ordering cost and prevents overstocking; supports just-in-time approaches.
• Storage — keeps products safe and organised to protect quality; enables fast retrieval for distribution to retail outlets; minimises spoilage and obsolescence, critical for perishable FMCG goods.
• Control — tracks stock levels using ERP systems; identifies fast- and slow-moving items for better decisions; reduces carrying cost and improves operational efficiency.

Closing line: inventory is simultaneously an asset on the balance sheet and a symptom of uncertainty in the process — the goal is not to eliminate it but to hold the smallest amount that still protects service.

Definition. Independent demand for an item arises directly from the market and must be forecast. Dependent demand is derived from the demand for some other item and can therefore be calculated exactly.

Point of difference — draw this table

Why the distinction matters

• It determines which planning system to use — statistical reorder-point methods for independent items, MRP for dependent ones.
• Applying reorder-point logic to a dependent item causes excess stock, because it holds safety stock against a requirement that is actually known.
• A single item can be both: a tyre is dependent demand for the assembly line and independent demand as a spare sold to customers — and the two streams should be planned differently.

Example

• A car plant forecasts demand for the finished car (independent). Once it schedules 1,000 cars, the requirement for 5,000 wheels is not a forecast at all — it is arithmetic (dependent). Holding safety stock of wheels "just in case" is pure waste.

Closing line: the rule is simple — forecast what the market decides, calculate what your own schedule decides.

Definition. Inventory costs fall into three main categories — ordering (setup), holding (carrying) and shortage (stockout) costs — and the whole of inventory theory is the search for the order quantity that minimises their total.

The three main cost categories

Stockout cost and reputation — the Final Exam's question

• A stockout occurs when customer demand cannot be met because of insufficient inventory.
• If the shortage results in a permanent loss of sales, shortage cost includes the lost profit.
• Shortages cause customer dissatisfaction and loss of goodwill, which can mean permanent loss of customers and future sales — the reputational damage far exceeds the single lost sale.
• When demand is internal, a shortage causes work stoppages and delays, producing downtime cost and the cost of lost production.
• Example: a pharmacy repeatedly out of a chronic-illness medicine loses not one sale but the patient's monthly repeat business permanently — and in the age of reviews, the complaint is public and durable.

Hidden costs of inventory — the Re-Exam's question

• Component devaluation cost — component prices usually fall by the time the product is released, forcing the firm to devalue the stock it holds.
• Price protection cost — a policy under which a retailer refunds the difference if an item's price drops after purchase; it forces shorter manufacturing turnaround, frequent replenishment, and incentives to distributors to keep stock low.
• Product return cost — unsold products resulting from excess inventory are returned by distributors, sometimes for a full refund.
• Obsolescence cost — short product life cycles make stock obsolete; new models must be launched only after existing stock clears the shelves.

The trade-off to state

• Ordering cost and holding cost move in opposite directions with order size — that opposition is what creates a minimum-cost order quantity.
• Shortage cost is the hardest to measure and the most damaging, because most of it is invisible: the customer who simply never returns.

Closing line: the visible costs of inventory sit on the balance sheet, but the expensive ones — obsolescence, devaluation and lost goodwill — mostly do not, which is why inventory is so consistently under-managed.

Definition. An inventory control system decides when to order and how much. The continuous (Q) system monitors stock constantly and orders a fixed quantity whenever stock hits the reorder point. The periodic (P) system checks stock at fixed time intervals and orders a variable quantity to top up to a target level.

Point of difference — draw this table

Why the P system needs more safety stock — the key insight

• In a Q system, stock is watched continuously, so a demand surge is detected immediately and only the lead time is exposed.
• In a P system, nobody looks between reviews, so a surge just after a review goes unnoticed until the next one — the exposure is the review period plus the lead time.
• Longer exposure means more uncertainty to cover, hence larger safety stock and higher average inventory. That is the price paid for lower monitoring effort.

How to recommend one — the application skill

• Choose Q when the item is expensive or critical, when stockouts are costly, and when the firm already has barcode/ERP tracking that makes continuous monitoring free.
• Choose P when items are cheap and numerous, when many items come from one supplier and can be consolidated into a single order, or when the supplier delivers on a fixed schedule anyway.
• Many firms use both, allocated by ABC class — Q for A items, P for C items.

Example

• A pharmacy uses a Q system for expensive prescription drugs where a stockout is serious and stock is tracked electronically; and a P system for over-the-counter items, because the vendor calls every 60 days anyway and consolidating one large order is cheaper than tracking hundreds of low-value lines.

Closing line: the choice between P and Q is a trade of monitoring effort against inventory investment — Q spends attention to save stock, P spends stock to save attention.

Definition. ABC classification is a selective inventory control technique that divides inventory items into three classes by their annual rupee usage value, so that management attention is concentrated where the money is. It is an application of the Pareto (80/20) principle.

The three classes

The steps

1. For each item, compute annual usage value = annual demand × unit cost.
2. Rank all items in descending order of that value.
3. Compute the cumulative percentage of total value.
4. Cut the list into A, B and C classes at the natural breaks.
5. Apply a different control policy to each class.

The key principle — and the classic mistake

• Classification is by annual rupee usage, not unit price and not quantity. A cheap item consumed in huge volume can be class A; an expensive item bought once a year can be class C.
• The logic: control effort is itself costly, so spend it where it saves the most money.
• Important caveat — a class C item can still be critical. A ₹20 gasket that halts a production line must not be managed loosely just because its annual value is low. This is exactly why VED analysis (Vital / Essential / Desirable) is used alongside ABC, and the two are often combined into an ABC–VED matrix.

Other selective inventory control techniques worth naming

• VED — Vital, Essential, Desirable: by criticality to operations.
• FSN — Fast, Slow, Non-moving: by consumption rate; identifies dead stock.
• HML — High, Medium, Low: by unit price alone.
• XYZ — by value of stock actually held in the storeroom.
• SDE — Scarce, Difficult, Easy to obtain: by procurement difficulty.

Example

• A hospital pharmacy stocking 3,000 line items finds that 250 of them account for 78% of annual spend. Those become class A with weekly review and a Q system. But it separately flags a handful of low-value emergency drugs as Vital under VED and stocks them generously despite their class C status — because the cost of a stockout is not measured in rupees.

Closing line: ABC analysis is about the allocation of management attention, not of stock — its value lies in giving the manager permission to stop worrying about the 60% of items that account for almost none of the money.