CHAPTER FOUR

INVENTORY MANAGEMENT

4.1 Introduction
Inventory constitutes one of the most important elements of materials management in any organization
dealing with supply, manufacture and distribution of goods and services. It is a major type of control
system applied in most organizations.
The concept of inventory control is as old as the concept of business itself. But the practical application
of inventory management got emphasis after the Second World War. The development of operations
research and computer technology paved the way for the practical application of inventory management
The choice of which items to include in inventory depends on the organization. A manufacturing
operation can have an inventory of personnel, machines, and working capital, as well as raw materials
and finished goods. In services, inventory generally refers to the tangible goods that are sold and the
supplies necessary to administer the service.

4.2 Meaning of Inventory

The meaning of inventory can be defined as:

 Inventory is an idle resource (physical stock of goods) possessing economic value which is
waiting or kept for future use or sale. Here the responsibility of materials management is to
maintain sufficient inventories to meet demand for goods and at the same time incurring the
lowest inventory handling costs.
 Inventory is a stock of materials that are used to facilitate production or to satisfy customers’
demand (Ahuja, 1992).
4.3 Importance and Types of Inventory
4.3.1 Importance (Functions) of Inventory
Inventories serve a number of functions. Among the most important are; (Stevenson, 2005)
1. To meet anticipated customer demand - A customer can be a person who walks in off the street
to buy a new stereo system, a mechanic who requests a tool.
2. To smooth production requirements - Firms that experience seasonal patterns in demand often
build up inventories during pre-season periods to meet overly high requirements.
3. To decouple operations - To provide a buffer between successive operations.
4. To protect against stock outs - Delayed deliveries and unexpected increases in demand increase
the risk of shortages.

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 5. To take advantage of order cycles - To minimize purchasing and inventory costs, a firm often
buys in quantities that exceed immediate requirements.
6. To hedge against price increases - Occasionally a firm will suspect that a substantial price
increase is about to occur and purchase larger-than-normal amounts to beat the increase.
7. To take advantage of quantity discounts - Suppliers may give discounts on large orders.
4.3.2 Types of Inventories
Although inventories are classified in many ways, but according to (Dobler and Burt, 1996) inventories
are classified in to:
i. Production inventories - Raw materials, parts, and components which enter firm’s product in the
production process.
ii. MRO inventories - Maintenance, Repair, and Operating supplies which are consumed in the
production process but which do not become part of the product (e.g., lubricant, soap).
iii. In-process inventories - Semi finished products found at various stages of the production
iv. Finished goods inventories - completed products ready for shipment, or awaiting for sale.
4.4. OBJECTIVES OF INVENTORY MANAGEMENT
Inventory management has two main concerns. One is to have the right goods, in sufficient quantities, in
the right place, at the right time. The other is the cost of ordering and carrying inventories.
The overall objective of inventory management is to achieve satisfactory levels of customer service
while keeping inventory costs within reasonable bounds. Specifically, inventory control has the
following objective;
 Minimize - the investment in inventory.
- Warehouse costs.
- Losses from damage, obsolescence and perishablity.
- Chances of going out of stock.
 Maximize - customer service.
- The efficiency of purchasing and production.
- Profit.
 Make forecasts of inventory requirements for the future.
 Establish an inventory system (policies and regulation that monitors inventories).
 Ensures availability of materials
 Offers advantage of price discounts from bulk purchasing.
Inventory Management/control thus, determines the levels of inventories or parts, materials and products
that will most effectively protect the production, sales and financial requirements of the business. In
inventory control, we are primarily concerned with the inventory cost control. The aim is focused to

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bring down the total inventory cost per annum as much as possible. Two important questions are (1) how
much to stock or how much to buy and (2) how often to buy or when to buy. An answer to the above
questions is usually given by certain mathematical models, popularly known as “economic order
quantity models” or “economic lot/batch size models.”

4.5 INVENTORY COSTS

Because we are interested in optimizing the inventory system, we must determine an appropriate
optimization or performance criterion. Virtually all inventory models used cost minimization as the
optimization criterion. An alternative performance criterion might be profit maximization. However,
cost minimizations and profit maximizations are essentially equivalent criteria for most inventory
control problems. Although different systems have different characteristics, virtually all inventory costs
can be placed in to one of the three categories; holding cost, order cost, or penalty cost. Each will be
discussed as follows:
1) Holding Costs
The holding cost, also known as the carrying cost or the inventory cost, is the sum of all costs that are
proportional to the amount of inventory physically on hand at any point in time. The components of the
holding cost include a variety of seemingly unrelated items. Some of these are:
i. Cost of providing the physical space to store the items
ii. Taxes and insurances
iii. Breakage, spoilage, deterioration, and obsolescence
iv. Opportunity cost of alternative investments
v. The salaries and wages of storing, receiving and issue of material personnel.
vi. Stationary and other consumables use by the stores.
The fourth item turns out to be the most significant in computing holding costs for most applications.
Inventory and cash are in some sense equivalent capital must be invested to either purchase or produce
inventory, and decreasing inventory levels results increased capital. This capital could be invested by
the company either internally, in its own operation, or externally.
What is the interest rate that could be earned on this capital? You and I can place our money in a saving
account with an interest rate of 3%, or possibly invest in a high-yield bond with a return of more than
3% per annum.
In general, however, most companies must earn higher rates of return on their investment than do
individuals in order to remain profitable. The value of the interest rate that corresponds to the
opportunity cost of alternative investment is related to (but not the same as) a number of standard
accounting measures, including the internal rate of return, the return on assets, and the hurdle rate (the
minimum rate that would make an investment attractive to the firm). The value of the interest rate for

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the opportunity cost is usually estimated by the firms accounting department and it is an amalgam of the
accounting measures listed above. For example, we will use the term cost of capital to refer to this
component of the holding cost. Therefore, we may think of the holding cost, as an aggregated interest
rate comprised of the four components listed above.
For example;
20% = cost of capital
2% = Taxes and Insurance
6% = Cost of Storage
2% = Breakage and Spoilage
30% = Total interest charge
This would be interpreted as follows: We would assess a charge of 30 cents for every birr that we have
invested in inventory during a one-year period. However, as we generally measure inventory in unit
rather than in birr, it is convenient to express the holding cost in terms of birr per unit per year rather
than birr per birr per year.

2) Order (setup) Costs

The holding cost includes all of those costs that are proportional to the amount of inventory on hand,
whereas, the order cost depends on the amount of inventory that is ordered or produced. Placement of
purchase order for a material is associated with certain obvious cost due to advertising, consumption of
stationary and postage, telephone charges etc. In fact all the annual expenditure of the purchasing
department of a company can be considered to be on the purchase order it places during the year.
The cost associated with ordering would, therefore, consist of;
o Salaries of the staffs in the purchasing department.
o Negotiating purchases, placing orders and follow up.
o Rent for the space used by the purchasing department.
o The postage, telegram, telephone bills.
o The stationary and other consumables used by the purchasing department.
o Entertainment charges for vendors.
o Traveling expense.
o Lawyers and court fees due to any legal matters arising out of purchase.
o Inspecting shipment & moving goods to storage.
When more order placed in a period, the more would be the stationary and postage consumed, more staff
and officers will be required for handling the work, the more will be the space required for
accommodating them and soon. Thus the total expenditure on purchasing or ordering would depend on
the number of orders placed. It is assumed that the expenditure on ordering of material is directly
proportional to the number of orders placed. The ordering cost is expressed as cost/order.

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 3) Penalty Costs
The penalty cost, also known as the shortage cost or the stock-out cost, is the cost of not having
sufficient stock on hand to satisfy demand when it occurs. This cost has a different interpretation
depending on whether excess demand is back-ordered (orders that cannot be filled immediately are held
on the books until the next shipment arrives) or lost (known as lost sales). In the book-order case, the
penalty cost includes whatever bookkeeping and /or delay costs might be involved. In the lost-sales
case, it includes the lost profit that would have been made from sales. In either case, it would also
include the “lost good-will” cost, which is a measure of customer satisfaction. Estimating the loss of
goodwill component of the penalty cost can be very difficult in practice.

4.6 NATURE OF DEMAND IN INVENTORY

The demand for inventory may be dependent or independent.
 Dependent Demand of Items:
Items: are those items where their demand is related to the demand
for another item. This demand is also known as Derived Demand.
 Independent Demand of Items:
Items: are those items that are not influenced by
production/operation but by the market forces.
For example, if an automobile company plans on producing 500 automobiles per day, then obviously it
will need 2,000 wheels and tires (plus spares). The number of wheels and tires needed is dependent on
the production level for automobiles and not derived separately. The demand for automobiles, on the
other hand, is independent-it comes from many sources external to the automobile firm and is not a part
of other products and so is unrelated to the demand for other products.

4.7 INVENTORY MODEL

4.7.1 Inventory Model for Independent Demand
There are a number of mathematical models that can be applied to determine the optimum (economical)
level for independent demand of materials.

1. Economic Order Quantity (EOQ) Model

The EOQ (Economic Order Quantity) model is one method of determining the adequate (optimum)
inventory level for independent demand of materials. It is used to identify a fixed order size that will
minimize the sum of the annual costs of ordering and hold inventory.
Assumptions of this model are;
- Only one product is involved. - Lead time does not vary.
- Annual demand requirement are known. - Demand is constant.
- Each order is received in a single delivery. - There are no quantity discounts

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 Annual Carrying
Cost (Acc)

6000 Total Inventory

Lowest Cost

5000 Cost

4000
Order Size
3000 Order Cost
ACC=AOC
Cost

2000 Carrying
Cost
1000

0 1 2 3 4 5 6 7 8
Order Annual Ordering Cost
Size
(AOC)

EOQ

Figure 4.1 above shows clearly that as the order quantity increases, carrying costs rise-and at the same
time ordering costs decrease. Carrying cost is thus a linear function of Q: carrying costs increase or
decrease in direct proportion to changes in the order quantity Q o. On the other hand, annual ordering cost
will decrease as order size increases. Therefore, at the point of EOQ, the total inventory cost will be kept at
minimum level.
In constructing any inventory model, the first step is to develop a functional relationship between the
variables of interest and the measure of effectiveness. Thus, total cost obtained by;
A
Total Annual cost = Annual ordering cost
+ Annual Holding cost + Annual Purchase cost

To develop an equation for total inventory cost and for the purpose of analyzing inventory models, the
following symbols will be used throughout the chapter.
TC = Total annual cost CO = Set up or Ordering cost
D = Annual demand in units Q = Quantity to be ordered
Cc = Carrying cost per unit P = Purchase price per unit or cost per unit.
NB: D and Cc must be in the same units, e.g., daily, monthly, Quarterly, semi annually, yearly.
i. Annual Ordering Cost
Annual (Number of orders (Ordering cost
Ordering cost = Placed per year) x per order)

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NB - the number of orders per year will be D/Q, and hence:
D
Annual Ordering cost = Q Co
Annual
Holding cost = (average inventory value) x (inventory carrying cost as a % of inventory value)

ii. Annual Holding Cost

In order to calculate the annual carrying cost (AC c) let us look at the concept of average inventory. The
concept of average inventory is based on the following assumption; Purchase is made at the beginning,
Usage rate is constant and the last item is used on the last date. Then the average inventory will be Q/2
where Q is the order quantity in units.
Q
Annual holding cost = 2 Cc
iii. Annual Purchase Cost

Annual purchase cost = DP

iv. Total Cost Equation.

D Q
Co+ Cc+DP
TC = Q 2

The next step is to find that order quantity, Q, for which total cost is a minimum. This can be done by
equating ordering and carrying costs, i.e.

D Q
( Co)= ( Cc )
Q 2
Q2
. Cc
D.Co = 2
2D.Co = Q2. Cc
2 D . Co
Q = Cc
2

√
2 . D. Co
Q = Cc

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NB - Minimum Inventory Cost = ACc + ACo
Example1.
Example1. A local distributor for Addis Tire Company expects to approximately 9,600 steel belted tires
of certain size next year. The annual carrying cost is 16.00 Birr per tier per year and the ordering cost
are 75.00 Birr per order. The distributor operates 288 days a year.
Required:
1. Determine EOQ.
2. What is the Ordering Cost per year and annual carrying cost at EOQ?
3. What is the total incremental or total inventory cost at EOQ
4. If purchase price per tire is 80.00 Birr. What is the total cost at EOQ?
5. How many times per year the store does reorders?
6. Determine the length of an order cycle.
7. Compute Ordering, Carrying, Total Inventory costs & overall total costs. If order quantities are
100, 150, 200, 250, 300, 350, 400 and 450 units. What do you infer from this exercise?
Solution: Given: D = 9,600
Cc = 16.00 Birr
Co =75.00 Birr
Working days per year 288

1. Q0 = √ 2×D×OC
CC Where, Q0 is optimum Quantity.

= √ 2×9600×75
16 = 300 tires per order.
order. ACo = D/Q x Co
= 9600/300x75
2. ACc = Q/2 x Cc = 300/2 x 16
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 = 2,400 Birr = 2,400 Birr
3. Minimum Inventory Cost = ACc + ACo = 2,400 +2,400
= 4,800 Birr
4. Total Cost = ACo + ACc+ DP Pc = is purchase cost
= 2,400 +2,400 +80(9600) = 772,800 Birr
5. Number of Order per year = Annual Demand = 9,600 =32 order
Order Size 300

6. Length of Order Cycle = Annual Working Days x Q0 = Annual Working Days = 288
D No. of orders per year 32

= 9 Working Days

7. It means the optimum quantity will be used within working days

Order AOC = ACC = Annual Total APc Overall

Quantity (D/Q x OC) (Q/2 x CC) Inventory Cost Total Cost
100 7200 800 8000 Birr76800 Birr
0 776,000
150 4800 1200 6000 774,000
200 3600 1600 5200 773,200
250 2880 2000 4880 772,880
300 2400 2400 4800 772,800
350 2057 2800 4857 772,857
400 1800 3200 5000 773,000
450 1600 3600 5200 773,200
From this we can infer that that at EOQ, total inventory or overall total cost will be minimum, when the
order size is large, the ACC will be high & for small order sizes the AOC will be high.
EOQ with Quantity Discount and Price Breaks
Example with Quantity Discount
A producer of photo equipment buys lenses from a supplier at Birr 100 each. The producer requires 125
lenses per year, and the ordering cost is Birr 18 per order. Carrying costs per unit per year are estimated
to be Birr 20 each. The supplier offers 6% discount for purchases of 50 lenses and an 8% discount for
purchases of 100 or more lenses. Determine the optimal order quantity.
Solution:
Given: P = Birr 100 per unit
D = 125 lenses per year
Co = Birr 18 per order
Cc = Birr 20 per unit per year
We have three alternatives: ordering
1. EOQ size

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 2. 50 units size
3. 100 units size
Alternative 1: Ordering EOQ size

EOQ = √
2 . D. Co
Cc
=
20 √
(2)(125 )(18)
= 15 units
D Q
Co + Cc +DP
TCEOQ = Q 2
TC15 = (125/15) (18) + (15/2) (20) + (125) (100)
= Birr 150 + Birr 150 + Birr 12,500
= Birr 12,800
Alternative 2: Considering the discount for a 50 unit order
Discount = 6% of 100 = 6.
Hence purchase price will be 100-6= 94
TC50 = (D/Q) (Co) + (Q/2) (Cc) + DP
= (125/50) (18) + (50/2) (20) + (125) (94)
= Birr 45 + Birr 500 + Birr 11,750
= Birr 12,295
Alternative 3: Discount of 8% for a 100 unit order
Discount = 8% of 100 = 8, i.e. PC = 100-8 = 92
TC100 = (D/Q) Co + (Q/2) Cc + DP
= (125/100) (18) + (100/2) (20) + (125) (92)
= Birr 22.5 + Birr 1000 + Birr 11,500
= Birr 12,522.5
Summary
Order Ordering Carrying Purchase Total
Quantity cost cost cost cost
15 units 150 150 12,500 12,800
50 units 45 500 11,750 12,295
100 units 22.50 1000 11,500 12,522
Therefore, the ordered quantity of 50 unit results in the minimum total cost and is the most economic
amount to order at a time.
Example with Price Breaks
Determine the order quantity that will minimize total annual inventory cost for the price schedule below.
Annual demand is 1200 units, ordering cost is Birr 41, and holding cost is Birr 2 per unit per year.

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 Quantity in unit Unit price (Birr)
1 to 199 27
200 to 299 26
300 to 399 25
400 or more 24

Solution:
Step 1: Calculate EOQ

EOQ = Cc√
2 . D. Co

= √
(2)(1 , 200)( 41)
2
= 222 units
The EOQ is in the range of 200 to 299 which is not optimal because of the price breaks.
Step 2: Calculate the total cost at EOQ and the price breaks of 300 to 399 and 400 or more.
TC = (D/Q) (Co) + (Q/2) (Cc) + DP
Tc222 = (1200/222) (41) + (222/2) (2) + (1200) (26) = Birr 31, 644
Tc300= (1200/300) (41) + (300/2) (2) + (1200) (25) = Birr 30,464
Tc400 = (1200/400) (41) + (400/2) (2) (1200) (24) = Birr 29,323
Therefore, the fourth range’s value is optimal because it has the lowest total cost i.e. the optimal order
quantity is 400 units.
Reorder Point (ROP)
The reorder point occurs when the quantity on hand drops to a predetermined amount. That amount
generally includes expected demand during lead time and perhaps an extra cushion of stock.
Lead-time:- is defined as the time interval between the placing of the orders and the actual receipt.
i. ROP when demand and lead time are both constant. If demand and lead time are both constant, the
reorder point is simply

ROP = d x LT

Where: d = Demand rate (units per day or week)

LT = Lead time in days or weeks.
Note: Demand and lead time must be expressed in the same time units.
Example1: Mr. X takes two vitamins tablets a Day, which are delivered to his home by a route man
seven days after an order, is called in. At what point should Mr. X reorder?

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 Solution:
Usage = 2 vitamins a day
Lead time = 7 days
ROP = Usage x Lead time
= 2 vitamins per day x 7 days
= 14 vitamins
Thus, Mr. X should reorder when 14 vitamin tablets are left.
ii. Reorder point when variability is present in demand or lead time. Variability in demand or lead time
creates the possibility that actual demand will exceed expected demand. Consequently, it becomes
necessary to carry additional inventory, called safety stock. The reorder point then increases by the
amount of the safety stock:

ROP = Expected demand + Safety stock

during lead time

Safety Stock and Service Level

Safety stock is used in order to prevent a stock out occurring.
Service level can be defined as the probability that demand will not exceed supply during lead time.
Hence, a service level of 95% implies a probability of 95% that demand will not exceed supply during
lead time and 5% of stock out risk.
Service level = 100 % – stock out risk.
The models used in this case, generally assume that any variability in demand rate or lead time can be
adequately described by a normal distribution. The value of z used in a particular instance depends on
the stock out risk that the manager is willing to accept.
The first model can be used if an estimate of expected demand during lead time and its standard
deviation are available. The formula is:
ROP =
Expected demand + zdLT
during lead time
Where: z = Number of standard deviations.
dLT = The standard deviation of lead time demand.
Example
Suppose that the manager of a construction supply house determined from historical records that demand
for sand during lead time averages 50 tons. In addition, suppose the manager determined that demand
during lead time could be described by a normal distribution that has a mean of 50 tons and a standard

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deviation of 5 tons. Answer these questions, assuming that the manager is willing to accept a stock out
risk of no more than 3 %:
a. What value of z is appropriate?
b. How much safety stock should be held?
c. What reorder point should be used?
Solution:
Given: Expected lead time demand = 50 tons
dLT = 5 tons
Risk = 3 %
a. Service level = 100 % – stock out risk
= 1-0.03 = 0.970
From the normal curve, you obtain a value of z = +2.17 corresponding to the service level of 0.97
b. Safety stock = zdLT = 2.17(5) = 10.85 tons
c.ROP = Expected lead time demand + Safety stock
= 50 + 10.85 = 60.85 tons
Example
A company uses annually 48,000 units of raw material costing birr 1.25 per unit. Placing each order
costs birr 45 and carrying cost is 15% of the average inventory. The company follows EOQ purchasing
policy and it operates for 300 days a year and the procurement time is 12 days with safety stock of 500
units. Find
a) The EOQ.
b) The ROL.
c) The maximum inventory.
d) The minimum inventory.
e) The average inventory.
Solution:
Given: D = 48,000 units Safety stock (SS) = 500 units
P = Birr 1.25 per unit LT = 12 days
Co = Birr 45 per order
Cc = 15% of 1.25
= 0.1875

b) EOQ = √
2 . D. Co
Cc

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 = √
(2)( 48 ,000 )(45 )
0 .1875
= 4,800 units
c) ROP = Safety Stock + Lead time demand (LTD)
LTD = Lead time x Average demand/day
48 ,000 units
= 12 days x 300 days
= 1920 units
ROP= 500 + 1920= 2420 units
c) Maximum inventory = SS + EOQ
= 500 + 4,800
= 5,300 units
d) Minimum Inventory = SS = 500 units
EOQ
e) Average inventory = SS + 2
4 ,800
= 500 + 2
= 2,900 units
I. Economic Production Quantity (Economic Run Lengths)
When the company is the producer and user of its items, the run size is the economic production quantity
(EPQ). In other words the company is the supplier for itself.
In the determination of the EPQ the carrying cost remains the same but the ordering cost is replaced by
set-up-cost which is the cost of preparing production for operations.
If d = demand per day and P = production per day, then the ratio d/p represents the proportion of
production that is allocated to daily demand, and 1-d/p represents that portion of the production run that
goes in to inventory. If we take into account the decreased carrying cost of this reduced level of
inventory, the economic run length (ERL) or the economic production quantity (EPQ) number of units to
produce per projection set up is

√2.D.S
EPQ = Cc (1−d / p )
Where:
S = Set up cost in birr/set up
D = annual demand in units
Cc = Carrying costs in birr//unit/year

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 d = demand rate
P = production rate
Example2 A toy manufacturer uses 48,000 rubber wheels per year for its popular dump- truck series.
The firm makes its own wheel, which it can produce at a rate of 800 per day. The toy trucks are
assembled uniformly over the entire year. Carrying cost is Br 1.00 per wheel a year. Set up cost for a
production and change over from the previous production is Br. 45.00. The firm operates 240 days per
year. Determine each of the following.
A) The optimum Size (EPQ)
B) The minimum total inventory cost.
C) The cycle time for the optimal size.
D) The run time.
E) The number of production runs in a year.
F) Maximum level of inventory.
Solution:
Given: D = 48,000
P = 800/day
CC = Br. 1/unit /year
Sc = Br. 45/production
Run
Working Days = 240 days

Daily demand = 48000 = 200/day

240
A) The optimum Size

= EOQ = √ 2×D×Sc
(1−d / p )×cc

√
2×48 , 000×45
= (1−200 /800 )×1 = 2400 Wheels

Here one run will last for 3 days = 2400/800 and form these quantity level 600 wheels will be consumed
(3 x 200) and the remaining 1,800 units will be kept in the sore.
B) The minimum Total inventory cost is = ASc + ACc

 The Total Annual =

( )
D
Q0
Q
2
d
×Sc 1− ×CC
p ( )
=
(2400
48 , 000
)×45+ 2 , 400
2 ( 1−
800 )
200
×1

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 = 900 + 900
= Birr 1,800
B) The cycle time for the optimal run size:

Optimum Quantity = 2,400 =12 Working days

Daily Demand 200
The optimal run size covers 12 working days. i.e. 3 days for production & usage time & 9 days will be
idle time.
D) The Run time:
t = Q0 = 2,400 = 3 days
p 800
E) The number of production runs in a year:

= Annual demand = 48000 = 20 runs.

Optimal Quantity 2,400
The 20 runs cover 60 production days. I.e. 20 x 3 = 60 days and in this period there is production and
consumption simultaneously. The remaining 180 days are idle time between runs & during these
periods there is only consumption.
F) Maximum inventory level:
= Q0 x (1 – d/p)
= 2,400 (1- 200/800) = 1800

4.7.2 Inventory Model for Dependent Demand

To address the inventory issues that are associated dependent products for example, the demand for
automobile tires is dependent on the demand for cars. Similarly, the demand for keyboards is dependent
on the demand for personal computers, a concept known as Materials Requirements Planning (MRP) is
used.
Before directly going to materials requirement planning (MRP), there are two plans that should be
developed prior to MRP:
Aggregate planning:- is the process of planning the quantity and timing of output over the intermediate
time horizon (often 3 months to 1 year). The main purpose of the aggregate plan is to specify that
combination of production rate, workforce level, and the resulting inventory on hand.
Master production schedule (MPS):- is developed directly from the aggregate plan-and is the
instrument that drives the firm’s entire production system. The aggregate plan establishes an overall
level of operations that balances the plant’s capability with external sales demand. The master schedule
translates the aggregate plan into specific numbers of specific products to be produced in identified time
periods.

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Material Requirements Planning (MRP)
MRP is a computer-based information system that translates the finished product requirements of the
master schedule into time-phased requirements for subassemblies, component parts, and raw materials,
working backward from the due date using lead times and other information to determine when and how
much to order.
MRP is designed to answer three questions: what is needed? How much is needed? And when it is
needed?
MRP Inputs
An MRP system has three major sources of information/inputs: a master schedule, a bill-of-materials
file, and an inventory records file.
The Mater Schedule
The master schedule also referred to as the master production schedule, states which end items are to be
produced, when they are needed, and in what quantities. The quantities in a master schedule come from
a number of different sources, including customer orders, forecasts, and orders from warehouses to build
up seasonal inventories.
The Bill of Materials
A bill of materials (BOM) contains a listing of all of the assemblies, subassemblies, parts, and raw
materials that are needed to produce one unit of a finished product. Thus, each finished product has it
own bill of materials. The listing in the bill of materials is hierarchical and it is clear when you consider
a product structure tree.
X

B (2) C

E(2) X
D(3) E F (2)

E(4)

Use the information presented above

a. Determine the quantities of B, C, D, E, and F needed to assemble one X.
b. Determine the quantities of these components that will be required to assemble 10 Xs, taking into
account the quantities on hand (i.e., in inventory of various components):

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 Component On hand
B 4
C 10
D 8
E 60

Solution:
1xX

B: 2x1=2 B (2) C=1x1=1 C

E: 2x1=2 E (2) F: 2x1=2 E (2)

D: 3x2=6 D (3) E: 1x2=2 E

E: 4x6=24 E (4)

Thus, one X will require

B: 2 D: 6
C: 1 F: 2
E: 28 (Note that E occurs in three places, with requirements of 24+2+2 = 28)
The Inventory Records
Inventory records refer to stored information on the status of each item by time period, called time
buckets. This includes gross requirements, scheduled receipts, and expected amount on hand. It also
includes other details for each item, such as supplier, lead time, and lot size policy changes due to stock
receipts and withdrawals, canceled orders, and similar events also are recorded in this file.
MRP Processing
The essence of MRP is determining the quantity and timing necessary for each component in order to
achieve the quantity and timing of end items in the master schedule.
Conceptually, this is the same as identifying and end items product tree. Next, the actual amounts (net
requirements) of each component are determined, level-by-level, beginning at the top of the tree and
working down.

Net = Gross - Projected + Safety stock

requirements requirements in inventory (if any)
in period t period t in period t
Definition of Terms
Gross requirement: The total expected demand for an item or raw materials during each time period
without regard to the amount on hand.
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Scheduled receipts: Open orders (orders that have been placed and are) scheduled to arrive from
vendors or elsewhere in the pipeline by the beginning of a period.
Projected on hand: The expected amount of inventory that will be on hand at the beginning of each time
period: scheduled receipts plus available inventory form last period.
Net requirements: The actual amount needed in each time period.
Planned-order receipts: The quantity expected to be received by the beginning of the period. Under lot-
for-lot ordering, this quantity will equal net requirements.
Planned-order releases: Indicates a planned amount to order in each time period; equals planned-order
receipts offset by lead time. This amount generates gross requirements at the next level in the assembly
or production chain. When an order is executed, it is removed from “planned-order releases” and entered
under “scheduled receipts.”
Lot-for-Lot Ordering: Perhaps the simplest of all the methods is lot-for-lot ordering. The order or run
size for each period is set equal to demand for that period. Not only is the order size obvious, it also
virtually eliminates holding costs for parts carried over to other periods. Hence, lot-for-lot ordering
minimizes investment in inventory.

Format for MRP

Week Number 0 1 2 3 4 5 6 7 8
Item:
Gross requirements
Scheduled receipts
Projected on hand
Net requirements
Planned-order receipts
Planned-order releases
Illustration on MRP
To demonstrate how the various elements of an MRP system are integrated, a simple problem is
presented here to demonstrate how quantities are calculated, lead times are offset, and order releases and
receipts are established.
Suppose that we want to produce product T, which consists of two parts U, three parts V, and one part
Y. Part U, in turn, is made of one part W and two parts X. Part V is made of two parts W and two parts
Y. Figure 4.5 shows the product structure tree for product T.

U (2)
Materials Management V (3)Page 19
 Figure 4.5 Product Structure Tree for Product T
Assume that the lead times to make the parts and their respective on-hand inventories and scheduled
receipts are as follows:

Part Lead On-Hand Scheduled

Time(weeks) Inventory Receipts*
T 1 25 -
U 2 5 5
V 2 15 -
W 3 30 -
X 2 20 -
Y 1 10 -
*Subassemblies or pats that have been previously ordered but are not scheduled for delivery until a
future date (week three for subassembly U in this example).
If 100T is required, we can create a time schedule chart specifying when all the material necessary to
build T must be ordered and received to meet this requirement.

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4.8 Inventory Analysis System (Classification)
Items that are in the inventory are not of equal importance in terms of the amount invested, profit
potential, sock-out penalties…etc. Therefore, all items do not deserve the same degree of attention.
Inventories can be classified in to various groups on the basis of the selective inventory management
approach as follows.
1. ABC Inventory Analysis (Always, Bette, Control) Analysis.
2. VED Inventory Analysis (Vital, Essential, Desirable) Analysis.

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 3. SDE Inventory Analysis (Scarce, Difficulty, Easy) Analysis.
4. HML Inventory Analysis (High, Medium, Low) Analysis.
5. FNSD Inventory Analysis (Fast moving, Normal, Slow Dead) Analysis.
6. XYZ Inventory Analysis (High, Moderate & Low closing inventory items) Analysis.
1. ABC Inventory Analysis
The technique tries to analyze the distribution of any characteristic by money value of importance in
order to determine its priority. In materials management, this technique has been applied in areas
needing selective control, such as inventory, criticality of items, obsolete stocks, and purchasing orders,
receipt of materials, inspection, store keeping and verification of bills.
Even though there is lack of clear-cut principle to classify items in to A, B and C for all organizations,
the normal items in most organizations show the following pattern:
1- “A” items constitute about 5-10% of the total number of items purchased (in inventory) that would
account for about 70–80% of the total dollar value (usage value).
2- “B” items constitute about 10-20% of the total number of items purchased (in inventory) that
would account for about 10–15% of the total dollar value.
3- “C” items constitute about 65-80% of the total number of items purchased (in inventory) that
would account for about 5 to 10% of the total dollar value.
ABC procedure
The mechanics of classifying the items into ‘A’, ‘B’ and ‘C’ categories is described in the following
steps.
1. Calculate the annual usage in birr for each item by multiplying the annual usage with unit price.
2. Rank the items from highest birr usage annually to the lowest annual usage in birr.
3. Determine the cumulative annual usage value and total number of items.
4. Convert the annual usage value and total number of items in to percentage.
5. Categorize the items in A, B, and C categories

Example1: XYZ factory adopts the ABC method of classifying inventories. Currently, the factory has
10 items. The following is the data related to the items.

Item No Annual usage, Q Unit cost (birr)

22 1100 2
68 600 40
27 100 4

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 03 1300 1
82 100 60
54 10 25
36 100 2
19 1500 2
23 200 2
41 500 2
Classify the items into ABC with A items taking 80%, B items taking about 15% and C taking 5% of
the total birr value.
Solution:
Step 1: Calculate the annual usage in birr.
Item No Quantity Unit cost Total cost
22 1100 2 2,200 (4)
68 600 40 24,000 (1)
27 100 4 400 (8)
03 1300 1 1,300 (5)
82 100 60 6,000 (2)
54 10 25 250 (9)
36 100 2 200 (10)
19 1500 2 3,000 (3)
23 200 2 400 (7)
41 500 2 1,000 (6)
Step 2: Rank the items from highest to lowest annual usage in birr. (Shown next to the total cost column
of step 2 above, in bracket)
Step 3: Determine the cumulative annual usage value and total number of items.
Step4: Convert the annual usage value and total number of items in to percentage.
Item NoAnnual Expenditure % of total value Com. % of total value
68 24,000 61.93 20% A
77.41
82 6,000 15.48
19 3,000 7.74
22 2,200 5.68 16.77 30% B
03 1,300 3.35
41 1,000 2.58
23 400 1.03
27 400 1.03
5.8 50% C
54 250 0.645
36 200 0.516
38,750
Implementing ABC analysis

Factor Item A Item B Item C

1-Degree of Control High Moderate Low

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 2-Ordring procedure High Moderate Low
3-Priority Treatment High Moderate Low
4-Safety Stock Low Moderate High
5- Price Discount Low Moderate High
6-Physical Stock Taking High Moderate Low
7-Value analysis Heavy emphasis Moderate Less emphasis
8-Nature of purchasing Centralized Combined Decentralized
2. VED (Vital, Essential, Desirable) Analysis

The analysis if based on the criticality of inventory.

 V-item – are items when go out of stock or when not readily available, completely bring the
production to a halt. So, they should be stored adequately to insure continuous production.
 E-item – are items without which temporary losses of production or dislocation of production
work occurs.
 D-item – are all other items which are necessary but do not cause any immediate effect on
production.
3. SDE (Scarce, Difficult, Easily) Analysis
This analysis is based on availability of items (raw materials).
 S-item – are items which are in small supply and are usually imported items.
 D-item – are items which are available in the market but cannot be procured easily. For example,
items which have to come from far off cities.
 E-item – are easily available items; mostly local items
4. HML (High, Medium, Low) Analysis
The cost per item is considered for this analysis. High cost item (H), Medium cost items (M) and Low
cost items (L) help in bringing control over consumption at the department level.
5. FSN (Fast, Slow, Normal) Analysis
Here the quantity and rate of consumption is analyzed to be classified as fast moving, normal, and slow.
This classification helps in arranging stocks in the stores according to the frequency that the items are
used or consumed.
6. XYZ Analysis
The analysis is based on the value of closing inventory.
 X-items – Items with high closing inventory.
 Y-items – Items with moderate closing inventory.
 Z-items – Items with low closing inventory.
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4.9JUST IN TIME (JIT) OPERATION
The JIT approach was developed at the Toyota Motor Company of Japan by Taiichi Ohno (who
eventually became vice president of manufacturing) and several of his colleagues. The development of
JIT in Japan was probably influenced by Japan being a crowded country with few natural resources. Not
surprisingly, the Japanese are very sensitive to waste and inefficiency. They regard scrap and rework as
waste and excess inventory as an evil because it takes up space and ties up resources.
According to Voss, JIT is viewed as a “Production methodology which aims to improve overall
productivity through elimination of waste and which leads to improved quality”. JIT provides an
efficient production in an organization and delivery of only the necessary parts in the right quantity, at
the right time and place while using the minimum facilities”.
The term just-in-time (JIT) is used to refer to an operations system in which materials are moved through
the system, and services are delivered with precise timing so that they are delivered at each step of the
process just as they are needed-hence the name just-in-time. Initially, the term JIT referred to the
movement of materials, parts, and semi finished goods within a production system.
The ultimate goal of JIT is a balanced system, that is, one that achieves a smooth, rapid flow of materials
and/or work through the system. The idea is to make the process time as short as possible by using
resources in the best possible way. The degree to which the overall goal is achieved depends on how
well certain supporting goals are achieved. Those goals are eliminate disruptions, make the system
flexible, eliminate waste, especially excess inventory.
Benefits of JIT
The most significant benefit is to improve the responsiveness of the firm to the changes in the market
place thus providing an advantage in competition. Following are the benefits of JIT:
 Product cost—is greatly reduced due to reduction of manufacturing cycle time, reduction of
waste and inventories and elimination of non-value added operation.
 Quality—is improved because of continuous quality improvement programs.
 Design—Due to fast response to engineering change, alternative designs can be quickly brought
on the shop floor.
 Productivity improvement.
 Higher production system flexibility.
 Administrative and ease and simplicity.

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