1. Inventory Management I: Inventory Fundamentals
This module covers definitions and types of inventory, the role of inventory, cycle and safety stock, inventory costs, and ABC analysis.
Authors: Stu James and Robert Robicheaux
© 2013 Stu James and Management by the Numbers, Inc.

2. Topics Covered
Topics Covered
This MBTN Module introduces the fundamentals of inventory management including:
Definition of Inventory
Types of Inventory
Roles of Inventory
Cycle and Safety Stock
Inventory Costs
ABC Analysis
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3. What is Inventory Management?
When a business has items beyond their immediate use, those items are considered inventory. Inventory management is the planning and controlling of inventories to best meet the objectives of the organization. Successful management of inventory control systems requires balancing of competing forces on the business.
Pressures to lower inventories include:
Cost of Capital – using (investing) cash for inventory rather than some other purpose.
Storage and Handling Costs – Inventory must be put somewhere and the more inventory, the higher the storage and handling costs.
Taxes, Insurance, and “Shrinkage” – Shrinkage includes spoilage, damage, obsolescence, theft, etc.
So, when inventory levels increase, all of these costs also increase, leaving the company in a weaker position unless there is some offsetting benefit.
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4. What is Inventory Management?
So, if costs always increase with higher inventory, then we should always minimize inventory, right? Well, no. As you might expect, there are some benefits to inventory which push in the other direction.
Pressures to increase inventories include:
Customer Service – fewer delays in delivery, stock outs, loss of sales.
Ordering Costs – Ordering can be expensive. Higher inventory levels means ordering less often.
Potential Quantity Discounts – If more is ordered, businesses often receive a higher discount based on quantity.
Improved Utilization of Transportation, Labor and Equipment. Having additional inventory may allow for better economies of scale or open up alternative methods not available with low inventory.
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5. Types and Roles of Inventory
Now let’s talk more about different types of inventory and the reasons for holding inventory in the first place.
The major accounting categories used to describe inventory are:
Raw Materials – Components and materials that have been purchased and are waiting for use in production.
Work-in-Progress – Parts or products in various stages of the manufacturing process.
Finished Goods – Completed items that are being held for sale to customers.
Maintenance, Repair and Operating Supplies - Components used to maintain or repair equipment, or supplies used in the normal operation of the business.
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6. Types and Roles of Inventory
There are five different purposes for holding inventory:
Cycle Stock – Inventory required to have in stock to meet normal demand; amount varies directly with lot size (Q).
Safety Stock – Inventory to protect against uncertainties in demand, lead time, and supply changes.
Pipeline Inventory – Inventory moving from point to point in the material flow system.
Seasonal or Anticipation Inventory – Inventory used to smooth a mismatch between demand and supply such as unusually high or low seasonal demand, potential for disruption in supply, etc.
Speculation Inventory – Additional inventory generally purchased to secure a particular price farther into the future.
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7. Cycle Stock
Cycle Stock
Cycle stock represents the inventory carried between orders. Where demand is constant over time and orders are received instantaneously, we can visualize inventory flow as in the graphic below. In this “perfect world”, inventory would drop to zero just as Order Quantity or Lot Size (Q) arrives to replenish inventory. The average cycle inventory level in the system would be represented by Q / 2. Q
Inventory
Level
Q/2 P1 P2
Time
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8. Cycle Stock Definitions Insight
Average Cycle Stock = Order Quantity or Lot Size (Q) / 2
Therefore, as the order quantity, Q, increases, the average cycle stock also increases. What other impact does an increase in Q have?
Orders are made less frequently
The total expenditures for an order are higher (though perhaps with a lower unit cost)
More storage space is necessary for inventory
The odds of a stock out (running out of an item) are less because low levels of inventory are reached less often.
Insight
The choice of lot size has significant implications for the cash flow, cost, and service level of a business.
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9. Pipeline Inventory Definitions
Pipeline Inventory = Average Demand * Lead Time
Be sure to use the same time period, such as average demand (per week) * the lead time (in weeks). If they are not provided in the same units of time, you’ll need to use the appropriate conversion.
Question 1: Jamie works for an electronics retailer. The store sells an average of three 50” flat screen TVs each day. It take 2 weeks to receive orders from their supplier and they order 100 TVs at a time. What is the average cycle inventory and pipeline inventory for the TVs if Jamie is currently waiting on delivery of one order?
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10. Pipeline Inventory Answer:
Avg. Cycle Stock = Q / 2
= 100 / 2 = 50 units
Pipeline Inventory = Average Demand * Lead Time
= 3 * (2 * 7) = 42 units (Note: convert into days)
It may seem odd to calculate 42 units when you know that there are 100 actual units in transit. The pipeline inventory is considered units in transit equal to the average demand during the lead time.
Question 2: The same retailer also has a daily order to replenish their fast moving eFones. The daily demand for the eFone averages 150 units, and therefore the daily order is also 150 units. It takes 12 days to receive an order of eFones. What is the pipeline inventory?
Answer:
Pipeline Inventory = Average Demand * Lead Time
= 150 * 12 = 1800 eFones
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11. Safety Stock
Safety Stock
If the pipeline inventory represents the average amount of inventory that would need to be in stock when an order is placed, it would seem to follow that it might also represent the level of inventory at which it would be time to place an order. And, if all were perfectly predictable, it would be. However, often demand and lead times are not constant, so a company might decide to have additional stock on hand to protect against the variability in demand, or delays in receiving orders placed. This additional stock is called Safety Stock.
There are several approaches for calculating safety stock.
Minimize the sum of holding costs and stock out costs
Apply a probabilistic model to achieve a certain service level. The model would differ depending on whether:
Demand alone is variable
Lead time alone is variable
Both demand and lead time are variable
Here, we will explain where demand varies and lead time is known.
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12. Safety Stock With Variable Demand
If we assume that demand during the lead time varies with a normal distribution, we can calculate the amount of safety stock necessary to achieve a service level of X% where lead time is constant and known. Visually, this is shown below for 95% service level (1.65 std. dev.)
50% Service Level
95% Service Level
Safety Stock
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13. Safety Stock With Variable Demand
Safety Stock with Variable Demand Only
Safety Stock With Variable Demand
We can see from this graphic that the vast majority of the demand values fall between say 60 and In fact, if daily demand follows a normal distribution, 95% of all demand will be under the mean * standard deviation.
This means that we can use the 95% as a service goal that we can, in turn, use to set our safety stock. The mean represents our previously calculated pipeline inventory and 1.65 * standard deviation would be the safety stock required to meet our service goal (of 95% in our example). Therefore, 1.65 * 25 = or 42 units of safety stock.
Insight
This model works under the assumption where demand varies according to a normal distribution but lead times are constant.
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14. Safety Stock With Variable Demand Only
Definitions
Safety Stock as a function of standard deviation and service level
Example: Saul has analyzed the last year of demand and found that the average demand for the length of the lead time is 47 widgets with a standard deviation of 5. If Saul wants to target a 99% service level, what should his safety stock be?
Answer: Service level of 99% corresponds to a 2.33 * Std Deviation. Safety Stock = 2.33 * 5 = 12 widgets.
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15. Safety Stock with Variable Demand Only
Question 3: Jamie wonders what the appropriate safety stock would be for the fast moving eFones to meet a service level of 95%. Analyzing the demand in more depth, the demand during the lead time is 150 units with a standard deviation of 14. What is the appropriate level of safety stock required to meet Jamie’s goal?
Answer:
Service level of 95% corresponds to 1.65 standard deviations.
Safety Stock = # StdDev for Service Level (95%) * Std.Dev.
= 1.65 * 14 = 23.1 or 24 (always round up)
Question 4: How many additional eFones would be required to reach a 98% service level?
Answer:
Safety Stock = # StdDev for Service Level (98%) * Std.Dev.
= 2.06 * 14 = 28.8 or 29 eFones
Therefore, Jamie would need an additional 29 – 24 or 5 ePhones for 98%.
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16. ABC Analysis
ABC Analysis
ABC analysis divides inventory into three classifications based on the annual dollar volume of items. This is based on the Pareto Principle, more commonly called the 80 / 20 rule. Here, it is applied to the annual capital flow of inventory where:
A items roughly comprise 20% of the items, and 80% of the value.
B items roughly comprise 30% of the items, and 15% of the value.
C items roughly comprise 50% of the items, but just 5% of the value.
Insight
These are rough guidelines, and it may also be that a B or C item may be a critical part (in a process) or have particularly difficult supplier issues. So there is more than just the dollar volume that may impact classification. The key is that the focus of management time is appropriate for the importance of the item to the success of the business.
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17. Annual Demand (Volume)
ABC Analysis
ABC Analysis
Definitions
Annual Dollar Volume = Annual Demand * Unit Cost
Example: Here is a very simple example of how a business’ inventory could be categorized. Notice that 667I and UFO3 could be either B or C based on annual dollar volume.
Item
Annual Demand (Volume)
Unit Cost
Annual Dollar Value
% Annual Dollar Volume
A, B or C
144C
5,000 $
$ 435,000.00
51% A
304B
2,500 $
$ 300,000.00
35%
99XY
10,000 $
$ ,000.00 6% B
67Q
4,000 $
$ ,000.00 5%
667I
300 $
$ ,000.00 2%
B or C
UFO3
2,000
$ ,000.00 1%
677T
250 $
$ ,000.00 0% C
333Y
22,000 $
$ ,200.00
ROF3
500 $
$ ,000.00
664C
800 $
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18. Annual Demand (Volume)
ABC Analysis
ABC Analysis
Item
Annual Demand (Volume)
Unit Cost
Annual Dollar Value
% Annual Dollar Volume
A, B or C
144C
5,000 $
$ 435,000.00
51% A
304B
2,500 $
$ 300,000.00
35%
99XY
10,000 $
$ ,000.00 6% B
67Q
4,000 $
$ ,000.00 5%
667I
300 $
$ ,000.00 2%
B or C
UFO3
2,000
$ ,000.00 1%
677T
250 $
$ ,000.00 0% C
333Y
22,000 $
$ ,200.00
ROF3
500 $
$ ,000.00
664C
800 $
Question 5a: Item QQ55 has annual demand of 200 units and costs $250 each. What is the annual dollar value and should it be classified as an A, B or C part?
Question 5b: Item CC24 has annual demand of 5000 units and costs $2.50 each. It is also a subcomponent in the 144C assembly. What is the annual dollar value and should it be classified as an A, B or C part?
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19. Annual Demand (Volume)
ABC Analysis
ABC Analysis
Item
Annual Demand (Volume)
Unit Cost
Annual Dollar Value
% Annual Dollar Volume
A, B or C
144C
5,000 $
$ 435,000.00
51% A
304B
2,500 $
$ 300,000.00
35%
99XY
10,000 $
$ ,000.00 6% B
67Q
4,000 $
$ ,000.00 5%
667I
300 $
$ ,000.00 2%
B or C
UFO3
2,000
$ ,000.00 1%
677T
250 $
$ ,000.00 0% C
333Y
22,000 $
$ ,200.00
ROF3
500 $
$ ,000.00
664C
800 $
Answers:
QQ55 Annual $ = Annual Demand * Unit Cost
= 200 * $300 = $60,000
CC24 Annual $ = 5000 * $2.50 = $12,500
The QQ55 would fall at the top of B range, but clearly is a step below the A parts. The CC24 falls in between B and C, but because it is a component of the most important inventory item, it would probably be classified as a B part.
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20. Inventory Management– Further Reference
Please see MBTN Inventory Management modules 2-4 that cover other important concepts related to this module.
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