Chapter Summary
Chapter 12: Inventory Management.

Inventory is a stock or storage of goods.

Different types of Inventory:
  • Raw materials and purchased parts
  • work in process (WIP)
  • finished goods inventories or merchandise
  • maintenance and repairs (MRO) inventory
  • goods-in-transit to warehouses or customers (pipeline inventory)

Nature and Importance of Inventory
Inventories are necessary for a firm to operate efficiently and almost all business transactions involve the delivery of a product or service in exchange for currency. For this reason, inventory management is a very important part of core operations activities. Most retail businesses and wholesale organizations acquire most of their revenue through the sale of merchandise (inventory). In order for business and supply chains to run effectively, and efficiently they must meet all the listed requirements for effective inventory management. Some of the main concerns are the level of customer service and the cost of ordering, storing, and carrying inventory. Therefore, in order to be a successful and profitable company, inventory management must be managed wisely.

There are certain requirements that must be taken into consideration during the inventory management process. These requirements are: keep track of the inventory, have a reliable forecast of demand, knowledge of lead times and lead time variability, reliable estimates of inventory holding costs, ordering costs, and shortage costs, and have a classification system for inventory items.

Some important Functions
of inventories include -

1. to meet anticipated customer demand (to meet the anticipation stocks, average demand)
2. to smooth production requirements (create seasonal inventories to meet seasonal demand)
3. to decouple operations (eliminate sources of disruptions)
4. to protect against stock-outs (hold safety stocks to prevent the risk of shortages)
5. to take advantage of order cycles (buys more quantities than immediate requirements - cycle stock, periodic orders, or order cycles)
6. to hedge against price increases (purchase large order to hedge future price increase or implement volumn discount)
7. to permit operations (Little's Law: the average amount of inventory in a system is equal to the product of the average demand rate and the average time a unit is in the system)
8. to take advantage of quantity discounts (supplies may give discount on large orders)

For company's management, the most important reasons for having an inventory management system is to:
1. track existing inventory
2. know what quantity will be needed
3. know when these items will be needed
4. know how much items will cost

There are two types of inventory control used- Perpetual and Periodic. In a perpetual inventory system (usually used in supermarkets or department stores), a continuous flow of inventory count is tracked using a point of sale (POS) check out system. This system is perfect for companies to manage what is sold and reorder when a reorder point is reached. Another advantage of this system is its ability to account for shrinkage (theft) and inventory turnover. The periodic system (used in smaller retailers) is used to take a physical count of inventory at periodic intervals to replenish the inventory. This system would be most beneficial for companies that do not have products with UPC or bar codes, such as nuts and bolts and are purchased in large quantities at a time. In this case, someone on a line would monitor the level of the bin and notify a manager when an order would need to be placed.

Economic Order Quantity Models - the order size that minimizes annual costs ( 3 types)

1)Basic economic order quantity model (EOQ)

  • used to identify a fixed order size that will minimize the sum of the annual costs of holding inventory and ordering inventory
1. Only one product involved
2. Annual demand requirements are known
3. Demand is spread evenly throughout the year so that the demand rate is reasonably constant
4. Lead time does not vary
5. Each order is received in a single delivery
6. There are no quantity discounts

2)Economic production quantity model (EPQ)

  • the batch mode of production is widely used in production; the reason for this is that capacity to produce a part exceeds the part’s usage or demand rate ( the larger the run size, the fewer the number of runs needed and, hence, the lower the annual setup cost; as long as production continues, inventory will continue to grow; (see formulas below)


1. Only one item is involved
2. Annual demand is known
3. Has a constant usage rate
4. Usage occurs continually, but production occurs periodically
5. The production rate is constant
6. Lead time does not vary
7. There are no quantity discounts

3) Quantity discount model

  • Price reductions for large orders offered to customers to induce them to buy in large quantities; If quantity discounts are offered, the buyer must weigh the potential benefits of reduced purchase price and fewer orders that will result from buying in large quantities against the increase in carrying costs caused by higher average inventories; The buyers goal is to select the order quantity that will minimize total cost (see total cost formula below);

Equations to know:

Annual carrying cost = (Q/2)*H [Q = Order quantity in units, H = Holding (carrying) cost per unit]
Annual ordering cost = (D/Q)*S [ D = Demand, S = Ordering cost]
Total cost (TC) =(Q/2)*H + (D/Q)*S

  • Total cost curve is U-Shape
Length of order cycle = Q/D

EPQ= square root[(2DS)/H]*square root[p/(p-u)]
p=production or delivery rate
u=usage rate
Reorder Point: ROP=d*LT
d=demand rate(units per period/day/week)
LT=lead time(same units as d)
EOQ=square root of (2DS)/H

Inventory point-of-sale (POS) systems,
which record items at time of sale electronically, can help make forecasting more accurate. Knowing the lead time of a product, which is the time interval between ordering and receiving the order, is crucial to the success of a business. Long lead times impair the ability of a supply chain to quickly respond to changing conditions, such as changes in the quantity demanded, product or service design, and logistics.

1. Which one is NOT a function of inventory? (pg. 543)
a. meet anticipated customer demands
b. smooth production requirements
c. decouple operations
d. protect against stock outs
e. they are all functions of inventory

(answer e.)

2. When dealing with inventory, the Little's Law is used for? (pg. 544)
a. counting inventory
b. quantifying pipeline inventory
c. preventing shortages in inventory
d. all of the above
e. none of the above

(answer b.)

3. Which of the following are functions of inventory that management is concerned with? (P.544)
a. Make sure you never run out of inventory
b. Make decisions about how much to order
c. Make sure there is enough space available for all the inventory
d. Make decisions about when to order
e. both b and d

(answer e)

4. Which of the following best describes lead time? (pg. 547)
a. The time that sales are at a profit
b. The time that the company is ahead of it's competitors
c. The time interval between submitting and receiving the order
d. The time it takes to record items at time of sale
e. none of the above

(answer c)

5. Which costs is associated with keeping items in inventory? (pg. 547)
a. Holding costs
b. Ordering costs
c. Shortage costs
d. A and B
e. All the above

(answer A)

6) Which is the most commonly used measure of managerial performance. Pg. 542
a. Capital structure
b. ROI(return on investment)
c. Demand
d. Inventory costs
e. Forecasting

Answer: b

7) What are independent-demand items? Pg. 542
a. Items that are ready to be sold and used
b. Components of products rather than finished products
c. Special order items
d. Products that appeal to a certain demographic of customers
e. Seasonal demand items

Answer: a

8) Which of the following is
not a function of inventory? Pg. 543
a. To meet anticipated customer demand
b. To smooth production requirements
c. To protect against stock-outs
d. To know lead times and lead time variability
e. To hedge against price increases

Answer: d

9) Which inventory counting system keeps track of removals from inventory on a continuous basis? Pg. 545
a. Two-bin system
b. Periodic system
c. Perpetual system
d. Online system
e. Operations system

Answer: c

The economic order quantity model (EOQ), identifies:
Pg 550
a. Production of batch items or lots
b. A constant usage rate
c. Units received incrementally during production
d. Fixed order size by minimizing the sum of annual costs of holding and ordering inventory.
e. Total cost of all orders produced annually

Answer: d

11. Which of the following (is/are) types of inventory?
a. Tools and Supplies
b. Maintenance and Repair (MRO)
c. Pipeline
d. Finished Goods
e. all of the above are inventories

answer e. Pg551

12. A perpetual Inventory system takes a physical count of inventory on which of the following intervals?
a. Fixed intervals
b. Annual intervals
c. Periodic intervals
d. A and B
e. A and C

answer a Pg 554

13. When the amount on hand reaches a predetermined minimum, which inventory system orders a fixed quantity?
a. Good organization
b. Perpetual inventory
c. Organized inventory
d. Periodic inventory
e. A and C

answer b
Pg 554

14. Effective inventory management estimates all of the following costs except:
a. Transaction cost
b. Shortage cost
c. Secretary cost
d. Holding cost
e. all of the above

answer c Pg556

15. The risk of stock-out increases as?
A. The amount of safety stock increases
B. The amount of safety stock decreases
C. The amount of safety stock remains constant
D. Safety stock has no effect on stock-out
E. none of the above

Answer: B pg 572

16. Which of the following are NOT part of the basic functions of inventory systems that management should be concerned with (p 553) ?
a. what quantity will be ordered
b. tracking existing inventory
c. how inventory will be delivered
d. when to order additional inventory
e. none of the above

Answer: c

17. Which inventory system is the best method to prevent inventory theft/loss?
a. Perpetual Inventory System
b. Periodic Inventory System
c. Both are equally good
D. none of the above
E. Studies are inconclusive regarding which is the best method

Answer: a pg554

18. Which of the following listed is/are function(s) of POS(point-of-sale) system?
a. record actual sales electronically
b. provide forecast of what items will most likely to attract customers and increase sales
c. calculate sum of total sales
d. a&b
e. all of above

Answer: d, pg. 555

19. Which one of these assumptions do NOT qualify to create an ideal situation to use the Basic EOQ Model?
a. there are no quantity discount
b. there is only one product involved
c. demand requirements are unknown
d. lead time does not vary
e. none of the above

Answer: c, pg. 559

20. Which one of these factors are NOT a determinant of the reorder point?
a. rate of demand
b. acceptable stock-out risk level to management
c. lead time variability
d. All of above are determinants of reorder point.
e. None of the above are determinants of reorder point
Answer: d, pg. 571

21. "A physical count of items in inventory made at periodic intervals", refers to _?
a. periodic system
b. perpetual inventory system
c. two bin system
d. universal product code
e. point of sale

Answer: a, pg. 553

22. Which of the following is NOT a function of inventories?

a) to meet anticipated customer demand
b) to smooth production requirement
c) to work more closer with suppliers to coordinate shipments
d) to take advantage of order cycles
e) all of the above

Answer: c, pg. 549

23. What is an inventory a stock or store of ?

a) ideas
b) goods
c) shipments
d) networks
e) a and b

Answer: b, pg. 549

24. Which of the following is NOT an order size model?

a) basic economic order quantity model
b) economic production model
c) quantity discount model
d) single period model
e) none of the above

Answer: d, pg. 559

25. Which is not an requirement for effective inventory management?

a) a system to keep track of the inventory
b) A reliable forecast of demand
c) effective transportation analysis
d) knowledge of lead times
e) a classification system

Answer: C, pg. 553

26. Which of the following is a function of inventory?
a) To smooth production requirements
b) To meet anticipated customer demand
c) Decouple operations
d) both a and b
e) all of the above

Answer: E, pg. 551-552

27. Which of the following (is/are) a result of a company's failure to manage their inventory properly?
a) Decline in Level of customer service
b) Increase in Ordering,carrying, and storage costs
c) Stock-outs or overstock
d) both a and c
e) all of the above are results of improperly managing inventory

Answer: E, pg. 553

28. Little's Law states:
a) The average amount of inventory in a system is constant.
b) The average amount of inventory in a system is equal to the product demand rate and time in the system.
c) The average amount of inventory in a system is equal to last year's forecast.
d) The average amount of inventory cannot be predicted.
e) All the above

Answer: B, pg. 552

29. Which of the following is/are acceptable inventory counting systems?
a) Perpetual
b) Normal
c) Periodic
d) both a and b
e) both a and c

Answer: E, pg. 553-554

30. Which of the following is NOT a requirement for manager to effectively managing inventories?
a) Income from operations must equal income from financing activities
b) Have a reliable forecast of demand that include an indication of past forecast orders
c) Know lead times and lead time variability
d) Have a classification system for inventory items
e) all of the above

Answer: A, pg. 553