Inventory control

The basic function of stock (inventory) is to insulate the production process from changes in the environment .

Note here that although we refer in this note to manufacturing, other industries also have stock e.g. the stock of money in a bank available to be distributed to customers, the stock of policemen in an area, etc).

One point to note from the above diagram is that most of the activities are a cost - it is only at the final point (sales of finished goods) that we get revenue to set against our costs and hopefully make a profit (= revenue - cost). Hence if we have cost associated with stock we need to deal with that stock in an Effective, Efficient and Economic manner (the 3E's as I tend to term it).

The question then arises: how much stock should we have? It is this simple question that inventory control theory attempts to answer.

There are two extreme answers to this question:

a lot

• this ensures that we never run out
• is an easy way of managing stock
• is expensive in stock costs, cheap in management costs

none/very little

• this is known (effectively) as Just-in-Time (JIT)
• is a difficult way of managing stock
• is cheap in stock costs, expensive in management costs

We shall consider the problem of ordering raw material stock but the same basic theory can be applied to the problem of:

• deciding the finished goods stock; and
• deciding the size of a batch in a batch production process.

The costs that we need to consider so that we can decide the amount of stock to have can be divided into stock holding costs and stock ordering (and receiving) costs as below. Note here that, conventionally, management costs are ignored here.

Holding costs - associated with keeping stock over time

• storage costs
• rent/depreciation
• labour
• overheads (e.g. heating, lighting, security)
• money tied up (loss of interest, opportunity cost)
• obsolescence costs (if left with stock at end of product life)
• stock deterioration (lose money if product deteriorates whilst held)
• theft/insurance

Ordering costs - associated with ordering and receiving an order

• clerical/labour costs of processing orders
• inspection and return of poor quality products
• transport costs
• handling costs

Note here that a stockout occurs when we have insufficient stock to supply customers. Usually stockouts occur in the order lead time, the time between placing an order and the arrival of that order.

Given a stockout the order may be lost completely or the customer may choose to backorder, i.e. to be prepared to wait until we have sufficient stock to supply their order.

Note here that whilst conceptually we can see that these cost elements are relevant it can often be difficult to arrive at an appropriate numeric figure (e.g. if the stock is stored in a building used for many other purposes, how then shall we decide an appropriate allocation of heating/lighting/security costs).

To see how we can decide the stock level to adopt consider the very simple model below.