Page 184 - DMGT206_PRODUCTION_AND_OPERATIONS_MANAGEMENT

Unit 9: Inventory Model and Safety Stocks

Shortage or Stock-out Costs Notes

When the stock of an item is depleted, an order for that item must either wait until the stock is
replenished or be canceled. There is a trade-off between carrying stock to satisfy demand and the
costs resulting from stock out. The costs that are incurred as result of running out of stock are
known as stock- out or shortage costs. As a result of shortages, production as well as capacity can
be lost, sales of goods may be lost, and finally customers can be lost.
In this context, it is important to understand the difference between dependent and independent
demand. In manufacturing, inventory requirements are primarily derived from dependent
demand, however, in retailing the requirements are basically dependent on independent demand.

Inventory systems are predicated on whether demand is derived from an end item or is related
to the item itself. Because independent demand is uncertain, extra inventory needs to be carried
to reduce the risk of stocking out.
To determine the quantities of independent items that must be produced, firms usually use a
variety of techniques, including customer surveys, and forecasting. However, a balance is
sometimes difficult to obtain, because it may not be possible to estimate lost profits, the effects
of lost customers, or penalties for delayed order fulfillment.
Where the unfulfilled demand for the items can be satisfied at a later date (back order case), in
such a case, the cost of back- orders are assumed to vary directly with the shortage quantity (in
rupee value) and the cost involved in the additional time required to fulfill the backorder (`/`/
year). However, if the unfulfilled demand is lost, the cost of shortages is assumed to vary
directly with the shortage quantity (`/unit shortage). Frequently, the assumed shortage cost is
little more than a guess, although it is usually possible to specify a range of such costs.

Self Assessment

Fill in the blanks:

4. The heart of ……………… decisions lies in the identification of inventory costs and
optimizing the costs relative to the operations of the organization.

5. The costs that are incurred as result of running out of stock are known as ………………
costs.

6. Ordering costs have two components in which one component is relatively ………………
and another component will ……………… .

9.3 Inventory Control by Classification Systems

It is useful to visualize the inventory of a medium sized business organization. The inventory
would comprise thousands of items, each item with different usage, price, lead time and
specifications. There could be different procurement and technical problems associated with
different items. In order to escape this quagmire, many selective inventory management
techniques are used.

9.3.1 ABC Classification and Analysis

Vilfredo Pareto postulated the 80-20 rule, surprisingly, inventory also seems to follow that rule.
In other words, typically only 20 percent of all the items account for 80 per cent of the total rupee

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