Inventory Models

Inventory model is a mathematical model that helps business in determining the optimum level
of inventories that should be maintained in a production process, managing frequency of
ordering, deciding on quantity of goods or raw materials to be stored, tracking flow of supply of
raw materials and goods to provide uninterrupted service to customers without any delay in
delivery. The term ‘inventory’ refers to the stock of raw materials, parts and finished products
held by a business firm. It is the aggregate quantity of materials, resources and goods that are
idle at a given point of time. In a wider sense, “inventory consists of usable but idle resources.
The resources may be of any type; for example, men, materials, machines or money. When the
resource involved is material or goods in any stage of completion, inventory is referred to as
stock”. It may, therefore, be said that inventory comprises 4 M’s—men, materials, machines and
money. Inventory or stock control is a quantitative control technique with strong financial
implications. For many organizations, inventory control is the single most important control
technique having direct relationships with production, purchasing, marketing and financial
policies.

Economic Order Quantity

The economic order quantity (EOQ) model is used in inventory management by calculating the
number of units a company should add to its inventory with each batch order to reduce the total
costs of its inventory. The costs of its inventory include holding and setup costs. The EOQ model
seeks to ensure that the right amount of inventory is ordered per batch so a company does not
have to make orders too frequently and there is not an excess of inventory sitting on hand. It
assumes that there is a trade-off between inventory holding costs and inventory setup costs, and
total inventory costs are minimized when both setup costs and holding costs are minimized.

To calculate the economic order quantity for inventory you must know the setup costs, demand
rate, and holding costs. Setup costs refer to all of the costs associated with actually ordering the
inventory, such as the costs of packaging, delivery, shipping, and handling. Demand rate is the
amount of inventory a company sells each year. Holding costs refer to all the costs associated
with holding additional inventory on hand. Those costs include warehousing and logistical costs,
insurance costs, material handling costs, inventory write-offs, and depreciation. Ordering a large
amount of inventory increases a company's holding costs while ordering smaller amounts of
inventory more frequently increases a company's setup costs. The economic order quantity
model finds the quantity that minimizes both types of costs. EOQ considers the timing of
reordering, the cost incurred to place an order, and costs to store merchandise. If a company is
constantly placing small orders to maintain a specific inventory level, the ordering costs are
higher, along with the need for additional storage space.

For example, consider a retail clothing shop that carries a line of men’s shirts. The shop sells
1,000 shirts each year. It costs the company $5 per year to hold a single shirt in inventory, and
the fixed cost to place an order is $2. The EOQ formula is the square root of (2 x 1,000 shirts x
$2 order cost) / ($5 holding cost) or 28.3 with rounding. The ideal order size to minimize costs
and meet customer demand is slightly more than 28 shirts. A more complex portion of the EOQ
formula provides the reorder point.
ABC Inventory Analysis

ABC inventory analysis is a method used to classify a business’s stock items into three
categories – A, B and C, based on their value to the business. The items are the most important in
terms of the value they bring a company, whilst C items are the least valuable. The objective of
ABC inventory analysis is to help managers focus their time on their most valuable / important
products and adapt their inventory control policies accordingly. ABC analysis is a simple
framework to work out which items in your warehouse are the most important, and, should
therefore consume most of your time in terms of stock control and management. Focus on your
category A items. This could include reviewing and updating their demand forecast more
frequently to guarantee stock availability or interacting more regularly with suppliers to improve
lead times. ABC analysis can also help you work out appropriate inventory rules for each
category. It makes sense to set different service levels, safety stock levels and re-ordering
parameters for each category. You can then priorities the management of the policies based on
their category classification.

For example, you may want to focus on improving the service levels of your A class products,
over your Bs and Cs by increasing your safety stock levels. Avoiding stockouts on A items
should be a priority. Another example, San Miguel uses ABC analysis to determine which items
are critical, important and not very important. The company makes ice creams, dairy products,
beer, etc. Ingredients used are milk, sugar, preservatives, malt, hops and chemicals. Different
items are categorized as per their level of importance.

Safety Stock

Safety stock is an additional quantity of an item held by a company in inventory in order to

reduce the risk that the item will be out of stock. Safety stock acts as a buffer in case the sales of
an item are greater than planned and/or the company's supplier is unable to deliver additional
units at the expected time. If the company is a manufacturer, a safety stock of materials could
minimize the risk of production being disrupted. Of course there are additional holding or carry
costs associated with safety stock. However, the holding costs could be less than the cost of not
filing a customer's order on time or having to stop its production line. It is the additional stock
that is kept on hand so as to avoid stock outs. This helps in reducing losses due to stock outs.
Safety stock can be determined by calculating the stock out costs, the service level and the
probability of a stockout. The driving factor is that stock outs should be avoided. Calculating the
required safety stock using a simple probability model can be easily done in Microsoft excel, on
a statistics calculator or a cumulative distribution table. The data needed before performing the
calculation is: The average demand per time period, the standard deviation of demand per time
period, the assumption that demand is normally distributed.

For example, Assume that a company uses the economic order quantity (EOQ) model to
determine the amount of product or materials it orders. Since the model requires an assumption
(estimate) of annual demand, there is a risk that demand will be greater than the estimate used.
Let's say that the company's EOQ is 1,000 units. As a precaution, the company may decide to
always have an additional 100 units on hand as its safety stock. If demand is not constant, the
company could increase the quantity of its safety stock during its peak sales periods and then
reduce the quantity during periods of low sales.

Inventory Turnover Ratio

Inventory turnover ratio, defined as how many times the entire inventory of a company has been
sold during an accounting period, is a major factor to success in any business that holds
inventory. It shows how well a company manages its inventory levels and how frequently a
company replenishes its inventory. In general, a higher inventory turnover is better because
inventories are the least liquid form of asset. A Flash Report is a useful tool in measuring and
managing inventory turns. Inventory turnover ratio explanations occur very simply through an
illustration of high and low turnover ratios. Despite this, many businesses do not survive due to
issues with inventory. A low inventory turnover ratio shows that a company may be overstocking
or deficiencies in the product line or marketing effort. It is a sign of ineffective inventory
management because inventory usually has a zero rate of return and high storage cost. Higher
inventory turnover ratios are considered a positive indicator of effective inventory management.
However, a higher inventory turnover ratio does not always mean better performance. It
sometimes may indicate inadequate inventory level, which may result in decrease in sales.
Inventory Turnover Ratio Formula: Inventory turnover = Sales / Inventory Or Inventory
Turnover = Cost of goods sold / Average inventory.

As Example, For the fiscal year ending January 2018, Wal-Mart Stores (WMT) reported annual
sales of $500.34 billion, year-end inventory of $43.78 billion, and an annual cost of goods sold
(or cost of sales) of $373.40 billion.  Walmart's inventory turnover for the year equals:
$373.40 billion ÷ $43.78 billion = 8.53. Its days inventory equal: (1 ÷ 8.53) x 365 = 42 days.
This indicates that Walmart sells its entire inventory within a 42-day period, which is quite
impressive for such a large, global retailer.