If you are reading this article it likely means that you already understand the basics of Inventory Management, purchased an inventory management system, and have things up and running. Now you are looking to get a grasp on how to understand different models of inventory forecasting and control that will help you lower your inventory levels without taking a hit to your level of service. If all of that is true; you are in the right place. This article is written from an academic standpoint and by learning these concepts it should help you apply them to your own inventory practices, or at the minimum understand what your inventory software is trying to do for you.
In my inventory forecasting article I go over a single period inventory forecasting model called the newsvendor model which you can read here. The newsvendor (newsboy) model works for a very specific type of situation where you make a prediction of how much inventory to order before a pre-specified selling season. Typically this is not the case for most businesses wherein business is conducted continually over an indefinite period of time. That doesn’t mean that the newsvendor model doesn’t have a purpose, and in fact it can always be used as a simple gut check to see if you are in the right ballpark for a specific inventory item.
Inventory Control Systems
You have an operation and you are carrying inventory. Business is continuous and takes place over multiple periods of time. So we need a model to help us make decisions. There are two main systems used for setting inventory levels in this environment and they are:
- Reorder Point System
- Base Stock Inventory System
Under the Reorder Point System we continuously monitor inventory status and whenever inventory drops below a predefined threshold we reorder more inventory. Each time we reorder, we will order the same fixed amount of inventory.
Using the Base Stock System we will review inventory at some regular interval of time (P denotes the period of time and is determined by the formulas) and always order inventory at that time. The amount of inventory that we order will be the amount necessary to bring the inventory back to our desired base stock level.
Both systems require that we have information regarding the lead time it takes for inventory to be replenished. This means that retaining data on how long it takes to replenish your inventory is essential, and any good inventory software system will do this for you.
You will also need to use the Economic Order Quantity (EOQ) method for determining either the base stock level, or the period of time P for the Reorder Point System. Depending on which inventory control system you choose to use, you will have to understand the Economic Order Quantity model.
Economic Order Quantity
Wikipeidia has a really good rundown of the EOQ model. For any inventory control system you are going to want to select the right quantity of inventory to order based on the demand of the customer but also to minimize economic costs. This is the purpose of the EOQ model. The basis of the model attempts to determine the total cost for inventory and is expressed as the total cost equals the sum of the following:
- Purchase cost: This is the variable cost of goods.
- Ordering cost: This is the cost of placing orders. This portion of the total cost relies on understanding the daily demand for the items in inventory as it relates to how many times over a year we will have to incur the ordering cost.
- Holding cost: the average quantity in stock times the cost of holding each item.
Once we have determined the all of these factors we can derive the value of Q, the optimal amount of inventory to order. Once we have Q we can then either calculate the value of the period P for the Reorder Point System or we can use it to determine T, the base stock level if we are using the Base Stock System.
To use either of these systems we need to gather information, which should be gathered by any good inventory management system. Here is a list of the information we need to gather:
- The cost of ordering inventory
- The cost of carrying the inventory in our own warehouses
- The average daily demand of each item
- The supplier lead time to deliver the inventory order
- Our desired service level
If we have all of this information, we can use either of the two main systems for inventory control and can determine the amount of inventory to order in the most economical way. For the sake of this article I have left out all of the formulas used in these systems, however if you need to look them up they are easily found on Wikipedia. Assuming you are using software, you just need to understand what the system is attempting to do and alter any parameters based on which system you want to utilize.