Inventory Management

Read this summary. Pay close attention to the types of inventory control and the EOQ model. This source is useful because of the detailed information provided related to the function of inventories, reasons for inventory management, and types of inventory control that is useful.

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 continuousflow 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

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.

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.

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Last modified: Tuesday, April 9, 2019, 6:23 PM