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Employee Productivity, Workforce Productivity, Return on Investment in Human Resources
Personal Productivity Defined, Measured, Facilitated

Inventory management is the art of making in-demand products available when customers want them, while keeping inventory costs low.

This article is currently under revision. Please return later for the complete revised version.

Employees are expected to produce value for their employers business value that exceeds the cost of keeping them on the payroll. Employees, in other words, are expected to be productive.

Managers often have a pressing need to understand how productivity of their own employees is defined, measured, enhanced, and degraded. Such an understanding is especially critical when undertaking activities such as the following:

  • Workforce planning, recruiting, and hiring.
  • Empoyee performance reviews.
  • Decisions on pay raises and promotions
  • Employee discipline or termination.
  • Planning for employee training.
  • Negotiating with organized labor or employee unions, especially where the central issues include job descriptions, compensation, benefits, and working conditions.
  • Business case analysis to support funding decisions for projects, programs, and initiatives.
  • Reorganizing organizational structure and management reporting lines.
  • Redesigning workflow process.
  • Updating the organization's business plan.
  • Proposing new products and product lines especially where engineering design, esthetic design, and other creative accomplishments are called for.

Managers who wish to participate usefully in any of these activities should have an understanding of employee productivity that is practical and quantitative. Most managers, understand, moreover, that their own leadership performance will be measured largely in terms of the productivity of the organizations they mange.

For some job roles, objective and acceptable productivity measures are obvious and even standardized throughout an industry.

Contents

•  Defining and measuring productivity.
•  The value of time at work in the business case.

Related Topics

  • Return on investment ROI as a cash flow metric for investments and actions:
    See Return on Investment.
  • Defining, measuring, valuing, and comparing business benefits.
    See Business Benefits.
  • ROI metrics for company performance, earnings from capital assets and equity:
    See Profitability.
  • An overview of cash flow and financial statement metrics: see Financial metrics.

The meaning of the return on Investment concept

Contents

Defining and measuring Productivity

xxxx

The value of time at work in business case analysis

Enhancing employee productivity

exceeds to productivity is often defined in conjunction with the idea of efficiency.and services, inventory (or stock) may be called rightfully the "lifeblood" of the business. A healthy inventory flow enables sale closings, customer shipments, and productive work for company employees. Without this flow, the business dies. It should be no surprise to find that in many industries, a company's financial performance and position depend heavily on the firm's ability to manage inventory effectively and efficiently.

Inventory has several definitions:

  1. In business, the primary definition—as used above and in the rest of this article—refers to goods, raw materials, and other tangible items that a business holds, intended ultimately for sale.
  2. As a verb the term means to take count of (or list) units of a resource on hand at one point in time. A hotel business, for instance, might inventory the contents of a hotel room when a guest departs as a check against loss.
  3. The term also refers to a list created for a specific purpose. A hospital might create an inventory (list) of medical equipment and supplies that should always be on hand in an operating room.

Companies that acquire, hold, and sell inventory face a double challenge. On the one hand, in-demand products have to be readily available for shipment when customers are ready to buy. On the other hand, acquiring and managing stock that meets this objective can be very costly (see the section on costs below). Accordingly, management in many companies gives substantial and constant attention to finding ways to improve stock management, while minimizing costs at the same time.

This article further defines, explains, and illustrates inventory related terms, mainstream methods for stock management, relevant accounting practices, and performance metrics.

Contents

• Kinds of Inventory
    –  Merchandise
    –  Manufacturing: raw materials, work in progress, fInished goods
    –  Other kinds of Inventories
• Inventory as an Asset 
    –  Valuing the asset
         - Original valuation
         - Updating total value
         - FIFO vs LIFO conventions
         - Writing down value
    –  Reporting
    –  Activity and Efficiency Metrics
        - Inventory turns
        - Days Sales in inventory
• Management
    –  Costs
    –  Taking Inventory
    –  Forecasting and ordering
• Minimizing and avoiding costs

Kinds of inventory

Business inventory is normally classified either in the category "merchandise " or "manufacturing," although several other classifications are also mentioned here that fit neither of those categories.

Merchandise

Merchants who buy finished goods and then sell them in that form deal primarily with merchandise inventory. Retail shops and food stores, for instance, acquire, hold, and sell merchandise stock. Merchants earn margin on these goods for making them available when and where customers want them. The merchant's role may include packaging, shipping, delivery, or minor assembly, but these operations are not considered "manufacturing."

Strictly speaking, merchandise stock refers only to inventory actually owned by the merchant. As such, it is considered a company asset, to be valued and accounted for at the end of each accounting period. Merchandise held for sale on consignment and actually owned by someone else is not considered part of the Merchant's merchandise stock.

Manufacturing

Companies that buy raw materials or basic parts, and then manufacture finished goods from them normally classify inventory as either raw materials, work in progress, or finished goods.

  • Raw materials include goods in the form acquired from suppliers. For an oil production company, raw materials include untreated crude oil. For a sheet metal stamping company that produces automobile parts, raw materials include unworked sheet metal as acquired from the supplier.
  • Work in progress includes goods that have been worked or partially assembled, but which are not yet finished goods. For an automobile manufacturer, vehicles half way through the assembly line process are work in progress inventory.
  • Finished goods include goods the company may have manufactured from raw materials and work in progress which are now in condition to be sold and shipped. For the automobile manufacturer, finished vehicles not yet purchased or shipped to dealers are finished goods stock.

Note that one company's finished goods can be another company's raw materials. Flat sheets of steel may be finished goods for the steel company, but raw materials for the sheet-metal stamping company.

Other kinds of Inventory

The term legitimately applies to several other kinds of items that are not easily described as merchandise or manufacturing stock. For example ...

  • Hotels refer to guest rooms not yet sold for a given night as inventory. Airlines refer to unsold seats in each ticket class, for each scheduled flight, each day, as inventory.

    These assets become worthless with no recoverable value if they remain unsold at the end of their designated days. As a result, hotels and airlines sometimes offer last-minuted price discounts, believing it is better to recover at least some value instead of none.
  • Repair shops and other businesses that provide some kinds of services maintain a spare parts stock. Automobile repair shops, appliance repair shops, shoe repair shops, and watchmakers, for instance, either maintain spare parts stock of their own, or else work closely with parts suppliers who can supply them on short notice.

    Repair shops typically make at least some margin on the parts themselves, but these are not considered merchandise or finished goods. The customer may or may not receive a bill summarizing individual "parts" and "labor" charges.
  • Medical clinics, hair salons, and cleaning services normally maintain a supplies stock. These items are not sold directly to customers as merchandise, but they are used in the delivery of services.
  • Sellers of electronic books (ebooks) carry a product title inventory of programs or book titles. They hold master copies of each title, stored electronically, from which they produce and ship any number of individual customer copies at almost no cost. For these vendors, stock is not physical goods but rather a collection of rights to use intellectual properties. For non physical goods of this kind, some of the other major cost areas with traditional physical stock are also absent, such as storage costs and handling costs.

Inventory as an asset

Inventories are carried on the Balance sheet as assets. As such, they contribute to asset-related metrics such as total asset turnover and return on total assets. Moreover, they are usually listed under current assets because they are considered relatively liquid assets, that is, they will be or could be converted into cash in the near term. As current assets, they contribute also to liquidity metrics such as working capital and current ratio. Their contribution to these metrics can be substantial where they make up a significant part of the total asset base, as in manufacturing companies such as Cummins Engine, for instance, where inventories account for 18%-25% of the company's asset structure.

Valuing the asset

     Original valuation

The value of inventory on the Balance sheet is usually required by tax authorities and local GAAP to represent either:

  • Historical cost: The sum of all original direct and indirect costs of acquiring the stock and bringing it in house.
  • Cost or Market Value, whichever is lower: Under the lower of cost or market approach, market value may be estimated as current replacement cost except, however, for the following constraints on market price:
    • Market price cannot be higher than the estimated selling price, minus costs associated with the sale (net realizable value). This is the ceiling of permissible market values.
    • Market price cannot be lower than net realizable value minus a normal profit margin. This is the floor of permissible market values.
    • In other words, stock is valued at historical cost if that is lower than the market value "floor." Otherwise, it is valued at whichever is lower: market value ceiling, replacement cost, or market value floor

     Updating total value

Total inventory value normally changes more or less continuously, as new items are acquired and as existing items are either sold or lost. The value of individual items in stock can also change over time, as for instance, when items spoil or become obsolete.

In any case, total inventory value must appear on the Balance sheet at the end of the period as it stands at period end, after all value changes for the period have been recognized. A frequently used approach is to use the previous period's end total value as the beginning value for the currently ending period, and then apply this equation:

Ending value = Beginning value + Net purchases – Cost of Goods Sold

Note that cost of goods sold (COGS) is sometimes used as a stand-in for stock used up during an accounting period (see the inventory turns metric, below for instance). This is appropriate especially when a company turns raw materials into work in progress and then finished goods: Cost of goods sold reflects the direct and indirect labor costs and materials costs used to bring stock from one stage to the next, and thus it represents the total historical cost of these assets.

     LIFO and FIFO conventions

When the historical costs (or COGS) of each specific stock unit can be identified, the above instructions for reaching the total current inventory value are sufficient. However, additional valuing "rules" are required when both of two conditions apply:

  • Stocked units are interchangeable. One barrel of crude oil as raw materials may be considered interchangeable for all intents and purposes with any other barrel. One sealed can of prepared peas in finished goods may be considered interchangeable with thousands of others in stock.
  • Costs of acquiring units in stock are changing over time. Raw materials oil purchased in January may have cost $85/barrel. A barrel purchased in June may have cost $90, and an identical barrel purchased in December may have cost $98. Similarly, can of prepared peas may have a COGS of $1.00 in January, $1.10 in February, and $1.50 in March.

Using the canned peas example, suppose 75 cans were added to inventory during January, 125 in February, and 100 in March. A total of 60 cans were "used up" (sold) during these three months. The accounting question in such cases then is this: What was the COGS for the 50 units that left stock? Would that be January's COGS or another month's COGS?

With interchangeable units and changing price conditions, companies can choose any one of three approaches to valuing inventory. Once the approach is chosen for the first reporting period, however, tax authorities in most places do not change to a different approach in subsequent periods. Three acceptable approaches to valuing under these conditions are:

  • First In First Out (FIFO). When items are used up, the accountant precedes as though the single item that has been in stock for the longest time leaves first, followed by the item that has been on hand second longest, and so on. Under FIFO, all 60 cans of peas removed would be accounted for as 60 of the 75 "January" cans, for a COGS of 60 x $1.00 = $60.00.
  • Last in First Out (FIFO). Under FIFO, the accountant precedes as though the first to leave is the item that has been there the shortest time, followed by the second newest item, and so on. Under FIFO, all 60 of the cans of peas removed from stock would be accounted for as 60 of the 100 "March" cans, for a COGS of
    COGS = 60 x $1.50 = $90.
  • Average cost. Under the average cost method, the accountant uses a computed weighted average cost of goods sold per unit. For the canned peas example:

    Weighted Average COGS per Unit
                                       = (75 x $1.00 + 125 x $1.10 + 100 x $1.50) / ( 75 +125 + 100)
                                       = $362.50 / 300
                                       = $1.21 / unit
    Under the weighted average COGS approach,
                          COGS = 60 x $1.21 = $72.60

Which costing approach should a company choose? Remember that once chosen, the costing method cannot be changed. With this reality in mind, the company will choose an approach with the following in mind:

  • In times of rising costs, LIFO maximizes COGS and thus minimizes total reported remaining item values. A higher COGS under LIFO leads to lower reported income (and lower taxes). Note that International Financial Reporting Standards (IFRS) simply do not allow the use of LIFO in many countries.
  • In times of rising costs, FIFO minimizes COGS and thus maximizes total reported remaining items value. A lower COGS under FIFO leads to higher reported income (and higher taxes).

Regardless of which accounting convention is chosen, FIFO in fact describes the actual flow of inventory in most companies. Few companies sell newer items before selling older stock items they are holding. Many companies choose the Average cost method instead of either LIFO or FIFO, believing the average provides a more accurate measure of true stock costs during period.

     Writing down total value

In December 2012, Research in Motion (RIM) of Canada took a "write down" of $485 million on its inventory of unsold Blackberry Playbook tablet computers. This was an unavoidable recognition by RIM that the tablets in stock would never bring in enough sales revenues to earn the value originally represented on the Balance sheet. In this case, the realizable market value of the tablets held dropped below the company's COGS. Inventory of various kinds can lose value for a several reasons. This occurs when ...

  • Market value is driven lower than originally estimated by market competition or lack of customer demand.
  • Stock suffers spoilage or damage. Perishable goods such as foods or flowers, for instance, have by nature a short "shelf life." This can be shortened further by inadequate storage and handling. Disasters such as a warehouse fire, or a rail accident during shipping can drastically reduce or destroy value.
  • Items become obsolete or out of date. Designer fashion clothing commands a high market value only for a relatively short "season" of a few weeks or a several months at most. Many consumer technology products can command high market prices for a few months at most. Printed magazines and other dated publications may have high value for no more than a few days.
  • Items are lost to theft. Theft can occur in the form of a warehouse burglary or store burglary, but also from pilferage by the company's own employees, by shippers, or by shoplifters. This kind of stock loss is so common, and so immune to complete eradication, that many companies call such losses "leakage" or "shrinkage" and then regularly report an expense item under one of these names that represents a significant percentage of value.

When inventory loss or devaluation due to one of these causes is relatively small, the accountant can incorporate the lost into COGS. When the loss is relatively large, however, (as in the Case of Research in Motion's 2012 write down), the loss impacts the company's period-end Balance sheet and Income statement.

With a write down, however, a Balance sheet asset account receives a credit transaction (CR) for the loss (in double entry accounting, a CR transaction reduces the asset account balance). At the same time, an equal and offsetting debit (DR) is entered for an Income statement Expense account (a DR transaction increases an expense account balance). The expense item is listed as an operating expense, moreover, thereby reducing reported operating profit. The only consolation to the reporting company is that reduction on operating income also reduces the company's tax liability.

Why are stock write downs reported as operating expenses and not as extraordinary expense items? By GAAP standards and tax laws almost everywhere, an expense qualifies as "extraordinary" only if it is not expected or usual in the company's normal line of business. Even though losses such as RIM's 2012 write down are infrequent, they are considered usual and expectable in the company's business.

Reporting

The simplest Balance sheet representation of Inventory has a single line item under Current assets on the Balance sheet.

This example Balance sheet shows the loaction of Current Assets, including Inventories

For companies where several different stock categories represent a substantial portion of the company's asset structure, it may be useful to report several categories separately. Instead of the single line in the example above, the Balance sheet may show categories in this way:

Instead of a single line for "Inventories" as shown in the example Balance sheet above, the Balance sheet may instead include separate lines for different inventory categories.

Activity and Efficiency Metrics

     Inventory turns

All assets are expected to produce returns. Inventories that sit idle for long periods of time are not working efficiently and may not be justifying their presence in the asset base. These assets "work" by getting off the shelves and turning into sales revenues.

Inventory turns per year is a measure of liquidity, that is, how efficiently these assets are turning into cash. Inventory turns are measured by comparing total net sales from the Income statement to the value of stock from the Balance sheet. The Balance sheet figures of course represent stock levels at  period-end. When used this way, the period-end total is viewed as a stand in for the typical or average total for the year, at least for the purpose of creating the turns metric. However, if the year-end figure is quite different from the average on hand throughout the period, the analyst may choose to use the actual average as more appropriate figure.

The example below uses these data from the sample Income statement and Balance sheet in this encyclopedia:

     Net sales revenues for the year (from the Income statement):  $32,983,000
     Cost of goods sold (COGS) for the year (from the Income statement): $22,043,000
     Total inventories at period end (from the Balance sheet): $5,986,000

Note that Balance sheet figures may include several asset sub categories, such as raw materials, work in progress, finished goods, office supplies, and others.

Inventory turns  (Method 1 using Net Sales) 
             = Net sales revenues / Total inventories
             = $32,983,000 / $5,986,000
             = 5.5 turns / year

Note that the turns metric is sometimes found using Cost of goods sold (COGS), or Cost of sales in place of Net sales revenues. Whereas Net sales revenues represents the market value of goods, COGS for the period represents their actual cost to the company: 

Inventory turns  (Method 2 using COGS) 
             = Cost of goods sold / Total inventories
             = $22,043,000 / $5,986,000
             = 3.7 turns / year

The second method using COGS will generally be lower or more conservative than Method 1 using Net Sales.

Note also, that average value is sometimes used in place of total. The latter represents the end of period balance sheet figure. When there are substantial seasonal fluctuations, however, some analysts view the period average value as the more appropriate representation. 

Rules of thumb for the "Turns" metric

Generally speaking, higher turns figures are usually preferred over lower turns for several reasons:

  • These assets represent an investment by the company. While the investment sits in stock, funds used for their purchase cannot be used for other purposes.
  • Stock may require expensive storage space and handling.
  • As mentioned above, some kinds of goods lose value quickly: Food, plant, and animal products may be subject to spoilage. Technology products may become outdated and obsolete. Fashion products may have high value only for a short season. Maintaining a high turn rate for products with a short  "shelf life" is critical. 

On the other hand, turn rates may be too high if shortages interfere with the company's ability to maintain manufacturing or production schedules, provide warranty service, expand into new markets, or otherwise meet customer needs.

  • In most cases, therefore, the optimal stock levels and optimal turn rates represent a tradeoff between storage and handling costs, on the one hand, and the negative business impact of insufficient stock on the other hand. 
  • The difference between "good" and "poor" turn metrics varies widely from industry to industry, and even between good companies in the same industry.
  •  A turn rate that is substantially below industry average  may signal a serious problem in production or sales. For a specific company, turn rates should be compared from year to year, to track changes in efficiency.

Days sales in inventory (DSI, or Average turnover period, or Days inventory outstanding, DIO)

The days sales in inventory metric (or average turnover period, or days inventory outstanding) metric carries the same information as the turns metric (above). Whereas turns is a rate, the DSI metric express the same information as a number of days per turn.

The days sales in inventory examples are calculated from the following data:

Inv. turns per year (based on Net sales revenues): 5.5
Inv. turns per year (based on Cost of goods sold):  3.7
Days per year: 365 (some analysts prefer 360)

DSI is calculated by dividing the number of turns per year into the number of days per year. For the same example data used above:

DSI, or Average turnover period 
(Method 1, using turns based on Net sales revenues)
             = Days per year / turns per year
             = 365 / 5.5
             = 66.4 days

Note, however, that there are two commonly used approaches to calculating inventory turns per year (as shown in the section above). One turns metric represents Net sales revenues divided by total value, but the other uses Cost of goods sold divided by Total value (or average value). When the latter approach to turns is used, the DSI metric is more likely to be called Days inventory outstanding, or DIO.

DIO (or DSI, or Average turnover period 
(Method 2, using turns based on Cost of goods sold)
             = Days per year / turns per year
             = 365 / 3.7
             = 98.7 days

DIO, calculated this way is one of the three components of the liquidity metric, Cash conversion cycle (CCC), illustrated in the liquidity metrics pages. The two other CCC components are other efficiency metrics, Days sales outstanding (DSO) and Days payable outstanding (DPO).

Days Sales in Inventory Rules of Thumb

Since this metric carries the same information as the Inventory turns metric (above), see the rules of thumb and guidelines for the turns metric, above. A minor note of caution when comparing days sales in inventory metrics, however, is to be sure that all values compared are based on the same number of days per year. The metric is sometimes computed with 365 days and sometimes 360 days.

Management

Those responsible for inventory management are accountable for meeting two objectives that sometimes conflict with each other: (1) making available the right inventory when needed for manufacturing and sales, and (2) reducing and minimizing inventory costs.

Costs

As targets for minimization, costs for physical inventories are normally identified and managed in several categories. A simple review of the categories listed here suggests that cost control and product availability both require that resources and processes be planned as a single integrated system.

  • Ordering and Acquisition Cost: Total Stocking Costs
    • Procurement costs: Costs of finding appropriate vendors, costs of negotiating prices, cost of placing orders, and in some cases financing costs for purchasing. Other costs that may be legitimately called procurement costs include the extra costs of ordering too much or running out of stock (stocking out) from having not ordering in time or having ordered too little.

      Inbound logistics costs: Costs of shipping from the supplier to the buyer, costs of receiving incoming goods, costs of registering incoming stock and assigning SKU numbers, costs of placing goods on shelves or appropriate floorspace.
  • Carrying Costs
    • Storage costs: Costs of storage building/warehouse construction costs of storage building configuration; cost of storage building leasing; costs of storage building maintenance, heating, electricity; cost of material handling equipment (conveyor belt systems, forklift trucks, etc.); cost of materials handling information technology hardware and software, human labor costs for goods management, warehouse administration, handling, costs of warehouse security systems and security personnel.
    • Cost of Capital: Costs of financing purchases, costs of insurance, costs resulting from with legal liabilities.
  • Loss or Devaluation
    • WriteDown: Costs of write down due to eroding market value, costs of write down due to obsolescence, costs of spoilage, costs of damage in handling or storage.
    • Loss: Costs of theft (burglary, employee pilferage, shipper pilferage, shoplifting), costs of administrative loss (lost within the system because inventory tracking fails).

Taking Inventory

Bar-code and other on-the-spot scanning technologies now make tracking easy and relatively certain—if tracking discipline is applied rigorously where inventory consists of discrete tangible units or merchandise, finished goods, work in progress, or raw materials. The objective is to provide management at all times with immediate information on each unit's arrival date, storage location, cost, condition, and perhaps other data.

Accordingly, each arriving new unit is "tagged" and scanned with one or more numbers, in the form of a tag that can be read with optical scanning (such as a barcode) or an electronic scanning technology (such as a radio frequency identification tag, RFID). The numbers may include a stock keeping unit number (SKU), a unique item serial number, a universal price code number (UPC number), or (in the case of books and other published media) an International Standard Book Number (ISBN number). Each item (or each case, crate or box) is then scanned or "read" whenever the unit is handled, such when an item is moved from a storage shelf to a customer shipping area.

The last scanning for an item normally occurs when it is sold and shipped to a customer. The departure scan signals the system software to adjust the inventory account downward, and then passes the departure and sale information to other software systems that track shipping, update the bookkeeping and accounting system, update the customer data base—and update the ordering system. So-called point-of-sale barcode readers and RFID readers make possible this kind of "cradle to grave" inventory tracking even in retail establishments such as food stores, bookstores, and hardware stores, where a single customer purchase may include many relatively small items.

Automated tracking systems such as those described above will not produce an over count, unless the same item is scanned more than once, and then only if items do not have individual identification such as serial numbers. Automated tracking systems, however, are quite capable of producing an undercount, in situations where loss is due to successful theft (described above as pilferage, shrinkage, leakage, or shoplifting).

For this reason, most businesses that own and handle inventory find it necessary to conduct a physical inspection from time to time, at least at the close of each accounting period. Most people are familiar with the situation where they find a retail establishment suddenly "closed for inventory" on a business day, where employees are seen inside, in the aisles with clipboards or bar code readers, physically identifying and counting every item on the shelves. A physical inspection in a warehouse is similarly labor-intensive.

In businesses where shrinkage runs at a rate of several percent of total inventory, or more, a periodic physical inspection provides the only means of avoiding overstating the value of goods on hand, or misleading customers into thinking they are available when in fact they are not.

Forecasting and Ordering

Obviously the company must order new inventory to replenish what is used up. For those who place the order, the objective is to order enough quantity, soon enough, to ensure that goods are always on hand to meet customer demand, or manufacturing needs, but at the same time not order too much or too soon. Orders placed too son result in excess stock on hand, which brings extra storage and handling costs.

In situations where inventory usage is regular and predictable, managers can rather easily calculate the optimal times and amounts to reorder. Order ing is often based on a well known mathematical model, the economic order quantity model (EOQ model).

Before calculating the optimal reorder quantity, however, it is useful to determine the reorder point: the inventory level (in units) that signals a need to reorder. The reorder point requires knowledge of several variables:

  • Daily usage rate: number of units used up (e.g., sold) per day .
  • Order lead time: the time in days between placing and receiving the order for new inventory.
  • Lead time demand: The number of units that will be depleted from inventory during order lead time. Lead time demand is calculated as daily usage rate times order lead time days.
  • Safety Stock: Units ordered in addition to lead time demand, as safety factor, to ensure availability in case lead time demand is actually higher than forecast. For more on safety stock considerations, see the discussion below the EOG example.

For the example below, assume the following values:
Daily usage rate: 25 units/day
Order lead time: 14 days
Safety stock: 150 units

With these factors known, the reorder point (in units) is easily calculated as:

Reorder point = (Daily usage rate) x (lead time days) + Safety stock units
                          = Lead time demand + Safety stock
                          = 25 x 14 + 150
                          = 500 units

Therefore a replenishment order should be placed when the current inventory level falls to 500 units.

The next question is: How many units should be ordered? The economic order quantity model prescribes an order quantity (the EOQ). The model identifies the optimal order quantity that minimizes the so-called total relevant cost, that is, the combined cost of placing orders and holding goods. The EOQ represents the optimal result from a combination of several interacting and sometimes conflicting factors involved with ordering. These factors are listed here, along with the symbols commonly used to represent them in computations, (although other authors and analysts sometimes present the model using different symbols):

 A = Unit demand for a year. 
 Assume for the example  A = Daily usage rate x 365 = 25 * 365 = 9,125 units

Cp = Cost to place one order.
Assume for the example Cp = Cost to place one order = $40

Ch= Cost to hold one unit for one year
Assume for the example Ch= $20

The Economic order quantity (EOQ) formula that minimizes total relevant costs is given with this formala.

 



Using for example numbers

EOQ = √(2 x 12,100 x $500) / $100
         = 1,100 units

Conclusion:  An order for 1,100 new units should be placed when the current inventory drops to the reorder point (500 units).

Note, incidentally, that a safety stock figure of 150 units was used in the above example (at the current daily usage rate, 150 units are an extra 6 days supply). A safety stock figure is added in calculating the reorder point, to guard against the high cost of stocking out while waiting for new inventory to arrive. In reality, however, the daily usage rate can fluctuate due to several factors (such as normal statistical variability, seasonal cycles, and other factors). Safety stock estimates refer to several special inventory terms, including:

  • Buffer: Safety stock added to guard against stock outage from statistical variation in daily usage.
  • De-coupling: inventory used to allow different work centers or groups to operate independently.
  • Anticipation: inventory ordered as safety stock, to anticipate expected future demand or supply interruption.
  • Pipeline: Extra safety stock ordered to recognize that inventory goods cannot be moved instantaneously.

Minimizing and avoiding costs

In the last two decades, several creative approaches have appeared, intended to minimize inventory costs and maximize product availability at the same time. These approaches include the following:

  • Just in time manufacturing. Just in time (JIT) manufacturing attempts to eliminate excess goods held by ordering raw materials or parts only at the last possible time, when manufacturing demand calls for the order. Under JIT, Excess goods are never ordered. Successful JIT manufacturing requires that the manufacturer and its suppliers be able to work together closely, and order and receive inventory reliably on short notice.
  • Consignment selling. As mentioned above, vendors who sell goods on consignment such as Amazon.com, hold but do not own many of the goods they sell. Amazon.com and other seller who use consignment selling effectively rely on an ability to accurately forecast sales, and order only the consignment goods they are confident of selling in the near time. Successful consignment selling thus has many similarities to successful just in time manufacturing: accurate forecasting and fast supply by consignment owners are essential.
  • Vendor-managed. Under a vendor-managed (VMI) business model, businesses allow their vendors to manage their inventories of goods. This means that vendors decide when and how many units to place in customer business, decide which products to include, and when to re-order for the customer business. VMI is meant to save the customer business the costs of ordering, the costs of holding excess, and the costs of stoking out.
  • Direct supplier-to-customer shipment. Vendors sometimes avoid the need to hold finished goods by simply arranging to have their own suppliers ship directly to their own customers. Apple computer, for example, uses this approach in selling computers and mobile phones for customers who shop online.

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