A healthy inventory flow enables sale closings, customer shipments, and productive work for employees. Without this flow, the business dies. It should be no surprise to find that in many industries, a firm's financial performance and position depend heavily on the firm's ability to manage inventory effectively and efficiently.
In business, Inventory has several definitions:
- Firstly, inventory refers primarily to goods, raw materials, and other tangible items that a business holds, intended ultimately for sale. The rest of this article assumes that definition.
- Secondly, as a verb, inventory means to count or list units of a resource on hand. A hotel business, for instance, might inventory the contents of a hotel room when a guest departs as a check against loss.
- Thirdly, inventory also refers to a listing 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.
The Inventory Challenge
Companies that acquire, hold, and sell inventory face a double challenge.
- On the one hand, in-demand products must be available when customers are ready to buy.
- On the other hand, acquiring and managing stock to meet this objective can be very costly (see the section on costs below).
As a result, many firms give substantial and constant attention to finding ways to improve and optimize stock management. The goal is to do this while minimizing costs at the same time.
Explaining Inventory in Context
This article further defines, explains, and illustrates inventory in context with related terms and concepts from the fields of inventory management, accounting, and finance. These fields are rich in inventory-related terms, including the following:
- What is Inventory?
- What are the major categories of inventory?
- How do firms account for inventory assets?
- Three inventory performance measures.
- Example Income Statement with Inventory Metrics Data
- What are important objectives in inventory management
- How do firms forecast and order inventory?
- How do firms minimize and avoid inventory costs?
Business inventory normally falls into two classes, merchandise inventory and manufacturing inventory. Note especially, however, there are several other kinds of inventory that fit neither of those categories.
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 by making them available when and where customers want them. The merchant's role may include packaging, shipping, delivery, or minor assembly, but these activities are not "manufacturing."
The term merchandise stock refers only to inventory the merchant actually owns. As such, stock is a company asset, to be valued and accounted for at the end of each accounting period. Merchandise held for sale on consignment and actually belonging to someone else is not part of the merchant's inventory.
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 inventory
Raw materials include goods in the same form suppliers provide them. For an oil production company, raw materials include raw crude oil. For a metal stamping company that produces automobile parts, raw materials include unworked sheet metal as acquired from the supplier.
Works In Progress Inventory
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 are work in progress inventory.
Finished Goods Inventory
Finished goods include goods the company produced from raw materials, now ready to sell and ship. For the automobile company, finished vehicles not yet sold or sent to dealers are finished goods stock.
Note that one firm's finished goods can be another firm's raw materials. Flat sheets of steel may be finished goods for the steel company, but raw materials for the metal stamping company.
Other Kinds of Inventory
The term inventory also applies to several other kinds of items that do not fit the descriptions for merchandise or manufacturing stock. For example:
Hotel Rooms and Airline Seat Inventory
Hotels refer to unsold guest rooms for a given night as inventory. Airlines refer to unsold seats in each ticket class, for each flight, each day, as inventory.
These assets become worthless if they are not sold by their designated days. As a result, hotels and airlines sometimes offer last-minute price discounts, trying to recover at least some value instead of none.
Repair Shop Spare Parts Stock
Repair shops and other service firms maintain spare parts stock. Firms that repair automobiles, appliances, shoes, or watches, for instance, either carry parts stock of their own, or else work closely with suppliers who can supply them quickly on short notice.
Repair shops typically make some margin on the parts themselves, but these do not qualify as merchandise or finished goods. The customer may or may not receive a bill summarizing individual "parts" and "labor" charges.
Supplies Stock for Services
Medical clinics, hair salons, and cleaning services normally maintain a supplies stock. They do not sell these items directly to customers as merchandise, because they use them to deliver services.
Non Physical Goods Inventories
Sellers of electronic books (ebooks) carry a product title inventory. They hold master copies of each title, from which they produce and ship any number of individual customer copies. For these vendors, stock is not physical goods but rather a collection of intellectual property usage rights, which they sell to individual customers.
Non physical inventories of this kind can also include other "electronic" products that ship by internet download. Examples include software, recorded music and videos, and documents in PDF format. Here also, the seller's "inventory" is not physical property, but rather, a set of intellectual property usage rights.
For non physical goods of this kind, most of the other major cost areas with traditional physical stock are also absent, such as storage costs and handling costs. Also, such inventory is never used up nor out of stock. It loses value, however, when it becomes obsolete, or when competitive market prices change.
Inventories appear on the Balance sheet as assets. As a result, they impact asset-related metrics such as Total asset turnover and Return on total assets. Note that inventories almost always appear under Current assets because firms consider them relatively liquid assets.
This means these assets will, or could, convert to cash in the near term. As current assets, they contribute also to liquidity metrics such as Working capital and Current ratio. And, their impact on these metrics can be substantial where they account for a large part of the firm's asset base. This can be the case for manufacturing firms such as Cummins Engine, for instance, where inventories account for 18%-25% of the asset structure.
What Determines Original Inventory Value?
What value does inventory originally take on the Balance sheet? Tax authorities and local GAAP usually require original inventory value to represent either:
- Historical cost.
This is the total of all original direct and indirect costs of acquiring the stock and bringing it in house. Most assets including inventories are at first valued at historical costs.
- Cost or Market Value,
Firms may sometimes apply the lower of cost or market rule to value inventories. Under this rule, in principle, inventory value is taken as the lower these two values: Firstly, historical cost, and secondly, market price. And, market value in this case usually means current replacement cost. Note, however, the following constraints on market price:
- Market price cannot be higher than the estimated selling price, minus the costs of selling. Selling price less selling costs is 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 value is historical cost if that is lower than the market value "floor." Otherwise, its value is whichever is lower: market value ceiling or replacement cost.
How Do Firms Update Inventory Values?
Total inventory value normally changes more or less continuously, as firms stock new items and either sell or lose existing items. The value of individual items in stock also changes over time, as for instance, when items spoil or become obsolete.
In any case, total inventory value must appear on the Balance sheet as it stands at period end, after all changes for the period. Firms normally apply this equation:
Ending value = Beginning value + Net purchases – Cost of Goods Sold
Note that cost of goods sold (COGS) sometimes appears 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. As a result, COGS represents the total historical cost of these assets.
LIFO and FIFO Conventions: How Do They Differ?
When the historical costs (or COGS) of each specific stock unit is known, the above instructions for reaching the total current inventory value are sufficient. However, the firm must refer to additional valuing rules when both of two conditions apply:
- Firstly, units in stock are interchangeable.
One barrel of crude oil as raw materials is probably interchangeable with any other barrel of the same kind of oil. One sealed can of peas in finished goods may be interchangeable with thousands of others in stock.
- Secondly, costs of acquiring units in stock are changing over time.
A firm may purchase oil as raw materials in January at $85 / barrel. In June, the same barrel may cost $90, and an identical barrel may cost $98 in December. Similarly, a can of peas may have a COGS of $1.00 in January, $1.10 in February, and $1.50 in March.
Choose any method when units are interchangeable
Referring to the example above, suppose the firm adds cans of peas to inventory as follows:
January, 75 cans added, @ $1.00 / can.
February, 125 cans added, @$1.10 / can.
March, 100 cans added, @$1.50 / can.
Suppose that a total of 60 cans are sold from inventory during these three months. The accounting question in such cases then is this: What was the COGS for the 60 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. After choosing an approach for the first reporting period, however, tax authorities do not make it easy to change approaches in subsequent periods.
In any case, three acceptable approaches to valuing under these conditions include:
1. First In First Out (FIFO)
Under FIFO, as items leave inventory, the accountant precedes as though the single item in stock for the longest time leaves first. And, the next item to leave has the value of the item on hand second longest, and so on.
Under FIFO, when 60 cans leave inventory, the firm reports them as 60 of the 75 "January" cans. As a result, COGS becomes the following:
COGS = 60 x $1.00
2 Last in First Out (LIFO)
Under LIFO, the accountant precedes as though the first to leave is the item that has been there the least time. And, the next item to leave is seen as the second newest item, and so on. Under LIFO, the firm reports all 60 of the cans leaving stock will be valued as 60 of the 100 "March" cans. As a result, for a COGS becomes the following:
COGS = 60 x $1.50
3. Average Cost
Under the average cost method, the accountant computes a weighted average cost of goods sold per unit. For the 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
Choosing a Costing Approach
Which costing approach should a company choose? Remember that once a firm chooses a costing method, tax authorities do not make it easy to change.
- When costs are rising, LIFO maximizes COGS and therefore minimizes total value of remaining items. A higher COGS under LIFO leads to lower reported income and lower taxes.
- When costs are rising, FIFO minimizes COGS and thus maximizes total value of remaining items. A lower COGS under FIFO leads to higher reported income and higher taxes.
Note that International Financial Reporting Standards (IFRS) simply do not allow the use of LIFO in many countries.
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 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.
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 enough sales revenues to earn their original Balance sheet value. In this case, the realizable market value of the tablets held dropped below the company's COGS.
How Does Inventory Lose Value?
Inventory of various kinds can lose value due to several factors. This occurs when:
- The Market value is driven lower.
Market value may be driven lower by competition or lack of customer demand.
- Stock suffers spoilage or damage.
Goods that perish, such as foods or flowers, for instance, have by nature a short "shelf life." Shelf life becomes even shorter with inadequate storage and handling. Disasters such as a warehouse fire, or a rail accident during shipping can drastically reduce the value of all classes of goods.
- 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 several months at most. Many consumer technology products can command high market prices for a few months at most. Magazines and other dated print media 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 common, and in some cases immune to complete eradication. As a result, many companies create accounts for "leakage" or "shrinkage," and regularly report an expense item under one of these names.
Accounting for Inventory Write Down
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.
Inventory Write Downs are Usually not Extraordinary Items
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.
Exhibit 1 below shows the simplest possible Balance sheet report of inventory. Here, inventory is a single line item under Balance sheet Current assets.
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 as they appear in Exhibit 2, below.
Businesses acquire assets expecting them to produce returns. And, inventory assets 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. Company owners and officers have a keen interest, therefore, in metrics that show how well inventory assets are performing.
Firms measure inventory performance with "activity and efficiency" metrics. Three of the most frequently used metrics for this purpose are (1) Inventory turns, (2) Days sales in inventory, DSI and (3) Days Inventory outstanding DIO.
Inventory turns per year is a measure of liquidity, that is, how efficiently these assets are turning into cash. This metric measures Inventory turns 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.
Calculating Inventory Turns
Note especially that example calculations for inventory turn use data from firm's Income statement (Exhibit 3, below) and Balance sheet (Exhibit 1, above).
Net sales revenues for the year (from the Income statement): $32,9
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
Inventory turns metrics are commonly found in two different ways. Firstly, from Net sales revenues, and secondly, from Cost of goods sold (COGS).
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" represents the market value of goods, COGS 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 inventory "average value" is sometimes used in place of" total inventories." 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.
Inventory Turns Rule of Thumb
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.
Inventory Turns Neither Too High Nor Too Low
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.
The Days sales in inventory DSI metric (or average turnover period, or days inventory outstanding) metric carries the same information as the Inventory turns metric (above). Whereas "turns" is a rate, the DSI metric sends the same message, expressed as a number of days per turn. Note that the DSI metric is also called Average turnover period.
Calculating Days Sales in Inventory
The days sales in inventory examples are calculated from the following data:
Annual inventory turns (based on Net sales revenues): 5.5
Annual inventory turns (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
(Using Inventory turns based on Net sales revenues)
= Days per year / turns per year
= 365 / 5.5
Days Sales in Inventory Rules of Thumb
Inventory turns and DSI present exactly the same information. As a result, the Inventory turns rules of thumb above apply equally to DSI results. "Turns" figures that are very high or very low may be indicators of inventory management problems. The same can be said for DSI figures. The firm may use either metric (Turns or DSI) to set inventory performance targets.
When comparing days sales in inventory metrics, however, 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.
The Days inventory outstanding DIO Metric is in fact simply another version of the Average turnover period DSI metric, from the previous section. Note that both DSI and DIO derive from a calculated Inventory turns figure. The only differences between DSI and DIO have to do with the method used to derive Inventory turns.
Note, that there are two commonly used approaches to calculating inventory turns per year (as shown above). One "turns" metric represents Net sales revenues divided by inventory value, while the other uses Cost of goods sold divided by inventory value.
- When the latter approach to turns is used, the DSI metric is more likely to be called instead Days inventory outstanding, or DIO.
- Recall that Inventory turns based on COGS is almost always more conservative than "turns" based on Net sales. As a result, DIO is likely to be higher than the DSI metrics for the same inventory.
Calculation Days Inventory Outstanding (DIO)
DIO, 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
Inventory turns, DSI, and DIO present exactly the same information. As a result, the Inventory turns rules of thumb above apply equally to DIO and DSI results. "Turns" figures that are very high or very low may be indicators of inventory management problems. The same can be said for DSI and DIO figures. The firm may use any of these metrics (Turns, DSI, or DIO) to set inventory performance targets.
When comparing days sales in inventory metrics, however, be sure that all values refer to the same number of days per year. Some The metric is sometimes computed with 365 days and sometimes 360 days.
Exhibit 3 below is an Example Income Statement providing input data for Inventory performance metrics.
Those responsible for managing inventory are responsible for meeting two objectives that sometimes conflict with each other:
- Firstly, making available the right inventory when needed for manufacturing and sales
- Secondly, reducing and minimizing inventory costs.
Where Are the Largest Costs in Inventory Acquisition and Management?
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
These inventory costs fall into four categories: (1) Procurement costs, (2) Carrying costs, (3) Cost of capital, and (4) Loss or Devaluation.
1. Inventory Procurement May Include the Costs of ...
- Shipping from the supplier to the buyer.
- Receiving incoming good.
- Registering incoming stock.
- Assigning SKU numbers.
- Placing goods on shelves
or appropriate floor space.
2. Inventory Carrying Costs Typically Include Storage Costs for...
- Building/warehouse construction.
- Building configuration.
- Building maintenance.
- Heating, electricity, and water.
- Building leasing.
- Material handling equipment.
- IT hardware and software.
- Goods management labor
- Warehouse administration labor.
- Handling labor.
- Security systems and
3. Inventory Cost of Capital May Include the Costs of ...
- Financing purchases.
- Costs of insurance.
- Costs resulting from legal
4. Inventory Loss or Devaluation May Include the Costs of ...
- Write down due to eroding market value.
- Write down due to obsolescence.
- Damage in handling or storage.
- Employee pilferage.
- Administrative loss due to failure of inventory tracking.
Bar-code and other on-the-spot scanning technologies now make tracking easy and relatively certain—if and only if they apply tracking discipline is 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.
Assigning and Scanning SKU Numbers
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.
In many cases, automatic systems simply cannot track inventory with 100% accuracy. Therefore, many firms that own and handle inventory must conduct a physical inspection from time to time, at least at the close of each accounting period.
Most people know the situation where they find a retail business suddenly "closed for inventory" on a business day. And, when this occurs, 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.
When do Firms Need Physical Inspection?
Physical inspection is necessary when management believes that automatic systems are undercounting.
- Automatic tracking systems do not 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.
- Automatic tracking systems, however, are quite capable of undercounting. Undercounts occur because:
- Some items bypass scanning.
- Inventory sustains loss through theft. Inventory theft is described variously, as pilferage, shrinkage, leakage, or shoplifting.
In businesses where annual shrinkage runs at a rate of several percent of total inventory, or more, a periodic physical inspection provides the only means of reaching two objectives:
- Firstly, avoiding overstating the value of goods on hand, or
- Misleading customers into thinking they are available when in fact they are not.
Obviously firms must order new inventory to replenish what they use up. Those who place the order try to order enough inventory, soon enough, to ensure that goods are always on hand to meet customer demand or manufacturing needs. At the same time, however, they try to avoid ordering too much, or ordering too soon. This is because such orders result in excess stock on hand, which brings extra storage and handling costs.
In situations where inventory usage is regular and predictable, managers can find the optimal times and amounts to reorder rather easily. Ordering in these cases typically involves a well known mathematical model, the Economic order quantity EOQ model.
The Optimal Reorder Point and Reorder Quantity
Before finding the optimal reorder quantity, it is useful to find first the reorder point. This is the inventory level (in units) that signals a need to reorder. Note especially that finding the reorder point requires knowledge of several factors:
- Daily usage rate.
This is the number of units used up (e.g., sold) per day .
- Order lead time.
This is the time in days between placing and receiving the order for new inventory.
- Lead time demand.
This is the number of units that will leave inventory during order lead time. Lead time demand calculates as follows:
Lead time demand = Daily usage rate * Order lead time.
- Safety Stock:
Safety stock refers to units ordered in addition to lead time demand. These provide a safety factor, to ensure availability in case lead time demand is actually higher than forecast. For more on these considerations, see the discussion below on safety stock.
Calculating the Reorder Point
For the example below, assume the following:
Daily usage rate: 25 units/day
Order lead time: 14 days
Safety stock: 150 units (6 days supply at the current daily usage rate)
With these factors, the reorder point (in units) is:
Reorder point = (Daily usage rate) x (lead time days) + Safety stock units
= Lead time demand + Safety stock
= 25 x 14 + 150
= 500 units
Therefore, the firm should replenish with an order when the current inventory level falls to 500 units.
The Optimal Order: Economic Order Quantity EOQ
How many units should the firm order? The economic order quantity model EOQ provides the answer.
The EOQ model finds the order quantity that minimizes the so-called total relevant cost—the total cost of placing orders and holding goods. The EOQ model finds this quantity by analyzing several interacting factors in using and ordering inventory. These factors are as follows.
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
Calculating Economic Order Quantity EOQ
The example above shows a reorder point of 500 units. When inventory falls to that level, the firm reorders. The objective is to order the optimal quantity—the order size that minimizes total relevant costs. The Economic order quantity (EOQ) for this purpose calculates from the formula in Exhibit 4 below.
Using the example figures for A, Cp, and Ch, above, the EOQ is calculates as:
EOQ = √(2 x 12,100 x $500) / $100
= 1,100 units
In conclusion, the firm should order 1,100 new units when the current inventory level drops to 500 units.
Safety Stock in Ordering
Note, incidentally, that the example above finds the reorder point using a safety stock figure of 150 units. Here, the firm chose to order safety stock to cover an extra 6 days usage (at the current daily usage rate).
Reorder point calculations include a safety stock figure to guard against the high cost of "stocking out" while waiting for new inventory to arrive. Finding the optimal safety stock level, however, requires accurate and detailed knowledge of the firm's operations and inventory needs.
Safety stock estimates refer to several special inventory terms, including:
The buffer is safety stock added to guard against stock outage from statistical variation in daily usage. Fluctuations are due to normal statistical variability, seasonal cycles, and other factors.
This is inventory that allows different work centers or groups to operate independently.
This is safety stock that anticipates future demand or supply interruption.
This is extra safety stock recognizing that inventory goods cannot be moved instantaneously.
Firms use several different approaches to minimize inventory costs and maximize product availability at the same time. These approaches include the following:
Just in Time Manufacturing
Just in time manufacturing (JIT) attempts to eliminate excess goods in stock. Firms using JIT order raw materials and parts only at the latest possible time--not until manufacturing demand calls for the order. Under JIT, firms never order excess goods. Successful JIT manufacturing requires that the manufacturer and suppliers work together closely and order and receive inventory reliably on short notice.
Consignment selling. Vendors who sell goods on consignment, such as Amazon.com, hold but do not own many of the goods they sell. Sellers who use consignment selling effectively rely on their ability to forecast sales accurately.
As a result, they order only the consignment goods they are confident of selling quickly. Successful consignment selling therefore is similar to just in time manufacturing in some ways. In both cases, accurate forecasting and fast re-supply are essential.
Under a vendor-managed inventory (VMI) model, businesses allow their vendors to manage their inventories of goods. This means that vendors decide:
- When and how many units to place in the customer business.
- which products to include.
- When to re-order for the customer business.
Vendor-managed inventory is common in pharmacies and shops that sell health care products, for instance. The objective in VMI is to save the customer business the costs of ordering, holding excess, or stocking 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.