# Inventory Modeling: The Comprehensive Guide for 2023

4 Minutes

In this article, we will explore what inventory modeling is and its common techniques. We will also share our process for choosing suitable inventory modeling techniques. Read on to learn more.

## What is Inventory Modeling?

Inventory modeling involves mathematical techniques and models used to determine optimal inventory levels and reorder points in various business scenarios. Its primary objective is to balance the costs of ordering and holding inventory with the benefits of meeting demand.

## Importance of Inventory Modeling

Inventory modeling is crucial for businesses that involve the production, storage, and distribution of goods. Here are some of the most common points highlighting its importance:

### 1. Financial Optimization:

By streamlining the balance between ordering and holding costs, inventory modeling promotes fiscally responsible management. This optimization process can lead to significant savings over time and allows for resource allocation to other strategic business areas.

### 2. Improved Customer Experience:

Ensuring timely product availability through adept inventory modeling enhances customer trust and satisfaction. By consistently meeting their needs and reducing wait times or product unavailability, businesses foster a stronger bond of brand loyalty with their clientele.

### 3. Balanced Stock Levels:

With accurate demand prediction through advanced modeling, businesses can proactively manage their inventory to avert excessive stockpiling or depletions. This approach minimizes storage costs and ensures that products are fresh if perishable.  This also reduces the risk of obsolescence.

A structured approach from inventory modeling aids in making strategic procurement, production, and distribution decisions. This ensures more harmonized operations as it aligns inventory practices with overarching company goals and adapts promptly to changing market dynamics.

## Inventory Modeling Techniques

Here are some of the most common inventory modeling techniques:

### 1. Economic Order Quantity (EOQ)

This model calculates the optimal order quantity that minimizes the combined costs of ordering and holding inventory. It is best suited for situations with constant demand and lead times.

Formula:

Where:

• D = Annual demand quantity
• S = Cost to place a single order
• H = Annual holding cost per unit

Example: A bookstore with an annual demand of 10,000 books, a cost of \$50 to place an order, and a holding cost of \$2 per book per year would calculate its EOQ as:

This suggests the bookstore should order 316 books at a time to minimize its total inventory costs.

### 2. Reorder Point Models

These models define the inventory level at which a new order should be placed. Depending on demand predictability, safety stock might be included to account for variability.

Formula:

Where:

• Daily Demand = Average number of items sold or used per day
• Lead Time in Days = Time taken for an order to be delivered once placed
• Safety Stock = Buffer stock to account for variability

Example:

For a retail store that sells 10 items per day and it takes 5 days for a new shipment to arrive, with a safety stock of 25 items:

Reorder Point = (10 × 5) + 25 = 75

This means the store should reorder when there are 75 items left in stock.

### 3. Safety Stock Models

These models are used to determine the amount of stock to be maintained to safeguard against uncertainties in demand or supply. It helps prevent stockouts due to unforeseen variations.

Formula:

(Various formulas exist; one example is):

Where:

• Z = Number of standard deviations (from Z-table) corresponding to desired service level
• Average Daily Demand = Expected demand per day
• Average Lead Time = Average time taken for replenishment
• Variance of Daily Demand = Variability in daily demand

Example:

For a company with an average daily demand of 20 units, variance in daily demand of 5, average lead time of 2 days, variance in lead time of 1 day, and a Z value (from Z-table) of 1.96 for 95% service level, the safety stock calculation would use the provided formula.

Safety Stock = 1.96 (201)+(25) = 10.74 units

### 4. Periodic Review Systems

Inventory levels are checked at regular intervals (e.g., monthly or weekly), and orders are placed to replenish stock to a specified level, irrespective of the current inventory level.

Formula

Where:

• Target Inventory Level = Desired stock level to be maintained at the end of the review period
• Current Inventory Level = Actual stock on hand at the time of review

Example:

If a shop aims to maintain a stock level of 500 items and, at the end of the month, has 300 items left, they would order:

Order Quantity = 500 - 300 = 200

### 5. Continuous Review Systems (Q, R Systems)

Inventory is constantly monitored, and orders are placed as soon as inventory reaches a predetermined reorder point. The quantity ordered may be fixed (Q) or variable.

Formula:

This system typically uses the EOQ for the order quantity (Q) and the reorder point formula for the reorder point (R).

Example:

A car parts supplier might continuously monitor a particular part. When the stock level dips below the predetermined reorder point (R), they order a fixed quantity (Q).

### 6. Single Period Models (News Vendor Problem)

This model is suited for products with a short selling season and no value afterward such as newspapers or seasonal items. It aims to balance the costs of under-ordering against the costs of over-ordering.

Formula:

The optimal order quantity balances the cost of under-ordering and over-ordering. Specific formulas can vary based on cost structures.

Example:

A vendor selling Christmas trees might use this model. If they order too many trees, they risk unsold trees after Christmas, but if they order too few, they miss potential sales.

## 6 Step Process for Choosing Inventory Modeling Techniques

Use our 6 step process for how to choose suitable inventory modeling techniques for your business. Simply follow the simple steps below:

### Step 1. Determine Demand Uniformity

If a product's demand is consistent, the Economic Order Quantity (EOQ) model is appropriate.

Example: 'ClassicToys' sees a steady demand of 1,200 units monthly for 'Building Blocks'. Using the EOQ model, they compute an optimal order quantity of 310 units per order to reduce costs and prevent stockouts.

### Step 2. Evaluate Lead Time Consistency

When lead times from suppliers fluctuate, but demand remains steady, the Reorder Point model is crucial.

Example: 'TechGurus' experiences constant demand of 70 smartphones daily. With lead times varying between 3-8 days and incorporating a safety stock of 150 units for unpredictability, they set a reorder point at 700 units. This ensures timely restocking.

### Step 3. Demand Variability

For products with variable demand, the Safety Stock model aids in accounting for sudden surges.

Example: At 'FashionForward', trendy 'Summer Caps' can have demand ranging from 40 to 120 daily due to changing fashion influences. With the Safety Stock model, they decided on keeping an extra stock of 150 units. This mitigates the risk of stockouts during unexpected demand spikes.

### Step 4. Assess Frequency of Inventory Reviews

Regular stock reviews rather than continuous monitoring calls for the Periodic Review System.

Example: 'BookBarn' checks its inventory of 'Mystery Novels' every fortnight. Their system suggests an order of 600 novels each time. This keeps them close to their target inventory level of 1,200 which accounts for expected sales.

### Step 5. Continuous Monitoring & Automatic Reordering

Businesses that prioritize real-time tracking and automated reordering use the Continuous Review System.

Example: For 'GadgetHub', the stock of 'Noise-Canceling Headphones' is essential. When their system detects stocks falling below 80 units, it instantly places an order for 300 units. This ensures stock levels remain healthy.

### Step 6. Consider Single Selling Season Products

Items with one major selling season necessitate the Single Period Model for optimal stocking.

Example: 'Seasonal Delights' prepares for the New Year with fireworks. Given fireworks are primarily sold in December, they calculate a stocking quantity of 5,500 units. They aim to maximize sales while being cautious of overstocking.

## Example

EcoWares is an eco-friendly household product company that wants to ensure they efficiently balance stock levels. Here’s how the company used our simple 6 step process:

### 1. Determine Demand Uniformity

For their "EcoClean Kitchen Sponges," EcoWares consistently sells 2,000 units every month. They have determined that using the EOQ model, the optimal order quantity is around 1,265 sponges each time. This minimizes the combined costs of ordering and holding inventory.

### 2. Evaluate Lead Time Consistency

The demand for "BambooFresh Toothbrushes" stands at 150 units daily. Given unpredictable lead times from suppliers which can range from 7 to 14 days, EcoWares uses the Reorder Point model. Combining their average daily demand with the longest lead time and adding a safety stock, they've found that reordering when stock hits 2,500 units is optimal.

### 3. Analyze Demand Variability

Their new "OrganicShine Cleaning Spray" has a variable daily demand as low as 20 units and sometimes spiking to 80 units. To ensure they don't run out during peak demand, EcoWares maintains a safety stock. After calculations, they've determined that a safety stock of around 120 units best buffers against unexpected demand.

### 4. Assess Frequency of Inventory Reviews

EcoWares conducts monthly stock reviews for their "GreenBag Reusable Shopping Bags." Based on the Periodic Review System, they've figured out that ordering up to a target inventory level of 10,000 bags each month considering their current stock and expected sales works best.

### 5. Continuous Monitoring & Automatic Reordering

The "PureWash Dish Soap" is a top seller for EcoWares. Their real-time tracking system and the Continuous Review System ensure that every time the stock dips below 100 units, an automated order of 500 units is placed.

### 6. Consider Single Selling Season Products

The "BioDecor Holiday Decorations" are primarily for the Christmas season. Using the Single Period Model, EcoWares aims to balance potential sales against the risk of overstocking. They've estimated that stocking 5,000 units for the start of the season strikes this balance considering potential lost sales and leftover stock costs.

We hope that you now have a better understanding of what inventory modeling is and how to choose which inventory modeling techniques are best suited for your business needs.