Inventory Models: The Comprehensive Guide for 2023
In this article, we will explore what inventory models are and the most common types. We will also share our process for choosing suitable models for your business. Read on to learn more.
What are Inventory Models?
Inventory models are mathematical frameworks used by businesses to determine the optimal quantity and timing for stock reordering to minimize costs and meet demand. They aid in balancing ordering, holding, and stockout costs to achieve efficient inventory management.
Types of Inventory Models
There are several types of inventory models depending on factors like demand predictability, order lead time, and review frequency. Here are some of the most common types:
1. Economic Order Quantity (EOQ):
The EOQ model identifies the optimal order quantity that will minimize the total inventory costs, which consist of holding and ordering costs.
where D is the demand rate (annual), S is the order cost per order, and H is the holding cost per unit per year.
D (Demand rate) = 12,000 units/year
S (Order cost) = $50/order
H (Holding cost) = $5/unit/year
Result: EOQ = 490 units (rounded).
2. Reorder Point Model:
This model calculates the inventory level at which a new order should be placed to ensure stock availability until the next shipment arrives, considering the lead time and average demand.
Lead Time = 10 days
Average Daily Demand = 40 units/day
Reorder Point = 10 x 40 = 400 units
3. Safety Stock:
Safety stock acts as a protective buffer against uncertainties in both demand and lead time to ensure product availability during unexpected fluctuations.
Z (z-score for a desired service level) = 1.65 (95% service level)
Average Lead Time = 5 days,
Variance of Demand = 10 units2,
Average Demand = 40 units/day
Variance of Lead Time = 2 days2
Result: Safety Stock ≈ 295 units (rounded)
4. ABC Analysis:
This method categorizes inventory into three groups based on their value and volume; 'A' items are high value but low volume, 'B' items have medium value and volume, and 'C' items are low value but high volume.
Calculation: This isn't a direct formula-based model. Instead, it involves ranking items by annual usage value (quantity used annually multiplied by unit price) and then categorizing them into the A, B, or C groups.
Item X: 500 units/year at $20/unit = $10,000
Item Y: 300 units/year at $5/unit = $1,500
Z: 2000 units/year at $2/unit = $4,000
By ranking: X > Z > Y.
Result: X is an 'A' item, Z is a 'B' item, and Y is a 'C' item.
5. Just-In-Time (JIT):
JIT aims to minimize inventory holding costs by producing or ordering goods just in time for them to be used or sold, reducing the need for stockpiling.
Calculation: JIT doesn't have a specific formula. It's more about synchronizing production and ordering schedules with demand. It is often aided by lean manufacturing tools and techniques.
Demand for Product A on Tuesday = 150 units
Lead time for Product A = 1 day
Action: If you need 150 units of Product A on Tuesday, order them on Monday.
6. Fixed Order Quantity System:
This system consistently orders the same predetermined quantity of an item whenever the inventory level falls to a specific reorder point.
Calculation: The order quantity is often determined using the Economic Order Quantity (EOQ) formula and the reorder point is calculated considering safety stock and lead time demand.
Example (using results from the above examples):
EOQ = 490 units
Safety Stock = 295 units
Average Daily Demand = 40 units/day
Lead Time = 10 days
Calculation: Reorder Point = 400 units (from our second example).
Action: Whenever inventory falls to 400 units, order another 490 units.
Importance of Inventory Models
Inventory models play a critical role in the management of resources in various industries. Here are some of the most common reasons highlighting its importance:
1. Cost Efficiency:
Inventory models streamline the balance between ordering and holding inventory which leads to significant savings. By reducing unnecessary stock and associated costs, businesses can operate more efficiently.
2. Service Consistency:
Maintaining the right inventory levels ensures that customer demands are consistently met without delay. This not only boosts customer satisfaction but also fosters trust and reliability.
3. Enhanced Cash Flow:
By optimizing inventory, businesses prevent capital from being unnecessarily tied up in excess stock. This improved cash flow can be reinvested which fosters growth and opportunity.
4. Demand Forecasting:
Effective inventory models aid businesses in anticipating future demand and reduces the chances of overstocking or facing stockouts. This proactive approach facilitates better planning and resource allocation.
10 Step Process for Choosing the Right Inventory Models
Choosing the right inventory model is crucial for efficient inventory management. You can follow our simple 10 step process below.
Step 1. Identify Demand Consistency
For businesses with consistent demand, an EOQ model is often suitable because it balances ordering and holding costs.
Example: "Everyday Essentials" sells 1,200 basic ceramic mugs monthly. By applying EOQ with a holding cost of $0.50 per mug and a $40 order cost, they determine an optimal order quantity of 200 mugs per order.
Step 2. Assess Lead Time Variability
If lead times are unpredictable, then a safety stock model can provide a buffer against unexpected delays.
Example: "TechBuddy Electronics" sells 50 wireless headphones per day but faces supplier delays ranging from 3 to 10 days. By calculating safety stock for a lead time of up to 10 days, they maintain a safety stock of 500 headphones.
Step 3. Determine Seasonality of Demand
For products with seasonal demand, businesses should focus on periodic review systems to adjust stock before peak seasons.
Example: "SunSaver Sunglasses" sells 5,000 sunglasses during summer. Using a periodic review system, they order an additional 1,000 sunglasses in preparation for the upcoming summer season.
Step 4. Evaluate Product Value and Volume
ABC analysis is best for businesses with a wide product range, varying in value and sales volume.
Example: "DiverseMart" stocks products from luxury watches to pencils. Using ABC analysis, they discover luxury watches, though only 10% of stock, account for 60% of revenue.
Step 5. Check Short Product Lifecycles or Perishability
For perishable items or those with short life cycles, a JIT system minimizes holding times and waste.
Example: "TastyBakes Bakery" produces 100 loaves of fresh bread daily. Using JIT, they order flour and yeast to arrive every morning, ensuring minimal leftover raw materials.
Step 6. Examine Capital Constraints
Businesses with limited capital might focus on fixed order quantities for essential items and JIT for less crucial products.
Example: "StartupTools Inc." has a budget of $10,000 for inventory. They use fixed order quantities for their top-selling drills and adopt JIT for secondary items, like drill bits.
Step 7. Analyze Storage Limitations
If storage space or conditions are limiting, prioritize fast-moving items and consider dropshipping or JIT for others.
Example: "CompactStore" can hold 1,000 items on its shelves. They prioritize stocking 700 best-selling items and use dropshipping for the remaining inventory.
Step 8. Gauge Supplier Reliability
With unreliable suppliers, a reorder point model combined with safety stock can help buffer against supply disruptions.
Example: "TechWorld Gadgets" sells 30 tablets daily. Given supplier variability, they've set a reorder point at 600 tablets and keep a safety stock of 90 tablets.
Step 9. Consider Business Scalability and Growth
Growing businesses might start with one model and evolve. Regularly review and adapt the model as the business scales.
Example: "RapidGrow Shoes" began selling 200 pairs monthly using EOQ. As demand grew to 1,000 pairs, they integrated JIT for certain shoe models to maintain stock levels efficiently.
Step 10. Seek Expert Validation
Before settling on a model, it's wise to validate the choice with industry experts or through pilot testing.
Example: "NovelTrends Apparel" anticipated a 20% sales increase. After consulting with a supply chain expert and piloting the periodic review system, they confidently integrated it into their inventory management.
TrendyThreads is a clothing retailer that aims to adopt inventory models to optimize stock levels, reduce costs, and meet the dynamic demands of their clientele. Here’s how the company implemented our simple 10 step process:
Step 1. Identify Demand Consistency:
For staple items like white T-shirts and blue jeans with consistent demand, TrendyThreads uses the EOQ model. Based on annual sales of 1,200 white T-shirts, a $10 ordering cost, and a $2 holding cost per shirt, they should order in batches of 100 shirts.
Step 2. Assess Lead Time Variability:
Their supplier's consistent 7-day lead time means they maintain a safety stock of 10 pairs of blue jeans. This covers two days of unexpected disruptions given the daily demand of 5 pairs.
Step 3. Determine Seasonality of Demand:
For seasonal items like summer dresses, a periodic review system is adopted. With last summer's sales at 500 dresses and a 10% growth prediction, they'll order 550 dresses for the upcoming season.
Step 4. Evaluate Product Value and Volume:
Their range includes luxury scarves to basic caps. ABC analysis indicates luxury scarves are 'A' items, accounting for 70% of revenue but only 20% of total items, while more numerous basic caps are 'C' items.
Step 5. Check Short Product Lifecycles or Perishability:
Fashion's fleeting nature means items can go out of style quickly. For a trendy hat expected to be in fashion for just one month, a JIT approach ensures they order minimal quantities to meet the predicted sales.
Step 6. Examine Storage Limitations:
Limited storage space means prioritizing fast-moving items and using dropshipping for bulkier seasonal goods. Bulky winter jackets, for instance, are drop-shipped directly from the supplier to customers during the winter.
Step 7. Gauge Supplier Reliability:
Their reliable supplier means they can maintain a lower safety stock. Yet, for essential items like best-selling summer dresses, a safety stock of 20 dresses provides a buffer against unforeseen supply issues.
Step 8. Consider Business Scalability and Growth:
Planning to expand their range, they've started using the reorder point model. For a new line of summer sandals, the reorder point is set at 30 pairs based on weekly sales predictions.
Step 9. Review and Adjust Periodically:
Due to the dynamic nature of fashion, they review their inventory model bi-annually. A recent review led to a slight increase in safety stock for staple items which anticipated potential supply chain disruptions.
Step 10. Seek Expert Validation:
They occasionally consult with supply chain experts to refine their approach. After a recent consultation, they're considering integrating a dynamic reorder model given the diverse and evolving nature of their inventory.
We hope that you now have a better understanding of what inventory models are and how to choose the right models to optimize your stock levels and reduce costs.