Inventory Management: Definition and Overview

Economic Order Quantity (EOQ)

One of the fundamental concepts in inventory management is the economic order quantity (EOQ) model. The EOQ model helps companies determine the optimal order quantity for their inventory by taking into account factors such as lead time, carrying costs, and demand. For example, a retail company that sells clothing may use the EOQ model to determine the optimal order quantity for a popular item, such as a specific style of jeans. By ordering the right amount of inventory, the company can avoid the costs of holding too much inventory, such as storage and insurance costs, while also avoiding stockouts, which can lead to lost sales.

How to Calculate Economic Order Quantity

EOQ takes into account the timing of reordering, the cost incurred to place an order, and the cost to store merchandise. If a company is constantly placing small orders to maintain a specific inventory level, the ordering costs are higher, and there is a need for additional storage space.
Assume, for example, a retail clothing shop carries a line of men’s jeans, and the shop sells 1,000 pairs of jeans each year. It costs the company $5 per year to hold a pair of jeans in inventory, and the fixed cost to place an order is $2.

Here is the formula for EOQ

where S is the fixed cost per order, D is the demand in no. of units and H is inventory holding cost per unit per annum.

The EOQ in this example, according to the above formula, is the square root of (2 x 1,000 pairs x $2 order cost) / ($5 holding cost) or 28.3 with rounding. The ideal order size to minimize costs and meet customer demand is slightly more than 28 pairs of jeans. A more complex portion of the EOQ formula provides the reorder point.

Benefits of EOQ

- Improved Order Fulfillment: When you need a certain item or something for a customer order, optimal EOQ ensures the product is on hand, allowing you to get the order out on time and keep the customer happy. This should improve the customer experience and may lead to increased sales.
- Less Overordering: An accurate forecast of what you need and when will help you avoid overordering and tying up too much cash in inventory.
- Less Waste: More optimized order schedules should cut down on obsolete inventory, particularly for businesses that hold perishable inventories that can result in dead stock.
- Lower Storage Costs: When your ordering matches your demand, you should have less products to store. This can lower real estate, utility, security, insurance and other related costs.
- Quantity Discounts: Planning and timing your orders well allows you to take advantage of the best bulk order or quantity discounts offered by your vendors.

Limitations of EOQ

Economic order quantity or EOQ seems to be a perfect way to keep the inventory cost at its lowest. However it is based on the following assumptions and if these assumptions are not met, there will be a gap between the theoretical calculations vs. service levels and cost efficiencies. Following are the assumptions, basis which EOQ calculations are based.

- Demand is known & constant – no safety stock is required
- Lead time is known & constant
- No quantity discounts are available
- Ordering (or setup) costs are constant
- All demand is satisfied (no shortages)
- The order quantity arrives in a single shipment

Another important aspect of inventory management is inventory control. Inventory control systems assist companies in tracking and managing their inventory levels, including monitoring stock levels, setting reorder points, and generating reports. For example, a manufacturing company that produces electronic devices may use an inventory control system to track the stock levels of various components, such as microchips and batteries. By monitoring stock levels, the company can ensure they have enough inventory to meet customer demand, while also avoiding overstocking, which can lead to markdowns and wasted inventory.

In addition to these concepts, inventory management also involves forecasting and demand planning. Forecasting helps companies predict future demand for their products, while demand planning helps them align their inventory levels with that demand. For example, a company that produces seasonal items such as umbrellas, may use forecasting and demand planning to predict demand for the rainy season. By aligning their inventory levels with the forecasted demand, the company can ensure that they have the right amount of inventory to meet customer demand while also avoiding overproduction, which can lead to excess inventory.

Also Read – New Product Development: A Step-By-Step Process

In conclusion, inventory management is a vital function of any business and MBA students must understand its concepts to be successful in the corporate world. The concepts of economic order quantity, inventory control, forecasting, and demand planning can all help companies minimize costs and maximize profits by ensuring they have the right amount of inventory at the right time. By using these concepts, MBA students can assist their companies to improve their inventory management and achieve success in the marketplace.