Inventory refers to raw materials or finished goods that a business holds to meet customer demands or for production. Proper inventory management is essential to prevent overstocking or out-of-stock issues. Overstocking can lead to unnecessary holding costs, while understocking can cause a negative impression of the business to customers.
But how will a business know how much inventory to store in the warehouse storage to meet customer demands? Well, here comes the importance of inventory models. They are mathematical tools that help a business determine the quantity and timing of stock reordering to reduce costs and effectively meet demand. These models can optimize a business’s inventory-related decisions.
What is The Inventory Model?
Inventory model is mathematical model used by businesses to find out the optimal inventory required for storage or reordering. The inventory management model ensures that the right amount of products is always available in smart warehouses to meet customers’ demands. Thus, it increases customer satisfaction and loyalty in a business.
Some businesses keep a lot of inventories inside the warehouse. However, that can lead to an increase in holding warehousing costs. Perishable items get damaged when stored for a longer time. A business can avoid the goods being damaged and high costs through an inventory model.
An inventory model streamlines supply chain operations and makes it easier for business owners. Inventory models help them to decide how many products they need to store at a time in order to run the business smoothly.
Different Types Of Inventory Models
Inventory management models are of various types, which are listed below. In this guide, we explained the top 5 models of inventories that were used a lot at this time:
- Economic Order Quantity (EOQ) Inventory Model
- Economic Production Quantity (EPQ) Model
- Reorder Point (ROP) Model
- Just In Time Inventory
- ABC Analysis
1. EOQ Inventory Model
The EOQ inventory management model is a mathematical formula used to determine the exact number of product quantities the business should place every time while ordering from the supplier. This model is also known as the Wilson model. The Economic Order Quantity model is based on various assumptions, like the constant ordering and holding costs.
The EOQ Inventory formula
EOQ = √ [2DS/H]
- D is the annual demand rate. It means the total number of units required every year.
- S is the ordering cost incurred each year. It includes transportation costs, administrative costs, and other procurement-related expenses.
- H is the holding cost per unit every year. It includes the cost of storing a product and maintaining it over a complete year.
Example: A bookstore sells 14,000 books annually. The cost to place an order is Rs 200, and the annual holding cost for every book is Rs 5.
Here D =14,000 units
H = Rs 5 per unit annually
S = Rs 200 per year.
Now the EOQ is √ [2*14,000*200/5] = 1058.300 = 1058
This means that the bookstore should order 1058 units every time to reduce total inventory and logistics costs.
This model is used in manufacturing and retail to prevent overstocking and out-of-stock problems.
2. Economic Production Quantity (EPQ) Model
EPQ is a mathematical model that determines the number of items a company should order in a single batch to reduce storage costs.
Formula of EPQ:
EPQ = √ [2DS/H]  √ [P/P-D]
Here, D = Annual demand cost per year
S is the set-up cost for each production run, and h is the holding cost for each unit per year.
P is the production rate per year.
Let’s discuss with an example
A plastic bottle company wants to determine the EPQ
D =12,000 bottles
S = Rs 600
H =Rs 3
P = 24,000
EPQ = √[2*12000*600/3] √[24000/24000 -12000] = 3099
The Company should produce 3099 plastic bottles on each production run to reduce its holding costs.
3. Reorder Point Model (ROP)
The reorder point model is the inventory level at which you have to place a new order to avoid out-of-stock problems. Supermarkets order milk, curd, and bread based on this model. Again, factories reorder steel and plastic based on ROP.
ROP formula
ROP = (D*L) + SS
D = Average Sales per day
L = Lead time(time taken for a new order to arrive)
SS = Safety Stock (extra stock to keep in hand)
Let’s discuss this with an example: A retailer sells 100 units of body lotions every day. It takes 5 days to receive the new order. The extra stock with the retailer is 200 body lotions to avoid stockout problems.
Now ROP = (100*5) + 200 = 700
So, the retailer should place a new order when the body lotions fall to 700 items.
4. Just In Time
It is a unique inventory model that focuses on ordering the amount of inventory required at present to meet customer demands.
Here, businesses don’t have to bear the holding costs of the inventories. This inventory mode saves money for the Company. However, it does not have any particular mathematical formula. It requires careful coordination of suppliers with retailers and distributors.
5. ABC Analysis
ABC analysis divides inventory into three groups, A, B, and C, based on its value and turnover. The model is based on the Pareto principle.
A Items: These items comprise only 20 per cent of the total inventory but 80 per cent of the total revenue. Class A items are highly valuable and are given the most importance.
B items: These items account for only 30% of the total inventory but 25% of the total revenue. They are managed with moderate control.
C Items: These items account for 50% of the total inventory but 5% of the total revenue. Inventory controls are loose as they do not provide much profit to the business.
Let’s discuss with an example:
- Item X: 700 units per year At Rs 20 per unit =Rs14000
- Item Y: 300 units per year at Rs30 per unit = Rs9000
- Item Z: 2000 units per year at Rs 2 per unit = Rs4000
So here, Item X will be considered a Class A category. Item Y is categorized under Class B, and Item Z will be under the Class C category.
How do Inventory Models Improve Business Operations?
1. Reduce Costs
EOQ inventory management model can calculate the optimal order size and reduce the business’s overall cost.
2. Prevent Out Of Stock Problems
Inventory models, like the reorder point model, can determine the exact inventory level you need to reorder items. This helps prevent stockout problems in a business.
3. Enhances Cash Flow
ABC inventory models can improve a business’s cash flow. A business can prioritize fewer Class C items and invest the saved money in other core activities like product development or exploring new markets.
4. Increase Customer Satisfaction
Constant stock availability ensures that customers get the required products when needed. This builds trust and increases customer satisfaction. For example, if someone places an order on a marketplace like Meesho, and the Meesho seller has the product readily available in stock, they can process and ship it immediately. This streamlined process ensures quick deliveries and enhances customer satisfaction.
5. Reduce Wastage
Inventory models like Just-in-time reduce spoilage of perishable products in a food business.
How To Choose The Best Inventory Model For Your Business?
Choosing the right inventory model can bring many benefits to your business. Below are a few factors you should consider while selecting the inventory model.
1. Understand The Nature Of Your Business
If you are doing business with perishable or seasonal products, then consider the JIT inventory model. Simultaneously, the ABC analysis inventory model will work best when doing business with precious items.
In short, you must understand the nature of your business and then decide which inventory model is best for you.
2. Access Your Business Goal
You should consider your business goal when choosing an inventory model. For example, if your main goal is to reduce holding costs, choose the EOQ model. Simultaneously, if you wish to reduce stockout problems and increase customer satisfaction, select the Reorder point model.
Key Challenges In Adopting Inventory Management Models In Business
1. Inaccurate Data
Inventory models require accurate data about demand, lead times, and other factors. Inaccurate data gives inefficient results and can cause problems with inventories.
2. Unpredictable Demand
Sometimes, it’s hard to predict the number of items the customer will buy. Demand may change suddenly, and inventory models will not work at that time. This can cause overstocking or out-of-stock issues.
3. Model Complexity
Some inventory models require proper understanding, and small business owners cannot apply them properly without training. If businesses apply them without proper knowledge, they get inaccurate inventory data.
4. Technology
Some inventory models depend on software that some business owners may not have. This software may be expensive, and small businesses can’t afford them.
Conclusion
Inventory models are essential tools that help businesses to manage stock, reduce costs, and increase customer satisfaction effectively. However, choosing the right model may come with certain challenges. With the right approach and adoption of advanced technology, a business can choose the appropriate inventory management model and achieve long-term success.
AAJ Supply Chain Management
