Inventory Planning - Basic Concepts

Every organization that is engaged in production, sale or trading of Products holds inventory in one or the other form. While production and manufacturing organizations hold raw material inventories, finished goods and spare parts inventories, trading companies might hold only finished goods inventories depending upon the business model.

When in case of raw material inventory management function is essentially dealing with two major functions. First function deals with inventory planning and the second being inventory tracking. As inventory planners, their main job consists in analyzing demand and deciding when to order and how much to order new inventories. Traditional inventory management approach consists of two models namely:

  • EOQ - Economic Order Quantity
  • Continuous Ordering
  • Periodic Ordering

  1. EOQ: Economic Order Quantity method determines the optimal order quantity that will minimize the total inventory cost. EOQ is a basic model and further models developed based on this model include production Quantity Model and Quantity Discount Model.

  2. Continuous Order Model: works on fixed order quantity basis where a trigger for fixed quantity replenishment is released whenever the inventory level reaches predetermined safety level and triggers re ordering.

  3. Periodic System Model: This model works on the basis of placing order after a fixed period of time.

EOQ Model

Example: Biotech.Co produces chemicals to sell to wholesalers. One of the raw material it buys is sodium nitrate which is purchased at the rate of $22.50 per ton. Biotech’s forecasts show a estimated requirement of 5,75,000 tons of sodium nitrate for the coming year. The annual total carrying cost for this material is 40% of acquisition cost and the ordering cost is $595. What is the Most Economical Order Quantity ?

D = Annual Demand
C = Carrying Cost
S = Ordering Cost

D = 5,75,000 tons
C =0.40(22.50) = $9.00/Ton/Year
S = $595/Order

= 27,573.135 tons per Order.

This model pre supposes certain assumptions as under:

  • No safety Stocks available in inventory.
  • No Shortages allowed in order delivery.
  • Demand is at uniform rate and does not fluctuate
  • Lead Time for order delivery is constant
  • One order = One delivery no shortages allowed.
  • This model does not take into account other costs of inventory such as stock out cost, acquisition cost etc to calculate EOQ.

In this model, the demand increases for production the inventory gets depleted. When the inventory drops to a critical point the re order process gets triggered. New order is always place for fixed quantities. On receipt of the delivery against the order the inventory level goes up.

Using this model, further data extrapolation is possible to determine other factors like how many orders are to be placed in a year and what is the time lapse between orders etc.

EOQ For Production Lot:

This model is also used to determine the order size and the production lot for an item to be produced at one stage of production and stored as work in progress inventory to be supplied to the next state of production or to the customer.

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