Inventory Management Models

Inventory management models fall into two fundamental categories: independent and dependent inventory demand models.

Independent Demand

Independent demand inventory systems are at their very essence market driven. Whether the inventory is raw materials or a finished product, it is the end product of that particular organization. Pulls from inventory occur as an external customer purchases the units, either directly or as restock to a forward retail position.

Items with an independent demand tend to be managed through one of two processes: periodic review or perpetual inventory management.

• Periodic Review: This process involves regular review of usage and reorder to a carrying point.
• Perpetual Inventory: This process revolves around reorders when an item reaches a pre-set minimum stocking level, or reorder point.

While demand can be somewhat indirectly influenced via pricing, merchandising, marketing and a whole spectrum of marketing initiative, in the end the market determines the inventory turns. The challenges in predicting independent demand is that there may not be a history, or the history may not match due to the life cycle stage of the product.

Dependent Demand

Dependent demand inventory systems are classically associated with Enterprise Resource Planning systems. The known demand is generally based on production numbers and the inventory represents the raw materials required to meet those requirements.

This overall demand model allows the use of such inventory management models as Economic Ordering Quantity, Safety Stock Analysis, Fill Rates, and Cycle Service Levels.

In this demand model, supply chain concerns become more and more critical to inventory control decisions. Lead times, quantity price breaks, and the costs of expediting orders all play a role.

Knowing the type of demand you need to accommodate is the first step in developing your own customized inventory management models. Different segments of your inventory may actually service a different demand type.

Learning how to recognize the operating demand conditions is the first step to growing into a more efficient organization. The next step is implementing the processes that support the inventory management models.

Mathematical Models

Inventory management is aimed at deciding the quantity of inputs or resources that need to be arranged, and the time when they need to be ordered, in order to reduce the production costs, in sync to the key requirements. On account of various abnormalities in the production inventory, no particular inventory model is important to the whole variant inventory situations. Therefore, different inventory models have been established to address these specific inventory issues.

An inventory system provides the organizational structure and the operating policies for maintaining and controlling goods to be stocked. The system is responsible for ordering and receipt of goods: timing the order placement and keeping track of what has been ordered, how much and from whom. The system also needs to follow up to answer such questions as: Has the supplier received the order? Has it been shipped? Are the dates correct? Are the procedures established or reordering or returning undesirable merchandise?

The classic inventory model is usually used by organizations to make forecasts on optimum inventory level or for evaluating two or more inventory systems. Nevertheless, inventory models are adopted on the basis of level of uncertainty with lead time or demand situations.

Situation	Demand	Lead time	Type of Model to be adopted
1	Constant	Constant	Deterministic Model
2	Constant	Variable	Probabilistic Model
3	Variable	Constant	Probabilistic Model
4	Variable	Variable	Probabilistic Model

There are two fundamental techniques being employed mostly, to develop inventory reserve estimates, viz. deterministic and probabilistic methods. While deterministic methods involve making a single best estimation of existing inventory reserves on identified engineering, economic and geological information, probabilistic methods utilize the identified engineering, economic and geological information to create a collection of rough stock reserves and their related probabilities. Each categorised inventory reserve indicates the prospect of revival.

The best part about a probability approach is that one can create a model in a better way when provided with values within a bandwidth modeled by an organised distribution density, in comparison to using deterministic figures.

Deterministic models are generally used to depict the optimal inventory of a single item, in the presence of an obscure demand, whereby the inventory builds up at a constant rate to meet an accepted or determined demand. For example, if a contract is received in February with a delivery deadline of December (in a period of 10 months), the product can be manufactured at a rate of 10 per month.

Further, stochastic one time models can also be used for inventory control, when the demand is unknown. These are more realistic models and hence, fetch more relevance, since they take into account factors such as cost of shortfalls, stacking away, arranging for reserves, and accordingly create an optimal inventory plan.

Let us now take hypothetical Deterministic and Probabilistic inventory control conditions:

A deterministic circumstance is basically one whereby the system parameters can be ensured accurately, also referred to as a situation of definiteness as it is known, things will occur as ensured. Further, the information system under consideration should be complete for clear demarcation of parameters. However, such kind of system rarely exists, and if it does, there lies uncertainty most of the times. In a deterministic model, the state of affairs is assumed to be deterministic and hence, a numerical model is produced to optimize on system arguments. As it conjures the system to be deterministic, it indicates that one has complete details about the system.

On the other hand, a probabilistic model depicts an uncertainty situation, which is as a matter of fact more pervasive, yet less comforted. Therefore, people tend to reduce uncertainty. The prototypes of probabilistic inventory comprising probabilistic demand and supply are more applicable in real life situations, though can be troublesome and uncontrollable during analysis.

So, we conclude that in general cases, the suitable inventory plan should be to reduce the costs associated with holding stock of both raw materials as well as finished goods. As for the model to be chosen, it should largely depend on the type of the industry, and you can select to adopt a deterministic or probabilistic model.

Inventory accounting system

The two most widely used inventory accounting systems are the periodic and the perpetual.

• Perpetual: The perpetual inventory system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out.
• Periodic: In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods

Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year.

Inventory Valuation Methods

Inventory valuation methods are used to calculate the cost of goods sold and cost of ending inventory. Following are the most widely used inventory valuation methods

• First-in-First-Out Method (FIFO) – According to FIFO, it is assumed that items from the inventory are sold in the order in which they are purchased or produced. This means that cost of older inventory is charged to cost of goods sold first and the ending inventory consists of those goods which are purchased or produced later. This is the most widely used method for inventory valuation. FIFO method is closer to actual physical flow of goods because companies normally sell goods in order in which they are purchased or produced.
• Last-in-First-Out Method (LIFO) – This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is assumed that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower. This is because the cost goods sold mostly consists of newer higher priced goods and ending inventory cost consists of older low priced items.
• Average Cost Method (AVCO) – Under average cost method, weighted average cost per unit is calculated for the entire inventory on hand which is used to record cost of goods sold. Weighted average cost per unit is calculated as – Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory
• The weighted average cost as calculated above is multiplied by number of units sold to get cost of goods sold and with number of units in ending inventory to obtain cost of ending inventory.
• specific cost – Using the specific cost method, the cost of each inventory item is tracked individually. This is a highly complex valuation method and requires sophisticated tracking methods. It’s used only for very expensive items, such as custom-made goods.

EOQ

Economic order quantity (EOQ) is an equation for inventory that determines the ideal order quantity a company should purchase for its inventory given a set cost of production, demand rate and other variables. This is done to minimize variable inventory costs, and the formula takes into account storage, or holding, costs, ordering costs and shortage costs. The full equation is as

where :

S = Setup costs

D = Demand rate

P = Production cost

I = Interest rate (considered an opportunity cost, so the risk-free rate can be used)

The EOQ formula can be modified to determine different production levels or order interval lengths, and corporations with large supply chains and high variable costs use an algorithm in computer software to determine EOQ.

EOQ is an important tool for management to minimize the cost of inventory and the amount of cash tied up in the inventory balance. For many companies, inventory is the largest asset balance owned by the company, and these businesses must carry sufficient inventory to meet the needs of customers. If EOQ can help minimize the level of inventory, the cash savings can be used for some other business purpose.

One component of the EOQ formula calculates a reorder point, which is a level of inventory that triggers the need to place an order for more inventory. By determining a reorder point, the business avoids running out of inventory and is able to fill all customer orders. If the company runs out of inventory, there is a shortage cost, which is the revenue lost because the company does not fill an order. Having an inventory shortage may also mean the company loses the customer or the client orders less in the future.