Inventory Management – Techniques and methods



Inventory management: In order to meet the customer demand as soon as it arises, companies might need to hold large amounts of inventory. It requires care
Inventory Management

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Inventory Management Overview

Costs associated with inventory:

  • Purchase Price.
  • Re-order costs:
    • cost of delivery of purchase items.
    • cost associated with placing order.
    • cost associated with checking the inventory after delivery.
  • Inventory holding costs:
    • capital tied-up.
    • insurance costs.
    • cost of warehousing.
    • obsolescence, deterioration and thief.
  • Shortage costs/Stock-out costs.

Changing inventory levels will affect variable holding costs but not fixed cost


There is a trade-off between ordering costs and holding costs:

  • The holding costs reduces , as when average inventory falls as order size falls, thus increases order cost as there will be more number of orders. The inverse is also correct.

Economic Order Quantity (EOQ)

Economic Order Quantity

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EOQ is a mathematical model used to calculate the quantity to order each time an order is made, in order to minimize the annual inventory costs.

Assumptions of EOQ

  • There are no bulk purchases discount. All units purchased cost the same unit price.
  • The order lead time/Re-order period (the time between placing an order and receiving delivery) is constant. and known.
  • Annual demand is constant throughout the year.

Based on the assumptions; the relevant costs are the annual holding cost per item per annum and the annual ordering costs.

Formula to be used:

Economic order quantity


Q = Quantity purchase in each order.
CO= Cost per order
CH= holding cost per item per annum
D = Annual Demand

  • At EOQ total annual ordering costs and holding costs are always same.
  • EOQ precludes safety inventory.

Other formulas: (if maximum inventory held is ‘Q’ i,e EOQ)

  • Average inventory = Q/2
  • Total holding costs = (Q/2) x CH
  • No. of orders = D/Q
  • Total ordering cost = (D/Q) x Co

Optimum order quantity with price discount for large orders

  • EOQ formula uses to calculate purchase quantity and assumes purchase cost constant. Therefore purchase cost irrelevant.
  • If a supplier offers a discount on the purchase price above a certain quantity. The purchase price becomes relevant.
  • In this situation in order to minimize costs, compare;
    • EOQ ; and
    • Minimum ordering quantity necessary to obtain price discount.

The total costs must be calculated for both:

  EOQ Quantity if discount obtained
Annual ordering cost x x
Holding costs x x
Purchase costs x x
Total costs xx xx

Decision: should be which order quantity minimizes total costs.

Inventory Valuation

Valuation of Inventory

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Basic Rule:

Inventory must be measured at lower of;

  • Cost; or
  • Net realizable value (NRV)

Valuation of Inventory

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It would be impossible to identify the actual cost for all inventory items because of the large numbers of such items.

Therefore, cost formulas are used for determining cost of group of similar items.

The following cost formulas are used:

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First in, first out (FIFO)

  • Large and expensive items are readily recognizable but cost of similar items are impossible to identify.
  • To establish the cost of inventory using FIFO it is necessary to record:
Received Issued
Date Units Price Date Units Price
  • This approach assumes that the first inventory sold is always the inventory bought earliest date.

This means closing inventory is always assumed to be the most recent purchase.

Weighted Average cost (AVCO)

  • This approach assumes that all units are issued at the current weighted average cost per unit.
  • A new average cost is calculated whenever more items are purchased and received in stores as:

Cost in store + New items cost
No. of units in stores + New units

Inventory Reorder level and other warning levels

When certain lead time and constant demand

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When the demand is constant and lead time is certain, the Re-order level can be calculated as:

= Demand for material per day/week (multiply-by) lead time in days/weeks.

UN-certain demand and supply lead-time

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Three warning levels of inventory

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Maximum inventory level

Inventory held above this would incur extra holding cost without adding benefit to company.

It can be calculated as:

[Reorder level + Reorder quantity]


[maximum demand per day/week x maximum supply lead time]

Re-order level

Re-order level

[maximum demand per day/week x maximum supply lead time]

Safety Inventory

  • If supply lead time and demand is uncertain there should be a safety level of inventory (also called safety stock, Buffer stock):
  • It is actually the average amount of inventory held in excess of average requirements.

It can be calculated as:

[maximum demand per day/week x maximum supply lead time]


[average demand x average lead time]

Minimum inventory level

When inventory falls below this amount, management should check that a new supply will be delivered before all the inventory is used up.

It can be calculated as:

[Reorder level]


[average demand per day/week x average supply lead time]