A major challenge in inventory management is to determine the right amount of stock. Safety stock is needed to absorb the variability of the customer demand. An excess stock in the face of less demand would mean high inventory costs whereas less stock under high demand would mean that the customer demands won't be met which would ultimately lead to loss of customer base. Every organization wants to have an optimal level of safety capacity or buffer capacity.
So, what should be the right level of stock? The optimal level of safety stock is determined by following factors:
- Replenishment lead times: The total period of time that elapses from the moment it is determined that a product should be reordered until the product is back on the shelf available for use. The shorter the replenishment lead time, the lower the safety stock level should be to satisfy demand during replenishment. However, logistics costs are more if replenishment lead times are less.
- Forecasting : The more accurate the forecast, the smaller the safety stock needed.Usually, nowadays, ERPs are capable enough to predict the demand. However, it is not advisable to depend entirely on these systems. In 2001, Nike implemented an updated version of their inventory management software.Based on historical sales data of different products, and based on some market growth estimates, Nike would first prepare a demand forecast for different families of products. However, they ran into some serious software implementation issues - bugs, and data errors – which resulted in incorrect demand forecast. So, Nike over-produced products that were less in demand and produced less of those product that were in high demand resulting in huge loss.
- Economic Order Quantities: It is the order quantity of inventory that minimizes the total cost of inventory management.Two most important categories of inventory costs are ordering costs and carrying costs. Ordering costs are costs that are incurred on obtaining additional inventories. They include costs incurred on communicating the order, transportation cost, etc. Carrying costs represent the costs incurred on holding inventory in hand. They include the opportunity cost of money held up in inventories, storage costs, spoilage costs, etc.Ordering costs and carrying costs are quite opposite to each other. If we need to minimize carrying costs we have to place small order which increases the ordering costs. If we want minimize our ordering costs we have to place few orders in a year and this requires placing large orders which in turn increases the total carrying costs for the period.
We need to minimize the total inventory costs and EOQ model helps us just do that.
| Total inventory costs = Ordering costs + Holding costs |
By taking the first derivative of the function we find the following equation for minimum cost
EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)
(for complete derivation see here: http://ir.washburnlaw.edu/bitstream/10425/114/1/Origins%20of%20the%20Economic%20Order%20Quantity%20Formula.pdf)
Underlying assumptions:
Can you point out the flaws in this approach? |
Sources:
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