Inventory Management / Control basics

Inventory management or control refers to the management of idle resources which have economic value tomorrow. Alternatively, Inventory may be defined as usable but idle resources that have economic value.

What is Average Inventory Level ?

The ideal inventory level is a material's Economic Order Quantity (EOQ). This is the amount ordered when an order is placed.

Next you need to determine your Safety Stock (SS). This is the amount that you should have remaining when the EOQ arrives.

Basically, Safety stock is the average bare minimum you will have at any give time, and EOQ+SS is the average maximum amount you will have at any given point in time. This should be intuitive because safety is what you have when your shipment arrives and when the order arrives (EOQ) it gets added to the safety stock.

There can be average minimum and maximum because you might not receive the EOQ exactly when you planned to and therefore may have more or less. On average you should have the SS amount when you receive shipments. Between these two average minimum and maximum values lies your long-term average inventory.

The formula for this is:

Optimal Average Inventory = (EOQ+SS+SS)/2

This is for materials. For finished goods, you should aim to keep an inventory level designed to prevent a stock out. This level would be a safety stock of finished goods, thus making the ideal average inventory for finished the safety stock value based on your company's service level.

How to Assess Inventory Levels ?

Simplistic Method - Historical Inventory Levels

Most methods of accounting take the beginning inventory of a period, add it to the ending inventory of a period, and divide by 2. This essentially provides the mathematical average for a given month.

For example, if your inventory level for a good is 2000 on July 1st, you produce 3000 units and sell 1000 units by July 31st. This leaves you with 4000 units. The formula is:

Avg. Inventory = (Beginning Inventory+(Beginning Inventory+Units Produced-Units Sold))/2

Avg. Inventory = (2000+(2000+3000-1000))/2 = 3000

Or more simply:

Avg. Inventory = (Beginning Inventory+Ending Inventory)/2

Avg. Inventory=(2000+4000)/2=3000

So this covers historical looks using an accounting approach. A lot of firms use this method to evaluate their average inventory levels.

Daily Weighted Average Inventory Approach

Suppose you start with 10,000 units on May 1st. Also suppose you produce 10,000 units in that month spread out across 21 business days. Now (and this is the important part) suppose you sold 20,000 units in May. This brings the ending inventory to 0. Using accounting methods, the formula gives us 10,000 as the average inventory.



So why is this so bad? In short, because the average inventory is not 10,000 units. In fact, there were only two days in which 10,000 units or less were held and these days were May 1st (10,000 units) and May 31st (0 Units). Assuming that production was level through the 21 day working month, this means that 500 units were produced daily, thus raising inventory by 500 units a day until inventory was dropped by 20,000 on the 31st.

Thus weighted average is more suited than the simple average.

Why are inventory levels so important?

To put it simply, average inventory levels are important because they allow you to determine how much money you have tied up in inventory and how much value your inventory assets hold. Helping to determine what they should be can help cut back on unneeded inventory, and knowing what they are can help you determine average warehouse usage, inventory risk, percentage of assets that are made up inventory, holding costs, etc.

Learn Optimization of Inventory here  

Inventory Holding Costs :

I have been receiving a lot of inquiries regarding the specifics of calculating holding costs. By and large, you can read about what drives holding costs in my article A Simplified Look at the Pros and Cons of Inventory. This article is intended to provide greater detail regarding the quantification of holding costs. The first section is going to discuss rough estimates and the second section will discuss methods involved with detailed holding cost analysis.

Rough Estimations :

Typically, holding costs are estimated to cost approximately 15-35% of the material's actual value per year.


The primary factors that drive this up include additional rent needed, great insurance premiums to protect inventory, opportunity costs, and the cost of capital to finance inventory.

A More Detailed Look at Holding Costs :

First of all, it is generally best to think of holding costs in terms of their annual costs. To do this, you will need accurate representations of your annual inventory levels. It is always better to track inventory month by month and using these values to find the average holding cost as opposed to taking the year's beginning, the year's end and averaging the two.

So now you have your average inventory. This needs to be performed for finished goods, work in process, and raw materials inventory.

Now, you need to figure out what percentage of the total value of the good is being incurred as a holding cost. Cost of capital and opportunity costs should be the first things you think of.

If you are financing the goods with a 10%/year loan then the holding costs are at least 10% annually. When you are evaluating the total value, include the value of any labor that has been added to the goods.

Next step would be to consider the cost of storage. Based on the inventory you need to carry, how much space do you need and how much does that space cost per unit as a percentage of each good.
Again, determine the insurance cost that should be allocated to each good as a percentage of that good.

Evaluate the probability that a good will rot, or otherwise become obsolete and assess the average rate at which this occurs and use this to quantify the average holding cost per good as a percentage of that good on an annual basis.

Determine if there are any other costs you can think of that are incurred simply by being in possession of a good. If you can think of any, treat them as holding costs.
Add up all of these percentages and together they make your holding costs.

What is EOQ?

EOQ is a mathematical formula designed to minimize the combination of annual holding costs and ordering costs. There is a lot of hype about just in time inventory systems (JIT), which achieve smaller inventories through very frequent orders, but frequent ordering can often result in an over-spending on ordering costs. Even though companies often miscalculate their ordering costs, which makes frequent ordering seem costly, EOQ is an important tool for determining what inventory should be.

Safety Stock

First of all, here's the formula so you don't have to dig through my well-written article for it.

Safety Stock: {Z*SQRT(Avg. Lead Time*Standard Deviation of Demand^2 + Avg. Demand^2*Standard Deviation of Lead Time^2}


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