Three inventory models

Sample Solution

There are three main inventory control models, each driven by a distinct factor:

1. Economic Order Quantity (EOQ) Model

• Driving Factor: Balancing ordering costs and holding costs. The EOQ model aims to calculate the optimal order quantity that minimizes the total inventory costs, which are the sum of the costs associated with placing purchase orders (ordering costs) and the costs associated with storing inventory (holding costs).
• Main Features:
  • Assumes constant demand rate.
  • Assumes fixed ordering costs per order.
  • Assumes fixed holding costs per unit per year.
  • Calculates a fixed order quantity to be placed whenever inventory reaches a specific reorder point.
  • Does not typically account for demand or lead time variability.
• Where it might be used: Businesses with relatively stable demand and predictable costs for ordering and holding inventory. It's often used for basic raw materials or standard products.
• Example: A small manufacturing company, "Precision Parts Inc.," uses the EOQ model for ordering standard steel bolts. Their annual demand is consistently 10,000 bolts, the cost to place an order is $50, and the cost to hold one bolt in inventory for a year is $0.50. The EOQ formula would help them determine the most economical number of bolts to order at a time.

2. Periodic Review System (Fixed-Interval System)

• Driving Factor: Convenience and synchronized ordering at fixed time intervals. In this model, inventory levels are reviewed at fixed periods (e.g., weekly, monthly), and an order is placed to bring the inventory up to a target level. The order quantity varies depending on the inventory on hand at the time of review.
• Main Features:
  • Inventory is checked at regular intervals.
  • Order quantity changes with each review to reach the target inventory level.
  • Suitable for items where it's efficient to order together or when suppliers make regular, periodic visits.
  • Requires a target inventory level that accounts for demand during the review period and the lead time.
• Where it might be used: Retailers with multiple products from the same supplier, where it's more efficient to place one order for various items at a set time. Also suitable for smaller businesses with less sophisticated inventory tracking systems.
• Example: A local pharmacy, "HealthPlus Pharmacy," reviews its stock of over-the-counter medications every Monday. For a particular pain reliever, they have a target inventory level of 100 units. If on Monday, they have 30 units in stock, they will order 70 units to bring the level back to 100. The driving factor here is the convenience of a weekly ordering schedule from their pharmaceutical distributor.

Full Answer Section

Continuous Review System (Fixed-Quantity System or Reorder Point System)

• Driving Factor: Maintaining a specific service level and minimizing the risk of stockouts. This model involves continuously monitoring inventory levels. When the inventory reaches a predetermined reorder point, a fixed quantity of items is ordered.
• Main Features:
  • Inventory levels are tracked in real time or near real time.
  • A fixed quantity is ordered whenever the inventory drops to the reorder point.
  • The reorder point is set to cover demand during the lead time plus any safety stock.
  • Well-suited for high-value or critical items where stockouts can be costly.
• Where it might be used: Businesses using sophisticated inventory management systems, dealing with high-demand or critical parts, and those prioritizing avoiding stockouts.
• Example: Amazon utilizes a continuous review system for many of its products. For a popular electronics item, they set a reorder point based on sales velocity and supplier lead time. As soon as the available inventory hits that point, their system automatically triggers a new order for a pre-calculated quantity to ensure continuous availability for customers. The driving factor is to meet customer demand and avoid losing sales due to stockouts.

In summary, the choice of inventory control model depends on various factors, including the nature of the products, demand patterns, cost structures, and the company's strategic objectives regarding inventory management and customer service. Many companies also use a combination of these models for different types of inventory.