INVENTORY MODELS

Inventory also referred as stocks are basically the goods and raw materials that any business
would hold and are ready or will be ready for sale.

Inventory model is a mathematical model that helps business in determining the optimum level
of inventories that should be maintained in a production process, managing frequency of
ordering, deciding on quantity of goods or raw materials to be stored, tracking flow of supply of
raw materials and goods to provide uninterrupted service to customers without any delay in
delivery.

The purpose of an inventory system is to balance the differences between production and
demand that occur in almost all cases. Inventory theory concentrates on the problems of
optimization of inventory systems. The basic feature of an inventory system is some space for
storage or stock—that is, required to meet the demand, and inventory replenishment. The
purpose of the inventory model is an optimal inventory policy with various constraints.
Inventory models are often classified according to the nature of the system variables. An
important aspect of inventory models is the time factor. The model without an explicit time
effect is called “static.” A characteristic feature of deterministic inventory model is a unique
description of the inventory process where no random input occurs. Solution of a deterministic
problem is often easy but differences occur, depending on the type of model, in relation to
maximum storage.

Consider the following situation, commonly called the economic order quantity problem. A
product is produced (or purchased) to inventory periodically. Demand for the product is
satisfied from inventory and is deterministic and constant in time. How many units of the
product should be produced (or purchased) at a time to minimize the annual cost, assuming
that all demand must be satisfied on time? This number of units is called the batch size.

Inventory Decision
In an inventory control situation, there are three basic questions to be answered. They are as
follows:

1. How much to order? That is what is optimal of an item that should be ordered.
 
2. When should the order be placed?
 
3. How much safety stock should be kept? what quantity of items in excess requirements
should be held as a buffer stock.
Inventory Cost

This costs accomplice alongside procurement, storage and management of inventory.

1. Ordering Cost: In the production process, required raw materials ordering cost is said as
ordering cost. Ordering cost depends on workers’ salaries, telephone calls, computer
cost, transportation cost, analysis of raw materials, etc.  A firm produced to its own
product from exterior source then the cost of resetting for equipment production. The
cost is expected as the cost per order or per setup.

2. Purchase Cost or production cost: Purchase cost is the procurement cost of unit items
(or production). Important of the purchase price is when large production runs the
process, these result in reduction of production cost or purchase cost per unit. For
purchase “quality discounts” is specific quality, the ordered quantity may suitably be
adjusted, so as to take advantage of these discounts.
3. Holding cost: holding cost usually denoted by C1C1 or CbCb per unit time.

The following components constitute the holding cost: Invested capital costs, Storage space
cost, Handling costs, Recordkeeping costs, Deprecation, Deterioration and Obsolescence costs,
Taxes and insurance costs, Salvage costs and selling price.

4. Setup cost: Set up cost is acquired to obtain material to provide another goods bunch.
The variety of organizations this cost is independent.

5. Shortages or stock out: Shortages cost is a lack of inventory stock. This cost is included
when customer fulfills their needs outside. Trouble of demand means business is not
fulfilled by the company.

6. Salvages value: Salvages value is to measure value that benefits after fulfilling criteria.

Other Factors Involved in Inventory;

7. Demand: Demand is a known number otherwise it will be completely unknown.

Further, if it is known, it may be either fixed or variable per unit time. This introduces
two types of inventory models. They are the following:

o Deterministic Model: In this model, the demand is known and fixed.

 
 o Probabilistic Model: The model in which the demand is not known exactly which
is assumed to be a random variable and is given by a known probability function
is known as a probabilistic or stochastic model.
 

8. Replenishment: In a manufacturing system, the inventory of raw material, semi-

finished goods, etc. may be required either to keep the warehouse for future need or
to be used for immediate processing on arrival. The replenishment of such items may
be instantaneous, constant or gradual, depending upon the lead time.

9. Order cycle: Time duration of placing one order to another order is known as order
cycle. There are two types of order cycle: Continuous review, periodic review.

10. Lead time: Lead time is time interval within placing order and appearance of inventory.
Level of inventory of an item depends upon the length of its lead time. It is divided into
two parts one is Administrative lead time and other is Delivery lead time.
Administrative lead time is the time for inception activity of  store required. Delivery
establishment for placing an order material is called as Delivery lead time.

11. Time horizon/Planning: Time horizon/planning is the time duration for inventory level
until it is not composed. This time is either finite or infinite for the production of
inventory.

12. Buffer (or safety) stock: Naturally, demand and lead time of product are not sure and it
is not fixed. Therefore, demand deviation and supply deviation is not limited, it must be
needed extra product/material to overcome the problem is called safety stock.

13. Number of items: Number of items is very important in inventory system. This system
needs the extra stock to fulfill customer demands.

14. Maximum stock: Maximum stock level is inventory level that is not exceeded for
inventory planning. Maximum stock level = Re-order level + Re-order quantity–
(Minimum usage*minimum lead time).
Schematic diagram of basic inventory model

EOQ (Economic Oder Quantity)

Company needs to control inventories. If it may grow up then the company faces suffer and
similarly if it may be limited then the company may fail business. So, the optimal level of
inventories can overcome this problem. Economic Order Quantity is a model to measure
optimal volume that reduces total holding cost, ordering cost, shortages cost. These models
are considered demand as a constant level and inventory are reduced constant amount until it
reaches zero. No inventory lack is considered in this model. 

Schematic diagram of an EOQ Model

Mathematical models or formula that can help us firm determining the EOQ and the frequency
of ordering. Without interruption or delay of customer demand can play good services of firm.
There are two types of inventory models. Deterministic Inventory Models and Probabilistic or
Stochastic inventory Models.

Types of Inventory Models

1. Fixed Reorder Quantity System
2. Fixed Reorder Period System.

Fixed Reorder Quantity System

Fixed Reorder Quantity System is an Inventory Model, where an alarm is raised immediately
when the inventory level drops below a fixed quantity and new orders are raised to replenish
the inventory to an optimum level based on the demand. The point at which the inventory is
ordered for replenishment is termed as Reorder Point. The inventory quantity at Reorder Point
is termed as Reorder Level and the quantity of new inventory ordered is referred as Order
Quantity.
Inventory Model: Fixed Reorder Quantity System

1. Average Demand (DAv): It is the average number of order requests made per day.
2. Average Lead Time (TL): The time required to manufacture goods or product.
3. Average Lead Time Demand (DL): Average number of orders requested during the Lead
Time
Average Lead Time Demand (DL) = Average Demand (DAv) X Average Lead Time (TL)
 4. Safety Stock (S): It is the extra stock that is always maintained to mitigate any future
risks arising due to stock-outs because of shortfall of raw materials or supply,
breakdown in machine or plant, accidents, natural calamity or disaster, labour strike or
any other crisis that may the stall the production process.
The quantity of safety stock is often derived by analysing historical data and is set to an
optimized level by evaluating carefully the current cost of inventory and losses that may be
incurred due to future risk.

5. Reorder Level (RL): Reorder level is the inventory level, at which an alarm is triggered
immediately to replenish that particular inventory stock. Reorder level is defined,
keeping into consideration the Safety Stock to avoid any stock-out and Average Lead
Time Demand because even after raising the alarm, it would take one complete process
cycle (Lead Time) till the new inventories arrive to replenish the existing inventory.
Reorder Level (RL) = Safety Stock (S) + Average Lead Time Demand (DL)
6. Order Quantity (O): Order quantity is the Demand (Order requests) that needs to be
delivered to the customer.
7. Minimum Level: At least Safety Stock has to be always maintained to avoid any future
stock- outs as per the standard practices of inventory management.
Minimum Level (LMin) = Safety Stock (S)
8. Maximum Level: The maximum level that can be kept in stock is safety stock and the
demand (the quantity ordered).
Maximum Level (LMax) = Safety Stock (S) + Order Quantity (O)
Example: The order quantity of an Item is 600 Units. The safety Stock is 200 Units. The Average
Lead Time is 5 Days and average consumption per days is 40 units.
Order Quantity (O) = 600 Units
Safety Stock (S) = 200 Units
Average Lead Time (TL) = 5 Days
Average Demand ( DAv ) = 40 Units
Average Lead Time Demand (DL) = Demand (DAv) X Lead Time (TL) = 200 Units
Reorder Level (RL) = Safety Stock (S) + Average Lead Time Demand (DL) = 400 Units
Minimum Level (LMin) = Safety Stock (S) = 200 Units
Maximum Level (LMax) = Safety Stock (S) + Order Quantity (O) = 800 Units

Fixed Reorder Period System

Fixed Reorder Period System is an Inventory Model of managing inventories, where an alarm is
raised after every fixed period of time and orders are raised to replenish the inventory to an
optimum level based on the demand. In this case replenishment of inventory is a continuous
process done after every fixed interval of time.
Inventory Model: Fixed Reorder Period System
Order Quantity (O) = (M) – (It).
1. Regular Intervals (R): Regular Interval is the fixed time interval at the end of which the
inventories would be reviewed and orders would be raised to replenish the inventory
2. Inventory on Hand (It): Inventory on hand is the Inventory level measured at any given
point of time.
3. Maximum Level (M): It is the maximum level of inventory allowed as per the production
guidelines. The maximum level is derived by analysing historical data.
4. Order Quantity: In this system, inventory is reviewed at regular intervals (R), inventory
on hand (It) is noted at the time of review and order quantity is placed for a quantity of
(M) – (It).
Example: Inventory is replenished at every regular interval of 5 days. The maximum allowable
inventory is 800 Units. The inventory reviewed on Day-5, Day-10, Day -15 and Day -20 were 387
Units, 201 Units, 498 Units and 127 Units respectively.
Regular Intervals (R) = 5 Days
Maximum Level (M) = 800 Units
Inventory on Hand: I5 = 387 Units, I10 = 201 Units, I15 = 498 Units and I20 = 127 Units
Order Quantity (O) = (M) – (It).
Order Quantity (O5) = 800 – 387 = 413 Units
Order Quantity (O10) = 800 – 201 = 599 Units
Order Quantity (O15) = 800 – 498 = 302 Units
Order Quantity (O15) = 800 – 127 = 673 Units
Inventory theory deals with the management of stock levels of goods with the aim of ensuring
that demand for these goods is met. Most models are designed to address two fundamental
decision issues: when a replenishment order should be placed, and what the order quantity
should be. Their complexity depends heavily on the assumptions made about demand, the cost
structure and physical characteristics of the system.