What is inventory management model?

Initially, it assists with understanding what the issue is. Inventory management models
enhance your business by keeping up the perfect measure of inventory while lessening
costs. The objective of inventory management, otherwise called inventory control, is to
get the most benefit from your inventory with minimal measure of the venture. You need
to ensure you have sufficient stock in stock so you can keep clients glad, yet you would
prefer not to squander cash requesting stock that probably will not sell.

Inventory management is a systematic approach to sourcing, storing, and selling

inventory—both raw materials (components) and finished goods (products). In business
terms, inventory management means the right stock, at the right levels, in the right
place, at the right time, and at the right cost as well as price. The stock might be kept
“in-house”, which means in the vicinity or close by for sure-fire use; or it could be held in
a removed stockroom or dispersion place for some time later. Except for firms using in-
the nick-of-time strategies, usually, the expression “stock” infers a put-away amount of
merchandise that surpasses what is required for the firm to work at the current time.

The significance of inventory management models is in the exactness it gives. You can
discover which items are selling and which ones are not, which things you need to have
available, and explicitly what amount is required. Also, when you know these subtleties,
you can lessen operational costs, lower stockpiling expenses, and set aside your
business cash.

Accounting for Inventory

Inventory represents a current asset since a company typically intends to sell
its finished goods within a short amount of time, typically a year. Inventory
has to be physically counted or measured before it can be put on a balance
sheet. Companies typically maintain sophisticated inventory management
systems capable of tracking real-time inventory levels.

Inventory is accounted for using one of three methods: first-in-first-out

(FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing.
An inventory account typically consists of four separate categories:

1. Raw materials — represent various materials a company purchases for

its production process. These materials must undergo significant work
before a company can transform them into a finished good ready for
sale.
2. Work in process (also known as goods-in-process) — represents raw
materials in the process of being transformed into a finished product.
 3. Finished goods — are completed products readily available for sale to
a company's customers.
4. Merchandise — represents finished goods a company buys from a
supplier for future resale.

Inventory Management Methods

Depending on the type of business or product being analyzed, a company will
use various inventory management methods. Some of these management
methods include just-in-time (JIT) manufacturing, materials requirement
planning (MRP), economic order quantity (EOQ), and days sales of inventory
(DSI). There are others, but these are the four most common methods used
to analyze inventory.
1. Just-in-Time Management (JIT)
This manufacturing model originated in Japan in the 1960s and 1970s.
Toyota Motor (TM) contributed the most to its development.2 The method
allows companies to save significant amounts of money and reduce waste by
keeping only the inventory they need to produce and sell products. This
approach reduces storage and insurance costs, as well as the cost of
liquidating or discarding excess inventory.

JIT inventory management can be risky. If demand unexpectedly spikes, the

manufacturer may not be able to source the inventory it needs to meet that
demand, damaging its reputation with customers and driving business toward
competitors. Even the smallest delays can be problematic; if a key input does
not arrive "just in time," a bottleneck can result.

2. Materials Requirement Planning (MRP)

This inventory management method is sales-forecast dependent, meaning
that manufacturers must have accurate sales records to enable accurate
planning of inventory needs and to communicate those needs with materials
suppliers in a timely manner.3 For example, a ski manufacturer using an
MRP inventory system might ensure that materials such as plastic, fiberglass,
wood, and aluminum are in stock based on forecasted orders. Inability to
accurately forecast sales and plan inventory acquisitions results in a
manufacturer's inability to fulfill orders.

3. Economic Order Quantity (EOQ)

This model is used in inventory management by calculating the number of
units a company should add to its inventory with each batch order to reduce
the total costs of its inventory while assuming constant consumer demand.
The costs of inventory in the model include holding and setup costs.

The EOQ model seeks to ensure that the right amount of inventory is ordered
per batch so a company does not have to make orders too frequently and
there is not an excess of inventory sitting on hand. It assumes that there is a
trade-off between inventory holding costs and inventory setup costs, and total
inventory costs are minimized when both setup costs and holding costs are
minimized.4

4. Days Sales of Inventory (DSI)

This financial ratio indicates the average time in days that a company takes to
turn its inventory, including goods that are a work in progress, into sales. DSI
is also known as the average age of inventory, days inventory outstanding
(DIO), days in inventory (DII), days sales in inventory or days inventory and is
interpreted in multiple ways.

Indicating the liquidity of the inventory, how many days a company’s current
stock of inventory will last. Generally, a lower DSI is preferred as it indicates a
shorter duration to clear off the inventory, though the average DSI varies from
one industry to another.

Economic Order Quantity Model

The economic order quantity (EOQ) refers to the ideal order quantity a
company should purchase in order to minimize its inventory costs, such as
holding costs, shortage costs, and order costs. EOQ is necessarily used
in inventory management, which is the oversight of the ordering, storing, and
use of a company's inventory. Inventory management is tasked with
calculating the number of units a company should add to its inventory with
each batch order to reduce the total costs of its inventory.1

The EOQ model seeks to ensure that the right amount of inventory is ordered
per batch so a company does not have to make orders too frequently and
there is not an excess of inventory sitting on hand. It assumes that there is a
trade-off between inventory holding costs and inventory setup costs, and total
inventory costs are minimized when both setup costs and holding costs are
minimized.
KEY TAKEAWAYS

• The economic order quantity (EOQ) refers to the ideal order quantity a
company should purchase in order to minimize its inventory costs.
• A company's inventory costs may include holding costs, shortage costs,
and order costs.
• The economic order quantity model seeks to ensure that the right
amount of inventory is ordered per batch.
• This is so a company does not have to make orders too frequently and
there is not an excess of inventory sitting on hand.
• EOQ is necessarily used in inventory management, which is the
oversight of the ordering, storing, and use of a company's inventory.

The Formula for Economic Order Quantity

The formula for Economic Order Quantity is:

where:S=Setup costs (per order, generally includingshipping and han

dling)
D=Demand rate (quantity sold per year)
H=Holding costs (per year, per unit)

How to Use Economic Order Quantity

To calculate the EOQ for inventory you must know the setup costs, demand
rate, and holding costs.

Setup costs refer to all of the costs associated with actually ordering the
inventory, such as the costs of packaging, delivery, shipping, and handling.
Demand rate is the amount of inventory a company sells each year.

Holding costs refer to all the costs associated with holding additional
inventory on hand. Those costs include warehousing and logistical costs,
insurance costs, material handling costs, inventory write-offs,
and depreciation.

Ordering a large amount of inventory increases a company's holding costs

while ordering smaller amounts of inventory more frequently increases a
company's setup costs. The EOQ model finds the quantity that minimizes
both types of costs.

Reorder Point model

What is a reorder point?
A reorder point (ROP) is a specific level at which your stock needs to be replenished.

In other words, it tells you when to place an order so you won’t run out of stock.

Significance of reorder points

If you’re a business owner, knowing when to order more stock is important. If you

order when you still have a lot of stock on hand, it will lead to extra stock piling up,

which will increase your holding costs. If you order when you have zero stock on

hand, you’ll be unable to make sales for as long as it takes to receive the order. The

your vendor takes to supply the items, the more sales you’ll be losing. Setting a

reorder point helps you optimize your inventory, replenish your stock of individual

items at the right time, and meet your market demand without going out of stock.

How to calculate a reorder point

You need to know when to order each item in your inventory separately, because

different items have different sell-through rates. To calculate the ROP for each item,

you’ll need to know the following parameters:

Lead time: Time taken (in days) for your vendor to fulfill your order

Safety stock: The amount of extra stock, if any, that you keep in your inventory to

help avoid stockouts

 Daily average usage: The number of sales made in an average day of that particular

item

Reorder Point Formula

Let’s look at how to calculate a reorder point both with and without safety stock. Then

we’ll cover how to handle reorder points when you have multiple vendors.

▪ Determining ROP with safety stock

▪ Determining ROP without safety stock

Determining ROP with safety stock

This method is used by businesses that keep extra stock on hand in case of unexpected

circumstances. To calculate a reorder point with safety stock, multiply the daily

average usage by the lead time and add the amount of safety stock you keep.

Let’s understand this with an example. Suppose you’re a perfume retailer who sells

200 bottles of perfume every day. Your vendor takes one week to deliver each batch

of perfumes you order. You keep enough excess stock for 5 days of sales, in case of

unexpected delays. Now, what should your reorder point be?

Lead time = 7 days

Safety stock = 5 days x 200 bottles = 1000 bottles

ROP = (200 x 7) + 1000 = 2400 bottles

The order for the next batch of perfume should be placed when there are 2400 bottles

left in your inventory.

Graph

This simplified reorder point graph shows you the relationship between your reorder

point, stock level, and safety stock over a period of time. It helps you visualize how

your reorder point is based on your sales trends.

Multi-Echelon Inventory Optimization

Motivation:

For a large enterprise such as Nike and Oracle, managing inventory can be a challenging task with
thousands of products located in thousands of locations all over the world. The challenge magnifies
when locations are placed in different tiers or echelons of the enterprise’s distribution channel.
According to Forrester Research, the key differentiator these days between a highly successful
company (e.g. Wal-Mart) and a company that has sub-optimal performance (e.g. Kmart) is an ability
to increase the inventory turnover.

Broadly, there are two types of inventory systems: - the single-echelon (or, single-tier) inventory
system and the multi-echelon (or, multi-tier) inventory system. We will look at them briefly here.

Single-Echelon Inventory System:

A single-echelon inventory system is one wherein a single Distribution Center (DC) acts as a central
repository between the supplier of the inventory and the customer-facing outlets.

In a single-echelon network, an individual material-location combination is not affected by any other

material or location. If a business was selling products from a single location, then it would be
categorized as a single-echelon system. The DC is under the control of a single enterprise.

Multi-Echelon Inventory System:

A multi-echelon inventory system is one that relies heavily on layers of suppliers distributed across
multiple distribution centers and that is based on outsourced manufacturing. In such a system, new
inventory shipments are first stored at a central or regional distribution center (RDC). These central
facilities are the internal suppliers to the customer-facing outlets, also called forward distribution
centers (DCs). For example, Nike’s distribution network consists of 7 RDCs and more than 300,000
DCs; and these DCs serve end customers. Here, the DC and RDC both are under the control of a
single enterprise – Nike, Inc.
Multi-Echelon Inventory Optimization:

Multi-echelon inventory optimization (MEIO) right-sizes safety stock buffers across the entire supply
chain, taking into account the complex interdependencies between stages, as well as variables that
cause chronic excess inventory, such as long lead times, demand uncertainty, and supply volatility.

However, there are some significant issues in optimizing a multi-echelon inventory system:-

• Demand variation measure for the RDC.

• Demand measure for the RDC, and how to forecast this demand.
• Defining optimal service level goals between the RDC and its “customers” - the DCs.
• Allocation of inventory down to the DCs when faced with a limited supply situation at the
RDC.
Managing Inventory in Multi-Echelon Networks:
The objective of multi-echelon inventory management is to deliver the desired end customer service
levels at minimum network inventory, with the inventory divided among the various echelons. With
the primary focus on inventory, transportation and warehouse operations expenses also are taken
care of, because their cost factors are part of the overall optimization.

The inventory drivers, denoted in red in Figure 1, are

• Replenishment review frequency
• Order supply strategy
• Service level goal
With a multi-echelon approach, the decisions regarding the inventory drivers are made at the
enterprise level in a single optimization exercise rather than in a sequence of sub-exercises for each
echelon.

A multi-echelon approach optimizes the networks inventory on various counts:-

• Avoid multiple independent forecast updates per echelon: The forecasts in all echelons
are dependent on the primary customer demand signal at the DCs. A multi-echelon approach,
however, is independent of demands from the immediate downstream customer.
• Account for all lead times and its variations: In each echelon, the replenishment
decisions account for lead times and its variations of all upstream suppliers, not just the immediate
suppliers.
• Monitor and manage the bullwhip effect: The enterprise measures the demand distortion
and determines the respective root cause in order to take corrective measures.
• Enable visibility up and down the demand chain: Each echelon takes advantage of
visibility into the other echelon’s inventory positions—what is on hand, on order, committed and back
ordered.
• Synchronizing order strategies: Synchronizing the ordering cycles at the DCs with RDC
operations reduces lead times and lead time variation between the RDC and the DCs. Multi-echelon
models can evaluate the impact on both echelons of different synchronization strategies.
• Offering differentiated service levels, etc.: The RDC can provide different service levels
(for the same product) to different DCs. A multi-echelon approach makes this possible, because the
enterprise controls how and when a product enters and leaves the RDC.

Stochastic vs Deterministic Models:

Deterministic
Deterministic (from determinism, which means lack of free will) is the opposite of
random.
A Deterministic Model allows you to calculate a future event exactly, without the
involvement of randomness. If something is deterministic, you have all of the data
necessary to predict (determine) the outcome with certainty.
A simple example of a deterministic model approach

Stochastic
Having a random probability distribution or pattern that may be analysed statistically but
may not be predicted precisely.
A Stochastic Model has the capacity to handle uncertainties in the inputs applied.
Stochastic models possess some inherent randomness - the same set of parameter
values and initial conditions will lead to an ensemble of different outputs.
A simple example of a stochastic model approach
The Pros and Cons of Stochastic and Deterministic
Models
Deterministic Models - the Pros and Cons

Pros

• Deterministic models have the benefit of simplicity. They rely on single assumptions
about long-term average returns and inflation.
• Deterministic is easier to understand and hence may be more appropriate for some
customers.

Cons

• Cash flow modelling tools that use deterministic or over-simplistic stochastic

projections are fundamentally flawed when making financial planning decisions because
they are unable to consider ongoing variables that will affect the plan over time.
 • Deterministic tools tend to overestimate the level of sustainable income (on a like for
like basis) because they are unable to take into account market volatility, which causes
‘pound cost ravaging' and sequencing risk, both of which have a significant negative
effect on sustainable income.
• The choice of future increase assumption is critical and puts the responsibility of the
final outcome on the provider of the tool

All of which renders deterministic models inadequate and potentially misleading.

Stochastic Models - the Pros and Cons

A stochastic model will not produce one determined outcome, but a range of possible
outcomes, this is particularly useful when helping a customer plan for their future.

Pros

• Stochastic models can reflect real-world economic scenarios that provide a range of
possible outcomes your customer may experience and the relative likelihood of each.
• By running thousands of calculations, using many different estimates of future
economic conditions, stochastic models predict a range of possible future investment
results showing the potential upside and downsides of each.
• A stochastic model also has the ability to avoid the significant shortfalls inherent in
deterministic models, which gives it the edge.

Cons

• Managing drawdown effectively and choosing suitable investment strategies requires

the ability to model investment risk and return realistically. The problem is that nearly all
strategies and solutions are currently designed using an assumed fixed rate of
investment return throughout retirement. This is obviously unrealistic and ignores the
important effect that the sequence of returns and volatility has on drawdown outcomes.
• The problem of ignoring specific risk factors not only applies with deterministic
modellers, but also with a commonly used type of simple stochastic model - mean,
variance, co-variance (MVC) models. For instance, MVC models provide time-
independent forecasts, which means that they ignore the fact that specific investment
risks change over time depending on the combination of assets held within the
customer’s portfolio.

Vendor Managed Inventory (VMI):

Definition, Benefits, Limitations
Vendor managed inventory is a collection of processes and inventory management
software wherein a manufacturer, who’s also a supplier, takes up the responsibility of
optimizing the distributor’s inventory stocks.
It’s a B2B strategy that enhances the supplier-distributor relationship and collaboration,
helping both parties align their objectives for optimized operations.

In a traditional business model, product buyers are responsible for deciding inventory
volume and when to place orders. A vendor managed inventory model shifts this
responsibility from the buyer to the supplier.

In some cases, third-party logistic vendors may also be responsible for maintaining
adequate inventory levels on the buyer’s end.

Key Features
Demand Forecasting
Forecasting the right demand for goods is one of the imperative capabilities that VMI
solutions offer. They help forecast demand for efficient product manufacturing,
assembly and shipping.

It coordinates the data of individual units from various businesses that make up your
customer base and facilitates supply chain planning backed by insights. The software
also helps you identify non-performing stock-keeping units and avoid overstocking
goods in your warehouse or retail outlet.

Inventory Management
You can effectively track information for the products your business stores, purchases,
manufactures or sells. The software also facilitates accurate pricing and helps maintain
optimum stock levels. A good vendor managed inventory system should include serial
and lot tracking capabilities.

Data Exchange
VMI solutions support easy data and document exchange from one device to another
within a company or between clients, customers and business partners. This may
include custom and tax information, inventory documents, purchase orders and
receipts, shipping and order status, and more.

E-commerce Integration
You can select a VMI solution that integrates with major web stores, shopping carts and
eCommerce platforms. This will help streamline inventory levels, payment options,
including cash and digital, and shipping modes and options.

How VMI Works

VMI solutions combine point-of-sale and demand forecast data from both
suppliers and customers. They also take into account pre-defined settings like
 min/max shelf presence, service levels, or inventory turn targets. Here’s how it
works:

• The VMI system receives data (called a Product Activity Report) from a
distribution partner. This report contains data on sales, product transfers and
inventory positions (on hand, on order, in transit).
• The VMI platform reviews the data and sends a recommended inventory
replenishment order based on key factors and agreed objectives.
• The supplier reviews and approves the recommendations.
• The VMI platform then sends a purchase order (PO) to the supplier and a
PO acknowledgement. to the distribution partner in an electronic data
interchange (EDI) format.
• Once the partner approves the PO, the order can be shipped.

Benefits of VMI for Suppliers

VMI and collaborative replenishment solutions are strategic initiatives that
offer numerous supplier benefits:

• Strengthen relationships with distribution partners through better supply chain

planning
• Ensure partners get the right quantities and types of products
• Increase sales (typically by 5% to 25% or more) by enhancing sellers’ product
assortments and eliminating stockouts
• Reduce operating costs by streamlining order management and eliminating
order errors, product returns and emergency orders