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Inventory-Management Formulas for Improving Business Operations

Part of the Operations Management For Dummies Cheat Sheet

Managing inventory is an important way for a business to manage variations in demand. Inventory can provide a means to manage demand fluctuation so that process capacity and resource utilization are kept steady and used most efficiently.

Of course, maintaining an inventory isn't cost-free or risk-free, because inventory represents tied-up cash and storage costs and comes with the risk that the inventory will spoil or become obsolete. In the case of bank or restaurant customers, if they have to wait in a line too long, the risk is a lost customer.

Following are some formulas for the three most common inventory policies that companies use to try to minimize their risk:

  • Newsvendor inventory policy

  • Continuous review inventory policy

  • Periodic review inventory policy

Newsvendor inventory policy

The newsvendor policy is often also called single period inventory management. As the name implies, the business has one shot to purchase the inventory that it believes it will need to meet customer demand. This policy is typically used for seasonal items, such as swimsuits and snowblowers.

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Newsvendor optimal order quantity is Q such that:

image1.png

Continuous review inventory policy

In a continuous review inventory policy, you continually monitor your inventory and order a fixed quantity every time your inventory level reaches a preset quantity. The fixed quantity is often called the economic order quantity (EOQ) because it's the quantity that minimizes your total inventory costs. You place an order for the EOQ whenever your inventory level reaches the set reorder point (ROP). To calculate the EOQ and ROP, use the following equations.

Let D = annual demand for the product, S = setup cost to place one order, H = holding cost to keep one item in inventory for a year, SS = safety stock, and z = the z value for the desired service level.

image2.png

Periodic review inventory policy

In some cases, it's impractical to continuously monitor inventory levels, and a business may choose to periodically monitor. In this policy, the firm sets a certain time (T) to check inventory levels. At this time, the company orders inventory to bring levels up to a target inventory (TI). The company typically sets the T based on its operations and calculates the TI based on this T using the following equation:

image3.png

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