Inventory Control and EOQ
Business Arithmetic — how much to order, when to order, and why 20% of items deserve 80% of your attention
Inventory and Inventory Control
Item characteristics to consider
Key factors: SKU code (unique identifier), value (Pareto — high vs low), lead time (procurement duration), seasonality of supply, demand predictability, shelf life (perishability), safety requirements, and obsolescence risk.
Pareto's Principle and ABC Analysis
Pareto's 80/20 rule
A small percentage of causes produce a large percentage of effects. In inventory, ~20% of items account for ~80% of total value — the “vital few” vs the “trivial many”.
ABC Analysis
A items (10–20% of SKUs, 70–80% of value): tightly controlled, close monitoring, weekly reports. B items (15–25% of SKUs, 10–20% of value): moderate control, monthly reports. C items (65–75% of SKUs, 5–10% of value): loose control, bulk ordering, quarterly reports. ABC = Always Better Control.
The Economic Order Quantity
An effective inventory control system aims to avoid stock-outs while minimizing ordering and holding costs. We need to determine when to place an order (Reorder Point) and how much to order (EOQ).
REORDER POINT
Reorder Point = Average daily usage rate × Lead time in days
REORDER LEVEL (WITH SAFETY STOCK)
Reorder Level = (Average daily usage rate × Lead time) + Safety Stock
ECONOMIC ORDER QUANTITY (EOQ)
Variables
D = Annual demand (units). P = Cost of placing one order (₹). C = Inventory carrying cost per unit per year (₹). Q* = EOQ — the order quantity that minimizes total annual cost.
Assumptions
Basic EOQ assumes: (1) future demand (D) is known and uniform; (2) unit price is constant (no quantity discounts). Safety stock doesn't impact EOQ but is vital for control.
Solved Examples
Solved Example
Problem
Annual jeans sales D = 1,200 units/year. Cost of placing an order (P) = ₹ 500. Inventory holding cost (C) = ₹ 30 per unit per annum. What is the EOQ?
Solution
EOQ = 200 jeans.
Solved Example
Problem
Annual pen sales D = 30,000 units. Purchase cost = ₹ 6 per pen. Holding cost per annum = 20% of purchase cost. Ordering cost (P) = ₹ 500 per order. What is the EOQ?
Solution
EOQ = 5,000 pens.
Key Takeaways
Key Takeaways
- Inventory means the tangible items a business holds for sale or production.
- Inventory control aims at avoiding stock-outs while minimizing costs.
- Pareto's 80/20 rule: a small percentage of items account for a large percentage of inventory value.
- ABC analysis: A items (high value, tight control), B moderate, C (low value, loose control).
- Reorder Point = Average daily usage × Lead time; add Safety Stock for variability.
- EOQ = √(2PD/C) — minimizes total annual cost (ordering cost = carrying cost).
- So what? — Ordering in bulk saves per-order cost but burns carrying cost; EOQ is the sweet spot.