Chapter 16. Inventory Management

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Inventory analysis is one of the most popular topics in management science. One reason is that almost all types of business organizations have inventory. Although we tend to think of inventory only in terms of stock on a store shelf, it can take on a variety of forms, such as partially finished products at different stages of a manufacturing process, raw materials, resources, labor, or cash. In addition, the purpose of inventory is not always simply to meet customer demand. For example, companies frequently stock large inventories of raw materials as a hedge against strikes. Whatever form inventory takes or whatever its purpose, it often represents a significant cost to a business firm. It is estimated that the average annual cost of manufactured goods inventory in the United States is approximately 30% of the total value of the inventory. Thus, if a company has $10.0 million worth of products in inventory, the cost of holding the inventory (including insurance, obsolescence, depreciation, interest, opportunity costs, storage costs, etc.) would be approximately $3.0 million. If the amount of inventory could be reduced by half to $5.0 million, then $1.5 million would be saved in inventory costs, a significant cost reduction.

In this chapter we describe the classic economic order quantity models, which represent the most basic and fundamental form of inventory analysis. These models provide a means for determining how much to order (the order quantity) and when to place an order so that inventory- related costs are minimized. The underlying assumption of these models is that demand is known with certainty and is constant. In addition, we will describe models for determining the order size and reorder points (when to place an order) when demand is uncertain .