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What is the inventory policy?
An inventory policy is an operating framework or a standard operating procedure (SOP) in implementing an inventory model. The inventory model will depend upon the choice of inventory policy adopted. Typically, an inventory policy results in an inventory graph as a function of time. This visually depicts how the inventory status changes over time and when procurement intervention takes place. In practice, three inventory policies are normally employed. These are described as follows:
1. Economic Order Quantity (EOQ)-Reorder Point (ROP) Policy
Under this policy, the inventory status is continuously monitored. Whenever the inventory level falls to a predetermined level called a reorder point (ROP), a replenishment order of fixed quantity called economic order quantity (EOQ) is placed. Thus EOQ (Q) and ROP (R) are the two-decision variables involved in solving the problem of how much to buy and when to buy. The figure below shows the graphical operation of the (Q, R) policy. Such an inventory model must have (Q, R) as decision variables.
This model is the earliest analytical model in inventory control that has been developed under highly limiting assumptions as can be seen from the following:
1. The demand rate is known and is constant with linear depletion of the stock level.
2. Lead time is known and constant.
3. The entire lot of size Q arrives in one go (instantaneous replenishment or infinite replenishment rate).
4. Shortages are not allowed.
5. The cost of carrying inventory and ordering costs is known and are time-invariant.
6. The unit purchase price is constant and is independent of order size. (No quantity discounts are available.)
7. Ordering cost is independent of the order quantity.
8. Inventory cost is a linear function of the inventory level.
It is interesting to note that though the EOQ model is developed under highly restrictive assumptions, it is still very relevant and helpful in procurement planning due to the robustness of the optimal decision as will be seen through the sensitivity analysis. However, each limiting condition can be relaxed to develop variants of the classical EOQ model, which marginally perturbs the earlier decision. That is why the EOQ model is still relevant. The figure below depicts the two conflicting costs that the model attempts to reconcile. If the order size is large, the inventory carrying cost increases though the ordering cost decreases. Hence the EOQ is that quantity at which the total system cost comprising of these two costs is minimum as represented by Q*. Here shortages are not allowed.
It can be seen from the graph in the figure below that EOQ is the quantity at which TC (total system cost) is minimum. This occurs at the intersection point of two opposing costs – the carrying cost and the ordering cost.
2. Periodic Review Inventory Policy
The stock status is periodically reviewed under this policy after a fixed time interval (T). When the review period is reached, the order is placed which is determined by the following relationship:
Q = order quantity = (S – X)
S = maximum stock level (or order up to level) X X = stock on hand at the time of review
The figure below illustrates the periodic review policy graphically
Under this policy, S, the maximum stock level, and the time interval between two reviews (T) are the two decision variables for optimization. Therefore, it is also called as (S, T) policy. Operation of this policy is relatively easy because the status of inventory is taken only after a fixed time interval. However, this policy is quite sensitive to consumption during the review cycle. If stock on hand is high, the order quantity for the next period is low, and vice versa. However, under this policy, an order has to be mandatorily placed even if the stock levels are quite high during the review period due to which the order size is a small quantity.
3. Optional Replenishment Policy
This is a variant of the periodic review inventory policy wherein there are two levels of inventory identified as S (the maximum level) and s (the minimum level). The stock levels are periodically examined at fixed time intervals T. However, if the stock levels are more than the minimum level (s) at the time of review, the replenishment decision is deferred to the next review cycle, and no order is placed because the current stock is deemed to be adequate for the time being until the next review cycle. If at the time of review, the stock level (X) is less than or equal to (s), then the order quantity Q is determined so that it raises the stock level to S. Thus, under this policy,
Q = S - X if X ≤ s
= 0 if X > s
Figure below depicts the operation of this policy graphically:
This policy is also called a minimum-maximum stock level policy or (s, S) policy. Here the decision variables are s, S, and T. This is also called an optional replenishment policy because there is an option of skipping the replenishment decision to the next review period if the current inventory on hand is more than the minimum level prescribed. Thus, intuitively, this would appear to be better than the (S, T) policy provided (s, S) and T are optimized.
There may be other variants of these three basic policies, but the most common policies are only these. The inventory model to be developed depends upon the choice of inventory policy. Hence, we have to first decide on the inventory policy to be employed before we develop an inventory model for the optimal choice of the decision variables.
It has been shown in the inventory control research that if (s, S, T) are optimized, then the optional replenishment policy is the best among the three policy options outlined above. However, as will be seen later, optimization of these three decision variables simultaneously leads to a very complex model of inventory in case of probabilistic demand and lead times. For practical purposes, the EOQ-ROP policy is a good choice for high-usage value items, while the (S, T) policy is good for low-usage value items. (s, S) the policy may be employed for very high usage value items where modeling complexity will be justifiable even if one may have to resort to simulation to optimize decision variables.
How to implement the inventory policy?
1. Economic Order Quantity (EOQ)-Reorder Point (ROP) Policy
Maximum inventory level is Q and the minimum level is zero; hence average inventory level is (Q/2) because of linear consumption.
No. of orders/year = D / Q if D is the annual demand
Total system cost TC(Q) = C1. Q/2 + C3 . (D/Q)
where
C1 = unit inventory carrying cost: LE/unit/time.
C3 = ordering cost/order (LE/order).
It can also be simply obtained by the fact that optimal order quantity will be at the intersection point of two opposing costs, using marginal analysis.
Hence for optimal Q, carrying cost = ordering cost:
C1. Q/2 = C3 . (D/Q)
This gives
EOQ = Q* = 2DC3C1 and TC* = 2DC1.C3
Q* is known as EOQ formula. TC* is the minimum total cost (it does not include the cost of materials).
The EOQ model is very insightful. If the item is expensive or perishable, then the carrying cost (C1) is high. Hence optimal policy will be to order in smaller quantities more frequently. However, if the process of procurement is bureaucratic and costly and C3 is high, then Q∗ will be higher. Thus, the model can quantify the costs increase due to inefficient procurement practices. We can also evaluate the economic consequences of procurement process simplification and e-procurement and its impact on inventory reduction and total system cost reduction.
For deterministic demand (D) and lead time (L), the reorder point R is a simple affair. We should place an order so that the fresh shipment arrives at the time inventory status reaches zero and it will have the effect of instantaneously raising the stock status to Q. Thus, reorder point can vary depending on:
· Determining ROP with safety stock
· Determining ROP without safety stock
ROP = (D . L) + Safety stock
Where
D = average daily usage
L = lead time
Example:
Demand for an item is assumed to be constant at the rate of 3,200 units/year. The ordering cost is assumed to be fixed and independent of the order size and is estimated to be 400 LE per order. If the item costs 400 LE /unit and the annual fraction of inventory carrying cost is 25 % of the unit price, find the economic order quantity and the total system cost at the EOQ. No shortages are permitted.
Using the EOQ model, Q* = 2*3200*400400*.25 = 160 units/order
TC* = 2*3200*400*400*.25 = 1600 LE/year
TC* excludes the cost of purchasing materials, being constant/year
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
2. Periodic Review Inventory Policy
In the periodic review inventory policy, the stock status is periodically reviewed after a fixed time interval t. If at the time of review, the stock on hand is X, then the order quantity Q = S – X where S is the maximum stock level. The figure below shows the inventory graph for a periodic review policy. Order quantity plus stock on hand must equal maximum stock level S, which could be a decision variable.
The total system cost TC(S) is optimal in the range 0 < S < Qp.
For this range of S,
TC(S) = C1.S22QP+C2(QP-S)22QP
Where
C1 = unit inventory carrying cost: LE/unit/time.
C2 = cost of backlogging QP = D * tp S = maximum stock level
S* = QP. (C2C1.C2) = D . tP . (C2C1.C2)
which is quite simple an expression as compared to the EOQ model:
TC* = 12.Qp . (C1.C2C1+C2) = 12.D.tp . (C1.C2C1+C2)
We can also numerically optimize T by evaluating few discrete options of tp and compare TC* for each to pick up the least cost option.
Why you should implement the inventory policy in your factory?
Inventory policies for your business offer several benefits that impact your bottom line. It’s a great way to grasp how much product needs to be purchased to maintain an efficient supply chain while keeping costs down. Here are the top benefits of inventory policies.
Inventory Planning Improves Service Level:
It remains the fact that good Inventory Management and power lead to what all businesses strive for continuity, and repeat clients. If you desire your hard-earned clients to come back to purchase your products and services, it is necessary always to improve your service level enough to be able to match customer requests swiftly. Inventory Management and control aid businesses in meeting such demand by permitting you to provide the right levels of hands-on service immediately your customers require them with the desired lead time, highlighting the importance of inventory management.
Inventory Planning and Management Reduces Storage Cost:
These benefits of inventory management envisage focusing on inventory planning and reducing storage costs as you maintain adequate inventories. The central values feature significant factor loadings and commonalities exhibited through proper Inventory Management and control. The factor lowers storage costs and increases revenue by using adequate inventory management and control emphasizing the importance of inventory management.
High Inventory Turnover Brings Revenues:
Applying Inventory planning to any business can serve as a bridge to bring in higher revenues. Through proper Inventory Management and control, a company is capable of increasing its profitability. If a business overlooks the benefits of inventory management in its trade, sales, and production, it is possible to hamper the maximization of its operational efficiency. The inventory’s cost of purchase and production has a substantial effect on gross profit. Using the lessened cost of production, a business raises its gross profit. That is why proper inventory planning is required. And with all accounts placed as equal, such a company would record superior revenues, which in effect, leads to more profits, again substantiating the importance of inventory management.
Inventory Control Makes Cost Accounting Activities Easier:
Business owners often develop internal strategies and measures that will guarantee better control and planning of production and sales. Such approaches involve binding every partaker in the business to delivering activities that make Accounting Activities Easier including managers. Usually, these strategies aid such industries to order, account for inventory values, and keep inventory flow, along with assistance on how to control obsolete goods. By executing such plans in inventory planning, several businesses can be able to manage their cash flow well. To enhance your business cash flow, it is expected you set aside some investment into the most effective and practical inventory system that is powerful enough to meet your requirement and is also suitable to match your business environment. For this reason, companies with well-thought-out plans can save a lot more from the use of active Cost Accounting Activities. Additionally, better Inventory Management and control aid your business in establishing cost benefits for you concerning the financial market conditions. Better cash flow lets companies attain better business and organizational goals.
Regular Supply at Reasonable Prices Builds Customer Confidence, with better strategies:
any given organization can use inventory planning and control to improve its cash flow by providing higher customer service at consistent pricing. Inventory control and planning solutions allow small businesses to gain insight into what products are selling more than others. This step will enable them to adjust their product line and make intelligent business decisions.
Inventory Control Enhances Product Quality:
The use of Inventory Management and control can assist in remarkably improving business efficiency and product quality. These benefits of inventory management would aid in eliminating waste and enhances focus on producing Right First Time or Six Sigma Quality. It remains a fact that having a good inventory management system leads to better success and repeat customers. If you desire your hard-earned customers always to keep coming, you have to enhance your product quality in the best ways possible.
Inventory Control Avoids Costly Interruptions in Operation :
Often costly interruptions in service in businesses can be averted with proper planning. Deprived of inventory control, companies may be none-the-wiser to such disruption. These benefits of inventory management ultimately improve business profitability. By avoiding costly interruptions, businesses can reduce any ‘hidden’ costs. Showing, the importance of inventory management.