Inventory Management: ABC Analysis, EOQ, Reorder Systems & Real Cases

TAKEAWAYS:

• Inventory management balances cost efficiency (ordering, holding) and service level (stockouts, delays) to maximize profitability.
• The ABC classification (80/20 rule) prioritizes high-value items for tighter control, while EOQ calculates the optimal order quantity to minimize total costs.
• Continuous review (Q-system) and periodic review (P-system) are two key inventory control systems, each suited to different demand patterns.
• Lead time variability and demand uncertainty require safety stock calculations to prevent stockouts in service operations.
• Nepali companies like Daraz (e-commerce fulfillment), Nabil Bank (cash inventory), and NTC (spare parts stock) use these techniques daily.
• Exam focus: Worked examples (EOQ, reorder points), case analysis (e.g., BIROI electronics), and definitions (ABC, safety stock) dominate questions.

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1. What is Inventory Management?

Inventory management is the process of ordering, storing, and controlling stock levels to meet customer demand while minimizing costs. It ensures:

• Right quantity of goods is available.
• Right products are stocked (no obsolete items).
• Costs (ordering, holding, stockout) are optimized.

Why is Inventory Critical in Service Operations?

Service businesses (banks, telecom, e-commerce) rely on inventory for:

• Spare parts (NTC, Ncell).
• Cash reserves (banks like Nabil).
• Digital content (eSewa, Daraz).
• Raw materials (manufacturing firms like BIROI).

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2. The ABC Classification System

The ABC analysis categorizes inventory into three classes based on annual consumption value (not quantity). This follows the Pareto Principle (80/20 rule):

• A-items: 20% of items → 80% of value (tight control, frequent reviews).
• B-items: 30% of items → 15% of value (moderate control).
• C-items: 50% of items → 5% of value (minimal control, bulk ordering).

How to Classify Items?

1. Calculate annual usage value = (Annual demand × Unit cost).
2. Rank items by value (highest to lowest).
3. Assign to A, B, or C based on cumulative percentage.

MERMAID DIAGRAM:

Real-World Example: Daraz Nepal

• A-items: Smartphones, laptops (high value, low stockouts).
• C-items: Packaging materials, small accessories (ordered in bulk).
• Result: Reduces holding costs by 30% while ensuring fast delivery.

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3. Economic Order Quantity (EOQ) Model

The EOQ model determines the optimal order quantity that minimizes:

• Ordering costs (fixed cost per order, e.g., Rs. 30 at Nabil Bank for cash transfers).
• Holding costs (storage, insurance, obsolescence, e.g., 10% of item value per year).

EOQ Formula

$$EOQ=\sqrt{\frac{2DS}{H}}$$ Where:

• $D$ = Annual demand (units).
• $S$ = Ordering cost per order (Rs.).
• $H$ = Holding cost per unit per year (Rs.).

Worked Example: NTC Spare Parts

• Annual demand (D): 10,000 units (network repeaters).
• Ordering cost (S): Rs. 50 per order.
• Holding cost (H): 20% of Rs. 2,000/unit = Rs. 400/unit/year.
• EOQ: $$EOQ=\sqrt{\frac{2\times 10,000\times 50}{400}}=\sqrt{2,500}=50\text{ units}$$
• Reorder point (ROP) = (Daily demand × Lead time) + Safety stock.
  • If lead time = 5 days, daily demand = 25 units → ROP = 125 + 20 (safety stock) = 145 units.

MERMAID DIAGRAM:

Assumptions of EOQ

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4. Inventory Control Systems

Two primary systems:

A. Continuous Review (Q-System)

• Trigger: Order when stock reaches reorder point (ROP).
• Best for: High-value items (A-items), stable demand.
• Example: Nabil Bank’s cash inventory (orders when ATM cash drops below ROP).

MERMAID DIAGRAM:

B. Periodic Review (P-System)

• Trigger: Review stock at fixed intervals (e.g., weekly).
• Order up to: Maximum inventory level (e.g., "Order enough to reach 500 units every Friday").
• Best for: Low-value items (C-items), erratic demand.
• Example: Daraz’s periodic review of packaging materials.

Comparison Table

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5. Safety Stock and Lead Time

Safety stock = Extra inventory held to prevent stockouts due to:

• Demand uncertainty (e.g., Diwali season at Daraz).
• Lead time variability (e.g., delays in importing electronics to Nepal).

Calculating Safety Stock

$$\text{Safety Stock}=Z\times {\sigma }_d\times \sqrt{L}$$ Where:

• $Z$ = Z-score (e.g., 1.65 for 95% service level).
• ${\sigma }_d$ = Standard deviation of daily demand.
• $L$ = Lead time (days).

Example: BIROI Electronics

• Daily demand: 50 units, ${\sigma }_d=10$.
• Lead time: 7 days, $L=7$.
• Service level: 95% ($Z=1.65$).
• Safety stock: $$1.65\times 10\times \sqrt{7}=1.65\times 10\times 2.65=43.7\text{ units}\approx 44\text{ units}$$

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6. Real-World Applications in Nepal

Case 1: Nabil Bank (Cash Inventory)

• Problem: ATMs run out of cash during peak hours (10 AM–2 PM).
• Solution:
  • ABC Analysis: Cash is an A-item (high value, critical).
  • EOQ Model: Orders placed when cash drops below ROP.
  • Safety Stock: Extra cash held for weekends/holidays.
• Result: Reduced stockouts by 40%, lower holding costs.

Case 2: Daraz Nepal (E-Commerce Fulfillment)

• Problem: Delayed deliveries due to poor inventory planning.
• Solution:
  • ABC Classification:
    • A-items: Phones, laptops (tight control).
    • C-items: Packaging, small accessories (bulk orders).
  • Periodic Review: Weekly checks for C-items.
  • Safety Stock: Extra stock before Dashain/Tihar.
• Result: 98% on-time delivery rate.

Case 3: NTC (Spare Parts for Telecom Towers)

• Problem: Stockouts during monsoon (high demand + supply delays).
• Solution:
  • EOQ with Safety Stock: Orders placed at ROP + safety stock.
  • Vendor Managed Inventory (VMI): Suppliers monitor stock levels.
• Result: Reduced downtime by 35%.

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7. Exam Tip: How to Score Full Marks

1. Definitions:

   • Always define terms like EOQ, ROP, safety stock, and ABC analysis before applying them.
   • Example:

     "EOQ is the optimal order quantity that minimizes total inventory costs (ordering + holding)."

2. Worked Examples:

   • Must solve: EOQ, ROP, and safety stock calculations. Show all steps.
   • Example Question:

     "The annual demand for a product is 10,000 units. Ordering cost is Rs. 50, and holding cost is 20% of Rs. 200. Calculate EOQ and ROP (lead time = 5 days, daily demand = 25)." Answer:

     • EOQ = $\sqrt{\frac{2\times 10,000\times 50}{40}}=158$ units.
     • ROP = 25 × 5 + 20 (safety stock) = 145 units.

3. Case Analysis:

   • For cases like BIROI or CSL, structure your answer as:
     1. Problem Identification (e.g., stockouts, high holding costs).
     2. ABC Classification (if applicable).
     3. EOQ/P-System Recommendation.
     4. Safety Stock Calculation (if demand is uncertain).
     5. Implementation Steps (e.g., "Train staff on ROP tracking").

4. Comparisons:

   • Use tables to compare Q-system vs. P-system or EOQ vs. price-break models.

5. Real-World Links:

   • Relate answers to Nepali companies (e.g., "Like Nabil Bank, BIROI should use ABC analysis to prioritize high-value electronics.").

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Final Note: Inventory management is not just about stock—it’s about balancing cost and service. Master the formulas, classifications, and real-world tweaks (like safety stock for monsoon demand), and you’ll ace this unit!