Inventory Management: Models, Costs & Strategies

TAKEAWAYS:

• Inventory is a critical trade-off between holding costs (storage, obsolescence) and ordering costs (setup, transportation), optimized via the Economic Order Quantity (EOQ) model.
• The ABC classification prioritizes high-value items (A) over low-value ones (C) to improve efficiency in stock management.
• Just-in-Time (JIT) and lean inventory systems (used by Toyota, Daraz) minimize waste by aligning supply with demand.
• Safety stock acts as a buffer against demand uncertainty, calculated using service level and lead time variability.
• Technology (RFID, ERP systems like SAP) automates tracking and reduces human error in inventory management.
• Real-world case studies (Nabil Bank’s loan inventory, Daraz’s warehouse logistics) show how theory applies to Nepali businesses.

---

1. What is Inventory? Types and Classification

Inventory refers to raw materials, work-in-progress (WIP), finished goods, and maintenance/repair supplies held by a business to meet customer demand. Proper management ensures cost efficiency, customer satisfaction, and operational smoothness.

Types of Inventory

Why Classify Inventory?

Businesses use the ABC classification to prioritize items based on annual consumption value (not quantity). This helps focus resources on high-impact items.

ABC Analysis Table:

---

2. Inventory Costs: The Hidden Expenses

Inventory is not free—it incurs three major cost categories that must be balanced:

Worked Example: NTC’s Mobile Phone Inventory

Assume NTC sells 5,000 smartphones/year with:

• Annual demand (D) = 5,000 units
• Ordering cost (S) = Rs. 2,000 per order
• Holding cost (H) = 20% of item cost = Rs. 5,000/unit/year (assuming each phone costs Rs. 25,000)

Question: What is the optimal order quantity (EOQ) to minimize total costs?

Solution: The Economic Order Quantity (EOQ) formula balances ordering and holding costs: $$EOQ=\sqrt{\frac{2DS}{H}}=\sqrt{\frac{2\times 5000\times 2000}{5000}}=\sqrt{4000}\approx 63\text{ units}$$ Interpretation:

• Order 63 phones at a time, 78 times/year (5000/63 ≈ 79).
• Total cost = Ordering cost + Holding cost = (78 × 2000) + (63/2 × 5000) = Rs. 471,500.

---

3. Inventory Management Models

A. Deterministic Models (Certain Demand)

1. EOQ Model (Basic)

   • Assumes constant demand, no stockouts, instantaneous replenishment.
   • When to use? For items with stable demand (e.g., office supplies in an office).

2. EOQ with Quantity Discounts

   • If suppliers offer bulk discounts, the EOQ changes to balance lower per-unit cost vs. higher holding cost.
   • Example: A Daraz supplier offers:
     • Rs. 10,000/unit for <50 units
     • Rs. 9,000/unit for 50-100 units
     • Rs. 8,000/unit for >100 units
   • Decision: Order in larger quantities if the discount outweighs holding costs.

B. Probabilistic Models (Uncertain Demand)

When demand is variable, businesses use:

• Safety Stock Models (e.g., Wilson EOQ with safety stock)
• Reorder Point (ROP) Models $$ROP=\text{Average Demand during Lead Time}+\text{Safety Stock}$$ Example: A Kathmandu restaurant orders 50 kg of rice every 10 days. If lead time = 3 days and safety stock = 10 kg: $$ROP=(5\text{ kg/day}\times 3\text{ days})+10\text{ kg}=25\text{ kg}$$

---

4. Inventory Control Systems

A. Continuous Review (Q-System)

• Trigger: Order when stock reaches a reorder point (ROP).
• Best for: High-value items (e.g., Nabil Bank’s gold reserves).
• Example: A hospital orders 100 units of a critical medicine when stock hits 20 units (ROP = 20).

B. Periodic Review (P-System)

• Trigger: Check inventory at fixed time intervals (e.g., weekly).
• Best for: Low-value, slow-moving items (e.g., school stationery).
• Example: A shop reviews inventory every Friday and orders enough to reach a maximum level (ML).

Comparison Table:

---

5. Just-in-Time (JIT) and Lean Inventory

JIT (popularized by Toyota) aims to eliminate waste by receiving goods only as needed in production.

Key Principles:

• Zero inventory (or minimal safety stock).
• Supplier integration (e.g., Daraz’s suppliers deliver directly to warehouses).
• Pull system (production triggered by demand, not forecasts).

Advantages: ✅ Reduces holding costs. ✅ Improves cash flow. ✅ Enhances flexibility.

Disadvantages: ❌ Vulnerable to supply chain disruptions (e.g., COVID-19 lockdowns). ❌ Requires high supplier reliability.

---

6. Technology in Inventory Management

Modern tools automate tracking, reduce errors, and improve efficiency:

---

In the Real World

1. Daraz (E-Commerce)

   • Uses ABC analysis to prioritize fast-moving electronics (A items) while bulk-ordering low-value goods (C items).
   • Implements JIT logistics to reduce warehouse costs—suppliers ship directly to Daraz’s fulfillment centers.

2. Nabil Bank (Financial Services)

   • Manages loan inventory (pending approvals) using EOQ principles to balance processing costs vs. holding costs for unissued loans.
   • Uses safety stock for high-demand loan products (e.g., home loans during festive seasons).

3. NTC (Telecom Infrastructure)

   • Maintains safety stock of network equipment (e.g., routers, cables) to avoid stockouts during peak demand (e.g., Dashain).
   • Employs periodic review for low-cost items like batteries and SIM cards.

---

Exam Tip

How This Unit is Tested in PU Exams

1. Definitions & Concepts (20%)

   • Expect short-answer questions on:
     • Difference between EOQ and ROP.
     • ABC analysis vs. VED analysis (Vital, Essential, Desirable).
     • JIT vs. traditional inventory.

2. Calculations (30%)

   • Must-know formulas:
     • EOQ: $\sqrt{\frac{2DS}{H}}$
     • ROP: $\text{Average Demand}\times \text{Lead Time}+\text{Safety Stock}$
     • Total Inventory Cost (TIC): Ordering Cost + Holding Cost + Stockout Cost.
   • Worked examples will often use Nepali contexts (e.g., a Kathmandu restaurant’s rice inventory or a Daraz supplier’s bulk discount).

3. Case Studies (25%)

   • Analyze real scenarios like:
     • Why Nabil Bank keeps safety stock for gold loans.
     • How Pathao uses JIT for bike spare parts.
     • NTC’s inventory strategy for telecom equipment.
   • Key points to highlight:
     • Trade-offs (e.g., higher ordering cost vs. lower holding cost).
     • Technology integration (e.g., RFID in Daraz).
     • Risk management (e.g., safety stock for unpredictable demand).

4. Comparisons & Applications (25%)

   • Tables comparing models (EOQ vs. JIT vs. ABC).
   • Flowcharts of inventory control systems (Q-system vs. P-system).
   • Short cases (e.g., "How would you manage inventory for a Kathmandu-based e-pharmacy?").

Common Mistakes to Avoid

❌ Ignoring units in calculations (e.g., mixing Rs. and units). ❌ Assuming demand is certain unless stated (always check for variability). ❌ Overlooking safety stock in probabilistic models. ❌ Memorizing formulas without understanding (e.g., why EOQ minimizes total cost).

---

Final Checklist for Full Marks

Before submitting your answer: ✔ Define key terms (EOQ, ROP, safety stock, ABC analysis). ✔ Show calculations step-by-step (box your final answer). ✔ Relate to Nepal (use Daraz, Nabil Bank, NTC, or local businesses). ✔ Draw diagrams (EOQ cost curve, reorder point graph, ABC classification). ✔ Discuss trade-offs (e.g., "While JIT reduces costs, it increases risk."). ✔ Use real examples (e.g., "Like Daraz’s RFID system, NTC could...").