It is so important to maintain the optimum level of inventory, but sometimes it is easier said than done. The good news is that there are proven models and methods that have been developed for determining the optimum level of inventory stock for your business.
Models can only help with predictions and forecasts, and they each have their shortfalls. When considering the optimum level of inventory, models can be classified into two major types: deterministic models and probabilistic models.
What is a deterministic model in the context of inventory management?
In brief, a deterministic model is a method based on the assumption that all parameters and variables associated with an inventory stock are known and that there is no uncertainty associated with demand and replenishment of inventory stock.
On the contrary, the probabilistic models recognise the fact that there is always some degree of uncertainty associated with the demand pattern and lead times for inventory stock.
Deterministic models of inventory control are used to determine the optimal inventory of a single item when demand is mostly largely obscure. Under this model, inventory is built up at a constant rate to meet a determined or accepted demand.
For example, a business has received an order in January for 100 model trains for delivery to be completed by November for the holiday season. Due to the deadline being 10 months away, the trains can be produced at a rate of ten per month.
The most common deterministic models used in inventory control today are:
- Economic Ordering Quantity (EOQ) Model
- ABC Analysis
- Inventory Turnover Ratio
Economic Ordering Quantity (EOQ) Model
One of the important decisions to be made in inventory management is how much inventory stock to actually buy. The EOQ is a company’s optimal order quantity that minimises its total costs related to ordering, receiving and holding the inventory.
Because of this model’s assumptions that demand, ordering, and holding costs remain constant over time — it is best to use this model in similar circumstances. EOQ also gives solutions to other problems like, at what frequency, when and helping determine reserve stock quantities.
Also known as selective inventory control, the ABC analysis suggests that inventory values are not equal, and so divides your inventory stock into three categories A, B and C. The inventory stock with the highest value are classified as ‘A’ inventory. The items with relatively low value as ‘B’ inventory and the items which are the least valuable are classified as ‘C’ inventory. The ABC Analysis allows different inventory management techniques to be applied to different segments of the inventory in order to increase revenue and decrease costs.
Read more about how an ABC analysis can work for you.
Inventory Turnover Ratio
This inventory ratio establishes the relationship between the average inventory and the cost of inventory sold during a particular period. This is calculated using the following formula:
Inventory Turnover Ratio = Cost of Goods Sold /Average Inventory
Average inventory is used instead of ending inventory because many businesses merchandise fluctuates greatly throughout the year. When comparing the current year’s inventory ratio with those of previous years, it will reveal the following points relating to inventories:
- Fast-Moving Items: High inventory ratio as this has high demand
- Slow-Moving Items: Low turnover ratio, as they have a lower demand they should be maintained at minimum quantity levels
- Dormant or obsolete Items: Zero demand. These should be liquidated or disposed of as early as possible to curb further losses
Read more about how you can improve your inventory turnover.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.