Planning is extremely important when it comes to inventory resources. The lack of planning can be costly to the firm either because of the carrying and financing costs of excess inventory or the lost sales from inadequate inventory. The inventory requirements to support production and marketing should be incorporated into the firm’s planning process in an orderly fashion.
- The production side: Every product is made up of a specified list of components. The planner must realize the different mix of components in each finished product. Each item maintained in inventory will have a cost. This cost may be based on volume purchases, lead time for an order, historical agreements or other factors. Each component can be assigned a value. Once the mix is known and each component has been assigned a value, the planner can calculate the materials cost.
- The marketing side: The second step in inventory planning involves a forecast of unit requirements during the future period. The marketing department should also provide pricing information so that higher profit items can receive more attention.
An important component of inventory planning involves access to an inventory database. It is a structured framework that contains the information needed to effectively manage all items of inventory, from raw materials to finished goods. This information includes the classification and amount of inventories, demand for the items, cost to the firm for each item, ordering costs, carrying costs and other data.
The task of inventory planning can be highly complex. At the same time it rests on fundamental principles. In doing so we must understand and determine the optimal lot size that has to be ordered. The EOQ (economic order quantity) refers to the optimal order size that will result in the lowest total of order and carrying costs and ordering costs. By calculating the economic order quantity the firm attempts to determine the order size that will minimize the total inventory costs.
An examination of the two curves reveals that the carrying cost curve is linear i.e. more the inventory held in any period, greater will be the cost of holding it. Ordering cost curve on the other hand is different. The ordering costs decrease with an increase in order sizes. The point where the holding cost curve i.e. the carrying cost curve and the ordering cost curve meet, represent the least total cost which is incidentally the economic order quantity or optimum quantity.
The EOQ can be calculated with the help of a mathematical formula. Following assumptions are implied in the calculation:
- Constant or uniform demand- although the EOQ model assumes constant demand, demand may vary from day to day. If demand is not known in advance- the model must be modified through the inclusion of safe stock.
- Constant unit price- the EOQ model assumes that the purchase price per unit of material will remain unaltered irrespective of the order offered by the suppliers to include variable costs resulting from quantity discounts, the total costs in the EOQ model can be redefined.
- Constant carrying costs- unit carrying costs may very substantially as the size of the inventory rises, perhaps decreasing because of economies of scale or storage efficiency or increasing as storage space runs out and new warehouses have to be rented.
- Constant ordering cost- this assumption is generally valid. However any violation in this respect can be accommodated by modifying the EOQ model in a manner similar to the one used for variable unit price.
- Instantaneous delivery- if delivery is not instantaneous, which is generally the case; the original EOQ model must be modified through the inclusion of a safe stock.
- Independent orders- if multiple orders result in cost saving by reducing paper work and the transportation cost, the original EOQ model must be further modified. While this modification is somewhat complicated, special EOQ models have been developed to deal with it.
These assumptions have been pointed out to illustrate the limitations of the basic EOQ model and the ways in which it can be easily modified to compensate for them.
The formula for the EOQ model is: 2 M Co/S Cc
Where, M = is the annual demand
Co is the cost of ordering
Cc is the inventory carrying cost
S = is the unit price of an item.
Limitations of the EOQ formula:
- Erratic changes usages- the formula presumes the usage of materials is both predictable and evenly distributed. When this is not the case, the formula becomes useless.
- Faulty basic information- order cost varies from commodity to commodity and the carrying cost can vary with the company’s opportunity cost of capital. Thus the assumption that the ordering cost and the carrying cost remains constant is faulty and hence EOQ calculations are not correct.
- Costly calculations: the calculation required to find out EOQ is extremely time consuming. More elaborate formulae are even more expensive. In many cases, the cost of estimating the cost of possession and acquisition and calculating EOQ exceeds the savings made by buying that quantity.
- No formula is a substitute for common sense- sometimes the EOQ may suggest that we order a particular commodity every week (six-year supply) based on the assumption that we need it at the same rate for the next six years. However we have to order it in the quantities according to our judgement. Some items can be ordered every week; some can be ordered monthly, depends on how feasible it is for the firm.
- EOQ ordering must be tempered with judgement- Sometimes guidelines provide a conflict in ordering. Where an order strategy conflicts with an operational goal, order strategy restrictions should be developed to permit honouring the goal.
Quantity discounts: In the EOQ analysis, it has been assumed that material prices and transportation costs were constant factors for the range of order quantities considered. In practice, some situations occur in which the delivered unit cost of a material decreases significantly if a slightly larger quantity than the originally computed EOQ is purchased. Quantity discounts, freight rate schedules and price increases may create such situations. These additional variables can also be included in the formula.