3 Inventory Planning Models to Know

Everything is better in moderation, they say. This is particularly true when it comes to inventory stock. There should not be too much or too little as it can greatly affect your sales and profitability. Here’s when inventory planning and management can help.

Companies that source, produce and manufacture raw materials must analyze demand, decide when and how much to order. This is called inventory planning. Effective inventory planning augments company efforts in forecasting demand while minimizing costs. It also reduces the amount of inventory stored (and therefore, storage costs) and make best use of their manufacturer’s space, time and equipment.

Merchants that deal with partially completed goods (called work in progress or WIP), finished goods and/or goods-in-transit to warehouses or customers (or GIT) must focus on inventory review and tracking.

You’re probably thinking… with all this work involved, why should I hold inventory, then?

There are 3 main reasons to hold inventory:

1. Transaction Motive: Economies of scale. Buying raw materials in larger quantities and holding that inventory is known to be cheaper than buying in smaller lots. Large production brings down per unit cost. Inventory also makes it possible for manufacturers to specialize in the products they create. The finished products, then, can be stored in a warehouse and fulfill customer orders.
2. Precautionary Motive: Inventory is used as protection against uncertainties when there’s a flux in demand. Main reason is to prevent stockouts. This move also caters to cyclical, seasonal and surges in demand. Companies stock up raw materials and hold inventory in order to increase production and rush supplies to the market to meet increased demand.
3. Speculative Motive: Managers hedge on price increases in materials or labor, and must look at the trade-off between inventory cost and benefits. Inventory is also used as a buffer in critical supply chain interfaces including:

          a. Supplier-procurement or purchasing

          b. Procurement-production

          c. Production-marketing

          d. Marketing-distribution

          e. Distribution-intermediary

          f. Intermediary-consumer/user

Related blog: Identify & optimize top selling products with ABC inventory management

Inventory planning model: For companies dealing with raw materials

Most successful eCommerce merchants and retail operators are driven by a precautionary motive to avoid stockouts. Using a deterministic inventory model – like the Economic Order Quantity (EOQ) model – will help you compute an optimal order quantity that minimizes inventory costs (and avoid the most feared aspect of eCommerce).

The EOQ is a formula that calculates the most economical number of items a business should order to minimize costs and maximize value when re-stocking inventory.

For example:

ACME Inc. produces cosmetics to sell to wholesalers. One of the raw materials it purchases is lavender hydrosol, bought at the rate of $22.50 per ton. ACME Inc.’s forecasts show an estimated requirement of 5,75,000 tons of lavender hydrosol for the coming year. The annual total carrying cost for this material is 40% for cost of acquisition, and the ordering cost is $595. What is the Most Economical Order Quantity?

D = 5,75,000 tons

C =0.40(22.50) = $9.00/Ton/Year

S = $595/Order

= 27,573.135 tons per Order

This means that if you order 27,573 tons of lavender hydrosol of inventory, every time you place an order, you will minimize your inventory costs – both your ordering and carrying costs.

However, the EOQ model assumes constant (steady) demand of a product and immediate availability of items to be restocked. It does not account for seasonal or economic fluctuations. It assumes fixed costs of inventory units, ordering charges and holding charges. No stockouts are permitted.

This inventory model requires continuous monitoring of inventory levels. The effectiveness of the basic EOQ model is most limited by the assumption of a one-product business, and the formula does not allow interaction between products.

Moreover, EOQ assumes an infinite planning horizon and that there’s no limit on capital availability.

Related blog: QuickBooks Commerce and Inventory Planner: Integration

Inventory review models: For companies dealing with partial or finished goods

Accurate business accounting also requires inventory counting. Two methods allow you to review your inventory on two different timeframes:

Continuous (or perpetual) inventory system keeps a constant track of quantities; as soon as they get below a cutoff level (called the reorder point), the manager places an order for a predetermined quantity which is calculated to keep inventory costs low.

Advantages:

• Knowing your stock levels in real-time.
• A centralized system makes it easier to track stock across multiple locations.
• Allows for management to have more direct inventory control.
• Easier to see if a product is in stock.

Disadvantages:

• This system cannot be maintained manually. A business must install specialized equipment or software, resulting in higher costs.
• Recorded inventory may not reflect actual inventory.
• Greater complexity, requiring companies to train staff on the system or software used.
• Time-consuming since each transaction must be recorded immediately.

Periodic inventory system uses a very simple method: counting what's in the store or the warehouse by hand. Using this system, the amount of stock on hand is assessed periodically (i.e., every week or month or some other fixed-time interval). The amount to order is then determined based on the amount on hand and expected demand. Therefore, all the orders are placed in one batch per period.

Advantages:

• Allows you to start without major prep, and you can set the period (timeframe) measured to fit your company’s needs.
• It’s simpler to use, so long as your company is small.

Disadvantages:

• Complexity in keeping several different accounts that keep track of sales, cost of goods sold, purchases and other key info.
• Problems such as product theft can be difficult to notice in periodic inventory system, leading to potential losses in revenue.

For most businesses, these three models can seem daunting. Imagine calculating the above EOQ formula manually! Or paying a professional inventory company to come in to count your inventory manually.

Good inventory planning and management lies in understanding what stock you have on hand, where it is in your warehouse(s), and how it’s coming in and out. With the right inventory planning tool, you’ll be able to:

• Gain better cash flow by having clear visibility into raw material costs, products that turnover fast or that are surplus / obsolete.
• Achieve larger profit margins by having a single, central source of truth behind costs, customer demands, conversions, diverse data streams across multiple channels.
• Limit abuse with inventory policies and procedures in place.

Spend less time on these back office functions, and remain at the forefront of making a profit for your business with an inventory planning tool like QuickBooks Commerce.