Inventory Management
This domain tests inventory purpose, cost structure, order quantity and reorder point calculations, and segmentation for control.
Why inventory exists and what it costs
Categories are raw material, work in process, finished goods and MRO. Functions are cycle stock from lot sizing, safety stock against variability, pipeline stock in transit, seasonal stock, and decoupling buffers between stages. Holding cost typically runs 20-30% of unit value per year and covers capital, storage, insurance, handling, obsolescence and shrinkage. Ordering cost covers setup, paperwork and receiving. Shortage cost is the hardest to quantify and often dominates the decision. Turns = COGS / average inventory value; days of inventory outstanding = 365 / turns.
Sizing rules
EOQ = square root of (2DS / H), where D is annual demand, S order cost, H annual holding cost per unit. EOQ balances ordering and holding cost but assumes constant demand, no quantity discounts and no stockouts. Reorder point = demand during lead time + safety stock. Safety stock = z x sigma of demand during lead time; when lead time itself varies, both demand and lead-time variability enter the formula. Cycle service level converts to z: 90% = 1.28, 95% = 1.65, 97.5% = 1.96, 99% = 2.33.
Segmentation and control
ABC by annual usage value: A items are few and high value, tight control and frequent counting; C items are many and low value, simple rules. XYZ adds demand variability. Cycle counting replaces annual wall-to-wall counts by counting A items more often. Vendor-managed inventory and consignment move ownership or replenishment responsibility to the supplier.
Worked example
Annual demand 12,000 units, order cost $50, holding cost $6 per unit per year, 250 working days, lead time 5 days, daily demand standard deviation 6, target cycle service level 95%.
- EOQ = square root of (2 x 12,000 x 50 / 6) = square root of 200,000 = 447 units.
- Daily demand = 48. Lead-time demand = 240.
- Safety stock = 1.65 x 6 x square root of 5 = 1.65 x 13.4 = 22 units.
- Reorder point = 240 + 22 = 262 units. Order about 447 units whenever on hand plus on order falls to 262.
Traps that cost marks
Using annual demand in a daily formula. Forgetting that safety stock protects against variability, not against average demand. Applying basic EOQ when quantity discounts exist, which requires comparing total cost at each break. Treating ABC as permanent. Computing turns from revenue instead of COGS. Ignoring lead-time variability for imported items.