4.2 Inventory Management
Key Takeaways
- Inventory functions include decoupling, cycle (lot-size), safety, anticipation, pipeline (in-transit), and hedge stock, each serving a distinct supply chain purpose
- Inventory carrying cost typically runs 20–30% of inventory value annually and combines capital, storage, service, and risk costs
- The Economic Order Quantity formula is EOQ = the square root of (2 x annual demand x order cost) / annual unit holding cost
- Reorder point = (average demand during lead time) + safety stock, and safety stock rises with the desired service level and demand/lead-time variability
- ABC analysis applies Pareto's 80/20 principle so tight control is focused on the ~20% of items driving ~80% of annual dollar usage
Why Inventory Is Tested Heavily
Inventory policy sits at the financial center of the supply chain: it ties up working capital, drives service levels, and absorbs variability. The CSCP exam expects you to know why inventory exists, what it costs, and how to size orders and buffers. Several questions are quantitative, so you must apply the standard Economic Order Quantity (EOQ), reorder point (ROP), and safety stock formulas correctly.
Inventory Types and Functions
Inventory is classified by position in the process and by the purpose it serves.
| Function | Purpose |
|---|---|
| Cycle (lot-size) stock | Result of ordering or producing in batches larger than immediate need |
| Safety (buffer) stock | Protects against demand and lead-time variability |
| Anticipation stock | Built ahead of seasonal peaks, promotions, or planned shutdowns |
| Pipeline (in-transit) stock | Inventory moving between locations |
| Decoupling stock | Separates dependent process steps so they can operate independently |
| Hedge stock | Guards against price increases or supply disruption |
By process position, inventory is raw material, work-in-process (WIP), maintenance/repair/operating (MRO) supplies, and finished goods.
Inventory Costs
Four cost categories drive inventory decisions:
- Carrying (holding) cost — capital cost, storage/space, service (insurance, taxes), and risk (obsolescence, damage, shrinkage). Typically 20–30% of inventory value per year.
- Ordering cost — fixed cost to place and receive a purchase order, or the setup cost to produce a lot.
- Stockout cost — lost sales, backorders, expediting, and lost customer goodwill.
- Capacity-related cost — overtime, hiring, layoffs, and idle time tied to changing output.
EOQ exists precisely because ordering cost and carrying cost move in opposite directions: order more often and ordering cost rises while carrying cost falls.
Economic Order Quantity (EOQ)
The Economic Order Quantity (EOQ) is the order size that minimizes the sum of annual ordering and carrying costs:
EOQ = sqrt( (2 x D x S) / H )
where D = annual demand (units), S = cost per order, and H = annual holding cost per unit.
Worked Example
A distributor uses D = 12,000 units/year, ordering cost S = $50, and holding cost H = $6/unit/year.
EOQ = sqrt( (2 x 12,000 x 50) / 6 ) = sqrt( 1,200,000 / 6 ) = sqrt(200,000) ≈ 447 units.
At EOQ, annual orders = 12,000 / 447 ≈ 26.8 orders, and annual ordering cost (≈ $1,342) equals annual carrying cost (447/2 x $6 ≈ $1,341) — the balance point. EOQ is robust: being moderately off the optimal quantity changes total cost only slightly.
Reorder Point and Safety Stock
Under a continuous-review system you place an order whenever on-hand inventory drops to the reorder point (ROP):
ROP = (average demand during lead time) + safety stock
or ROP = (d x L) + SS, where d = average demand per period and L = lead time in periods.
Safety stock (SS) buffers variability. When only demand varies, a common form is:
SS = Z x sigma_d x sqrt(L)
where Z is the service-factor for the target cycle service level and sigma_d is the standard deviation of demand per period.
Worked Example
Average demand d = 200 units/week, L = 3 weeks, weekly demand standard deviation sigma_d = 40, target service level 95% (Z = 1.65).
- Demand during lead time = 200 x 3 = 600 units
- Safety stock = 1.65 x 40 x sqrt(3) ≈ 1.65 x 40 x 1.732 ≈ 114 units
- ROP = 600 + 114 = 714 units
Higher target service levels raise Z and therefore raise safety stock non-linearly.
ABC Analysis
ABC analysis applies the Pareto principle (80/20 rule) to focus control where the money is. Items are ranked by annual dollar usage (unit cost x annual volume):
| Class | Approx. % of Items | Approx. % of Annual $ Usage | Control |
|---|---|---|---|
| A | ~10–20% | ~70–80% | Tight control, frequent review, low safety stock relative to value |
| B | ~30% | ~15–25% | Moderate control |
| C | ~50–60% | ~5–10% | Loose control, larger order quantities, simple rules |
ABC focuses scarce management attention; it does not mean C items are unimportant — a low-value C item can still halt production if unavailable, which is why some firms add a criticality dimension.
Inventory Accuracy and Cycle Counting
MRP and order promising are only as good as the inventory record accuracy (IRA). Cycle counting replaces a disruptive annual physical inventory with continuous counting of a subset of items, typically prioritizing A items more frequently than C items (ABC-based cycle counting). It finds and fixes root causes of errors throughout the year, keeps records reliable, and avoids shutting down operations. Best-practice IRA targets are commonly 95%+ for C items and approaching 99–100% for A items, measured within tight tolerance.
Independent vs. Dependent Demand
This distinction determines which inventory method applies.
- Independent demand — demand for finished goods/end items driven by the market and forecast. Managed with statistical methods: EOQ, reorder points, safety stock.
- Dependent demand — demand for components, subassemblies, and raw materials that is calculated from the demand for their parent items via the bill of materials. Managed with MRP, not forecasting.
Applying EOQ/ROP logic to dependent-demand components is a classic error: their requirements are lumpy and derived, so they should be planned with MRP.
Annual demand is 8,000 units, ordering cost is $40 per order, and annual holding cost is $4 per unit. What is the Economic Order Quantity?
Average demand is 50 units per day, lead time is 4 days, and the firm carries 30 units of safety stock. What is the reorder point?
Which inventory should be planned using Material Requirements Planning rather than reorder-point logic?
Under ABC analysis, which statement is most accurate?