Inventory analysis is one of the most popular topics in management science.

One reason is that

almost all types of business organizations have inventory. Although we tend to think of inventory
only in terms of stock on a store shelf, it can take on a variety of forms, such as partially
finished products at different stages of a manufacturing process, raw materials, resources, labor,
or cash. In addition, the purpose of inventory is not always simply to meet customer demand.
For example, companies frequently stock large inventories of raw materials as a hedge against
strikes. Whatever form inventory takes or whatever its purpose, it often represents a significant
cost to a business firm. It is estimated that the average annual cost of manufactured goods inventory
in the United States is approximately 30% of the total value of the inventory. Thus, if a company
has $10.0 million worth of products in inventory, the cost of holding the inventory
(including insurance, obsolescence, depreciation, interest, opportunity costs, storage costs, etc.)
would be approximately $3.0 million. If the amount of inventory could be reduced by half to
$5.0 million, then $1.5 million would be saved in inventory costs, a significant cost reduction.
In this chapter we describe the classic economic order quantity models, which represent the
most basic and fundamental form of inventory analysis. These models provide a means for determining
how much to order (the order quantity) and when to place an order so that inventoryrelated
costs are minimized. The underlying assumption of these models is that demand is
known with certainty and is constant. In addition, we will describe models for determining the
order size and reorder points (when to place an order) when demand is uncertain.
Elements of Inventory Management
Inventory is defined as a stock of items kept on hand by an organization to use to meet
customer demand. Virtually every type of organization maintains some form of inventory. A
department store carries inventories of all the retail items it sells; a nursery has inventories of
different plants, trees, and flowers; a rental car agency has inventories of cars; and a major
league baseball team maintains an inventory of players on its minor league teams. Even a family
household will maintain inventories of food, clothing, medical supplies, personal hygiene
products, and so on.
The Role of Inventory
A company or an organization keeps stocks of inventory for a variety of important reasons. The
most prominent is holding finished goods inventories to meet customer demand for a product, especially
in a retail operation. However, customer demand can also be in the form of a secretary
going to a storage closet to get a printer cartridge or paper, or a carpenter getting a board or nail
from a storage shed. A level of inventory is normally maintained that will meet anticipated or expected
customer demand. However, because demand is usually not known with certainty, additional
amounts of inventory, called safety, or buffer, stocks, are often kept on hand to meet
unexpected variations in excess of expected demand.
Additional stocks of inventories are sometimes built up to meet seasonal or cyclical
demand. Companies will produce items when demand is low to meet high seasonal demand for
which their production capacity is insufficient. For example, toy manufacturers produce large
inventories during the summer and fall to meet anticipated demand during the Christmas season.
Doing so enables them to maintain a relatively smooth production flow throughout the year.
They would not normally have the production capacity or logistical support to produce enough
to meet all of the Christmas demand during that season. Correspondingly, retailers might find it
necessary to keep large stocks of inventory on their shelves to meet peak seasonal demand, such
as at Christmas, or for display purposes to attract buyers.
A company will often purchase large amounts of inventory to take advantage of price discounts,
as a hedge against anticipated future price increases, or because it can get a lower price
by purchasing in volume. For example, Walmart has long been known to purchase an entire
manufacturer’s stock of soap powder or other retail items because it can get a very low price,
ELEMENTS OF INVENTORY MANAGEMENT 753
Safety stocks are
additional inventory
to compensate for
demand uncertainty.
Inventory is a stock of
items kept on hand to
meet demand.