ADVANCED APPAREL

MANUFACTURING MANAGEMENT

ASSIGNMENT – 2

TYPES OF INVENTORY MODEL WITH

FORMULA AND EXAMPLES

Submitted To:
Prof. Sumit Kumar
Submitted By:
Sulogna Sikidar [BFT/20/583]

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CONTENTS
INVENTORY MODEL ......................................................................3

TYPES OF INVENTORY MODEL ..................................................3

DETERMINISTIC INVENTORY MODELS:.................................3
1. ECONOMIC ORDER QUANTITY (EOQ) MODEL ............................................................................ 4
2. THE REORDER POINT (ROP) ........................................................................................................ 5
3. ABC MODEL ................................................................................................................................. 5

PROBABILISTIC INVENTORY MODEL .....................................7

1. CONTINUOUS REVIEW MODEL: .................................................................................................. 7
2. SAFETY STOCK MODEL ................................................................................................................ 8
3. PERIODIC REVIEW MODEL .......................................................................................................... 9

CONCLUSION ..................................................................................10

REFERENCES ..................................................................................11

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INVENTORY MODEL
An inventory model serves as a structured and systematic approach for businesses and
organizations to handle their inventory with efficiency and cost-effectiveness. Essentially, it
is a mathematical or analytical framework designed to guide decision-making processes
related to inventory management. The primary objective of these models is to strike a balance
between the costs linked to holding inventory and the costs associated with ordering or
acquiring new inventory.
Inventory constitutes the goods, raw materials, or finished products that a company maintains
to meet customer demand, either for consumption or resale. The challenge lies in managing
this inventory optimally to avoid unnecessary costs while ensuring that enough stock is
readily available to fulfill customer orders promptly. Inventory models provide a quantitative
basis for decision-makers to make informed choices regarding how much inventory to keep,
when to reorder, and how much to order.
The fundamental consideration in these models is the minimization of overall inventory costs.
Inventory costs can be broadly categorized into two main types: holding costs and ordering
costs. Holding costs include expenses associated with storing and maintaining inventory,
such as warehousing, insurance, and the opportunity cost of tying up capital in unsold goods.
On the other hand, ordering costs encompass the costs incurred when placing orders and
replenishing stock, including administrative expenses and potential transportation costs.
Ultimately, the goal is to ensure that the company maintains a sufficient inventory level to
meet customer demand and prevent stockouts, all while minimizing the associated costs.
Striking this balance is particularly critical in industries where demand fluctuates, as
maintaining excess inventory can tie up resources and lead to unnecessary expenses.
By utilizing inventory models, businesses can implement a systematic and data-driven
approach to inventory management. This not only helps in cost reduction but also contributes
to improved customer satisfaction by ensuring that products are available when needed. In
summary, an inventory model acts as a strategic tool, aiding businesses in navigating the
complexities of inventory management to achieve optimal operational and financial
outcomes.

TYPES OF INVENTORY MODEL

Two main types of inventory models exist: deterministic and probabilistic.

DETERMINISTIC INVENTORY MODELS:

A deterministic inventory model assumes that all parameters, including demand, lead time,
and order quantities, are known and constant over time. Deterministic models of inventory
control are used to determine the optimal inventory of a single item when demand is mostly
largely obscure. Under this model, inventory is built up at a constant rate to meet a
determined or accepted demand.
The most common deterministic models used in inventory control are:

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1. ECONOMIC ORDER QUANTITY (EOQ) MODEL
One of the important decisions to be made in inventory management is how much inventory
stock to actually buy. The EOQ is a company’s optimal order quantity that minimizes its total
costs related to ordering, receiving and holding the inventory.
Because of this model’s assumptions that demand, ordering, and holding costs remain
constant over time, it is best to use this model in similar circumstances. EOQ also gives
solutions to other problems like, at what frequency, when and helping determine reserve
stock quantities.
FORMULA:

2𝐷𝑆
EOQ = √ 𝐻

Where:
 D is the demand for the product (in units per year),
 S is the ordering cost per order,
 H is the holding cost per unit per year.
The EOQ formula balances the costs of holding inventory against the costs of ordering or
2𝐷𝑆
replenishing it. The square root of the product of 𝐻 gives the optimal order quantity, where:

 2DS represents the total ordering cost (ordering cost per order multiplied by the
demand),
 H is the holding cost per unit per year.
2𝐷𝑆
By finding the square root of the EOQ minimizes the total cost of inventory, including
𝐻
the holding cost and the ordering cost.
EXAMPLE:
Let's consider a company that sells 10,000 units of a product annually (D=10,000), has an
ordering cost of $50 per order (S = $50), and a holding cost of $2 per unit per year (H = $2).

2∗10,000∗50
EOQ = √ 2

1,000,000
EOQ = √ 2

EOQ = √500,000
EOQ ≈ 707.11
Therefore, the Economic Order Quantity (EOQ) for this example is approximately 707 units.
This means that ordering 707 units at a time would minimize the total cost of inventory,
considering both the costs of holding and ordering.

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 2. THE REORDER POINT (ROP)
ROP model is a deterministic inventory model that helps businesses determine when to
reorder inventory to avoid stockouts. The ROP is the inventory level at which a new order
should be placed to ensure that there is enough stock to meet demand during the lead time for
replenishing inventory. The lead time is the time it takes to receive the new inventory after
placing an order.
FORMULA:
ROP = Demand during lead time + Safety stock
ROP = µL + Z σL
Where:
 µL is the mean demand during lead time,
 Z is the z-score representing the desired level of service (probability of not running
out of stock),
 σL is the standard deviation of demand during lead time.
The ROP is calculated by adding the mean demand during lead time to the safety stock. The
safety stock is a buffer maintained to account for uncertainties and variations in demand or
supply. The z-score is used to determine the appropriate level of safety stock based on the
desired service level. The higher the service level, the higher the safety stock, providing a
greater assurance of not experiencing stockouts.
EXAMPLE:
Let's consider a company that sells a product with a mean demand during lead time (µL) of
100 units per week, a standard deviation of demand during lead time (σL) of 20 units, and a
desired service level corresponding to a z-score (Z) of 1.28.
ROP=100+(1.28×20)
ROP=100+25.6
ROP=125.6
Therefore, the Reorder Point (ROP) for this example is approximately 126 units. This means
that when the inventory level reaches 126 units, a new order should be placed to replenish
stock and avoid running out during the lead time.

3. ABC MODEL
The ABC inventory model is a classification system that categorizes items in a company's
inventory based on their importance and value. This model is derived from the Pareto
Principle, often known as the 80/20 rule, which suggests that a small percentage of items
contribute to the majority of the value. The ABC model is named after the three categories it
establishes: A, B, and C.

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FORMULA:
The ABC model does not have a specific formula, but it is based on the calculation of the
Annual Consumption Value (ACV) for each item, which is the product of the annual demand
and the unit cost:
ACV=Annual Demand × Unit Cost
Once ACV is calculated for each item, the items are ranked in descending order of their
ACV. The cumulative percentage of the total ACV is then calculated, and items are classified
into categories based on these cumulative percentages.
CATEGORIES:
 Category A: The top 80-85% of the total ACV. These items typically constitute a
small percentage of the total items but contribute significantly to the overall inventory
value.
 Category B: The next 10-15% of the total ACV. This category includes items with
moderate importance and value.
 Category C: The bottom 5-10% of the total ACV. These items, while numerous,
contribute relatively little to the overall inventory value.
EXAMPLE:
Let's consider a company that sells three products:
1. Product A: Annual Demand = 1,000 units, Unit Cost = $10
2. Product B: Annual Demand = 500 units, Unit Cost = $20
3. Product C: Annual Demand = 2,000 units, Unit Cost = $5
Calculate the Annual Consumption Value (ACV) for each product:
ACV_A = 1,000 \times $10 = $10,000
ACV_B = 500 \times $20 = $10,000
ACV_C = 2,000 \times $5 = $10,000
Rank the products based on ACV:
1. Product A and Product B (tie)
2. Product C
Since there's a tie for the top 80-85%, both Product A and Product B would typically be
classified as Category A, and Product C would be Category B.
The ABC model helps businesses prioritize their inventory management efforts and resources
based on the value and importance of items. Category A items, being the most valuable, often
require more attention in terms of monitoring, control, and strategic decision-making, while
Category C items may undergo less frequent review and scrutiny.

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PROBABILISTIC INVENTORY MODEL
A probabilistic inventory model, in contrast to deterministic models, considers uncertainty
and variability in demand, lead time, and other factors. The Probabilistic inventory model is
closely aligned to the manufacturing and retail reality that from time to time, demand will vary.
Demand variations cause shortages, particularly during lead time if a retailer only has a limited
amount of inventory stock to cover the demand during the lead time when replenishment stock has not
arrived.

The probabilistic inventory model incorporates demand variation and lead time uncertainty
based on three possibilities.
The first is when lead time demand is constant but the lead time itself varies and the second is
when lead time is constant but demand fluctuates during lead time. The third possibility is
when both lead time and demand during lead time vary.
Employing known economic, geological and production data the probabilistic inventory
model creates a collection of approximate inventory stock quantities and their related
probabilities. The advantage of a probabilistic approach is that by using values within a
bandwidth, modelled by a defined distribution density, you achieved greater reliability than
when using deterministic figures.

1. CONTINUOUS REVIEW MODEL:

The Continuous Review Model, often referred to as the (s, Q) model, is a probabilistic
inventory model used to manage inventory levels continuously. In this model, the inventory
level is continuously monitored, and replenishment orders are placed when the inventory
level reaches a predetermined reorder point (s). The order quantity (Q) is fixed each time an
order is placed.
FORMULA:
ROP = µL + Z σL

2𝐷𝑆
Q = EOQ = √ 𝐻

Where:
 ROP is the Reorder Point,
 µL is the mean demand during lead time,
 Z is the z-score corresponding to the desired service level,
 σL is the standard deviation of demand during lead time,
 Q is the order quantity (also known as Economic Order Quantity),
 D is the average demand rate,
 S is the ordering cost per order,
 H is the holding cost per unit per year.

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Where,
1. Reorder Point (ROP): The ROP represents the inventory level at which a new order
should be placed to avoid a stockout during the lead time. It is calculated based on the
mean demand during lead time (µL), the desired service level represented by the z-
score (Z), and the standard deviation of demand during lead time (σL).
2. Order Quantity (Q): The order quantity is determined using the Economic Order
Quantity (EOQ) formula. The EOQ represents the optimal order quantity that
minimizes total inventory costs, balancing ordering costs and holding costs.
EXAMPLE:
Let's consider a company with an average demand rate (D) of 1,000 units per week, an
ordering cost (S) of $100 per order, a holding cost (H) of $2 per unit per year, a mean demand
during lead time (µL) of 100 units per week, a standard deviation of demand during lead time
(σL) of 20 units, and a desired service level corresponding to a z-score (Z) of 1.28.

2𝐷𝑆
Q = EOQ = √ 𝐻

ROP = µL + Z σL
Calculate Q:

2∗1,000∗100
Q=√ 2

Q = √100,000
Calculate ROP:
ROP=100+(1.28×20)
ROP=100+25.6
ROP=125.6
Therefore, the order quantity (Q) is approximately 316 units, and the reorder point (ROP) is
approximately 126 units.
In practice, businesses might round the order quantity to a practical value and use these
values to continuously monitor and manage their inventory levels. The continuous review
model helps strike a balance between minimizing holding costs and ensuring a satisfactory
service level by avoiding stockouts during lead time.

2. SAFETY STOCK MODEL

The Safety Stock Model is a crucial aspect of inventory management, especially in
probabilistic inventory models. Safety stock is a buffer of extra inventory maintained to
mitigate the risk of stock outs due to uncertainties in demand, lead time, and other factors.
The Safety Stock Model helps determine the optimal level of safety stock to maintain.

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FORMULA:
Safety Stock = Z×σ×LT
Where:
 Z is the z-score corresponding to the desired service level,
 σ is the standard deviation of demand,
 LT is the lead time.
Where,
 Z-score: The z-score represents the number of standard deviations a data point is
from the mean in a normal distribution. It is used to determine the appropriate level of
safety stock based on the desired service level. Common z-scores for different service
levels are used (e.g., 1.28 for an 80% service level).
 Standard Deviation (σ): The standard deviation of demand is a measure of the
variability or uncertainty in the demand for the product.
 Lead Time (LT): The lead time is the time it takes to receive new inventory after
placing an order.
EXAMPLE:
Let's consider a company with a desired service level corresponding to a z-score (Z) of 1.28,
a standard deviation of demand (σ) of 20 units, and a lead time (LT) of 2 weeks.
Safety Stock = 1.28×20×2
Safety Stock = 1.28×20×2
Safety Stock ≈ 1.28×20×1.41
Safety Stock ≈ 35.91
Therefore, the Safety Stock for this example is approximately 35.91 units.

The Safety Stock Model plays a crucial role in preventing stockouts, especially in situations
where demand or lead times are uncertain. By carefully determining the appropriate safety
stock level, businesses can improve their ability to fulfill customer demand consistently, even
in the face of variability in the supply chain or market conditions.

3. PERIODIC REVIEW MODEL

The Periodic Review Model, also known as the (s, S) model, is a probabilistic inventory
management approach where the inventory level is reviewed periodically at fixed intervals.
In this model, the order quantity is adjusted periodically to maintain a target inventory level.
The model is particularly useful when demand and lead time are variable.
FORMULA:
Q=S−I

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Where:
 Q is the order quantity,
 S is the target inventory level,
 I is the current inventory level.
Where,
1. Target Inventory Level (S): This is the desired level of inventory that the company
aims to maintain until the next review period.
2. Current Inventory Level (I): This represents the actual inventory level at the time of
the review.
3. Order Quantity (Q): The order quantity is the difference between the target
inventory level and the current inventory level. It indicates the amount of inventory
that needs to be ordered to bring the inventory back to the desired level.
EXAMPLE:
Let's consider a company using the periodic review model with a target inventory level (S) of
500 units. At the time of the periodic review, the current inventory level (I) is 300 units. The
order quantity (Q) can be calculated using the formula Q = S − I.
Q = 500 − 300
Q = 200
Therefore, the order quantity (Q) is 200 units. This means that the company needs to place an
order for 200 units to replenish its inventory and bring it back to the target level.
Companies using the periodic review model typically perform inventory reviews at regular
intervals, such as weekly or monthly. During each review, the current inventory level is
compared to the target inventory level, and an order is placed to restore the inventory to the
desired level.
This model is advantageous when demand and lead times are variable because it provides
flexibility in adjusting order quantities based on the current inventory status. However, it
requires careful monitoring and control to ensure that the reviews are conducted consistently
at the specified intervals.
The periodic review model is particularly suitable for situations where order costs are
significant, and businesses want to consolidate orders to achieve economies of scale. It helps
strike a balance between holding costs and ordering costs, contributing to effective inventory
management.

CONCLUSION
In conclusion, effective inventory management is essential for businesses to maintain a
delicate balance between meeting customer demand and minimizing associated costs.
Various inventory models provide analytical frameworks to assist businesses in making
informed decisions regarding order quantities, reorder points, and safety stock levels.

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Deterministic models, such as the Economic Order Quantity (EOQ) and Reorder Point
(ROP), operate under the assumption of known and constant parameters, providing structured
approaches to minimize holding and ordering costs.
Probabilistic models, including the Continuous Review Model (s, Q) and Safety Stock
Model, introduce elements of uncertainty, considering variability in demand and lead times.
These models, grounded in statistical principles, enable businesses to strategically manage
risks associated with fluctuations in the marketplace and supply chain.
In practical application, businesses often combine elements of different models to tailor their
inventory management strategies to specific product characteristics, market dynamics, and
organizational goals. The goal is to optimize the trade-offs between holding costs, ordering
costs, and stock out costs, ensuring that sufficient inventory is available to meet customer
demand while minimizing excess stock that ties up capital.
Ultimately, successful inventory management involves a dynamic and adaptive approach,
leveraging the strengths of various models to align with the unique needs of the business. By
implementing these models judiciously, businesses can enhance operational efficiency,
improve customer satisfaction, and achieve a competitive advantage in the marketplace.

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