Inventory management is a crucial aspect of any business that deals with physical goods. It involves ordering, storing, using, and selling the inventory in a way that meets customer demand while minimizing costs and risks. One of the key decisions in inventory management is how much to order and how often to order. This decision affects the average inventory level, which is the amount of inventory that a business holds over a period of time.
The average inventory level is calculated by adding the beginning and ending inventory levels for a period and dividing by two. Alternatively, it can be calculated by multiplying the order quantity by the order cycle, which is the time between two consecutive orders, and dividing by two. The order quantity is the number of units that a business orders each time it places an order. The order cycle is determined by the demand rate, which is the number of units that a business sells per unit of time.
The average inventory level is important because it affects the inventory costs and the service level of a business. Inventory costs include holding costs, ordering costs, and shortage costs. Holding costs are the costs of storing and maintaining the inventory, such as rent, utilities, insurance, depreciation, obsolescence, and spoilage. Ordering costs are the costs of placing and receiving an order, such as transportation, handling, inspection, and administrative costs. Shortage costs are the costs of not having enough inventory to meet customer demand, such as lost sales, backorders, and customer dissatisfaction.
The service level is the probability that a business can meet customer demand without running out of stock. It depends on the safety stock, which is the extra inventory that a business keeps to protect against demand variability and supply uncertainty. The safety stock is calculated by multiplying the standard deviation of demand by a safety factor, which is based on the desired service level.
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The relationship between the average inventory level and the order quantity is inverse. This means that as the order quantity increases, the average inventory level decreases, and vice versa. This can be explained by looking at how each component of the average inventory level formula changes with respect to the order quantity.
- The beginning inventory level is equal to the ending inventory level of the previous period, which is equal to the order quantity minus the demand during that period. As the order quantity increases, the beginning inventory level increases.
- The ending inventory level is equal to the beginning inventory level minus the demand during that period. As the order quantity increases, the ending inventory level decreases.
- The order cycle is equal to the order quantity divided by the demand rate. As the order quantity increases, the order cycle increases.
- The average inventory level is equal to half of the sum of the beginning and ending inventory levels, or half of the product of the order quantity and the order cycle. As the order quantity increases, these two expressions have opposite effects on the average inventory level. The first expression increases it, while the second expression decreases it. However, since the second expression has a larger magnitude than the first expression, as shown by this graph, the net effect is that as
