Inventory Management

Logistics costs are equal to about 10% of U.S. GDP. They also represent approximately 8-10% of the typical company's cost of goods sold. Inventoryincluding raw materials, work-in-process, finished goods, and pipelineis the largest component of logistics costs. In addition to driving costs, inventory influences customer service. Simply stated, too much inventory and a company cannot be cost competitive. Too little inventory and the company will not be responsive to customer expectations.

To effectively manage inventory levels, two critical decisions must be made: 1) how much inventory to order (or make) and 2) when to order (or make) product.

How Much to Order

The amount of inventory to ordercalled the economic order quantity (EOQ)is calculated to minimize the total annual costs of inventory. Two cost categories are typically included in the total cost equation: 1) Ordering Costs and 2) Carrying Costs.

Ordering costs are calculated by multiplying the number of orders per year (Annual Demand / Order Quantity) by the cost per order (K).

Carrying costs are calculated by multiplying the average inventory on hand (Q/2) by the cost of each item (C) by the estimated carrying cost rate (i). This will give us the holding cost per unit (h). The carrying cost rate is typically a combination of interest rate plus a percent costs attributed to obsolescence and other costs.

This gives us the total cost of inventory equation: