Inventory Management Techniques

Inventory Management Techniques
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  • 0:03 Inventory Management
  • 1:00 ABC Approach
  • 2:19 Economic Order Quantity Model
  • 3:56 Derived-Demand Inventories
  • 5:16 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

How does a company know how much inventory to keep on hand? In this lesson, we'll examine inventory management and discuss three major approaches: the ABC approach, the economic order quantity model, and derived-demand inventory.

Inventory Management

Louis is the CEO of a large online store. His company has warehouses of inventory across the country, and they ship out as soon as someone orders a product online. But this comes with an issue. Louis has to decide which products to stock up on and which ones to keep in low numbers. How should he decide? What if he stocks up on a product that doesn't sell, and he doesn't stock up on one that does?

Inventory management is the process of planning the quantity of inventory for a business to keep. If Louis's company has too much inventory of a specific product, then they will have to pay money to store it in a warehouse. If they have too little inventory, they won't be able to meet their customer's needs. So how can Louis manage inventory? To help him out, let's look at three inventory management techniques: the ABC approach, economic order quantity model, and derived-demand inventory management.

ABC Approach

One way that Louis can manage his inventory levels is by separating products out into categories. The ABC approach to inventory management is short for 'always better control.' The idea is to divide inventory into categories A, B, and C based on things like quality, quantity, or function. Then, each category has its own stock levels or inventory process.

For example, let's say that Louis notices that mp3 players make up 60% of his company's sales, e-book readers make up 30% of company sales, and everything else makes up the last 10% of sales. Using the ABC approach, Louis will focus on his top sellers and put his mp3 players in category A, which receives the highest priority. Items of moderate importance, like e-book readers, will go into category B, and the items that don't account for a high percentage of sales will go into category C, which receives the lowest priority.

Using these categories as a guideline, Louis may stock more mp3 players than e-book readers. More importantly, if mp3 players are the items that offer his company the most profit, he'll want to devote more of his time and resources to keeping detailed records and having tighter inventory controls for that particular item.

Economic Order Quantity Model

The ABC approach is a simple way to manage inventory, but it doesn't provide a complete picture. After all, Louis might give higher priority to mp3 players than to e-book readers, but that still doesn't tell him how many of each of those things to stock. He might end up with way too many or way too few. The economic order quantity model of inventory management, on the other hand, is about establishing the ideal inventory level.

The economic order quantity model is best used when demand for a product is relatively stable. For example, people order mp3 players all year round, and Louis can forecast in advance approximately how many mp3 players he'll sell each month. That allows him to figure out the optimal number of mp3 players to keep in stock.

There are different variations and extensions of the economic order quantity model, but they all look at the carrying cost of inventory, or what it costs a business to keep products in stock. In order to reduce carrying costs, Louis, and others using the economic order quantity model, want to make sure they have enough inventory to be able to fill orders that come in, but not so much that they are spending a lot of money on storing inventory.

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