Establishing Inventory Ordering Policies

Trying to keep the right amount of inventory on hand is a tricky business. Keep

too much inventory, and you’re wasting money by tying up working capital. Keep

too little inventory, and you’ll miss out on revenue because you won’t have any-

thing to sell to your customers. Two of the most important decisions you can

make are when to order more inventory and how much to order. The approach you

use to make that decision is called your inventory policy.

Start with the question of when to order more inventory from your suppliers. You

may need to place an order when your current inventory levels drop below a cer-

tain level, in which case the current inventory level is the trigger for your inven-

tory policy. Or you may want to order inventory on a set schedule, such as once a

week, in which case your inventory policy is built on periodic orders. Triggering

orders based on inventory levels is usually more efficient than periodic orders. But

suppliers often schedule deliveries periodically because it is more convenient for

them. So you need to understand the dynamics of a particular supply chain to

make the best decision about which inventory trigger to use.

The next question is how much to order. A mathematically precise approach to

calculating your lot size is called the economic order quantity (EOQ). The EOQ for-

mula balances the cost of placing an order against the cost of holding inventory.

This formula works well on paper but usually needs to be tweaked to work in the

real world. You might calculate that your EOQ is 15 widgets but discover that wid-

gets actually come in packages of 20, for example. You also need to consider other

factors when deciding how much to order, such as when a big promotion is com-

ing up and whether you expect to have increases or decreases in demand for a

product

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