Corporate Value Creation: An Operations Framework for Nonfinancial Managers

APPENDIX F

Inventory Considerations and the EOQ Model

INTRODUCTION

Inventory management and control is one of the business areas that has been extensively quantified and heavily impacted by operations research. The basic inventory model is known as the Economic Order Quantity Model, which has been used for many years for inventory management. The “gold standard” is an EOQ = 1. As will be seen in this appendix, there are many factors that impact the EOQ and complicate the task of minimizing inventory and make unitary EOQ's out of reach.

COMPONENTS OF INVENTORY COSTS¹

Inventory represents a major investment for most manufacturing companies. The cost of inventory has three broadly defined components:

1. Carrying costs
2. Shortage costs
3. Procurement costs

Carrying costs represent the cost of physically having inventory on hand. They include costs such as financing, inventory management, facilities, insurance, depreciation, and obsolescence. These costs tend to mount as the quantity of inventory on hand increases.

Shortage costs are those costs incurred by a company when its production operations run out of parts and include such costs as idle direct labor, production disruption, scheduling changes, diversion of sales and marketing efforts for customer hand-holding, lost sales, and loss of ...