Evaluating managerial insights of 2 different models of inventory management.

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Executive Summary

This paper aims at evaluating managerial insights of 2 different models of inventory management. With the purpose of developing inventory policy this paper examines two different models; Economic Order Quantity model and Simulation with an identical hypothetical problem situation. Comparing the Results obtained from the two models illustrated EOQ model to be very simple and easy to use, but in complex and real world situation with an uncertain demand Simulation is the preferred model. 

 


Introduction

The optimal inventory level is delicate balancing act. Inventory decision is complicated because of conflicting goals within departments of a single company. Inventory includes not only on investment in material but also in investment in labor. However, as long as inventory remains with a company it represents a certain cost. The main reasons holding inventory are

  • Cycle – the minimum order amount required to cover the demand
  • Safety - stocks need to be held to avoids stoppage in production due to shortages
  • Stock outs represents a cost to company when production is halted

Inventory is also held in the case of an anticipation of demand trends. Undoubtedly there are costs associated of holding inventory. These are typically made up of the actual price of the product as well as cost associated with their storage  

The optimal management of inventories is one of the primary objectives for all the firms. As propounded by Bertolini and Rizzi, (2002), inventories have important implications for both the financial and the economic performance of the company; therefore it is widely acknowledged that an optimal inventory management policy allows companies to achieve higher profitability levels. In general terms, inventory management policies should be aimed at lowering the holding costs through higher inventory rotation, but without triggering substantial stock-outs and backorders, caused by demand peaks and/or lead time delays.

Different models can be used to formulate an inventory policy, which minimizes the cost associated with inventory. One of the simple and more popular is the Economic Order Quantity method. Although this method makes many simplifying assumptions, it is effective in formulating inventory policies for single periods where demand is trended possibly due to seasonality.

Simulation can also be used to determine alternative inventory policies. As a matter of fact inventory management is all about forecasting the future orders to minimize cost and meeting the uncertain demands. Simulation technique may be applied to practically any decision problem that involves uncertainty. As explained by Whisler and Lapin (2002) simulation is a procedure that imitates real world situation and tries out each alternative over and over again. It uses random numbers to generate the final solution, as if they were determined by spins of a roulette wheel. For this reason this procedure is also called as Monte Carlo Simulation.

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This paper compares the two analytical methods with a selected situation to determine inventory policy and managerial insights.

Economic Order Quantity model: Cited in Whisler and Lapin (2002)

The purpose of the Economic Order Quantity model is to find the quantity of an item to order so as to minimize the total inventory cost.

In an EOQ model there are three component costs involved in the computation

  1. Fixed cost per order (denoted by the variable ‘k’)
  2. Cost of holding $1 of inventory for 1 time-period – usually one year – denoted by the ...

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