Inventory management - EOQ, reorder levels, and safety stock

Learning Outcomes

After studying this article, you will be able to explain and apply essential inventory management techniques for ACCA Financial Management (FM). You will learn to calculate the Economic Order Quantity (EOQ), determine reorder levels, and explain how safety stock (buffer inventory) is used to manage uncertainty. You will also recognize the cost implications of holding inventory and the purpose of various inventory management systems.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand inventory management techniques as part of working capital management. Focus your revision on the following key points:

• The objectives of inventory management and inventory holding costs
• Calculation and application of the Economic Order Quantity (EOQ) model
• Determining reorder levels under certain and uncertain demand/lead time
• The role and calculation of buffer inventory (safety stock)
• The impact of inventory management on cash flows and risk of stockouts
• Choice and evaluation of different inventory management systems

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which two main costs does the EOQ model balance?
2. What is the formula to calculate the reorder level when both demand and lead time are certain?
3. True or false? Buffer inventory is only needed if demand or lead time varies.
4. Why might holding large amounts of inventory reduce profitability but also lower risk?
5. Which of the following would increase the required safety stock: a longer lead time or more predictable demand?

Introduction

Inventory management controls the levels of raw materials, work in progress, and finished goods to ensure efficient operations. Poor inventory management can tie up cash unnecessarily or lead to stockouts, causing lost sales or production delays. For the ACCA FM exam, you must know how to determine optimal order quantities, when to reorder, and how to safeguard against uncertainty by holding buffer inventory.

Key Term: inventory management
The process of planning and controlling inventory levels to balance the costs of holding inventory with the risks of running out, ensuring smooth operations and cost efficiency.

THE OBJECTIVE OF INVENTORY MANAGEMENT

The main goal is to keep enough inventory to meet demand without excessive investment. Companies must manage trade-offs between:

• Liquidity: Keeping inventory low to minimize capital invested and storage costs.
• Profitability: Avoiding stockouts that stop production or lose sales.

Too much inventory increases holding costs (such as storage, insurance, and opportunity cost). Too little incurs reordering and stockout costs.

Key Term: holding cost
The total of costs incurred from storing inventory, including storage, insurance, deterioration, and the opportunity cost of capital.

Key Term: stockout
A situation where inventory runs out, preventing customer orders from being fulfilled or halting production.

THE ECONOMIC ORDER QUANTITY (EOQ) MODEL

The EOQ model finds the order size that minimizes the total cost of ordering and holding inventory when demand and lead time are known and constant.

• Ordering costs: Fixed costs per order, such as administration and delivery charges.
• Holding costs: Cost to keep inventory in storage.

The EOQ formula:

Where:

• $C_0$ = cost of placing one order
• $D$ = annual demand (units per year)
• $C_H$ = cost of holding one unit for one year

Ordering in the EOQ quantity minimizes the total annual cost.

Key Term: Economic Order Quantity (EOQ)
The order quantity that minimizes total annual inventory costs by balancing ordering and holding costs, under assumptions of constant demand and lead time.

Worked Example 1.1

A company expects to use 18,000 units of a part per year. The cost per order is $100, and holding cost is $2 per unit per year. What is the optimal order quantity according to the EOQ model? Round your answer to the nearest whole unit.

Answer:

Exam Warning

The EOQ model assumes no quantity discounts and constant demand and lead time. For exam questions, check carefully for any discounts or variability and adjust your approach as required.

ORDERING AND REORDER LEVELS

Knowing how much to order is only part of managing inventory—knowing when to order is equally important.

• Lead time: The time from placing an order to receiving it.
• Reorder level (ROL): The inventory level at which a new order should be placed to avoid running out of stock.

When demand and lead time are constant:

Key Term: reorder level
The inventory level that triggers a new order, calculated to ensure new stock arrives before inventory runs out, assuming known demand and lead time.

Worked Example 1.2

A manufacturer uses 300 units per week. Supplier lead time is 4 weeks. What is the reorder level?

Answer:

BUFFER INVENTORY (SAFETY STOCK)

Real-world demand and lead time are rarely constant. Uncertainty means you risk stockouts unless you keep a safety buffer.

• Buffer (Safety) inventory: Extra stock held to cover unexpected increases in demand or supplier delays.
• The size of safety stock depends on the variability of demand and lead time, and on how much risk of stockouts the business is willing to accept.

Key Term: safety stock (buffer inventory)
Extra inventory held to protect against the risk of stockouts due to fluctuations in demand or supplier lead time.

Worked Example 1.3

Suppose average demand is 100 units/day, lead time is 8 days, and demand variability requires holding 200 units as safety stock. What is the correct reorder level?

Answer:

• Minimum required for lead time: $100 \times 8 = 800$ units
• Add safety stock: $800 + 200 = 1,000$ units

So, order at 1,000 units.

Revision Tip

For ACCA FM exams, you will not need to calculate safety stock using probability distributions, but you must understand why it is held and estimate reorder levels based on simple information.

SUMMARY OF KEY STEPS IN INVENTORY CONTROL

1. Calculate EOQ to minimize total inventory costs.
2. Determine reorder level – when to place the next order, factoring in lead time.
3. Assess if safety stock is needed due to uncertainty, and add it to the reorder level.
4. Review costs – balancing the financial impact of holding inventory against the risk of running out.

Key Point Checklist

This article has covered the following key knowledge points:

• Define inventory management objectives and main inventory costs
• Calculate EOQ and identify its assumptions
• Determine reorder levels with or without buffer inventory
• Explain the role and importance of buffer (safety) stock
• Recognize limitations and practicalities in applying EOQ and reorder calculations

Key Terms and Concepts

• inventory management
• holding cost
• stockout
• Economic Order Quantity (EOQ)
• reorder level
• safety stock (buffer inventory)