Managing Inventories: What is the Appropriate Order Quantity?

Abstract

This note examines a firm's decisions about its cycle of stock-ordering activities and the cost-element considerations behind those decisions. Students learn that, as materials flow from suppliers through a firm's operations to customers, the objective is to develop and implement a management system that can improve the cost effectiveness of the investments in inventory.

Excerpt

UVA-OM-1006

MANAGING INVENTORIES:

WHAT IS THE APPROPRIATE ORDER QUANTITY?

The management of inventories is an important task in nearly every type of organization, from manufacturing firms to hospitals and restaurants. In many manufacturing businesses, in fact, inventory is the single largest asset on the balance sheet. Inventory accounts for nearly 40 percent of the current assets of the typical manufacturing company and for 50 to 60 percent of the current assets in wholesaling and retailing industries. Redesigning the elements of a firm's inventory management system is often the key aspect in improving a firm's working-capital position and its return on assets.

Fundamental questions come up in every inventory system—what is the appropriate order quantity for replenishment of the items recently consumed? Should we order more than we need in the near term in order to get a volume discount from this new supplier? Should we issue a factory production order for several months' supply of an item in order to spread large machinery changeover and set-up costs across a large lot size? Should we be making more or less than our historical standard batch size because the firm's working capital costs have recently fallen sharply? How does a change in the item's manufacturing costs alter our order quantity rules in our computer-based ordering system? Shouldn't we be using an “economic order quantity” lot size formulation for our ordering decisions? What are the relevant costs we should be considering?

Ways to Categorize Inventory and Evaluate Inventory Planning Decisions

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Keywords: economic order quantity, inventory management, relevant costs