Inventory Management Techniques

Why This Matters

Inventory management sits at the heart of global supply operations—it's where cost control, customer service, and operational efficiency collide. You're being tested on your ability to understand why different techniques exist, when to apply them, and how they interact with broader supply chain dynamics like demand variability, supplier relationships, and cash flow management. The techniques in this guide represent fundamentally different philosophies: some prioritize cost optimization through mathematical precision, others focus on risk mitigation, and still others emphasize collaboration and waste elimination.

Don't just memorize definitions—know what problem each technique solves and under what conditions it works best. Exam questions will ask you to recommend approaches for specific scenarios, compare trade-offs between methods, and explain how techniques like JIT and safety stock can coexist despite seeming contradictory. Master the underlying logic of demand-driven replenishment, cost-quantity trade-offs, and inventory classification, and you'll be equipped to tackle any FRQ that comes your way.

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Cost Optimization Models

These techniques use mathematical formulas to find the sweet spot between competing costs. The core principle: every inventory decision involves trade-offs, and quantitative models help you find the optimal balance.

Economic Order Quantity (EOQ)

• Minimizes total inventory costs by calculating the order quantity where ordering costs and holding costs are equal—the mathematical "sweet spot"
• Formula balances two opposing forces: ordering more frequently reduces holding costs but increases ordering costs; EOQ finds the equilibrium point
• Assumes stable demand and costs, making it most applicable for items with predictable consumption patterns and consistent pricing

Reorder Point (ROP)

• Triggers replenishment orders at the exact inventory level needed to avoid stockouts during lead time—calculated as $ROP = (Average Daily Demand) \times (Lead Time) + Safety Stock$
• Bridges EOQ and real-world uncertainty by accounting for the time lag between placing and receiving orders
• Critical for service level maintenance, as setting ROP too low causes stockouts while setting it too high ties up working capital

Min-Max Inventory Control

• Establishes clear boundaries with minimum levels triggering orders and maximum levels capping inventory investment
• Simplifies decision-making by providing straightforward thresholds—when stock hits minimum, order enough to reach maximum
• Works best for items with moderate value where sophisticated optimization isn't cost-justified but some structure is needed

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Demand-Driven Replenishment Systems

These approaches determine when and how often to review inventory and place orders. The key distinction: continuous systems offer precision but require more resources, while periodic systems trade some responsiveness for simplicity.

Continuous Review System

• Monitors inventory in real-time and triggers orders immediately when stock reaches the reorder point—no waiting for scheduled reviews
• Ideal for high-value or critical items where stockouts carry significant costs and justify the investment in constant monitoring
• Requires robust tracking systems, typically supported by barcode scanning, RFID, or integrated ERP software

Periodic Review System

• Reviews inventory at fixed intervals (weekly, monthly) and orders variable quantities to bring stock up to target levels
• Reduces administrative burden by consolidating ordering activities into scheduled cycles rather than responding to continuous triggers
• Best suited for stable-demand items where the risk of stockout between review periods is acceptably low

Materials Requirements Planning (MRP)

• Calculates material needs backward from production schedules, ensuring components arrive precisely when manufacturing requires them
• Coordinates dependent demand items—items whose demand derives from the production of finished goods—across complex bills of materials
• Integrates with master production schedules to synchronize purchasing, production, and inventory across the entire operation

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Waste Elimination and Flow Optimization

These philosophies prioritize eliminating excess inventory and creating smooth, efficient material flows. The underlying principle: inventory often masks problems, and reducing it forces operational improvement.

Just-in-Time (JIT) Inventory

• Receives materials only when needed for production, dramatically reducing holding costs and warehouse space requirements
• Exposes supply chain weaknesses by eliminating the buffer that hides supplier unreliability, quality issues, or demand forecasting errors
• Demands exceptional supplier partnerships with reliable delivery, consistent quality, and geographic proximity or logistics excellence

Lean Inventory Management

• Treats excess inventory as waste (muda in lean terminology) that consumes capital, space, and management attention without adding customer value
• Drives continuous improvement by systematically identifying and eliminating the root causes of inventory accumulation
• Aligns stock levels tightly with actual demand, using pull systems rather than forecast-driven push approaches

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Risk Mitigation and Buffer Strategies

These techniques acknowledge uncertainty and build protection against supply chain disruptions. The core trade-off: buffers cost money but prevent costly stockouts and lost sales.

Safety Stock

• Buffers against demand variability and supply disruptions by maintaining inventory beyond what's needed for average conditions
• Calculated using statistical methods that consider demand standard deviation, lead time variability, and desired service level—$Safety Stock = Z \times \sigma_{demand} \times \sqrt{Lead Time}$
• Represents a deliberate trade-off between inventory carrying costs and the cost of stockouts, including lost sales and customer dissatisfaction

Consignment Inventory

• Shifts inventory ownership risk to suppliers who retain title until goods are sold or consumed by the customer
• Improves customer cash flow by eliminating payment for goods sitting on shelves—payment occurs only upon use or sale
• Requires trust and transparency between partners, typically supported by shared data systems and clear contractual terms

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Inventory Classification and Prioritization

These methods recognize that not all inventory deserves equal attention. The principle: focus management resources where they create the most value.

ABC Analysis

• Classifies items by value contribution: A items (typically 10-20% of SKUs, 70-80% of value), B items (moderate value), and C items (high volume, low value)
• Directs management attention strategically—A items get tight controls and frequent review; C items get simplified, low-cost management approaches
• Based on Pareto principle that a small percentage of items typically drives the majority of inventory value and business impact

Cycle Counting

• Audits inventory accuracy continuously by counting subsets of items on rotating schedules rather than conducting disruptive annual counts
• Prioritizes counting frequency by item class—A items might be counted monthly, C items annually, matching effort to importance
• Identifies and corrects discrepancies proactively, improving record accuracy and enabling more reliable planning and ordering decisions

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Inventory Flow Methods

These techniques determine which units are used or sold first, affecting both operations and financial reporting. The choice impacts spoilage risk, tax liability, and balance sheet valuation.

First-In, First-Out (FIFO)

• Uses oldest inventory first, ensuring stock rotates properly and reducing obsolescence and spoilage risk
• Essential for perishable goods including food, pharmaceuticals, and any product with expiration dates or shelf-life concerns
• During inflation, reports higher profits because older, lower-cost inventory is matched against current revenues

Last-In, First-Out (LIFO)

• Uses newest inventory first, matching recent costs against current revenues for potentially significant tax advantages during inflationary periods
• Can leave old inventory sitting indefinitely, creating obsolescence risk and potentially misleading balance sheet valuations
• Prohibited under IFRS (International Financial Reporting Standards), limiting its use to U.S. GAAP environments

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Collaborative Inventory Management

These approaches extend inventory management beyond company boundaries to include supply chain partners. The principle: shared information and aligned incentives improve outcomes for all parties.

Vendor Managed Inventory (VMI)

• Transfers replenishment responsibility to suppliers who monitor customer inventory levels and make restocking decisions
• Leverages supplier expertise in their own products' demand patterns and optimal stocking levels
• Requires deep information sharing, typically through EDI or integrated systems that give suppliers visibility into customer inventory and sales data

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Quick Reference Table

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Self-Check Questions

1. A company experiences highly variable demand and long supplier lead times. Which two techniques should they combine, and why might this seem contradictory at first glance?

2. Compare and contrast Continuous Review and Periodic Review systems. Under what specific business conditions would you recommend each?

3. How does ABC Analysis inform the implementation of Cycle Counting? Provide a specific example of how counting frequency might differ across item classes.

4. A food distributor is choosing between FIFO and LIFO. Which factors should drive their decision, and what are the operational and financial implications of each choice?

5. An FRQ describes a manufacturer seeking to reduce inventory costs while maintaining high service levels for critical components. Outline a strategy that integrates at least three techniques from this guide, explaining how they work together.