What Is Inventory Modeling?

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Inventory modeling is used to determine the correct amount of inventory for a business.
Inventory modeling is used to determine the correct amount of inventory for a business. (Image: Jupiterimages/Photos.com/Getty Images)

Inventory is more than just a line item on a company's financial statements. For many businesses, inventory is a key to their success. In short, inventory is the goods that a business keeps on hand in order to resell to the public. Businesses use inventory models to help them maintain accurate inventory levels.

Inventory Defined

Inventory consists of a business’ merchandise at a given point of time. Inventory is considered a current asset. For a retail business, the inventory consists of all the merchandise the business has for sale on the floor, in storage and in transit. For a company that manufactures goods and sells them to other businesses, inventory is made up of three main divisions – raw materials (e.g. the “ingredients” used to make the product), the “work-in-process” items (e.g. the items that are being put together) and the finished items.

Inventory Modeling

Inventory modeling is the use of financial equations to determine the right quantity of inventory to keep on hand. Inventory models help companies know when to order new inventory and how much is necessary. This is done to ensure that the customer does not have to wait on products and that there is enough, but not too much, product available.

Factors Considered

There are many factors that are considered in determining the optimal inventory level for a business. Some of these include how much it costs to store the inventory, how much it costs to order items for inventory or produce them, and what the business will lose in revenue if there is a shortage of inventory. The business must also consider “safety stock” in its inventory model. Safety stock refers to that inventory that is kept on hand in order to supply customer needs in between the time new inventory is ordered (or produced) and when it is on hand.

Methods

There are various ways of determining the appropriate inventory model for a business. One method often used is the economic order quantity (EOQ) method. The EOQ method is a formula that determines the optimal inventory level to ensure that the business has the lowest cost to house the inventory and the lowest cost to order new inventory. Another method is the fixed order quantity method. The business always orders the same amount of inventory with this method. The single period method is used for items that have a short shelf life and seeks to strike a balance between not having enough inventory and losing customers versus having too much inventory, which leads to spoilage.

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