Inventory Management: ABC Analysis and EOQ Frameworks

Effective inventory management balances the cost of carrying stock against the risk of stock-outs. Practitioners use two foundational frameworks to optimize this balance: ABC Analysis (prioritization) and Economic Order Quantity (replenishment math).

1. ABC Analysis (Pareto Principle)

Not all SKUs are created equal. ABC analysis categorizes inventory based on its annual consumption value (Unit Cost $\times$ Annual Demand).

Class A (80/20 Rule): ~20% of SKUs accounting for ~80% of value. Requires tight control, frequent audits, and accurate forecasting.
Class B: ~30% of SKUs accounting for ~15% of value. Moderate control.
Class C: ~50% of SKUs accounting for ~5% of value. Low control; prioritize avoiding stock-out of low-cost items (e.g., bin-stock).

2. Economic Order Quantity (EOQ) Math

The EOQ formula determines the optimal order size that minimizes the sum of Ordering Costs (S) and Holding Costs (H).

\text{EOQ} = \sqrt{\frac{2DS}{H}}

Where:- $D$ = Annual Demand (units). - $S$ = Setup or Ordering Cost per order ($). - $H$ = Holding or Carrying Cost per unit per year ($).

Concrete Example: Industrial Component Replenishment

Consider a high-value sensor (Class A):

Demand (D): 10,000 units/year.
Order Cost (S):$50 (Admin + Shipping).
Holding Cost (H): $4/unit/year (Capital cost + insurance).

Calculation:

\text{EOQ} = \sqrt{\frac{2 \times 10,000 \times 50}{4}} = \sqrt{\frac{1,000,000}{4}} = 500 \text{ units.}

Insight: Ordering 500 units at a time ensures the warehouse isn't overstocked with expensive sensors while minimizing the number of purchase orders issued (20 orders/year).

3. Safety Stock and Service Levels

Safety Stock ( $SS$ ) is the buffer against demand variability during lead time:

SS = Z \times \sigma_d \times \sqrt{L}

- $Z$ = Service level factor (e.g., 1.645 for 95% service).- $\sigma_d$ = Std Dev of demand. - $L$ = Lead time.

4. Inventory Performance Metrics

Metric	Definition	Target
Inventory Turnover	COGS / Average Inventory	High (indicates efficiency)
Days Sales of Inv (DSI)	(Inventory / COGS) * 365	Low (minimizes capital tie-up)
Fill Rate	% of orders fulfilled from stock	>98% for Class A
Stock-Out Rate	% of lost sales due to no stock	<1% for critical items