Inventory Control Systems, Explained with Examples

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Inventory Control Systems

Quantitative Analysis · Chapter 4: Inventory Management and QueuingSection 4.4 · lesson 15 of 5514 min · free with a free account

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In this lesson

Keeping track of what you have - when to reorder, how much to order, and which system fits which item.

  • Describe the continuous review (Q) and periodic review (P) systems and their trade-offs
  • Set the target level S in a P system from demand over (T + L) plus safety stock
  • Classify items with the ABC system and apply the Pareto principle to management effort
  • Weigh the Just-in-Time trade-off and match a control system to a given item

Transcript

Everything said in the video, section by section (2,136 words). Read along, or search it.

Inventory Management and Queuing · Section 4.4

Inventory Control Systems

Welcome to section four point four, Inventory Control Systems. Every business that holds stock keeps answering the same two questions. When should we reorder? And how much should we order? There is no universal answer, and that is the honest starting point. It depends on the item's value, the steadiness of demand, and the reliability of the supplier. It also depends on what a stockout would actually cost you. In this section we compare four approaches: continuous review, periodic review, ABC classification, and Just in Time. You will learn to set a target stock level for a periodic system. You will sort a catalog by value, and give each class the control it deserves. And you will see what happened when the leanest supply chains in the world met a pandemic.

Two Questions

Why Inventory Needs a Control System

Inventory is one of the largest assets on a typical balance sheet. It is also one of the largest sources of avoidable cost. That double character is the whole problem in one sentence. Hold too much, and capital is tied up in stock that may obsolesce or depreciate. Some of it will simply sit there, taking up space and earning nothing. Hold too little, and you risk a stockout. Stockouts lose sales, frustrate customers, and disrupt production. An inventory control system balances those two failures. It decides when to replenish, and how much to order. Now the part students most want to argue with. There is no single best system. It depends on item value, on how predictable demand is, on how often the item sells, and on how badly a stockout hurts. Most organizations run several systems in parallel. Tight control on expensive items, looser rules on cheap ones.

Continuous Review

The Q System (s, Q) - Watch Always, Order a Fixed Amount

The first approach is continuous review, usually called the Q system. It monitors inventory in real time. The moment stock falls to a predefined reorder point, an order fires automatically. The reorder point is written as a lower case s. The order is always the same size, a fixed quantity Q. Notice carefully what the trigger is. It is the stock level itself, not a date on the calendar. So orders go out exactly when they are needed, no sooner and no later. The quantity is fixed. What floats is the time between orders. If demand rises, orders happen more frequently. If demand falls, they happen less often. That responsiveness has a price, and the price is tracking. Point of sale systems, barcode scanning or radio frequency tags update stock with every transaction. Continuous monitoring costs more in technology and staff time. What you buy with that spend is speed. The system sees a demand surge immediately, so you can carry less safety stock. That is why the Q system belongs on high value or high demand items, where a stockout really hurts.

Periodic Review

The P System (T, S) - Check on a Schedule, Top Up to Target

The second approach is periodic review, the P system. Here inventory is checked only at fixed intervals. Every T periods, whether that is a week, a month or a quarter, someone looks at the stock level. An order is placed to bring inventory back up to a target level S. This is the mirror image of the Q system. The interval is fixed, and the order quantity floats. Each cycle you order exactly the gap between current stock and the target. In plain language, every T periods, top up to S. The operational advantage here is coordination: one supplier delivery can cover many items at once, cutting transaction and shipping costs. Monitoring is cheaper too, because stock is only counted on a schedule. But there is a cost, and the next slide is about it. A P system needs more safety stock than a Q system. That makes it the natural fit for low value items, and for suppliers who deliver on a fixed schedule.

The Target Level

Setting S - Why the Exposure Window Is T + L

Here is the idea that makes the P system work, and the one most often got wrong. A P system does not look at stock between reviews, so it cannot react to what happens there. So it must cover demand during the lead time L, exactly as a Q system does. But it must also cover demand during the review interval T itself. The formula follows directly. The target level S equals expected demand during T plus L, plus safety stock. T is the review interval, how often you count and order. L is the supplier lead time, how long an order takes to arrive. Safety stock is the buffer that absorbs variability across the whole exposure window. And that window is the crux. A Q system's safety stock only has to survive the lead time. A P system's has to survive the review interval and the lead time together. So there is a trade you cannot escape. Stretch the review interval to save monitoring cost, and the buffer must grow.

Side By Side

Q System vs. P System

Let us put the two systems side by side. They differ on one hinge, and everything follows from it. That hinge is what triggers the order. In a Q system the trigger is the reorder point. In a P system it is the calendar. Q orders a fixed quantity at variable times. P orders a variable quantity at fixed times. Q needs continuous monitoring, with point of sale, barcode, radio frequency or enterprise systems behind it. P often needs nothing more than a manual count on review day. Q covers the lead time with safety stock. P covers the review interval and the lead time. Administrative cost is higher for Q, and lower for P. Q suits high value, high demand items where stockouts hurt. P suits low value items, joint replenishment, and suppliers on fixed schedules. Here is the sentence worth remembering. Fix the quantity and the timing floats. Fix the timing and the quantity floats.

ABC Classification

Matching Control Intensity to Financial Stakes

Two systems, then. Now we need a rule for deciding which items get which, and that rule is ABC classification. It starts from the Pareto principle, an empirical observation rather than a law. Roughly eighty per cent of value comes from about twenty per cent of items. Apply that to a stockroom and the implication is immediate. Not every item deserves the same attention. Group items into three classes by their share of total inventory value. A items are about twenty per cent of the stock keeping units, and about eighty per cent of the value. They get tight control, frequent review, low safety stock multiples and continuous monitoring. B items are about thirty per cent of units and fifteen per cent of value. Moderate control, periodic review. C items are about half the units and only about five per cent of the value. They get loose control, large order quantities, infrequent review, and generous safety stock is perfectly acceptable. Now the argument that makes the whole scheme bite. If twenty per cent of items drive eighty per cent of value, then spreading effort evenly is a misallocation.

Exercise

Classifying a Distributor's Catalog

Let us make that concrete. A regional distributor carries fifty stock keeping units across hardware and electrical categories. The procurement manager wants the control system redesigned so that effort is matched to value. Ten representative items are shown, and the arithmetic is simple. Annual value equals annual usage multiplied by unit cost. Item one oh four moves twenty four hundred units a year at eighty five dollars each. That is two hundred and four thousand dollars of annual value, the largest in the sample. Item two one seven moves only six hundred units, but each one costs two hundred and ten dollars. That still comes to one hundred and twenty six thousand dollars, which puts it firmly in class A. Now look at item oh five eight, because this is the instructive one. It is the cheapest of the three A items per unit, at fourteen dollars fifty. But it moves eight thousand units a year, so its annual value is one hundred and sixteen thousand dollars. Compare that with item three two two, at ninety five dollars a unit. More than six times dearer per unit, and still class B, because it moves only four hundred units.

The Procedure

Five Steps From Raw Data to Class

The classification procedure is five steps, and it never changes. Step one, compute annual value for each item, usage times unit cost. Step two, sort all fifty items in descending order of annual value. Step three, compute the cumulative percentage of total value, item by item. Step four, apply the cut-offs. The top items contributing about eighty per cent of value become A. The next items contributing about fifteen per cent become B, and the remaining five per cent become C. Step five, match each class to a control system. Run those steps on the ten sampled items, and the numbers come out like this. The three A items carry four hundred and forty six thousand dollars of annual value. That is seventy seven point two per cent of the sample total, which is five hundred and seventy seven thousand, seven hundred and sixty dollars. The three B items add twenty per cent, taking the cumulative share to ninety seven point two per cent. The four C items contribute the remaining two point eight per cent. One honest caveat. These are ten items sampled from fifty, so the shares approximate the eighty, fifteen, five pattern.

Matching System To Class

Which Control System for Which Class

Classification is only worth doing if it changes what you do. Here is the pairing of class to control system. A items go on continuous review, the Q system. High value justifies real-time tracking and tight reorder discipline, and you minimize safety stock because you can react immediately. B items go on periodic review with a short interval, or a hybrid. Moderate value supports a shorter period, weekly for example. Some firms apply continuous review only to the fast-moving B items, which is a sensible middle path. C items go on periodic review with a long interval, or a two-bin system. Low value does not justify intensive control. Bulk orders and infrequent reviews are fine, and a two-bin method often suffices. Finish with a reflection question worth arguing about. Suppose a supplier offers a four per cent volume discount on an A item, in exchange for switching to a monthly P system. On the two hundred and four thousand dollars that item one oh four buys each year, that is eight thousand one hundred and sixty dollars. Set that against losing continuous visibility on the largest item in the sample, and decide.

Just-in-Time

Lean Inventory as a Philosophy, Not a Formula

The fourth approach is different in kind. Just in Time is not a control formula, it is a philosophy. Hold as little inventory as possible, by synchronizing supply with demand. Materials arrive only when they are needed for production, and finished goods ship as soon as they are made. It was pioneered at Toyota in the nineteen seventies, and it pushes inventory far below traditional norms. What does the organization get back? Lower holding costs, and less working capital tied up in stock. Faster response to product changes, because there is no old inventory to work through first. And a subtler benefit, easy to miss. Quality and process problems surface earlier, because no buffer of stock hides them. But look at what Just in Time demands in return. Reliable suppliers, delivering small batches on time, every time. A late delivery becomes a stockout almost immediately. Stable production processes, because variability in output wrecks the tight schedules the method depends on. Strong supplier relationships, usually long-term contracts, close communication and shared planning systems. High process quality, since defects cannot be absorbed by buffer stock and simply halt the line. And predictable demand, because Just in Time struggles when demand is highly variable or seasonal.

The Reckoning

What COVID Taught About Lean

Those requirements sound like fine print until they all fail at once, which is what the COVID nineteen pandemic did. Supply chains optimized for lean efficiency over decades collapsed under simultaneous shocks. Factory shutdowns, port congestion, container shortages, and rapid swings in demand. Look at the industries that had pushed inventory to absolute minima. Automotive was the most visible, with its global semiconductor shortage. And here is the finding that should stay with you. Savings from years of lean operation could vanish in one quarter. But be careful what conclusion you draw. The lesson was not that Just in Time is wrong. The lesson was that it must be balanced against resilience. Many firms have since adopted hybrid strategies. Lean for predictable, abundant inputs. Buffered for critical or single-sourced components. So, to close, four things to carry away. A Q system orders a fixed quantity when stock hits the reorder point. A P system orders up to a target every fixed interval, cheaper to monitor but heavier on buffer stock. ABC classification tells you where to spend management effort, and it is almost never spread evenly. And Just in Time trades holding cost for supply-disruption risk, a trade the pandemic made unmistakably visible.

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FAQ

Questions students ask us

About Inventory Control Systems

What is the difference between a continuous review (Q) system and a periodic review (P) system?
A continuous review or Q system tracks stock in real time and orders a fixed quantity whenever inventory hits the reorder point, so the timing varies. A periodic review or P system checks stock at fixed intervals and orders whatever brings it up to a target level, so the quantity varies. Q systems suit high-value items where stockouts hurt; P systems suit low-value items and fixed supplier schedules.
How do you set the target inventory level in a periodic review system?
The target level S equals expected demand over the review interval plus the lead time, T + L, plus safety stock. Because a P system does not watch stock between reviews, its buffer must cover the whole T + L window, while a Q system only needs to cover the lead time. Lengthening the review interval saves monitoring cost but requires a larger safety stock.
What is ABC inventory classification?
ABC classification ranks items by annual value, usage times unit cost, following the Pareto principle. A items are roughly 20 percent of items but about 80 percent of value and get tight, continuous control; B items, about 30 percent of items and 15 percent of value, get moderate periodic review; C items, about half the items but 5 percent of value, get loose control. A cheap item can still be class A if it sells in high volume.
What are the benefits and risks of Just-in-Time inventory?
Just-in-Time, pioneered by Toyota, keeps inventory minimal by having materials arrive only when needed. It lowers holding costs and working capital and exposes quality problems that buffer stock would hide. It requires reliable suppliers, stable processes, high quality and predictable demand. The COVID-19 pandemic showed the risk, as in the automotive semiconductor shortage, and many firms now combine lean supply for abundant inputs with buffers for critical parts.

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