Inventory Management: EOQ, Reorder Levels, Just-in-Time and ABC Analysis

Inventory is money that has taken the shape of goods. Too little and the shop shelf is empty, the production line stops and customers leave. Too much and the money is tied up, the goods are damaged, stolen or go out of fashion, and the interest on the funds is paid for nothing.

For a manufacturer or trader inventory is often the biggest single item of working capital, so even a small improvement in how much is ordered and when is worth real money.

This topic covers the objectives of inventory management, the four costs involved, the economic order quantity model and its assumptions, how a discount changes the answer, the reorder level and buffer stock, just-in-time purchasing and production, the periodic review system and ABC analysis, with worked numbers. The next topic covers managing receivables and credit control.

Inventory control appears in the scenario questions as part of a memo on working capital: in May Diet, 2026, Question 1(b) (15 marks) asked for methods other than ratio analysis to manage the working capital of a scooter manufacturer holding about five months of inventory, and the model approach named information technology (IT) based inventory information, making to order, just-in-time suppliers and central supply. Read the cash operating cycle, working capital ratios and overtrading first.

Objectives and costs

Inventory management is the planning, organising and controlling of the flow of goods and materials from the point of origin to the point of use, including storage, tracking and maintenance of the levels held, so as to meet customer demand while minimising cost.

The organisation must balance holding enough inventory to avoid stock-outs (which protects profit from lost sales) against reducing inventory to the lowest level to minimise funding costs (which protects liquidity). The objectives are to optimise inventory levels, to improve inventory turnover, to reduce both stock-outs and overstocking by forecasting demand, and to improve supply chain efficiency.

• Purchase costs: the cost of the materials, allowing for quantity, discounts and other acquisition costs.
• Ordering costs: placing the order (communication and administration), delivery (carriage inwards, logistics) and inspection of goods received.
• Holding (carrying) costs: the interest on the funds tied up (an opportunity cost), storage costs such as rent, utilities and maintenance, insurance, handling, and losses from deterioration or theft.
• Stock-out costs: lost sales, customer dissatisfaction, rush orders, production downtime and emergency purchases.

The economic order quantity

The economic order quantity is the order size that minimises the total of ordering costs and holding costs. Ordering costs each year = cost per order × number of orders = Co × D ÷ Q. Holding costs each year = holding cost per unit × average inventory = CH × Q ÷ 2. Ordering fewer, larger lots reduces ordering cost and raises holding cost; the EOQ is where the two are equal:

EOQ = √(2 × Co × D ÷ CH)

where D is annual demand in units, Co is the ordering cost per order and CH is the holding cost per unit per year (the cost of finance on the price plus storage). Always put demand in units and in the same period as the costs: a monthly demand must be multiplied by 12.

The model assumes: no discounts, constant and known demand, no stock-outs, a known lead time, a known holding cost per unit, a fixed cost per order and no buffer stock.

Example: annual demand is 240,000 units at ₦25; each order costs ₦1,200; the cost of finance is 12% and storage is ₦1.00 a unit a year, so CH = 12% × ₦25 + ₦1.00 = ₦4.00. EOQ = √(2 × 1,200 × 240,000 ÷ 4) = √144,000,000 = 12,000 units, giving 20 orders a year. Ordering cost = 20 × ₦1,200 = ₦24,000; holding cost = 12,000 ÷ 2 × ₦4 = ₦24,000, equal as expected. Purchases are ₦6,000,000.

Quantity discounts

A discount encourages larger orders: ordering cost falls and holding cost rises. To find the best order quantity, calculate the EOQ first, then compute the total cost (purchase + ordering + holding) at the EOQ and at each quantity that earns a discount, and choose the lowest. The holding cost per unit changes with the price, because the finance cost is a percentage of it.

For 24,000 units the price is ₦25 less 1%, holding cost per unit is 12% × ₦24.75 + ₦1.00 = ₦3.97 and the holding cost is 12,000 × ₦3.97; for 40,000 units the price is ₦24.50 (2% off) and holding cost per unit ₦3.94. The lowest total is at 40,000 units, so the discount is worth taking despite the higher holding cost, provided the company can fund and store the larger orders.

Reorder level and buffer stock

The EOQ model assumes immediate delivery. In practice there is a lead time, the period between placing an order and receiving the goods, and demand is uncertain. The reorder level is the inventory level at which an order is placed. With constant demand it equals daily demand × lead time in days. With uncertainty, the company keeps buffer (safety) stock, and the reorder level is maximum daily demand × maximum lead time.

• Buffer stock = reorder level − average usage in the lead time (average demand per day × average lead time).
• Average inventory = Q ÷ 2 + buffer stock. Cost of buffer stock = buffer units × holding cost per unit.
• Maximum inventory = reorder level + reorder quantity − (minimum daily demand × minimum lead time).
• Minimum inventory = reorder level − (average daily demand × average lead time).

Example, with the EOQ of 12,000 and a 300-day year: average demand 800 a day (240,000 ÷ 300), maximum 1,000, minimum 600; lead time averages 10 days, with a maximum of 14 and a minimum of 8. Reorder level = 1,000 × 14 = 14,000. Average use in the lead time = 800 × 10 = 8,000, so buffer stock = 14,000 − 8,000 = 6,000; average inventory = 6,000 + 6,000 = 12,000; the buffer costs 6,000 × ₦4 = ₦24,000 a year. Maximum inventory = 14,000 + 12,000 − (600 × 8) = 21,200; minimum inventory = 14,000 − 8,000 = 6,000.

Just-in-time and other techniques

Just-in-time (JIT) is based on the principle that holding inventory is an expense with no benefit and that producing for inventory adds no value. Materials are obtained only when they are needed and goods are produced only to meet customer orders, so there should be no stock of finished goods.

Its focus is to reduce the capital tied up in inventory, to make production fast and flexible in meeting demand and to eliminate every activity that adds no value. It needs reliable suppliers, short lead times, good quality and close communication; otherwise a delay stops production.

The periodic review system checks inventory at fixed intervals and orders enough to bring it up to a set maximum, so the quantity varies and the timing is fixed. ABC analysis classifies items by the value of annual usage and gives them different degrees of control.

For example, in a store of 1,000 items with annual usage of ₦50m, 150 items (15%) account for ₦35m (70%) and are class A, with tight control and frequent review; 350 items (35%) account for ₦10m (20%) and are class B, with moderate control; 500 items (50%) account for ₦5m (10%) and are class C, with simple controls and larger orders.

The ideas in more depth

Why the EOQ is where the two costs are equal

Ordering cost falls as the order size rises, and holding cost rises with it. The sum is lowest where the two curves meet, because there the extra holding cost of a slightly larger order just equals the saving in ordering cost. This is why setting Co × D ÷ Q equal to CH × Q ÷ 2 gives the formula.

Why a discount can beat the EOQ

The EOQ ignores the purchase price. A discount lowers the price of every unit bought in the year, which is a large amount compared with the ordering and holding costs, so a bigger order can win even though it is not the “economic” quantity. Always compare the totals.

Sources and references

• Inventory is measured under International Accounting Standard (IAS) 2 Inventories, at the lower of cost and net realisable value; the control techniques here are management methods and no standard governs them.

These points are stated as at 5 November 2026.

Worked examples

1. EOQ.
   √(2 × 1,200 × 240,000 ÷ 4) = 12,000 units.
2. Costs.
   20 orders × ₦1,200 = ₦24,000
   12,000 ÷ 2 × ₦4 = ₦24,000.

1. Reorder level.
   1,000 × 14 = 14,000.
2. Buffer.
   14,000 − (800 × 10) = 6,000.

1. Saving.
   ₦6,048,000 − ₦5,966,000 = ₦82,000 a year.

How to answer in the exam

• Put demand in units and in annual terms and build the holding cost per unit from finance cost and storage.
• With discounts, tabulate total costs for each order size and choose the lowest.
• Give the reorder level and buffer stock from the maximum and average figures.
• In a memo, recommend techniques that fit the facts: JIT with reliable suppliers, ABC for control, forecasting and IT systems.

Common mistakes in the exam

• Using monthly demand with annual costs.
• Forgetting to add the finance cost to storage in the holding cost.
• Choosing the discount quantity without comparing total costs.
• Dividing the full order quantity, not half, by two for holding cost.
• Calculating the reorder level on average, not maximum, use and lead time.
• Recommending JIT without noting the need for reliable supply.

Quick revision

• EOQ = √(2CoD ÷ CH); ordering cost = holding cost at the EOQ.
• Discount: compare total cost at each quantity.
• Reorder level = maximum use × maximum lead time; buffer = reorder level − average use in lead time.
• JIT minimises inventory; ABC focuses control on high-value items.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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