A single period inventory model is a business scenario faced by companies that order seasonal or one-time items. There is only one chance to get the quantity right when ordering, as the product has no value after the time it is needed. There are costs to both ordering too much or too little, and the company's managers must try to get the order right the first time to minimize the chance of loss.
The Newsboy Problem
The single period inventory model is often explained in terms of the "newsboy problem." A newsboy who stands on the corner and sells papers to passers-by must order the papers the day before. He only has one chance to order because the papers only have any value on the day they are published; the next day they are worth nothing. If he orders too many he'll have to absorb the loss of the unsold papers, and if he orders too few he will have lost profits and annoyed customers. Getting the order quantity correct is how the newsboy makes the most profit.
The Cost of Ordering Too Much
Stocking too much of a seasonal item can lead to large losses for a business. In the case of Christmas cards, for example, sales go to zero on the day after Christmas. The company has the choice of destroying the remaining inventory, selling some at huge discounts or storing them until next Christmas. The latter option may save the cost of the inventory, but will cost the company in warehouse and storage fees. Inventory that is dated, such as magazines or royal wedding memorabilia, may have no market after the date.
The Cost of Ordering Too Little
There are many costs associated with having too little inventory on hand, and not all of them are directly financial. The main cost is the lost opportunity to make profit. The difference between the sales price and the cost multiplied by the number of customers who had to be turned away equals the lost profit. It could even be higher if some customers told others that the company was out of stock and those potential customers did not show up. A more subtle but just as damaging cost is customer goodwill. If customers are expecting to be able to buy a product from you and cannot because you ordered ineffectively, their annoyance can extend farther and they may choose to buy products elsewhere in the future.
Marginal Analysis Approach
The marginal analysis approach is one way to find the order quantity that has the best chance of being correct. The cost of ordering one more unit is compared to the profit gained of ordering another unit. Quantitative analysis is used to determine the economic order quantity based on expected demand and the costs of getting it wrong. Complex calculations are often used to come up with a statistically sound order quantity.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.