INVENTORY CONTROL IN THEORY AND PRACTICE*

By T. M. WHITIN I. Current emphasis on inventory control, 502. II. The calculation of economic purchase quaintities and reorder points, 503. III. The interaction of economical purchase quantities and reorder point quantities, 508. IV. Analysis of inventory control problems for style goods, 513. V. The relationship between inventory control analysis, businessmen's behavior, and economic theory, 517.
I. C U R R E N T E M P H A S I S ON INYBNTOKY C O N T E O L

In recent times, inventory control problems have received attention from several different groups. Much logistics research has been devoted to the topic, both within the National Military Establishment and in military contracts at several universities. Projects under the supervision of Dr. C. B. Tompkins at George Washington University and Dr. Jacob Wolfowitz at Cornell have made considerable progress in the field on both theoretical and practical levels. Econometricians, also, have shown much interest in the topic; for example, Lloyd A. Metzler's description of self-generating inventory cycles appeared in 1941.^ More recently, articles have been written by Morehouse, Strotz, and Horwitz^ on an electro-analog method for investigating problems in dynamic economies, by Arrow, Harris, and Marschak' on "Optimal Inventory Policy," and by Dvoretzky, Kiefer, and Wolfowitz* on "The Inventory Problem." During recent months, businessmen also have become increasingly aware of the importance of inventory problems. Inventories of many types of goods have risen to extremely high levels this factor was instrumental in bringing about the price war in department
* The research for this article was done under Office of Naval Research Contract N6onr-27009. 1. Lloyd A. Metzler, "The Nature and Stability of Inventory Cycles," Review of Economic Statistics, August 1941, pp. 113-29. 2. N. F. Morehouse, R. H. Strotz, and S. J. Horwitz, "An Electro-Analog Method for Investigating Problems in Dynamic Economies: Inventory Oscillations," Econometrica, October 1950, pp. 313-28. 3. Kenneth J. Arrow, Theodore Harris, and Jacob Marschak, "Optimal Inventory Policy," Econometrica, July 1951, pp. 250-72. 4. A. Dvoretsky, J. Kiefer, and J. Wolfowitz, "The Inventory Problem: I. Case of Known Distributions of Demand," Econometrica, April 1952, pp. 186222, and "The Inventory Problem: II. Case of Unknown Distributions of Demand," Econometrica, July 1952, pp. 450-66. 502

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stores last spring. At the same time, inventory shortages of many other types of goods such as durable producers' goods, scrap metal, rubber, etc., are anticipated. The Defense Production Authority was set up to aid in controlling inventories of critical materials. Economic theorists too have begun to realize that they have neglected to acknowledge the importance of inventories both in the theory of the firm and in business cycle theory. Recent books by Boulding' and Abramovitz' have emphasized the past neglect by economists in this respect and have stressed the importance of inventories. In recent years the statement has often been made that "any resemblances between the models constructed and reality are purely coincidental," but such a statement is unnecessary here. In the field of inventory control, situations do exist to which extremely simple models can be (and in many instances have been) applied. To aid exposition, much of the discussion will be carried on in terms of a few specific and simple models.
II. THE CALCULATION OF ECONOMIC PURCHASE QUANTITIES AND REORDER POINTS

The best known "scientific" inventory control system involves the calculation of economical purchase quantities and reorder point quantities. Several authors' independently arrived at the same basic formula for determining economical purchase quantities in the 192O's. A number of different factors contributed to the development of such formulas. First of all, the increasing size of business establishments has played an important role. It was possible for most firms in the past to make use of highly inefficient inventory control methods and yet still maintain profit margins. Modern large-scale enterprises often operate with small profit margins which might well be eliminated by poor inventory control methods. Furthermore, size in itself makes obvious the existence of possibilities of substantial savings through improvement in inventory control. 5. Kenneth E. Boulding, A Reconstruction of Economics (New York: John Wiley and Sons, 1950).
6. Moses Abramovitz, Irwentories and Business Cycles (New York: National Bureau of Economic Research, 1950). See also T. M. Whitin, The Theory of Irwentory Management (Princeton: Princeton University Press, in press). 7. George F. Mellen, "Practical Lot Quantity Formula," Management and Administration, September 1925, p. 155. Ralph C. Davis, "Methods of Finding Minimum-Cost Quantity in Manufacturing," Manufacturing Industries, April 1925, pp. 353-56.

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Secondly, during the past century, there has been an enormous increase in the amount of business training. High schools now offer some business preparatory courses, and the growth of business administration colleges has been extremely rapid. This additional training has made recent generations of businessmen more aware of improvement possibilities. Also, trade publications on market research, purchasing, retailing, standardization, and many other topics have contributed much to businessmen's understanding of the various problems which confront them. A third factor that has aided the transition to modern inventory control methods is the increased emphasis that has been placed on the importance of engineers in business. The entrance of many trained engineers into business has brought with it the "scientific" approach, including scientific methods of production control, factory layout, standardization, etc. Also, cost accounting has helped entrepreneurs to evaluate the performance of various departments of their establishments, thus indicating specific areas where better control may be needed. A final factor that gave impetus to research on inventory control was the "inventory depression" of 1921, which taught businessmen to be extremely wary of inventory accumulation. As a result of these factors, formulas for determining economic purchase quantities have been derived. These formulas involve a simple application of elementary differential calculus to inventory control. The economic purchase quantity may be determined in the following manner. Two different sets of cost factors must be considered, namely, those which increase as purchase quantities increase and those which decrease as purchase quantities increase. Among those costs which increase are interest, obsolescence, risk, depreciation, storage, etc., while the forces making for decreasing costs include such items as quantity discounts, freight differentials, and procurement costs. In the following example, assume that the expense of procurement is constant and that interest, risk, depreciation, obsolescence, etc., may be lumped into one percentage figure (7). Let Y designate expected yearly sales (in $), Q be the economic purchase quantity (in $) and S be the procurement expense (in S). Then total annual variable costs involved in ordering and carrying purchase Q Y quantities may be expressed as follows: TVC =~ I -\- S. Differ-

entiating with respect to the purchase quantity, Q, and setting the derivative equal to zero, the solution

INVENTORY CONTROL IN THEORY AND PRACTICE Q

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results, where Q is the purchase quantity that minimizes combined ordering costs and carrying charges. This economical purchase quantity is thus seen to vary with the square root of sales and inversely with the square root of the carrying charges. This formula has been used in business and its use has been accompanied by good results. A similar formula can be used for calculating economical manufacturing lot sizes by using set-up costs (costs involved in tooling up and preparing for production of each lot) instead of procurement costs in the formula. Cleveland's Osborn Manufacturing Company brought about a saving of 18 per cent in combined set-up costs and carrying charges by applying this simple formula. A second basic facet of inventory control is the determination of reorder points. The reorder point quantity (expressed in terms of physical units) consists of two parts: (1) The first part is the amount necessary to fulfill mean expected demand during the replenishment period. (2) The second part is a safety allowance to provide protection against depletion due to variations in demand. If demand is certainly known as well as the time interval between the placing of orders and the arrival of the goods ordered, no safety allowance is necessary. But since, in most cases, levels of demand are at best not known precisely, it is necessary to have safety allowances. The optimum level of these allowances is determined by consideration of the costs and benefits resulting from storing additional units. As units are added to the safety allowance, the probability of depletion is reduced, and hence costs resulting from depletion are incurred with a smaller probability. However, additional costs such as interest, insurance, depreciation, risk, etc., are also incurred as the safety allowance is increased. For some level of safety allowance, the cost of storing an additional unit is balanced by the expected savings through avoidance of depletion. This level is the optimum level, for a net loss results from moving from it in either direction. The optimum safety allowance level is therefore one for which the probability of depletion brings into balance the expected costs of depletion and carrying charges for the marginal unit. If this probability level is kept constant, then safety allowances must vary with changes in lead time and in expected demand distribution. After finding appropriate probability levels for various inventory items.

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safety allowances should be set at levels which provide this desired amount of protection against depletion. In the event that an entrepreneur sets safety allowances so that he runs out of the item in question only a certain percentage of the time periods, it can be shown that the amount of inventory in the safety allowance varies with the square root of expected demand. If it is assumed that the demand distribution can be approximated by the Poisson distribution when the entrepreneur expects to run out infrequently, the probability of depletion can be obtained from Molina's tables.* Dr. Churchill Eisenhart' has given lectures on the determination of safety allowances. In one of his examples an average weekly demand of 24 units made a safety allowance of 12 units necessary if the entrepreneur was to run out of the item only one week in a hundred. If the average weekly demand increased to 100 units a week, a safety allowance of 24 was necessary. Thus a quadrupling of sales was accompanied by only a doubling of the safety allowance, yet the same degree of protection was maintained throughout. Eisenhart used the direct normal approximation to the Poisson distribution, which brings out the square root relationship clearly. Let K represent the number of a particular item on hand at the beginning of the week that will reduce the probability of running out during the week to 1/100. Let D be the number of units in the average weekly demand. Then K = Z) + 2.326 /Jj^ The safety allowance, K D, is then equal to a constant times the square root of D. In practice, most govemment agencies and private establishments do not apply safety allowance analysis. The level of safety allowances should be adjusted in accordance with the following factors: (1) The costs of depletion. The higher the costs of depletion, the higher the safety allowance should be. Although this would seem to be common sense, a great many establishments make no distinction whatever between the relative importance of items when they set their safety allowances. In an inventory control plan already in use in several large corporations, it has been found useful to divide items
8. E. C. Molina, Poisson's Exponential Binomial Limit (New York: D. Van Nostrand Company, 1942). 9. Churchill Eisenhart, So7ree Inventory Problems, National Bureau of Standards, Techniques of Statistical Inference A2.2c, Lecture 1, January 6, 1948, hectographed notes.

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into a few general categories according to some scheme such as the following: Very important items: allowances set in such manner that it is planned to run out of these items only once every eight years. Moderately important items: allowances set in such manner that it is expected that stock-outs will occur once every two years. Unimportant items: allowances set at levels such that stock-outs will occur once every year. The savings in inventory carrying charges brought about by such schemes are likely to be substantial. A study at the Bell Telephone Laboratories revealed the following:
Average Number of Years Each Item WiU Go Out of Stock Once Required Inventory

1 2 5 10 "never"

$ 76,000 100,000 134,000 167,000 276,000

This indicates the great change in safety allowances that correspond to different levels of protection against depletion. Even in the absence of adequate methods for measuring the costs of depletion, substantial savings can often be brought about through a crude partial ordering of inventory items. (2) A second factor that has a great deal of infiuence on the safety allowance is the length of the period between placing orders and the delivery of the goods ordered. As the length of this period is increased, safety allowances should be increased if the level of protection against depletion is to be maintained. Often safety allowances are set at a constant level (in terms of a certain number of days or months supply), irrespective of differences in delivery time. The delivery time should affect safety allowance levels, although the effect may not be of a simple nature in some cases. Dr. Tompkins has pointed out that complications may arise. For example, the costs of depletion may be dependent upon the length of time stocks are depleted, perhaps in a complicated manner. (3) A third factor that should be taken into consideration when safety allowances are set is the variability of demand. In a large majority of government and private institutions, this factor is given extremely little consideration. Often the mean expected demand estimates are used. If the mean expected dem.and for two items were the same, the same safety allowance would be established for both items, although the demand for one of the items might be subject to practically no variation and the demand for the other subject to

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extreme variations. It should be quite apparent that the degree of protection provided for these two items would not be nearly the same. (4) Finally, the lower the carrying charges, the larger the safety allowances should be. In spite of these considerations, safety allowances are often set at the same levels (in terms of number of months' supply) for all items in an establishment in spite of substantial differences in relative importance of items, in delivery times, in demand distributions, and in carrying charges.
III. THE INTERACTION OF ECONOMICAL PURCHASE QUANTITIES AND REORDER POINT QUANTITIES

Thus far, nothing has been said about the effect that the reorder point quantity has upon the economical purchase quantity. However, such an interaction does in fact exist. Although many articles have been written on the determination of purchase quantities and reorder point quantities,^ little mention has been made of any connection between the two. With the exception of an article by R. H. Wilson^ (which did not describe the relationship correctly) the intimate relationship between purchase quantities and reorder point quantities seems to have passed unnoticed. The following discussion describes the connection in detail and shows how the economical purchase quantity and reorder point quantity for any given set of data can be readily obtained. The following assumptions are made: (1) Costs involved in placing an order are constant. The costs of placing an order may be estimated by dividing the total administrative costs involved in purchasing by the number of orders. Although difference in costs of different orders are ignored in such an average, these differences will not be of great importance in the event that the costs of ordering are reasonably homogeneous. Another possible estimate of the costs involved in placing an order might be made by 1. G. F. Mellen, "Practical Lot Quantity Formula," Management and Administration, Vol. 10, No. 3, 1925, p. 155. H. S. Owen, "The Control of
Inventory Through the Scientific Determination of Lot Sizes," in nine installments. Industrial Management, Vols. 70 and 71, 1925 and 1926. R. H. Wilson, "Inventory Cut 42%," Purchasing, Vol. 9, No. 2,1940, pp. 49-53. G. Pennington, "Simple Formulas for Inventory Control," Manufacturing Industries, Vol. 13, No. 3, 1927, pp. 199-203. C. B. Tompkins, "Determination of a Safety Allowance," Engineering Research Associates, Inc., Logistics Papers, Issue No. 2, Appendix I to Bimonthly Progress Report No. 18, Submitted under Contract N6onr-240-Task Order I. R. H. Wilson, "A Scientific Routine for Stock Control," Harvard Business Review, Vol. XIII, No. 1 (October 1934), pp. 116-128. 2. R. H. Wilson, "A Universal System of Stock Control," Purchasing Vol. 11, No. 3, 1941, pp. 80-96.

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means of time studies. It must be realized that total ordering costs would probably be a nonlinear function of the number of orders placed. Nevertheless, a linear function may be a good approximation. (2) The number of units sold in the reorder period varies in accordance with the Poisson distribution. This assumption has been made by many authors' and is applicable to problems of the probability of points falling on a line interval or of events occurring within a time interval under the following conditions:^
Assumption 1: The probability of a demand for an item at any particular instant of time (in the interval between stocking points) is the same as the probability of a demand for the same item at any other instant of time (in the time interval) i.e., the likelihood of a demand being made at 1000 o'clock on a Tuesday is the same as the likelihood of a demand being made at 1420 o'clock on Thursday. Assumption 2: The probability of a demand for 5 units, say, of an item in one day is independent of the number of units already demanded during that day or any hour of that day (or any other day).

(3) In determining the economic purchase quantity and the safety allowance, the entrepreneur tries to minimize total variable costs. (4) The costs which vary with changes in the purchase quantity are assumed to be:
(a) ordering costs, (b) carrying charges (including interest, obsolescence, insurance risk, depreciation, etc.), (c) expected losses from depletion.

(5) The costs which vary with changes in the reorder point level are:
(a) carrying charges on the safety allowance, (b) expected losses from depletion.

(6) The cost of each unit demanded but not in stock is constant. This assumption might be modified but such modifications would greatly increase computational difficulties. The following symbols will be used for data required: Y = yearly sales estimate, in $ at cost value. I = carrying charges, %. C = unit cost, in $. IT = unit cost of depletion, in $. S = ordering cost, in $.
3. T. C. Fry, Probability and its Engineering Uses (New York, 1928), p. 218. C. Eisenhart, op. dt., p. 3. 4. J. S. Rhodes, Scientific Determination of Stock Level Requirements, Study No. 13, Standards Evaluation Branch, Planning Research Division, Program Standards and Cost Control, U. S. Air Force, pp. 9-10, 1950.

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The following symbols will be used for the unknowns in the problem: Q = the economic purchase quantity, in $. k = the reorder point, in physical units. Total variable costs for a year, therefore, consist of ordering costs, carrying charges, and expected losses from depletion. Annual ordering costs equal the ordering cost {S) multiplied by the number of times a year orders are placed (Y/Q). Annual carrying charges may be expressed as the carrying charge (/) multiplied by the average amount of stock carried (Q/2 + {k ujC). In the last expression, u is the average number of units demanded during the replenishment period, (fc u) therefore represents the number of units that, on the average, are kept as a safety allowance, and (k u) C is the cost of those units. The expected losses from depletion are equal to the product of the unit cost of depletion, 7r; the average number of units demanded but not available in a replenishment period; and the number of replenishment periods a year, Y/Q. The number of units demanded but not available during a replenishment period may be represented by the following expression: 2
m.=k + l

(m
ml

fc)

where

m = actual number of units demanded during the replenishment period, u = average number of units demanded during the replenishment period, fc = reorder point. The above equation may be simplified for computation: 2
m~k+l

{m- k) - =

- - k

-,

m-k + l {m 1)1 Letting p = m 1, m=k + l

m-=*+l W i

(m - fc) - - = M ^ ; - ~ k ^ m! P - * p.' m-*+l m!

Tml

Since the distinction between m amd p is purely formal,

(m k) m=* ml m=*+i ml = M 2/ ; k ^ _[.. (u fc) 2 k! m-'k+i ml

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This last expression lends itself to simple calculation, as values for and 2 can be obtained from Molina's tables.* fc.' m-t+i mt The expression for total variable costs (TVC) may be obtained from summing its three components:

TVC = S-\-l[^-\-{k-u)c] + T-[''^^^-{-{u-k)

Q L2 J QL fc.'

m=*+i ml J

2 ?^1.

Setting the partial derivative and difference with respect to Q andfcrespectively equal to zero, and solving for Q, the following equations are derived:

-^ (w - fc) 2 -^y^i =
SQ Q^ 2 Q^L kl
-u k

m-t+i

ml J

(1)

Q = /C+ T T +

fc.' m=*+i m!

ATVC Afc

( _fc_l)
^

S
m=~k+2 ml kl

QL(fc+l).'

-{U-k) This expression may be simplified to:

^ 1

= 0.

m~k + l ml
y r
0 0

70 - X -2 ^-?L = 0. 2 ^-?L QLm=t+i m.' J QL '

p , , "1

(2)

Q = II

2 ^-^.

JC m=k+l m!

Values forfcand values of the data may be inserted in these equations. For some value offcboth expressions for Q will have the same value. These values forfcand Q are thus the solution of simultaneous equations. For values offcgreater than the value offcin the solution, equation (1) results in a higher value for Q than equation (2); and for values offcless than the value offcin the solution, equation (1)
5. E. C. Molina, op. dt 6. For those not interested in following through the mathematical derivation, it may suflSce to state that the mathematics has merely helped us tofindthe values of k and Q that yield the minimum TVC.

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gives a lower value for Q than equation (2). In practice, indivisibility of units makes an exact solution unlikely. Therefore the correct reorder point should be that value offcwhich brings the two values of Q into closer agreement than any other value offcactually achievable. Equation (2) may be obtained readily from consideration of the balancing of carrying charges and expected costs of depletion. The entrepreneur weighs the cost of adding an additional unit to his safety allowance against the expected costs of depletion incurred by not storing the additional unit. It is clear that the entrepreneur will continue to add units to his safety allowance as long as the latter costs exceed the former. Similarly he will reduce his safety allowance if the former costs exceed the latter. The equilibrium safety allowance, then, will be that amount which makes the storage costs of the marginal unit equal to the expected costs of depletion due to not storing the marginal unit. The cost of storing the marginal unit is equal to the product of the carrying charge (/) and the unit cost (C). The expected losses due to depletion during each reorder period if the reorder point isfcunits are:

r e^^'w' -f(w-fc)
M - - - -

kl

m-k + l ml

If the reorder point is increased to (fc-|-l) units, the expected losses are reduced to: u(-(wfc1) ^ (fc-t-1)! m=k+2 ml J The expected loss from not storing the additional unit is equal to the difference between these equations which may be simplified to:
oo

_u. .m

m=*+i ml

(as above).

Since there are Y/Q reorder periods each year, the expected losses per year due to not storing the marginal unit are:
Q m=fc+i ml

Setting the above expression equal to the carrying charge IC and solving for Q gives equation (2). Thus the precise form of interaction between economical purchase quantities and reorder points has been demonstrated. This interrelationship has been almost completely ignored in the literature on inventory control, which has treated the problems as though they

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were independent of one another. Mistakes of this sort have been a frequent cause of divergence between theoretical solutions and reality. By considering more of the interactions between variables, theoretical formulations can be made more realistic. The above type of analysis can also be readily extended to include quantity discounts, price anticipations, and certain other complicating factors. When such factors are included, the analysis has a wider range of applicability.
IV. ANALYSIS OF INVENTORY CONTROL PROBLEMS FOR STYLE GOODS

Inventory control analysis involving the computation of purchase quantities and reorder point quantities is not applicable to all types of goods. For example, in the case of style goods, the costs of not selfing the goods before they are out of style (or out of season),are more than those indicated by a carrying charge figure the goods must often be liquidated at a substantial loss. It might be argued that this is obsolescence and can therefore be included in the carrying charge. However, to do so would be extremely unrealistic. The process of going out of style is likely to be a discontinuous sort of phenomenon, subject to the caprices of a fickle consumer demand. In the case of style goods, ordering costs and carrying charges are not the important variables. In fact, they are often not considered at all by businessmen in the style goods field. Often goods are purchased on a "one purchase" basis, sufficient quantities for the whole season being purchased by the start of the season. For such items, it is apparent that analysis based on a balancing of ordering costs and carrying charges is not applicable. The important variables to be considered in inventory control analysis of style goods are the costs of depletion and the costs involved in liquidating surplus material. Although other variables may be important, it is absolutely necessary that a careful study of these costs be made. Another complication that may arise in the case of style goods is that inventories and sales are not fikely to be independent of one another. An increase in inventories may bring about increased sales of some items. On the other hand, an increased inventory might lead to a decrease in sales of other items. For example, customers confronted with a large inventory of certain style goods might either be influenced by a "snob effect" which would reduce sales or by a "bandwagon effect" which would increase sales.' The net effect of inventory on sales could be detennined only after a careful weighing of these and other factors, a statistical task of no small order. 7. H. Leibenstein, "Bandwagon, Snob, and Veblen Effects in the Theory of Consumers' Demand," this Joumal, May 1950, pp. 183-207.

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This complication can be avoided and the inventory control problem simplified by considering the style goods problem for mail order houses. Here the desired independence between inventory levels and sales is maintained. Also, as will be seen, other simplifications are possible without great deviation from reality. A. A Static Illustration In the mail order business, situations exist that almost exactly fulfill the conditions for an extremely simple static model. The control buyers make important decisions concerning what quantities of the various items should be bought. These decisions to a large extent determine whether the supply of each item is less than, equal to, or greater than the demand. When supply is less than demand, customers' orders cannot be fulfilled, making letters of apology and refunds necessary, as well as losing possible profit opportunities. When supply is greater than demand, the excess usually must be liquidated at a loss. When supply is less than demand, an "omission" is said to occur; when supply is greater than demand, a "surplus." In the long run, the efficiency of the control buyer is tested by his record of omissions and surpluses. When either one of these has risen above a certain level, it is likely that the control buyer must appear before the management to justify his actions. To some extent, the goal of keeping surplus to a minimum is in conflict with the goal of reducing omissions. It is likely that a buyer's record which shows either no omissions or no surplus is evidence of inefficiency, for such a buyer has probably erred in the opposite direction, i.e., the buyer with no omissions has bought too much and the buyer with no surplus has bought too little. The following assumptions are made. Consultation with personnel in a large mail order house led to the conclusion that these assumptions are not in disagreement with reality. (1) During a short "catalog period," inventories for the whole period are purchased at the start of the period. Goods on hand at the end of the period must be liquidated at a loss. (2) Profit margins remain fixed during the period. (3) The average loss per unit of surplus material can be estimated and is constant. (4) The unit cost of omission is constant and can be calculated. (5) Expected sales can be represented by some sort of probability distribution. Those making decisions about how many units to buy must have in mind a probability distribution of expected sales. The nature of

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the distribution may be indicated by data on sales for the period in question during past years, by questionnaires sent to prospective customers, by the intuition of the buyers, or by any combination of these. From the probability distribution, a cumulative probability distribution is readily obtained. To each probability p, there corresponds a number of units, x, the last unit of which has probability p of being sold during the catalog period. For any number of units x, probability p is the probability of selling at least that many units.
Probability

Mean af Expected Sales

Expected Sales

FIGURE I

Let p be the probability of selling an additional unit during the period in question. Therefore, since an additional unit must either be sold or not sold in the period, (1p) is the probability of not selling the additional unit. Let 0 represent the cost of an omission it includes such factors as apologies, refunds, loss of good will, etc. P designates the unit profit for units sold during the period, and L the loss per imit not sold during the period. The expected profit from adding an additional unit to inventory may be expressed as the probability of selling the unit during the period multiplied by the unit profit. This may be represented as -pPThe expected loss from adding an additional unit to inventory may be expressed as the probability of not selling the unit during the period, multiplied by the unit loss. This may be expressed as: The losses due to omissions will be decreased by stocking an additional unit. The decrease in expected losses is equivalent to an increase in expected profit. The probability of incurring this loss

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(profit) is p and the unit cost of omission is 0; hence the expected gain through stocking an additional unit may be expressed as

voIf profits are to be maximized, the expected profits obtainable through stocking an additional unit must be equal to the expected losses. If expected profits are greater than expected losses, stocking an additional unit is to the management's advantage; if expected profits are less than expected losses, then it is not profitable to stock an additional unit. The maximization condition may be written: pP + pO = (1 - v)LSolving for p, L ^ P-\-O + L This equation indicates that profits will be maximized for this value of p. On the cumulative probability diagram, the number of units corresponding to probability p may be read off directly, and indicates the optimum number of units to stock. Certain characteristics of the results show that the intuition of the present buyers does not lead to the same results that the formula does. For example, if the expected sales distributions of each of two items are identical, more units of the lower-priced item should be stocked than of the higher-priced item. Also, control buyers often purchase exactly enough to satisfy mean expected demand. The above analysis indicates that such purchases will not ordinarily maximize profits. B. Extension to Dynamic Examples Probability analysis can readily be applied to dynamic situations as well as to simple static cases such as the above. In a dynamic case closely corresponding to the above static case, loss functions indicating expected loss of profits through omissions during each period and expected losses through surplus at the end of the sequence of periods may be formulated. These functions are to be minimized. The trick is to start at the last period and work back toward the present. The optimum amount with which to start the whole period may be discovered. For each period the optimum amount to order corresponding to various amoimts on hand may be calculated also. These optimum combinations might be entered in tables wtiich would provide an automatic guide for the stock clerk. A different approach may be useful sometimes, particularly if the nature of the probability distribution is not known. The entre-

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preneur may assume that nature is acting in such a manner as to maximize his loss, by choosing the worst possible probability distribution from the set of available distributions.
V. THE RELATIONSHIP BETWEEN INVENTORY CONTROL ANALYSIS, BUSINESSMEN'S BEHAVIOR, AND ECONOMIC THEORY

In practice, most businessmen use inventory-sales ratios as a guide for inventory control. The question arises as to the nature of the relationship between these inventory-sales ratios, the inventory control systems described in this paper, and conventional economic theory. The assumption concerning inventory-sales ratios that occurs most frequently in economic theory is that entrepreneurs maintain a constant inventory-sales ratio whether or not sales vary. In two models of Metzler,^ use was made of the assumption that entrepreneurs try to maintain a constant ratio. This assumption made solution of his difference equations simple; if it were relaxed, the whole nature of the solution would be changed. Tinbergen wrote of "a pronounced tendency to keep stocks, not only stocks of raw materials and semi-manufactured products, but also of finished products in proportion to the volume of sales."' Other examples of the use of the constant inventory-sales ratio assumption can be found without difficulty. Such an assumption is far from being in agreement with data on inventory-sales ratios, which indicate that the ratios are subject to variation over a wide range. Some economists may try to avoid this unpleasant fact by saying that, nevertheless, the rational entrepreneur attempts to maintain a constant ratio. However, this assumption is not valid either. The above analysis of economical purchase quantities and safety allowances has indicated that, under certain assumptions, the entrepreneur should attempt to vary his inventory levels with the square root of sales. Both the economical purchase quantities and the safety allowances should be varied with the square root of sales. Interviews with entrepreneurs have indicated that these entrepreneurs try to achieve higher rates of turnover, i.e., decrease inventory-sales ratios, as sales increase. On the basis of questionnaires concerning desired levels of inventory, "standard" inventorysales ratios for department stores were constructed by Dr. C. N.
8. Lloyd A. Metzler, op. dt. 9. Jan Tinbergen and J. J. Polak, The Dynamics of Business Cycles (Chicago* University of Chicago Press, 1950), p. 181.

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Schmalz of Michigan.' These standard ratios showed a decline in desired inventory-sales ratios as sales increased. Scatter diagrams indicated this relationship was true for all departments of the various stores as well as for the stores as a whole. Schmalz's ratios vary more than proportionately with the square root of sales, however. Inventory control systems based on the determination of economical purchase quantities and safety allowance levels indicate that a quadrupling of sales should be accompanied by a doubling of inventories while systems based on a constant inventory-sales ratio indicate a quadrupling of inventories. Schmalz's study indicated that, in fact, desired inventory levels were approximately tripled. The following table was used by the Department of Commerce* to
STOCK-SALES RATIOS FOB DEPARTMENT STOBES IN THE UNITED STATES, BT SIZE OF STOEE* Sales Over 10 MilUon Dollars Sate* SOOTkoawnd to 1 MOKon DoUws

Yew

Sales 5 to 10 Million Dollars

Sales 2 to 5 Sales 1 to 2 Million Dollars Million Dollars

1929.. . 1930 . . . 1931.... 1932 1933 1934.... 1935 1936.... 1937.. . 1938.. . 1939.... 1940 1941.... 1942 1943 1944 1945 1946 1947....

3.0 3.5 3.1 3.2 3.2 3.2 2.9 2.7 3.0 3.0 2.9 2.8 2.8 3.4 2.6 2.5 2.3 2.4 2.8

3.2 3.2 2.9 3.3 3.2 3.1 2.9 2.9 3.2 3.2 3.0 2.9 2.9 3.5 2.6 2.4 2.4 2.5 2.7

3.6 3.6 3.5 3.6 3.4 3.2 3.0 2.9 3.2 3.2 3.0 3.0 3.2 3.5 2.7 2.6 2.6 2.6 2.9

4.4 4.4 4.1 4.1 3.6 3.3 3.4 3.2 3.5 3.3 3.3 3.2 3.2 3.8 2.9 2.9 2.7 2.7 3.3

4.3 4.6 4.4 4.1 3.9 3.9 3.8 3.3 3.4 3.5 3.4 3.3 3.3 3.6 3.0 3.1 2.9 2.8 3.8'

1. These data are median ratios for eaeh i^oup. 2. Data for 1945 include ileiMtftment storm wiih salea under 1 million doUus; for 1946 and 1947 they include departmsat and nsedalty stares with sales under 1 million dollars. Source: National Retul Dry Goods Association.

demonstrate the secular downward trend of inventory-sales ratios. As well as illustrating the secular trend, the table shows that, in
1. Carl N. Schmalz, "Standard Departmental Stock-Sales Ratios for Department Stores," Michigan BuMnesa Studies, Vol. 1, No. 4, 19;^, pp. 1-16. 2. C. Winston and M. L. PugUsi, "Inventory Tum-over in Retail Trade," Survey of Current Biisiness, June 1948, p. 18.

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almost all instances, inventory-sales ratios become larger as the size of stores becomes smaller. The table indicates that the inverse variation of inventory-sales ratios with sales is not merely a cyclical or secular phenomenon, as simultaneous comparisons are made between the stock-sales ratios of stores of different sizes.
Inventory Average for Year (Billions of Dollors)

SO 100 ISO Soles, Total for Year. (Billions of Dollars)

200

290

FIGURE II Other Department of Commerce data' support the theory that inventory-sales ratios decline as sales increase. Figure II clearly demonstrates this phenomenon. The dotted line indicates the inventory levels that would prevail if 1926 were used as a base year and inventories varied proportionately with the square root of sales. While none of the above evidence is conclusive, it establishes a presumption that inventory behavior consistent with the inventory control theory outlined in this paper is in at least as good agreement with empirical evidence as behavior consistent with the usual assump*tion of a constant inventory-sales ratio. With increased adoption of modem inventory control systems, the theory outlined here should come into closer agreement with the facts. Economic theorists should carefully examine the assumptions underlying their models. In the 3. L. Bridge, "Sales and Inventory Trends of New Trade Finns," Survey
of Current Business, April 1949, p. 23.

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case of inventory-sales ratios, their assumptions are far from being in agreement with the facts. Dr. J. M. Clark, in his well-known article on the acceleration principle,^ reached a conclusion further removed from reality than the constant inventory-sales ratio assumption. He gave five reasons why entrepreneurs should vary inventories more than proportionately with sales: (1) Turnover rates can be increased in good times only if "the producers had previously been careless enough to let the turnover become unduly slow or else had been unable to speed up the turnover in slack times by carrying a decreased stock."* As indicated in the analysis describing the computation of economic purchase quantities, it becomes economical to speed up the rate of turnover (that is, to reduce the ratio of inventory to sales) when demand increases. The fact that the turnover rate was slower with a smaller demand is not evidence of careless management it is uneconomical to achieve the same rates of turnover during slack periods as during periods of high demand. (2) Clark argued that "one of the chief purposes of keeping a stock is to give assurance of being able to fill large orders without delay."* Therefore, he argued, stocks must be increased in a proportion corresponding to the increase in demand or incur more danger of being sold out. The safety allowance analysis above indicates the error of Dr. Clark's statement. In the example discussed, safety allowances which were increased only with the square root of demand maintained a constant level of protection against depletion. (3) With an increased demand, according to Dr. Clark, a wider selection of goods will be carried.' Even if such is the case (which is open to doubt), there is no a priori reason to assume the inventorysales ratio of the new goods is higher than that of the goods already in stock. (4) Clark's fourth argument was that the quality of service improves in good times. Inventories, as one aspect of the service, would therefore be increased.* It would be difficult to convince any housewife of the validity of such an argument. Economists have written of increased effi4. John M. Clark, "Business Acceleration and the Law of Demand: a Technical Factor in Economic Cycles," Joumal ofPoliiical Economy, March 1917,
pp. 217-35. 5. Ibid., pp. 230-31. 6. Ibid., pp. 231-32. 7. toe. cU. 8. Loc. eU.

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ciency in contraction and of the inefficiencies that creep in in boom times.' However, even if it were granted that the entrepreneur improves the quality of service in prosperous times, there is no reason to infer from this that inventories vary more than proportionately with sales. Maintenance of a constant ratio of inventories to sales would provide a tremendous increase in the quality of service. (5) Dr. Clark's final argument was that expected rises in costs lead entrepreneurs to hold larger inventories.^ While entrepreneurs will hold larger inventories, this does not necessarily imply that the inventory-sales ratios are increased. It is possible for inventories and the inventory-sales ratio to move in opposite directions. Analysis by statisticians and econometricians can undoubtedly be combined to yield fruitful results in the field of inventory control. However, it is important that the results of their work be carefully explained to nonmathematical economists and businessmen. This will enable economic theorists to construct more realistic theories and enable businessmen to behave in a more rational manner. Only in this way can a close correspondence result between the actual entrepreneur of the real world and the rational entrepreneur of economic theory.
T. M. WHITIN.
PBINCETON UNIVERSITY

9. W. C. Mitchell, "Business Cycles," Encyclopedia of the Social Sciences, Vol. 3, p. 102. 1. J. M. Clark, op. dt, pp. 232-33.