5 CHAPTER II THEORETICAL FOUNDATION This research begins by analyzing the existing inventory management system of the company. The best inventory policy to be used is using the probabilistic model and safety stock, this approach is used when the demand is not certain or not constant, and the safety stock is used to achieve a desired service level and avoid stock-outs (Heizer & Render, 2011) this approach is chosen because:  The current existing inventory management system is similar to this approach, thus can be applied and easily adapted by the company  A specified service level is required The illustration above is the probabilistic model, when the inventory level reaches the re- order point, a number of orders must be made to keep the inventory levels up to level, to Figure 1 Probabilistic Model 6 avoid stock out that leads to loss sales, and the amount to be ordered must also meet the demand, to avoid over stocking that could lead to high inventory keeping costs. Several variables or indicators are present in the probabilistic approach model; those are re- order point or re-order level, Economic order quantity or EOQ, Safety Stock, Lead time, and level of demand. 2.1 Re-order Point The re-order point in the probabilistic model is the minimum level of inventory existing at which a new order must be placed. The re-order point tells when to order (Heizer & Render, 2011). The formula for the re-order point is: ROP = LT x d Whereas:  LT: Lead time, which is the time required for an order to be made and delivered to the company, unit is in days  d: Daily demand, which is the amount of demands or sales per day faced by the company Lead Time for PT Idola Cahaya Semesta is seven days. The lead time is determined by the average days for the supplier to deliver the products to the distribution center (DC), and from the DC to the retail stores. The main transportation used is LTL (less than truckload). 2.2 Economic Order Quantity The economic order quantity or EOQ determines the optimum order quantity that a company should keep in its inventory. This is done to minimize variable inventory costs such as overstocking. The EOQ answers how much to order each time (Heizer & Render, 2011). 7 The illustration above describes the Economic Order Quantity’s cost curve. It is at the lowest possible point of the total inventory cost, the carrying cost, and the ordering cost. This formula is expected to produce the lowest under-stocks and overstocks for the company. The quantity is calculated by the formula: √ Whereas: Q: Economic order quantity D: The number of demands S: The amount of order setup cost H: Holding cost Figure 2 Economic Order Quantity 8 The inventory holding cost is the cost of keeping one unit of inventory for a year. According to the company, the annual inventory holding cost is 2% of the net profit times the yearly demand/sales per item. This assumption is based on historical data of the warehousing division, where all the goods got delivered from the suppliers, and then managed by the dedicated staffs of the warehouse or DC. The setup/ordering cost is the cost of placing an order to be delivered, the company’s monthly setup cost is assumed Rp10.000 each item. This is based on the procurement division historical data of ordering transportation cost from wholesalers or suppliers. 2.3 Safety Stock The safety stock is the amount of inventory that the company should keep in order to avoid loss of sales from stock outs.