Inventory management under working capital constraints

The objective of inventory management models is to determine effective policies for managing the trade‐off between customer satisfaction and the cost of service. Over the years, these models have become increasingly sophisticated, incorporating many complicating factors that are relevant in practice such as demand uncertainty, finite supplier capacity, and yield losses. Curiously absent from these models are the financial constraints imposed by working capital requirements. In practice, however, many firms are self‐financing, i.e., their ability to replenish their own inventories is directly affected not only by their current inventory levels, but also by their receivables (trade credit they have extended to their customers) and payables (trade credit they have received from their supplier). Such constraints have gained added significance during the lingering economic crisis, which has made external financing increasingly difficult to secure. In this paper, we analyze the materials management practices of a self‐financing firm whose replenishment decisions are constrained by cash flows, which are updated periodically following purchases and sales in each period. In particular, we investigate through simulation the interaction between the financial and operational parameters as well as the impact of working capital constraints on the long‐run average costs per period. Our study shows that arbitrarily imposed constraints on the working capital not only fail to prevent violations, but also significantly distort operational decisions.