Chapter 4 Managing Inventory

1. Chapter 4Managing Inventory IN V

2. The Cash Flow Timeline • Order Order Sale Payment Sent Cash • Placed Received Received • Accounts Collection • < Inventory > < Receivable > < Float > • Time ==> • Accounts Disbursement • < Payable > < Float > • Invoice Received Payment Sent Cash Disbursed

3. Objectives • Appreciate impact of holding and ordering costs on order quantity • Traditional EOQ & quantity discounts • Appreciate JIT concepts • Assess impact that different order quantities have on timing and amount of payments • Use of balance fractions to monitor inventory balances

4. Concept of Inventory • Factor in the length of cash cycle • Acts as a shock absorber • Three types • raw materials • work-in-process • finished goods • Motives for holding inventory • Transaction – Day-to-Day needs • Precautionary – Unexpected change in supply or demand • Speculative – Expected change in supply or demand

5. Inventory Investment Function • Demand for product • Cost of holding inventory • insurance • storage • cost of capital • Cost of ordering inventory • Total cost = Order Cost + Holding Cost = F x (T/Q) + H x (Q/2) • See example on page 103.

6. $ Holding cost = H x (Q/2) Order costs = F x (T/Q) Order quantity, Q Order Cost and Holding Cost Trade-off Total cost = Holding + Order

7. Economic Order Quantity • EOQ solution: SQRT (2TF/H) • Number of orders: T/Q • Average inventory: Q/2 • Usage rate: T/D (D=days) • Reorder point: (T/D) x Delivery Time • Where: • T = The total number of units required for the planning cycle. • F = Fixed order cost per order. • H = Holding cost per inventory unit. • Q = Order quantity. • D = number of days in the planning cycle. • Delivery time is the number of days it takes to receive an order once the order is placed.

8. Quantity Discounts • TC = Order Cost + Holding Cost + Item Cost • TC = (F x (T/Q)) + (H x (Q/2)) + (C’ x T) C’ = Cost per unit after discount Note that this formula does not account for the timing of the cash flows. See page 109 for an example using Present Values.

9. Inventory and the Cash Flow Timeline • Inventory ordered Inventory ordered • and received and received • < Inventory Held> <Inventory Held> • Time=> • Cash paid Cash paid Cash paid • for inventory for inventory for holding & • ordering costs

10. Monitor the Inventory Balance • Inventory control systems • Inventory turnover ratio • Sales or COGS / Inventory balance • Days COGS in inventory • Inventory balance / Daily COGS or Sales • Balance fraction approach • Develop monthly balance fractions based on the proportion of items remaining in inventory from a given month’s purchase. See page 113 for an example.

11. Reducing Investment in Inventory • Problems were solved by adding more inventory • JIT redesigns system • Redesign of production system • eliminate waste • eliminate production errors • improving quality • Need stable demand

12. Summary • Inventory decisions should be based on: • cost of holding inventory • cost or ordering inventory • opportunity cost of funds • quantity discounts • is quantity workable within inventory management system? • Inventory, if properly managed can be a major contributor to cash flow... • if mismanaged, it can be a significant drain on cash. • Some traditional inventory monitoring tools can be biased by sales and production trends.