Chapter 22 Management of Short-Term Assets: Inventory

1. Chapter 22Management of Short-Term Assets: Inventory

2. Learning Objectives • Understand the importance of short-term assets in the Australian economy. • Identify the three major types of short-term assets. • Evaluate the need for short-term asset management.

3. Learning Objectives (cont.) • Understand the relationship between short-term assets and short-term liabilities. • Identify the benefits and costs of holding inventory. • Understand the nature of acquisition costs, carrying costs, and stockout costs.

4. Learning Objectives (cont.) • Understand and apply the economic order quantity model. • Understand and apply models of inventory management under uncertainty. • Understand the difference between specifying an acceptable probability of stockout and specifying an acceptable expected customer service level.

5. Introduction • Both short-term and long-term assets require a commitment of resources by the company and, therefore, both forms of investment warrant careful analysis. • The management of short-term assets is important, given that the typical company holds around one-third of its total assets in short-term assets.

6. Types of Short-Term Assets • Inventory • Raw materials, work in process, supplies used in operations, and finished goods. • Liquid assets • Cash and assets that are readily convertible into cash. • Accounts receivable • Money owed to a business for goods and services sold in the ordinary course of business.

7. Short-Term Asset Management • The analysis of short-term asset management assumes markets are not frictionless and perfectly competitive. • Holding inventories and cash is not costless, but delays in daily business can result if such short-term assets are mismanaged. • Wealth maximisation remains the ultimate objective, but techniques other than net present value are often required.

8. Managing Short-Term Assets and Liabilities • Match maturity structure of assets and liabilities. • Cash inflows from sale or use of assets can meet liabilities. • If assets and liabilities are not matched well, company may not be able to meet obligations in timely fashion.

9. Overview of Inventory Management • Raw materials • Inventory that will form part of the completed product, but which has yet to enter the production process. • Work in process • Partially completed products which require additional processing before they become finished goods. • Finished goods • Completed products not yet sold (manufacturer) or merchandise on hand (retailer or wholesaler).

10. Overview of Inventory Management(cont.) • Inventory management is about balancing costs and benefits when choosing inventory levels. • Benefits are ‘cost avoided’. • Inventory management is therefore a problem of cost minimalisation. • Costs of holding inventory: • Acquisition costs • Carrying costs • Stockout costs

11. Inventory Costs: Retail and Wholesale • Acquisition costs • Relevant costs include: • Ordering costs • Freight and handling costs • Quantity discounts forgone • Per unit of inventory, each of these costs will be lower, the larger the order placed.

12. Inventory Costs:Retail and Wholesale (cont.) • Carrying costs • Relevant carrying costs include: • Opportunity cost of investment • Storage costs • Insurance premiums • Deterioration and obsolescence • Price movements • The higher the inventory level held, the higher the carrying costs.

13. Inventory Costs:Retail and Wholesale (cont.) • Stockout costs • Losses incurred when a company’s inventory of a particular item is completely exhausted. • Potential loss of goodwill and possibility of loss of customers. • Major benefit of holding inventory is the avoidance of stockout costs.

14. Inventory Costs: Manufacturing • Raw materials • Shortage of raw materials for a manufacturer will disrupt the production process and result in under-utilisation of labour and equipment. • Finished goods • The acquisition costs include set-up costs for a production run. • Carrying costs and stockout costs are similar to those faced by retailers and wholesalers.

15. Inventory Management Under Certainty • Economic order quantity model • The optimal quantity of inventory ordered that minimises total costs associated with inventory. • Assumptions • Demand for product is constant (per unit of time). • Demand is known with certainty.

16. Economic Order Quantity Model

17. Economic Order Quantity (cont.)

18. Economic Order Quantity (cont.) • Annual total costs (TC): • Acquisition costs will increase as the order quantity is reduced, but carrying costs will increase as the order quantity increases. • Economic order quantity:

19. Economic Order Quantity (cont.)

20. Cost Estimation • Relevant costs are incremental costs. • Difficult to estimate. • Fortunately, optimal order quantity and total inventory costs are fairly insensitive to errors in estimates of unit costs.

21. Economic Order Quantity (cont.) • EOQ with positive lead time: • EOQ model assumes order is instantly filled. • With positive lead time, need to place order earlier — such that delivered as inventory reaches zero. • EOQ with quantity discounts: • Discounts for quantity purchases reduce the price of inventory and spread acquisition costs over a larger base.

22. To Incorporate Discounts 1. Determine optimal quantity in the absence of quantity discounts. 2. Calculate price paid for that quantity with the discount. • For each of the quantity discounts, calculate the price payable for the quantity closest to the optimal quantity determined in 1. • Calculate the total cost for each combination of price and quantity. • Select the combination that achieves the lowest total cost.

23. Inventory Managementunder Uncertainty • In reality, the level of demand and the rate at which the raw materials inventory will be used in production are not known with certainty. • Decisions: • Quantity to be ordered. • Reorder point: level of inventory at which a new order will be placed.

24. Inventory Managementunder Uncertainty (cont.) • With certainty, inventory ordered when inventory levels equal the demand during lead time. • With uncertainty, an adjustment is necessary.

25. Incorporating Uncertainty • To incorporate uncertainty: • Quantity decision made as per EOQ. • Add a safety stock to the reorder point. • Safety stock • Additional inventory held when demand is uncertain, to reduce the probability of stockouts.

26. Determining Safety Stocks • The level of safety stock can be calculated by: • Specifying an acceptable probability of a stockout occurring during lead time; or • Specifying an acceptable expected level of customer service. • Level of customer service is ratio of sales to orders. • A stockout is costly if it means that orders are not filled — thus managing inventory to maintain a minimum customer service level is an important and useful approach.

27. Inventory Management and the ‘Just-in-Time’ System • The ‘just-in-time’ system is a way of organising the manufacture of goods such as motor vehicles, engines and power tools. • It is based on the concept that raw materials, equipment and labour are each supplied only in amounts required, and at the times required, to perform the manufacturing task.

28. Inventory Management and the ‘Just-in-Time’ System (cont.) • This synchronisation of delivery with demand reduces inventory levels, lead times and delivery quantities. • The aim of the system is to achieve an improvement in overall efficiency, as well as a reduction in inventory costs.

29. Summary • Short-term assets include: inventory, liquid assets and accounts receivable. • Short-term asset management is important because markets are not frictionless and perfectly competitive — these frictions lead to the need to hold short term assets. • Short-term or current liabilities are also very important when determining a current asset management strategy.

30. Summary (cont.) • Inventories: raw materials, work in progress and finished goods. • Too little inventory — stockout and lost sales. • Too much inventory — high storage and insurance costs. • Optimal inventory strategy involves balancing costs and benefits associated with inventory, including order and transport costs. • Demand known with certainty — Economic Order Quantity (EOQ).

31. Summary (cont.) • Demand is uncertain — include a margin for uncertainty. • Reorder point is brought forward compared to certainty case. • Probability of stockout is not as important as losses associated with a stockout. • Use a customer service goal to determine the margin for uncertainty. • Just-in-time system reduces need for inventories but requires high degree of reliability up the supply chain.