INVENTORY MANAGEMENT 1

I. Introduction

-- What is inventory?
- stored resource used to satisfy current or future demand.

-- Types of Inventories:
 Raw Materials/Components
 In-Process Goods (WIP)
 Finished Goods

-- Inventory Related Costs:

 Holding Cost
 Shortage Cost
 Order Cost
 Inventory is costly!

-- Why Hold Inventories?

 Meet anticipated demand
 Protect against stock-out
 Smooth production process
 Buy/Produce in economic lot sizes - take advantage of quantity discounts
 Hedge against price increases

-- Just-In-Time Inventory – minimum inventory needed to keep a system running, small

lot sizes
 Advantages
- lower inventory costs
- easy to identify problems and potential problems
 Disadvantages
- requires accurate timing and cooperation

Inventory Systems:

Objective:
Minimize total inventory cost and maintain satisfied service level.

 Fundamental Questions:

- How much to order?

- When to order?

To find the most economic level of stock, various stock control formulae can be used. These
formulae use some terminology that first we need to look at their definitions.

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1. Economic order quantity (EOQ):

Definition:

EOQ is the quantity that should be ordered at a time so that the total inventory cost is at its
minimum.
Total inventory cost consists of Ordering Cost + Carrying Cost.

Formula:
EOQ =√(2 x D x O)/H
OR
EOQ = √(2 x D x O)/{H + (P x i)}

Where: D = Annual demand or requirement

O = Cost to place an order
H = Annual carrying/holding cost per unit
P = the purchases/cost price per unit
i = the interest rate

2. Reorder level

Definition:

It is that quantity which the firm has in stock when the new order is placed.

Formula:
Reorder level = maximum usage x maximum lead time

3. Minimum/buffer (Safety stock)

Definition:
This indicates the lowest level to which the stock should drop.

Formula:
Minimum inventory/level
= Reorder level – (average usage x average lead-time)

4. Maximum inventory/level

Definition:
This is the highest level to which the stock should go.

Formula:
Maximum inventory/level
= Reorder level + EOQ – (minimum usage x minimum lead time)

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5. Average inventory/ level:

Definition:
The stock level will always move between the minimum level and maximum level.

Formula:
Average inventory/level = Minimum inventory/ level + EOQ/2

6. Lead time

Definition:
It is the time (days, weeks, etc) that elapses from the time an order is placed until the stock
arrives. The lead time is not always fixed. If it is given that the lead time is say 2 – 6 weeks, the
minimum lead time will be 2 weeks, the maximum lead time 6 weeks and the average lead time
4 weeks.

7. Usage

In order to calculate most of the stock levels mentioned above, the firm must establish how
many units it uses (demands) per day, week, month, etc. If it is given that the usage varies
between say 500 and 700 units per week, the minimum usage is 500, the maximum usage 700
and the average 600 per week.

8. Number of orders per year

= annual demand/ EOQ

9. Ordering costs are all the costs associated with the acquisition of inventory, examples are
clerical costs associated with ordering inventory, handling, costs associated with purchasing
department, transportation costs, etc.

Formula:
Annual ordering cost = No. of orders p.a. x cost to place an order

10. Carrying cost (Holding cost)

Carrying costs are all the costs associated with the holding of inventory in the storeroom
(warehouse), examples are storage costs, handling costs, insurance, rent, interest on the funds
invested in inventories, etc.
Formula:
Annual holding/carrying cost
= Average stock x annual carrying cost per unit

11. Total annual inventory cost

= Annual ordering cost + annual holding cost

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QUESTION 1

The following information relate to a material used by Xolisa cc in its production

process. No safety stock is kept.

Annual requirements 5 000 units

Economic order quantity (a)
Average inventory (b)
Number of orders per year (c)
Number of working days per year 250 days
Average daily usage (d)
Lead time 10 days
Reorder level (e)
Cost of placing an order N$200
Carrying cost per unit p.a. N$8
Annual ordering costs (f)
Annual carrying costs (g)
Total annual inventory costs (h)

REQUIRED:

Provide the missing figures which is numbered as items (a) to (h)

SUGGESTED SOLUTION TO QUESTION 1:

(a) EOQ =√(2 x D x O)/H

=√(2 x 5 000 x N$200)/N$8
= 500 units

(b) Average inventory = Buffer level + EOQ/2

= 0 + 500/2
= 250 units

(c) N0. Of orders p.a. = D/EOQ

= 5 000/500
= 10 times

(d) Usage per day = D/N0. Of working days

= 5 000/250
= 20 units

(e) Reorder level = Maximum usage x Maximum lead time

= 20 x 10
= 200 units

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(f) Total ordering costs p.a.

= No. of orders p.a. x cost to place an order
= 10 x N$200
= N$2 000

(g) Total holding cost p.a.

= Average inventory x holding cost per unit p.a.
= 250 x N$8
= N$2 000

(h) Annual total inventory costs = N$2 000 + N$2 000

= N$4 000

Safety/Minimum level = Reorder level – Average usage x Average lead time

= 200 – (20 x 10)
=0
Maximum level = Reorder level + EOQ – (minimum usage x minimum lead time)
= 200 + 500 – (20 x10)
= 500 units

QUESTION 2

Mr Y & Mr X run a small practice as manufacturers and need some advice from you as a Cost &
Management Accountant.
You are presented with the following information: it takes them two to four months to receive
the raw materials from their suppliers. The firm requires 30 000 units per month at most; but
normally uses 15 000 units per month. No buffer stock kept. Normally they require 180 000
units for their financial period. It costs them N$200.00 each time they order and pay N$32 per
unit of materials. They rent a warehouse and they are charged a 25% on inventory value per
annum.

REQUIRED:

(a) At what point should the inventory be replenished?

Reorder level = Maximum usage x Maximum lead time
= 30 000 x 4
= 120 000 units

(b) How many units would they order each?

EOQ = √(2 x D x O)/{H + (P x i)}
= √(2 x 180 000 x N$200)/{0 + (N$32 x 0.25)}
= 3 000 units

(c) What would be the annual holding cost?

= *Average inventory x {H + (Pxi)}
= 1 500 x N$8
= N$12 000

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*Average inventory = Buffer level + EOQ/2

= 0 + 3 000/2
= 1 500 units

(d) What would be the annual ordering cost?

= N0. of orders x Cost to place an order
= 180 000/3 000 x N$200
= N$12 000

(e) What would be the total inventory costs for the year?
= annual holding cost + annual ordering cost
= N$12 000 + N$12 000
= N$24 000

QUESTION 3

The calculation of an EOQ will need to be extended if bulk or quantity discounts are available to
the purchaser. Poly Press purchases 15 000 toner cartridges annually. An order costs N$135 and,
before any discount, the unit price is N$50. The annual holding cost is 10% of the purchase
price. Namprint is the sole supplier of these cartridges and they offer 2% discount for orders in
excess of 1 000 units of cartridges and a further 3%, if more than 3 000 units are purchased.

You are required to advise on the best purchasing option, Justify your answer.
SUGGESTED SOLUTION TO QUESTION 3:

1) EOQ =√(2 x D x O)/(H x i)

=√(2 x 15 000 x N$135)/N$5
= 900 units

Ordering cost p.a. = 16.666 x N$135 = N$2 250

Holding cost p.a. = 450 x N$5 = N$2 250
Purchases costs =15 000 x N$50 = N$750 000
N$754 500

2) Ordering cost p.a. = 15 x N$135 = N$2 025

Holding cost p.a. = 500 x N$5 = N$2 500
Purchases costs 15 000 x N$49 (N$50 x .98) = N$735 000
739 525

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QUESTION 4

Tau –Tau Ltd supplied the following information regarding a particular product in inventory:

Maximum lead time 30 days

Minimum lead time 20 days
Maximum Usage 1 500 kg per month
Minimum Usage 900 kg per month
Interest rate 10% p.a.
Cost price per unit N$200
Annual inventory carrying cost per unit N$100
Cost to place an ordering cost N$400

REQUIRED:

(a) Economic order quantity

(a) Maximum level
(b) Economic order quantity
(c) Minimum/buffer level
(d) Average inventory
(e) Number of orders per year
(f) Annual inventory ordering cost
(g) Annual inventory carrying cost
(h) Total annual inventory costs

QUESTION 5

The following data relates to cement used as raw material of a construction company:

Average monthly usage 2 400 bags

Lead-time 2 – 4 weeks
Cost to order cement N$120 per order
Annual Inventory carrying cost N$4 per bag
Working weeks per year 40 weeks

REQUIRED:

1. Economic order quantity

2. Reorder level
3. Maximum level
4. Buffer/Safety/Minimum level
5. Average inventory
6. Number of orders per year
7. Annual inventory ordering cost
8. Annual inventory carrying cost

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