CHAPTER 14

WORKING-CAPITAL MANAGEMENT

MANAGING INVENTORY
Learning outcomes
By the end of this chapter, you should be able
to:

• Discuss the importance of managing inventory

effectively
• Discuss the costs associated with inventory
• Calculate measures to manage inventory
Current assets and liabilities

• Short-term assets (current assets):

§ Cash
§ Accounts receivable (debtors)
§ Inventory
• Short-term liabilities (current liabilities):
§ Accounts payable (creditors)
Managing inventory
• Inventory management is important for a
number of reasons:
• Too little
§ It can be harmful to the image of a company if
they do not have enough goods to sell to
customers
• Too much
§ Perishable inventory items can spoil
§ All types of inventory can be destroyed in a
disaster
§ Where there is a lot of development, like
technology, inventory can become obsolete so
that customers won’t want to buy it anymore
Managing inventory
• Inventory causes a number of different costs
to a company:
• Carrying costs
§ Costs that a company incurs to keep inventory,
like storage and insurance. The more inventories
a company holds, the higher this cost will be
• Ordering costs
§ Costs of placing and receiving an order for
inventory, for example, clerical costs, handling
and transport
• Cost of not carrying enough inventory
§ Opportunity cost that occurs when a customer
cannot be helped due to a lack of inventory. The
lost sale is then a cost to the company
Methods to manage inventory

• The Economic Order Quantity (EOQ) can be

used to evaluate the best quantity of inventory
to purchase at a time that will reduce the
costs of inventory
• The EOQ calculates the optimal number of
units of inventory that needs to be ordered so
that costs are kept to a minimum
Methods to manage inventory

• The EOQ is calculated by using the

following formula:

Where:
O = Cost of placing an order
D = Annual demand
C = Annual cost of carrying one unit
Methods to manage inventory

• Another useful concept that helps to ensure a

company has the right amount of inventory at
the right time is the reorder point
• It is calculated by using the following
equation:
Reorder point = lead time x daily usage
Example 14.4
• The logistics manager of Manufacture Ltd
provides the following information:
§ The company uses 15 000 units of Ingredient X in
the product they manufacture
§ The cost to place an order for Ingredient X is R150
per order. Storage and insurance costs amount to
R19 per unit
§ The lead time for delivery of an order is 5 days
§ Assume the factory operates for 240 days per year

• Calculate the EOQ and the reorder point.

Example 14.4
Example 14.4
 CLASS EXERCISE
Bendit Plastics uses 800 units of a product per year on a
continuous basis. The product has carrying costs of R50
per unit per year and order costs of R300 per order. It
takes 30 days to receive a shipment after an order is
placed and the firm requires a safety stock of 5 days
usage in. The company operates for 360 days of the
year.

(a) Calculate the economic order quantity (EOQ).

(b) Determine the reorder point
(Taking into account the 5 days safety stock)