Topic: Week 8

MODULE 8: BASIC INVENTORY PLANNING AND MANAGEMENT

I. Pre-test / Activity:
One-Sentence Summary
On your class notebook, write a one-sentence summary (bullet points) of your key takeaways
during the discussion cost and performance monitoring.
II. Learning Outcomes
1. Differentiate independent from dependent demand
2. Identify the different types of inventories
3. Recognize the costs associated with inventory
4. Apply economic order quantity EOQ in managing inventory

III. Content:

Independent vs. Dependent Demand Inventory

Inventory is literally defined as a stock of goods which a business manages to produce products or
perform services. The two (2) general categories of inventory are as follows (Myerson, 2015):

• Dependent demand. This is represented by an item whose demand is linked directly to the demand
or production level of another item. An example of dependent demand inventory requirements
would be tires that go on a bike; the production of one (1) bicycle would require two (2) tires of a
specific size, and thus the demand for the tires is dependent on the number of bicycles being
produced.

• Independent demand. This refers to the inventory requirement for finished goods or a product
available for customers’ consumption or use. An example of independent demand inventory is a
bicycle ready for sale in the market.

Types of Inventory

The four (4) major types of inventory are as follows (Myerson, 2015):
1. Raw materials and components. These are made up of the resources a business uses to produce
its own goods. This category also includes goods used in the manufacturing process, such as
components used to assemble a finished product. For example, the major raw materials needed to
complete a bike are brakes, cables, wheels, tires, and the bike frame.

2. Work in process (WIP). These are materials and parts that have been partially transformed from
raw materials but are not yet finished goods and can include partially assembled items that are
waiting to be completed. For example, a complete bike structure with no brake cables is still
considered as WIP.

3. Finished goods. These are products that are ready to be shipped directly to customers, including
wholesalers and retailers. For example, after adding brake cables to a bike, it can now be considered

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 as a finished product ready for delivery to the market.

4. Maintenance, repair, and operations (MRO). These are items a business needs to operate, such
as office equipment, packing boxes, and tools and parts to repair equipment. For example, repairing
a bike requires tools such as screwdrivers and pliers.

Cost of Inventory

The following are the different types of costs associated with inventory (Myerson, 2015):
• Carrying costs. These are also known as holding costs. These are costs involved in the acquisition
and storage of inventory items. The components of holding costs are as follows:

o Capital or opportunity cost. The value of this cost depends on current interest rates which
can range from 5% to 25%. Money used to purchase inventory items can be derived from
borrowed capital and internal sources. Capital cost is derived from the interest rates of
borrowed finances while opportunity cost is derived from the return that a money would
generate if it is invested in other things. For instance, the money used to purchase inventory
items would generate a return by investing in facility expansion or equipment purchase.

o Physical space occupied by the inventory. The value of this cost ranges from 3% to 10%.
This includes building rent or depreciation, utility costs, insurance, and taxes among others.

o Handling of inventory. The value of this cost ranges from 4% to 10%. This includes
equipment lease or depreciation, power, and operating costs.

o Pilferage and scrap. The value of this cost ranges from 2% to 5%. The longer the period
an inventory item is stored in the warehouse, the greater the costs associated with
deterioration or obsolescence.

• Ordering costs. These include fixed and variable costs associated with placing an order to purchase
additional inventory. Fixed costs are expenses that are independent of output and are incurred no
matter what, such as rent, building, and machinery among others. Variable costs, on the other hand,
are expenses that vary with output. Generally variable costs increase at a constant rate relative to
number of units produced for manufacturing companies or volume of services rendered for service-
oriented firms. Variable costs may include wages, utilities, and materials used in production among
others. Variable costs associated with purchase orders include preparing a purchase request,
creating the purchase order itself, reviewing inventory levels, receiving and checking items as they
are received from the vendor, and the costs to prepare and process payments to the vendor when
the invoice is received.

• Setup costs. These are costs associated with changing production over, known as setup, which
includes labor and parts as well as downtime. Setup costs involve both fixed and variable costs.
The fixed costs of setups include the capital equipment used in changing over the production line.
The variable costs include the employee costs for any consumable material used in the teardown
and setup. The longer the setup takes, the greater the variable costs.

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Economic Order Quantity (EOQ) Model

Economic Order Quantity (EOQ) Model minimizes total inventory costs by optimizing the
tradeoffs between holding and ordering costs. It is the optimal inventory size that should be ordered
with the supplier to minimize the total annual inventory cost of the business. Other names used for
economic order quantity are optimal order size and optimal order quantity (Accounting Information
Management, n.d.).

EOQ is established under the following assumptions: ordering cost is constant; rate of demand is
known and spread evenly; lead time is known and fixed; purchase price of the item is constant;
replenishment is made instantaneously; and the entire order is delivered at one time (Myerson,
2015). Rate of demand is the number of units requested by a customer in a particular time period.
Lead time is the period between the initiation and completion of a production process.

ILLUSTRATION: Montgomery Corp. desires to determine the optimal order quantity for zippers
used in the production of their famous leather bags. The annual demand for their bags is 80,000
units, cost to place an order is P1,200, cost per unit is P50, and carrying cost is 6% of unit cost. Find
the EOQ, number of orders per year, ordering cost and carrying cost, and total cost of inventory.

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IV. Activity / V. Evaluation / Assessment

Part 1. Choose the best answer.

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Part 2. Problem Solving

VI. Other Reading Materials

N/A

VII. References

Accounting Information Management (n.d.). Economic order quantity (EOQ). Retrieved

September 9, 2019, from https://www.accountingformanagement.org/economic-order-
quantity
Myerson, P. (2015). Supply chain and logistics management made easy: Methods and applications for
planning, operations, integration, control and improvement, and network design. United States:
Pearson Education, Inc.

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(+63) 927-533-0342 – (+63) 923-949-5265 admissions-nubaliwag@nu.edu.ph