3 - Inventory Management

Financial Management (FIN MGT)

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 INVENTORY MANAGEMENT

Inventories
- Inventories are an essential part of virtually all business operations and must be
acquired ahead of sales.
- The main classifications of inventories are;

1) Manufacturing Firm 2) Trading Firms

a. Raw Materials a. Merchandise Inventory
b. Goods in process
c. Finished goods
d. Factory supplies

Cost associated with Investment in Inventory

The following are the costs associated with inventories which could vary from firm to firm,
from item to item and over time.

1) Carrying Costs
- Cost of capital tied up in inventory
- Storage and handling costs
- Insurance
- Property Taxes
- Depreciation and obsolenscence
- Administrative costs (e.g. accounting)

2) Ordering, Shipping and Receiving Costs

- Cost of placing orders including production and setup costs
- Shipping and handling costs

3) Costs of Running Short

- Loss of sales
- Loss of customer goodwill
- Description of production schedules

Inventory Management
- refers to the process of formulating and implementing plans and policies to efficiently
meet production and merchandising requirements while minimizing costs relative to
inventories.

Objective of Inventory Management

- To maintain inventory level that balances sales demand, the cost of carrying additional
inventory and the efficiency of inventory control.

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Inventory Management Techniques

1. Inventory Planning

- involves the determination of the appropriate quantity and quality, as well as the right
time of ordering to minimize the costs while meeting the demand for sales.
- How many units to place every order?  Economic Order Quantity
- When do we have to place the order?  Reorder Point

a. Economic Order Quantity (EOQ) - is the ideal order quantity a company should
purchase to minimize inventory costs such as holding costs, shortage costs, and order
costs.

Illustration:
 Assume a local gift shop is attempting to determine how many sets of wine glass to
order. The store feels it will sell approximately 800 sets in the next year at a price of
P18 per set. The wholesale price that the store pays per set is P12. Cost of carrying
one set of wine glasses are estimated at P1.50 per year while ordering costs are
estimated at P25.

Required:
1. Determine the Economic Order Quantity for the set of wine glass
2. Determine the annual inventory costs for the firm if it orders in this quantity.

Solution:

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 b. Reorder Point - is the minimum unit quantity a specific product reaches to trigger
inventory replenishment. Reorder points give businesses time to restock a product
before the item is out of stock and they are unable to fulfill orders.

 Lead time is the number of days between when you place a purchase order with your
manufacturer or supplier for a product and when you receive the product.

Lead Time Usage = Average Daily Usage x Lead Time

 Safety Stock is the extra “just in case” inventory you keep on hand to anticipate
variability in demand or supply.

Safety stock = (Max daily orders x Max lead time) – (Ave daily orders x Ave
lead time)
Safety stock = (Max daily orders x Max lead time) – Reorder Point w/o SS

EOQ & Reorder Point

Illustration:
The following inventory information and relationship for the Baguio Corporation are available.
1) Orders can be placed only in multiple of 100 units
2) Annual unit usage is 300,000 (assume 50-week year)
3) The carrying costs is 30% of the purchase price
4) The purchase price is P10 per unit
5) The ordering cost is P50 per order
6) The desired safety stock is 1,000 units (this does not include delivery-time stock.
7) Delivery time is 2 weeks

Required:
1. Determine the optimal EOQ level
2. How many orders will be placed annually?
3. At what inventory level, should a reorder be made?

Solution:

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EOQ, Reorder Point (w/ Safety Stock)

Illustration:
Clothes, Inc., has an average annual demand for red, medium polo shirts of 25,000 units. The
cost of placing an order is $80 and the cost of carrying one unit in inventory for one year is
$25.

Required:

1. Use the EOQ model to determine the optimal order size.

2. Determine the reorder point assuming a lead time of 10 days and a work year of 250
days.
3. Determine the safety stock required to prevent stock outs assuming the maximum lead
time is 20 days and the maximum daily demand is 125 units.

Solution:

2. Inventory control
- It is the regulation of inventory within the predetermined limits.
- Effective inventory management should provide adequate stocks to meet the
requirements of the business, while at the same time keeping the required
investment to a minimum.

a. Fixed Order Quantity System

o This is a system wherein each time the inventory goes down to a
predetermined level (reorder point) , and order for a fixed quantity
(EOQ) is placed. This system requires the use of perpetual inventory
records or the continuous monitoring of the inventory level.

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