Chapter-08 Working Capital Management: Inventory Control
The objective of inventory management
The main objective of inventory management is to reduce the levels of inventory
held to the necessary minimum.
Costs of High Inventory Levels
Carrying inventory involves a major working capital investment and therefore
levels need to be very tightly controlled. The cost is not just the purchasing the
goods, but also storing, insuring and managing them once they are in inventory.
Purchase Costs-
➢ Once the goods are purchased, capital is tied up in them and until sold on
the capital earns no return.
➢ This lost return is an opportunity cost of holding the inventory.
➢ Alternatively, if the business is less cash rich, a funding source such as
overdraft may needed and this comes with an associated interest cost.
Storage and Stores administration-
➢ In addition, the goods must be stored.
➢ The company must incur the expense of renting out warehouse space, or
if using space they own, there is an opportunity cost associated with the
alternative uses the space could be put to.
➢ There may also be additional requirements such as controlled
temperature or light which require extra funds.
Other risks-
➢ Once stored, the goods will need to be insured.
➢ Specialist equipment may be needed to transport the inventory to where
it is to be used.
➢ Staff will be required to manage the warehouse and protect against the
theft and if inventory levels are high, significant investment may be
required in sophisticated inventory control systems.
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Costs of low inventory levels
If inventory levels are kept too low, the business faces alternative problems:
Stockouts-
➢ If a business runs out of particular product used in manufacturing it may
cause interruptions to the production process-causing idle time,
stockpiling of work-in-progress or possible missed order.
➢ Alternatively, running out of goods held for onward sale can result in
dissatisfied customers and perhaps future lost orders if custom is switched
to alternative suppliers.
➢ If stockout looms, the business may attempt to avoid it by acquiring the
goods needed at short notice.
➢ This may involve using a more expensive or poorer quality supplier.
High re-order/setup costs-
➢ Each time inventory runs out, new supplies must be acquired.
➢ If the goods are bought in, the costs that arise are associated with
administration- completion of a purchase requisition, authorisation of the
order, placing the order with the supplier, taking and checking the delivery
and final settlement of the invoice.
➢ If the goods are to be manufactured, the costs of setting up the machinery
will be incurred each time a new batch is produced.
Lost quantity discounts-
➢ Purchasing items in bulk will often attract a discount from the supplier.
➢ If only small amounts are bought at one time in order to keep inventory
levels low, the quantity discounts will not be available.
The objective of good inventory management is therefore to determine-
➢ The optimum re-order level- how many items are left in inventory when
the next order is placed.
➢ The optimum re-order quantity- how many items should be ordered when
the order is placed for all material inventory items.
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Economic order quantity (EOQ)
➢ The aim of EOQ model is to minimise the total cost of holding and ordering
inventory.
➢ Annual holding cost = (Holding cost per unit * Average inventory), whereas
average inventory = Order size / 2
➢ Annual order cost = (Order cost per order * no of orders per annum) where
no of orders per annum = annual demand / order size.
➢ The formula for EOQ is-
Whereas:
Co → Ordering cost per order
D → Annual demand for the product
Ch → Holding cost per unit
Assumptions-
➢ Demand and lead-time are constant and known
➢ Purchase price is constant, and no discount is offered
➢ No buffer inventory is held
Dealing with quantity discounts/bulk-
Step 1: Calculate EOQ ignoring discounts.
Step 2: If the EOQ is below the quantity qualifying for a discount, calculate the
total annual inventory cost arising from using the EOQ:
Total annual inventory cost = Purchase costs (D*P where P is purchase price) +
ordering costs (Co*D/Q) + Holding Cost (Ch*Q/2)
Step 3: Recalculate total annual inventory costs using the order size required to
just obtain each discount. Take the available discount into account within the
purchase costs.
Step 4: Compare the totals from step 2 and step 3 and select the lowest cost
option.
Step:5 Repeat for all discount levels.
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Re-order level (ROL)
The ROL is the quantity of inventory on hand when an order is placed. Lead time
refers to time taken by the supplier to deliver goods once an order has been
placed. When demand and lead-time are known with certainly the ROL may be
calculated exactly-
➢ ROL = demand in the lead-time
➢ ROL = forecast weekly/monthly/daily demand * lead time
ROL with variable demand or variable lead-time
Where there is uncertainty, an optimum level of buffer inventory must be found.
This depends on:
➢ Variability of demand
➢ Cost of holding inventory
➢ Cost of stockouts
Inventory Management System
A number of systems have been developed to simplify the inventory
management process:
➢ Periodic Review System
➢ Just-in-time System
Periodic Review System (Constant order cycle system)
Inventory levels are reviewed at fixed intervals, e.g. every four weeks. The
inventory in hand is then made up to a predetermined level, which takes account
of:
➢ Likely demand before the next review
➢ Likely demand during the lead-time
Thus, a four-weekly review in a system where the lead time was two weeks
would demand that inventory be made up to the likely maximum demand for
the next six weeks.
Under this system orders are evenly spread, so it is popular with suppliers.
Just in Time (JIT) systems
It is a series of manufacturing and supply chain techniques that aim to minimise
inventory levels and improve customer service by manufacturing not only at the
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exact time customers requires, but also in the exact quantities they need and at
competitive prices.
In JIT systems, the balancing act is dispensed with. Inventory is reduced to an
absolute minimum or eliminated altogether.
Aims of JIT in the following ways are:
➢ To minimise inventory level
➢ A smooth flow of work through the manufacturing plant
➢ A flexible production process which is responsive to the customer’s
requirements.
➢ Reduction in capital tied up in inventory.
