Inventory Management

Seminar 10
Horngren (16th Edition), Chap
20

1
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 Chapter outline
1. Identify six categories of costs associated with goods for sale.
2. Balance ordering costs with carrying costs using the
economic- order-quantity (EOQ) decision model.
3. Identify the effects of errors that can arise between the EOQ
decision model and ways to reduce conflicts between the
EOQ model and models used for performance evaluation.

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 Inventory Management in
Retail Organizations
⚫ Inventory management is planning, coordinating, and
controlling activities related to the flow of inventory
into, through, and out of an organization.
⚫ E.g., Kroger
Revenues 100.0%
COGS 75.8%
SG&A 18.9%
Others 3.6%
Net Income 1.7%

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 Costs Associated with
Goods for Sale
⚫ Managing inventories to increase net income requires
effectively managing costs that fall into these six
categories:
1. Purchasing costs
2. Ordering costs
3. Carrying costs
4. Stockout costs
5. Quality costs
6. Shrinkage costs

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 Management of Inventory Costs
1. Purchasing costs—the cost of goods acquired
from suppliers, including freight

2. Ordering costs—the costs of preparing and issuing

purchase orders, receiving and inspecting the items
included in the orders, and matching invoices received,
purchase orders, and delivery records to make
payments

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 Management of Inventory Costs
3. Carrying costs—the costs that arise while holding
inventory of goods for sale. This includes the
opportunity cost of the investment tied up in
inventory, and costs associated with storage.

4. Stockout costs—the costs that result when a company

runs out of a particular item for which there is
customer demand (stockout) and the company must
act quickly to meet the demand or suffer the costs of
not meeting it.

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 Management of Inventory Costs
5. Quality costs—the costs that result when features
and characteristics of a product or service are not in
conformance with customer specifications. These
costs include:
1. Prevention (design engineering/training/evaluation)
2. Appraisal (inspection/testing)
3. Internal failure (spoilage/ r ework/scrap)
4. External failure (warranty repair/ lost sales/customer
support)

6. Shrinkage costs—costs that result from theft,

embezzlement, and clerical errors
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 The First Step in Managing
Goods for Sale
⚫ The first decision in managing goods for sale is how much
to order of a given product.

⚫ Economic order quantity (EOQ) is a decision model that

calculates the optimal quantity of inventory to order under
a given set of assumptions.

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 Basic EOQ Assumptions
⚫ There are only ordering and carrying costs.

⚫ The same quantity is ordered at each reorder point.

⚫ Demand, purchase-order lead time, ordering costs,

and carrying costs are known with certainty.

⚫ Purchasing costs per unit are unaffected by the

quantity ordered.

⚫ No stockouts occur.

⚫ EOQ ignores purchasing costs, stockout costs, and

quality costs.
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 EOQ Model
⚫ The EOQ minimizes the relevant ordering costs
and carrying costs.

⚫ Relevant total costs = Relevant ordering

costs + Relevant carrying costs

⚫ D = Demand in units for specified period

⚫ Q= Size of each order (order quantity)
⚫ P = Relevant ordering costs per purchase
order
⚫ C = Relevant carrying costs of one unit in stock for
10
the time period used
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 EOQ Formula
⚫ Number of purchase orders per period (one year)
= Demand in units for a period (one
year) Size of each order (order
quantity)
= D/Q
 Annual relevant ordering cost = D*P/Q
⚫ Average inventory in units = Q /2
 Annual relevant carrying cost = Q*C/2
⚫ Annual relevant total cost = DP/Q +
QC/2
⚫ The order quantity that minimizes annual
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 EOQ formula
⚫ The EOQ model is solved using calculus but the key
intuition is that relevant total costs (RTC) are minimized
when relevant ordering cost equal relevant carrying costs.
⚫  QC/2 = DP/Q

⚫  Q2=2DP/C

⚫  Q= 2 D P
C

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 EOQ example
⚫ CD world
⚫ Sell blank CDs.
⚫ Purchases CDs from Sontek at $14 a package (20 CDs each
package)
⚫ No inspection (good quality)
⚫ Annual demand 13,000 packages (250 packages per week)
⚫ 15% required
Purchase orderrate
leadof return
is 2on investment
⚫ weeks time
Relevant ordering cost per purchase order is
$200
⚫ Relevant carrying cost per package: $2.1
⚫ Relevant
Requiredcosts of insurance,
annual return on handling,
investmentbreakage, shrinkage0$
3.10
0.15*$14
⚫ Total$5.20
⚫ Question 1:What is EOQ?
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 EOQ example
⚫ D=
13,000
⚫ P=$200
⚫ C= $5.20 2 x13,000 x
⚫ EOQ= =1,000
packages 200 $5.20
⚫  number of deliveries per period =
13,000/1000=13
⚫  RTC=2,600
⚫ = 13*$200 + 1,000/2
+2,600 = *$5.2
$5,200

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 Ordering and Carrying Costs Illustrated

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 Ordering Points
⚫ The second decision in managing goods for sale is when
to order a given product.

⚫ Reorder point—the quantity level of inventory on hand

that triggers a new purchase order.

Reorder Number of units sold Purchase Order

Point = per unit of time Lead Time

X
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 Reorder example
⚫ Use the CD world example
⚫ Economic order quantity 1,000 packages
⚫ Number of units sold per week 250 packages
(13,000/52)
⚫ Purchase order lead time 2 weeks
⚫ Reorder point = 500

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 Ordering Points Illustrated

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 Inventory Management and
Safety Stock

⚫ Safety stock is inventory held at all times regardless of

the quantity of inventory ordered using the EOQ
model.
⚫ Safety stock is a buffer against unexpected increases in
demand, uncertainty about lead time, and unavailability of
stock from suppliers.

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 Safety stock example
⚫ CD World
⚫ Only uncertainty is the demand
⚫ Expected demand is 250 packages per week,
maximum demand is 400 packages per week
⚫ Management decides that the costs of
stockouts are prohibitive
⚫ How much safety stock should be carried?

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 Safety stockout
⚫ Frequency distribution:
example
⚫ Probability Total demand
⚫ for0.06
2 weeks: 200
⚫ 0.09 300
⚫ 0.20 400
⚫ 0.30 500
⚫ 0.20 600
⚫ 0.09 700
⚫ 0.06 800
⚫ Stockout cost is $4 per package
Relevant carry cost is $5.20 per
package
⚫ What is the optimal safety stock
level?
⚫ Expected
21
demand=0.06*200+0.09*300+0.2*400+0.3*500+0.2*6
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 Safety Stock Computation
Illustration

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 Estimating Inventory-Related Relevant
Costs
⚫ Estimates that need to be made to
calculate:
⚫ Carrying costs
⚫ Stockout costs
⚫ Ordering costs

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 Carrying Costs
⚫ Relevant inventory carrying costs consist of relevant
incremental costs and the relevant opportunity cost of capital.

⚫ Relevant incremental costs—those costs of the purchasing firm

that change with the quantity of inventory held.
⚫ E.g., warehouse rent, warehouse workers’ salaries, cost of
obsolescence, cost of shrinkage, cost of breakage
⚫ Relevant opportunity cost of capital—the return foregone by
investing capital in inventory rather than elsewhere.This cost
equals the required rate of return multiplied by the unit costs that
vary with the number of units purchased and are incurred at the
time the units are received.

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 Stockou
t ⚫The relevant opportunity cost is:
⚫1) the lost contribution margin on sales forgone due
to stockout
2) lost contribution margin on future sales
forgone due to customer ill will

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 Ordering cost
⚫ Relevant ordering costs are only those ordering costs
that change with the number of orders placed
⚫ -- e.g., costs of preparing and issuing purchase
orders, receiving and inspecting materials

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 Cost of a Prediction Error
⚫ Three steps in determining the cost of a prediction
error:
1. Compute the monetary outcome from the best action
that could be taken, given the actual amount of the cost
per purchase order.
2. Compute the monetary outcome from the best action
based on the incorrect amount of the predicted cost per
purchase order.
3. Compute the difference between steps 1 and 2.

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 Cost of prediction error example
⚫ CD World
⚫ Suppose relevant ordering cost per purchase order are
$100, while managers predict to be $200 at the time of
calculating the order quantity.
⚫ What is the cost of this prediction error?

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 Cost of prediction error example
⚫ Step 1 (calculate the correct
amount):
⚫ D=13,000
⚫ P=$100
⚫ C= $5.20
⚫  EOQ (correct)= ?
⚫ RTC(correct) = ?

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 Cost of prediction error example
Step 1 (calculate the correct amount based on
actual):
⚫D=13,000
⚫P=$100
⚫C= $5.20

⚫ EOQ (correct)= 707 units (rounded)

⚫RTC(correct) = $1839 + $1838 = $3,677

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 Cost of prediction error example
⚫ Step 2 (calculate the incorrect
amount):
⚫ D=13,000
⚫ P=$200
⚫ C= $5.20
⚫  EOQ (incorrect)= 1,000
⚫ RTC (incorrect)= ?

⚫ Step 3: Difference = ?

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 Cost of prediction error example
Step 2 (calculate the incorrect amount):
⚫D=13,000
⚫P=$200
⚫C= $5.20
 EOQ (incorrect)= 1,000

⚫By having an incorrect EOQ

 RTC (incorrect)= Relevant ordering cost + Relevant carrying
cost
= 13000/1000 x $100 +
1000/2 x $5.20
= $1,300 + $2,600 = $3,900
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 Evaluating Managers and Goal-
Congruence Issues
⚫ Goal-congruence issues can arise when there is an
inconsistency between the EOQ decision model and
the performance evaluation model
⚫ The opportunity cost of investment tied up in
inventory is a key input in the EOQ decision model.
⚫ Some companies now include opportunity costs as
well as actual costs when evaluating managers

33
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 Short Grass Incorporated is a distributor of golf balls. Martin's Golf Supplies is a local retail
outlet sells golf balls. Martin's purchases the golf balls from Short Grass Incorporated
which $0.75 at
per golf
the ball;balls are shipped in cartons of 72. Short Grass Incorporated pays all incoming freight, and
Martin's Golf Supplies does not inspect the balls due to Short Grass' reputation for high quality.
Annual
demandis 155,520 golf balls at a rate 2,991 balls per . Martin's Golf Supplies 12% on
of investments.The purchase-orderweek
cash lead one earns
.The following cost data are its
time is week available:
Relevant ordering costs per purchase $125.00
order
Carrying costsper carton per
year:
Relevant insurance, materials handling,breakage, etc., $
per year 0.77

1) If Martin's makes an order (1/12 of annual demand) once per month, what are the relevant
total costs?
A) $1,500
B) $652.50
C) $2,152.50
D) $3,000.00

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 Short Grass Incorporated is a distributor of golf balls. Martin's Golf Supplies is a
local retail outlet which sells golf balls. Martin's purchases the golf balls from Short
Grass Incorporated at $0.75 per ball; the golf balls are shipped in cartons of 72.
Short Grass Incorporated pays all incoming freight, and Martin's Golf Supplies does
not inspect the balls due to Short Grass' reputation for high quality. Annual demand
is 155,520 golf balls at a rate of 2,991 balls per week. Martin's Golf Supplies earns
12% on its cash investments. The purchase-order lead time is one week. The
following cost data are available:
Relevant ordering costs per purchase order

$125.00 Carrying costs per carton per year:

Relevant insurance, materials handling,breakage,
etc., per year

$ 0.77

2) What is the economic order quantity?

36
A)180 cartons
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B)273 cartons
 Short Grass Incorporated is a distributor of golf balls. Martin's Golf Supplies is a local retail outlet
which sells golf balls. Martin's purchases the golf balls from Short Grass Incorporated at $0.75 per
ball; the golf balls are shipped in cartons of 72. Short Grass Incorporated pays all incoming freight,
and Martin's Golf Supplies does not inspect the balls due to Short Grass' reputation for high quality.
Annual demand is 155,520 golf balls at a rate of 2,991 balls per week. Martin's Golf Supplies earns
12% on its cash investments.The purchase-order lead time is one week.The following cost data are
available: Relevant ordering costs per purchase $125.00
order Carrying costs per carton per
year: Relevant insurance, materials
handling, breakage, etc., per year $
0.77

3)Purchasing at the EOQ recommended level, how many deliveries will be made during each
time period?
A)2 deliveries
B)6.0 deliveries
C) 7.91 deliveries
D) 12 deliveries

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