Working Capital Management (2) – Inventory

1 Introduction

The purpose of this chapter is to examine approaches to managing inventory efficiently. The two most important approaches are the EOQ model and ‘Just-in-time’ inventory.

2 The EOQ (Economic Order Quantity) model

In practice, there are many ways in which inventory can be ordered from suppliers but the EOQ model assumes that fixed quantities are ordered each time.

For example, if a company needs a total of 12,000 units each year, then it could decide to order 1,000 units to be delivered 12 times a year. Alternatively, it could order 6,000 units to be delivered 2 times a year. There are obviously many possible fixed order quantities.

We will consider the costs involved and thus decide on the order quantity that minimises these costs (the economic order quantity).

3 Costs involved

3.1 The costs involved in an inventory ordering systems are as follows:

• the purchase cost
  

• the reorder cost
  

• the inventory-holding cost
  

3.2 Purchase cost

This is the cost of actually purchasing the goods. Generally, over a year the total purchasing cost will remain constant regardless of how we decide to have the items delivered and is therefore irrelevant to our decision. However, that assumption must change if the company can receive discounts for placing large orders as the purchase price can then vary with order size. This will be discussed later in this chapter.

3.3 Re-order cost

This is the cost of actually placing orders. It includes such costs as the administrative time included in placing an order, and the delivery cost charged for each order. The re-order cost does not vary with the quantity ordered - the same administration is needed whether 10 or 1,000 units are ordered at a time.

If there is a fixed cost for each order then higher order quantities will result in fewer orders needed over a year and therefore a lower total reorder cost over a year.

3.4 Inventory holding cost

This is the cost of holding items in inventory. It includes costs such as providing warehousing space and insurance and also the interest cost of money tied up in inventory.

Higher order quantities will result in higher average inventory levels in the warehouse and therefore higher inventory holding costs over a year.

4 Minimising costs

One obvious approach to finding the economic order quantity is to calculate the costs p.a. for various order quantities and identify the order quantity that gives the minimum total cost.

5 The EOQ formula

A more accurate and efficient way to find the EOQ is to use the formula that will be provided for you in the exam, if needed.

The formula is:

EOQ = √(2C_oD/C_h)

Where   C_o = fixed costs per order

    D = annual demand

    C_H = the stockholding cost per unit per annum

(Note:   you are not required to be able to prove this formula)

6 Quantity discounts

Often, discounts will be offered for ordering in large quantities. The problem may be solved using the following steps:

1. Calculate EOQ ignoring discounts
   

2. If it is below the quantity which must be ordered to obtain discounts, calculate total annual inventory costs - including purchase costs.
   

3. Recalculate total annual inventory costs using the order size required to just obtain the discount
   

4. Compare the cost of step 2 and 3 with the saving from the discount and select the minimum cost alternative.
   

5. Repeat for all discount levels
   

7 The Just-in-time system

Under this approach, minimum inventories are held of finished goods, work-in-progress, and raw materials. Rather than making goods and pushing them into inventory in they will sell, customer orders pull materials into and through the production line.

The conditions necessary for the business to be able to operate with minimum inventories include the following:

7.1 Finished Goods:

• a short production period, so that goods can be produced to meet demand (‘demand-pull’ production)
  

• good forecasting of demand
  

• good quality production, so that all production is actually available to meet demand.
  

7.2 Work-in-Progress:

• a short production period. If the production is faster, then the level of WIP will automatically be lower.
  

• a flexible workforce to allow expansion and contraction of production at short notice.
  

7.3 Raw Materials:

• supplies received as they are needed for production (instead of being able to take from inventory). This requires the selection of suppliers who can deliver quickly and at short notice
  

• guaranteed quality of raw material supplies (so that there are no faulty items holding up production)
  

• flexible suppliers to deliver more or less at short notice.
  

• tight contracts with suppliers, with penalty clauses, to enforce quality and delivery times.
  

A ‘just-in-time’ approach is a philosophy affecting the whole business and obviously requires great coordination both within the business and with outside entities. The benefits are not just cost savings from lower inventory-holding costs and less risk of obsolete inventory, but benefits in terms of better quality production (and therefore less wastage), greater efficiency, greater flexibility to meet customers' orders quickly and therefore greater customer satisfaction.

8 Ordering and storing inventory

• Set reorder levels using demand during supplier lead time plus a buffer for uncertainty. Choose order quantities by balancing ordering and holding costs. Review supplier reliability and stock-out consequences.

• Storage policy should address capacity, security, insurance, deterioration and obsolescence. Rotate perishable stock and review slow-moving lines; avoid buying excessive quantities just to obtain discounts.

8.1 Work in progress

Work in progress (WIP) is production which has started but is not yet complete. It ties up materials, labour and overhead expenditure before goods can be sold.

• Reduce WIP by shortening production lead times, removing bottlenecks, scheduling batches efficiently and preventing defects/rework. Coordinate supply and production so efficiency improvements do not cause shortages.

9 Chapter 2 questions

Question 2

If a company orders 1,200 units of a component at a time, how many units are assumed to be in inventory on average?

Question 3

A company orders 2,000 units at a time and uses 10,000 units per month. Units cost $10 each but the company would be given a 10% discount if it ordered at least 5,000 units per order.

If the company ordered 5,000 units at a time, what value of discount would it enjoy per year?  

Question 4

What is the economic order quantity of an item of inventory with the following characteristics?

Demand per month = 3,000 units

Cost of placing an order = $100

Cost of holding 1 unit per year is 10% of its purchase price (each unit costs $20)

EOQ = √(2C_oD/C_h)

  Where   C_o = fixed costs per order

      D = annual demand

      C_H = the stockholding cost per unit per annum