Transcript Chapter 4 Managing Inventory

Chapter 4
Managing Inventory
INV
Copyright  2005 by Thomson Learning, Inc.
The Cash Flow Timeline
Order
Placed
Order
Received
Sale
Payment Sent Cash
Received
Accounts
Collection
< Inventory > < Receivable > < Float >
Time ==>
Accounts
< Payable >
Invoice Received
Disbursement
<
Float
>
Payment Sent
Cash Disbursed
Copyright  2005 by Thomson Learning, Inc.
Objectives

Appreciate impact of holding and ordering costs on
order quantity

Traditional EOQ & quantity discounts

Appreciate JIT concepts

Assess impact that different order quantities have
on timing and amount of payments

Use of balance fractions to monitor inventory
balances
Copyright  2005 by Thomson Learning, Inc.
Concept of Inventory
Factor in the length of cash cycle
 Acts as a shock absorber
 Three types

– raw materials
– work-in-process
– finished goods

Motives for holding inventory
– transaction
– precautionary
– speculative
Copyright  2005 by Thomson Learning, Inc.
Inventory Investment Function
Demand for product
 Cost of holding inventory

– insurance
– storage
– cost of capital

Cost of ordering inventory

Total cost = Order Cost + Holding Cost
= F x (T/Q) + H x (Q/2)
Copyright  2005 by Thomson Learning, Inc.
Order Cost and Holding Cost Tradeoff
$
Holding cost = H x (Q/2)
Order costs = F x (T/Q)
Order quantity, Q
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Economic Order Quantity

EOQ solution:
SQRT (2TF/H)

Number of orders:
T/Q

Average inventory:
Q/2

Usage rate:
T/D

Reorder point:
(T/D) x Delivery Time
(D=days)
Copyright  2005 by Thomson Learning, Inc.
Quantity Discounts
TC = Order Cost
TC =
+ Holding Cost + Item Cost
(F x (T/Q)) +
(H x (Q/2)) +
(C’ x T)
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Inventory and the Cash Flow
Timeline
Inventory ordered
and received
< Inventory Held>
Inventory ordered
and received
<Inventory Held>
Time=>
Cash paid
for inventory
Cash paid
for inventory
Cash paid
for holding &
ordering costs
Copyright  2005 by Thomson Learning, Inc.
Monitor the Inventory Balance

Inventory control systems

Inventory turnover ratio
– Sales or COGS / Inventory balance

Days COGS in inventory
– Inventory balance / Daily COGS or Sales

Balance fraction approach
– Develop monthly balance fractions based on the proportion of
items remaining in inventory from a given month’s purchase.
Copyright  2005 by Thomson Learning, Inc.
Reducing Investment in Inventory

Problems were solved by adding more
inventory

JIT redesigns system

Redesign of production system
– eliminate waste
– eliminate production errors
– improving quality

Need stable demand
Copyright  2005 by Thomson Learning, Inc.
Summary

Inventory decisions should be based on:
–
–
–
–
–
cost of holding inventory
cost or ordering inventory
opportunity cost of funds
quantity discounts
is quantity workable within inventory management system?
Inventory, if properly managed can be a major
contributor to cash flow...
 if mismanaged, it can be a significant drain on
cash.
 Some traditional inventory monitoring tools can be
biased by sales and production trends.

Copyright  2005 by Thomson Learning, Inc.