14. Inventory Management

Question 1

State 6 reasons why a business may want to hold inventory.

Answer 1

1. To meet demand by acting as a buffer in times of unusually high consumption (ie to reduce the risk of stock outs).
2. To ensure continuous production.
3. To take advantage of quantity discounts.
4. To buy in ahead of an expected shortage or ahead of an expected price rise.
5. For technical reasons (eg maturing whiskey in casks or keeping oil in pipelines).
6. To reduce ordering costs.

Question 2

What are 5 costs associated with inventory?

Answer 2

1. Purchase price
2. Holding costs
   - cost of capital tied up
   - insurance
   - deterioration, obsolescence and theft
   - warehousing
   - stores administration
3. Reorder costs
   - transport costs
   - clerical and admin expenses
   - batch set up costs for internally produced goods
4. Shortage costs
   - production stoppages due to lack of raw materials
   - stock out costs for finished goods (eg lost sale)
   - emergency re-order costs
5. Systems costs - people and computers.

Question 3

What is the economic order quantity? State the formula for calculating the EOQ.

Answer 3

This is the optimal order quantity that minimises the total costs which are relevant to ordering and holding inventory.

x = √[(2C_oD)/C_h]

Where:

x = order quantity
C_h = cost of holding one unit for one year
D = annual demand
C_o = cost of placing an order

Question 4

What are the formulas for annual holding and recorder costs?

Answer 4

Annual holding cost
The cost of holding one unit in inventory for one year * the average number of units held.
= (x/2)*C_h

Annual reorder cost
The cost of an order * the number of orders in a year.
= (D/x)*C_o

Question 5

What is lead time?

Answer 5

This is the time between placing and receiving an order.

Question 6

Outline how the reorder level calculated when there is constant demand in lead time.

Answer 6

Reorder level (ROL) =
lead time (days) * demand per day

Unrelated but
ROL = (lead time * sales per week) + safety stock

Question 7

Outline how the reorder level calculated when there is uncertain demand in lead time.

Answer 7

If demand level is unknown then there can only be expected level of demand and buffer stock will be needed to reduce the risk of a stock out.

Method:
1. Calculate expected demand in the lead time.
Expected lead time demand =
Σx_ip(x_i)

Where:
x_i = level of demand
p(x_i) = probability of level of demand

2. Take each level of demand ≥ expected lead time demand as a possible reorder level and calculate the expected annual stock-out cost.
3. For each possible ROL, calculate the expected annual buffer holding cost.
4. Choose the ROL with the lowest sum of stock-out cost and holding cost.

Question 8

What is the formula for annual stock out cost?

Answer 8

Average units short * stock-out cost per unit * number of orders per year.

Question 9

Outline the following Just-In-Time systems:
1. Purchasing
2. Production
3. Inventory management

Answer 9

1. JIT purchasing system aims to minimise the cost of holding inventory by placing orders so that the time of delivery is when the goods are needed.
2. JIT production system aims to minimise the cost of manufacturing by only producing goods as they are needed.
3. JIT inventory system aligns purchasing and production to sales demand on a week-to-week or day-to-day basis.