17.1 Working capital management - Inventory control

Question 1

The objectives of inventory management

Answer 1

• Inventory is a major investment for many entities, it is therefore essential to reduce the levels of inventory to necessessary minimum

Question 2

Inventory balancing act between

Answer 2

• Liquidity - Reducing inventory to the lowest possible amount to minimise the level of capital employed (CE) to be funded
• Profitability - Ensuring sufficient inventory is held so as not to run out and disrupt business

Question 3

The costs of high inventory levels are

Answer 3

• The foregone interest that is lost from lying up capital in inventory
• Holding costs - storage, stores administration & risk of theft/damage/obsolescence

Question 4

Costs of low inventory levels are

Answer 4

• Stock outs - lost contribution, production stoppages, emergency orders
• High reorder / setup costs
• Lost quantity discounts

Question 5

The challenge / objective of good inventory management is to determine

Answer 5

• The optimum reorder level - how many items should be left in inventory when the next order is placed
• The optimum reorder quantity - how many items should be ordered when the order is placed

(In practice, this is a trade off between holding costs and stock-out / reorder costs)

Question 6

Lead time

Answer 6

the lag between when an order is placed and the item is delivered

Question 7

Buffer inventory

Answer 7

the basic level of inventory kept for emergencies, because both demand and lead time will fluctuate and predictions are only based on estimates

Question 8

Economic order quantity (EOQ)

Answer 8

the optimum order quantity for inventory items
(point where total holding costs = total ordering costs)

Question 9

The aim of EOQ model is to

Answer 9

minimize the total cost of holding and ordering inventory
(ie. balance the variable cost of holding inventory and fixed cost of placing order)

Question 10

EOQ formula

Answer 10

EOQ = Square of [2CoD / Ch]

Co = cost per order
D = annual demand
Ch = cost of holding one unit for one year

Question 11

The following EOQ assumptions are made

Answer 11

• demand and lead times are constant and known
• purchase price is constant
• no buffer inventory held as it is assumed that it is not needed since demand and lead times are known with certainty (no stock outs)

Question 12

Annual holding cost formula

Answer 12

Holding cost per unit (Ch) X Average inventory (x / 2)

x = quantity ordered

(we see an upward sloping, linear relationship between reorder quantity and total annual holding costs)

Question 13

Annual order cost formula

Answer 13

Order cost per order (Co) X No of orders per year (D/x)

D= annual expected sales demand
x = quantity ordered

(shows a downward sloping curved relationship)

Question 14

Dealing with EOQ and quantity discounts

Answer 14

If the EOQ is smaller than the order size needed for a discount should the order size be increased above the EOQ

Question 15

Steps to determine if order size should be greater than EOQ for a quantity discount

Answer 15

1) Calculate EOQ ignoring discounts
2) If the EOQ is below the quantity qualifying for a discount, calculate the total annual inventory cost (including purchase cost) resulting from using EOQ
3) Recalculate total annual inventory costs (including purchase cost) using the order size required to just obtain each discount
4) Compare the costs of steps 2 and 3 with the saving from the discount and select the minimum cost alternative
5) Repeat for all discount levels

Question 16

Inventory management systems

Answer 16

• Periodic review
• JIT

Question 17

Periodic review system (constant order cycle system)

Answer 17

• Inventory levels are reviewed at fixed intervals, eg every four weeks
• Inventory on hand is then brought up to a predetermined level which takes into account
  
  • likely demand before next review
  • likely demand during lead time

Question 18

Just in time (JIT) systems

Answer 18

• are a series of manufacturing and supply chain techniques that aim to minimise inventory levels and improve customer service by manufacturing at exact time customers require it, and also in exact quantities they need and at competitive prices
• no longer a balancing act between costs, rather inventory is reduced to an absolute minimum or eliminated
• involves the elimination of all activities that do not add value (ie. waste)

Question 19

Aims of JIT are:

Answer 19

• A smooth flow of work through the manufacturing plant
• A flexible production process which is responsive to the customers requirements
• Reduction in capital tied up in inventory

Question 20

Inventory level control systems

Answer 20

• Reorder level system - inventory is ordered at a particular, set order level
• Periodic review system - inventory is checked and ordered at set periods in time
• Mixed systems - using elements of above two systems

Question 21

Reorder level (ROL)

Answer 21

• is the quantity of inventory on hand when an order is placed
• when demand and lead time are known with certainty, the ROL is calculated exactly (ROL = demand in lead time)
• with variable demand and lead times, the ROL will be calculated as max demand x max lead time (leads to buffer stock)