Chapter 4 - management of working capital - inventory

Question 1

how to manage inventory effectively ?

Answer 1

The two most important approaches are the EOQ model and the ‘Just in Time’ approach

Question 2

what is the EOQ (economic order quantity ) ?

Answer 2

The EOQ is the optimum order amount that minimises cost. For example if we had to order 12,000 items over the year do we make twelves orders or maybe 6 orders every 2 months

Question 3

what are the costs involved in inventory ordering systems (EOQ)

Answer 3

The purchase cost - this is the cost to buy the goods, over a year the total costs will remain constant regardless of how we decide to have the items delivered and it is therefore irrelevant to our decision (unless we are given discounts)

The reorder cost - this is the cost in placing the order. It includes costs such as administrative time included in placing the order and the delivery charge for each item

The inventory holding cost - this is the cost to hold the goods. It includes warehouse space, insurance and the interest cost of money tied in inventory.

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

Question 4

What is the EOQ (economic order quantity) formula ?

Answer 4

EOQ = square root of (2Co/D) / Ch

Co = fixed costs per order
D = Annual demand
Ch = the stockholding cost per unit per annum

Question 5

how to factor in quantity discounts ?

Answer 5

1. Calculate the EQO Ignoring discounts
2. If it is below the quantity which must be ordered to obtain discounts, calculate total annual inventory costs
3. Recalculate total annual inventory costs using the order size requires 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

Question 6

What are the conditions necessary to operate with minimum inventories - finished goods

Answer 6

1. A short production period so that goods can meet demand (‘demand pull’ production)
2. Good forecasting of demand
3. Good quality production so that all production can meet demand

Question 7

What are the conditions necessary to operate with minimum inventories - work on progress

Answer 7

1. Short production period, if production is faster the WIP will be lower
2. Flexibility of workforce to expand and contract production at short notice

Question 8

What are the conditions necessary to operate with minimum inventories - raw materials

Answer 8

1. The ability to receive raw materials from suppliers as they are need for production ( instead of being taken from inventory)
2. Guaranteed quality of raw materials (so no faults holding up production)
3. Tight contracts with suppliers with no penalty clauses as the reliance placed upon suppliers for quality and delivery times
4. Flexible suppliers to deliver more or less at short notice

Question 9

what is the just in time system ?

Answer 9

Minimal inventories are held of finished goods, work in progress and raw materials

Benefits are not just cost saving from lower inventory but also better quality production and therefore less wastage, greater efficiency and customer satisfaction

This approach affects the whole business