Management of inventories Flashcards
What is management of inventories?
Inventory management is a key aspect of working capital management. It is crucial for businesses as it has a direct
impact on profitability.
The main objective of inventory management is to achieve maximum profits by maintaining adequate inventory levels for smooth business operations, while also monitoring the levels to minimise the costs of inventory holding.
Holding too much inventory can result in the company’s cash being tied up in purchasing, storing, insuring and managing inventory. It may also result in product obsolescence or waste, especially if the inventory is perishable.
What happens if you hold too much inventory?
What happens if you hold too much inventory?
By holding too little inventory, the business faces liquidity issues and costs of stock-outs, including re-order costs, setup costs and lost quantity discounts.
The key task of inventory management – striking a balance between holding costs and costs of stock-out – involves determining:
- the optimum re-order level
- the optimum re-order quantity
What do we mean by re-order level?
Re-order level
Companies need to identify the level of inventory that must be reached before an order is placed. This is known as the
re-order level (ROL).
It indicates how much inventory to re-order and when to re-order.
In reality, demand will vary from period to period. When demand and lead time are known with certainty, ROL equals the demand in the lead time.
Lead time is the time taken to receive inventory after it is ordered.
When demand and lead times are not known with certainty, inventory must include an optimum level of buffer (safety)
inventory to minimise the costs of stock-outs. This depends on the level of demand, holding costs and the cost of stock-outs.
What are the inventory management techniques that help in efficient inventory management?
What are the inventory management techniques that help in efficient inventory management?
- economic order quantity
- ABC inventory control
- just-in-time systems
- fixing the inventory levels
- vital, essential and desirable analysis
What is the Economic order quantity?
The economic order quantity (EOQ) focuses on maintaining an optimum order quantity for inventory items. The aim of
the EOQ model is to balance the relevant costs by minimising the total cost of holding and ordering inventory.
Holding costs
The model assumes that it costs a certain amount to hold a unit of inventory for a year. The variable cost of holding the
inventory is referred to as the holding cost. As the average level of inventory increases, so too will the annual holding
costs. The annual holding cost is calculated as:
Holding cost per unit × average inventory
Ordering costs
Ordering costs are the fixed costs of placing the order, incurred every time an order is placed. These include costs
of transportation, inspections and so on.
As the order quantity increases, the total ordering cost reduces. The annual ordering cost is calculated as:
Order cost per order × no of orders per annum
What is the calculation of Economic order quantity (EOQ)
Calculation of EOQ
The EOQ can be calculated using the formula:
EOQ = √2 × c × d ÷ h
Where:
d = annual demand,
c = ordering cost per order
h = holding cost per unit for one year
This provides the optimum inventory order size based on the annual inventory requirement, for which both the ordering
cost and carrying cost are kept at minimum.
What are Assumptions and drawbacks of Economic order quality?
The model assumes that:
- demand and lead time are constant: this model will be ineffective for the business whose demand fluctuates
frequently; - purchase price, ordering and holding costs remain constant;
- no buffer inventory is held or needed;
- seasonal fluctuations can be ignored; and
- inventory levels are continuously monitored
Quantity discounts
Economic order quantity must be compared with the quantity needed for quantity discounts. Companies must consider whether the order size should be increased above the EOQ to get the benefit of quantity discounts if the overall inventory cost is lower
How do you determining inventory levels?
How do you determining inventory levels?
The key to inventory management is to identify the correct level of inventory to hold. Inventory can be categorised into
four levels:
- minimum level
- reorder level
- maximum level
- danger level
Describe the following inventory levels:
- maximum level
- reorder level
- maximum level
- danger level
Minimum level
This is the lowest balance that should be maintained by the company at all times. This level ensures that production will
not be suspended due to lack of raw materials. While fixing the minimum level of inventory, one should keep in mind the
time required for delivery and daily consumption.
Re-order level
This is the level of inventory at which the company should make a new order for supply. It is between the minimum level and the maximum level.
When determining the re-order level, the minimum level and rate of consumption have to be considered.
Re-order level = minimum level + (rate of consumption × re-order period).
Maximum level
This is the maximum inventory level that the company can hold at any point of time. The inventory should not be more
than the maximum level. If the level of inventory exceeds the maximum level, it increases the carrying costs and it is
treated as overstocking.
Maximum level = re-order level + re-order quantity – (minimum rate of consumption × minimum re-order period).
Danger level
This level is fixed below minimum level. The inventory reaches this level when the normal issue of raw material is
stopped and issued only in case of emergency.
Immediate action must be taken by the company when the inventory reaches danger level.
Danger level = rate of consumption × maximum re-order period in case of emergency
What is Just in time (JIT)?
The just in time (JIT) system is a series of manufacturing and supply chain techniques that aim to reduce inventory to an
absolute minimum or eliminate it altogether by manufacturing at the exact time customers require, in the exact quantities they need and at competitive prices.
The JIT system, also known as the Toyota Production System (TPS), was developed in Japan in the 1960s and 1970s,
particularly at Toyota.
The key objective is to reduce flow times within the production system as well as response times
from suppliers and to customers.
JIT attempts to eliminate waste, capital being tied up in inventory and activities that do not add value by ensuring a
smooth flow of work at every stage of the manufacturing and the production process.
This also reduces storage and labour costs. Examples of waste include:
- capital and storage tied up in RM, WIP and FG
- materials handling costs
- rejects and reworks from poor quality
- queues and delays
- long raw material and customer lead times
- unnecessary clerical and accounting procedures
Why is relationship with suppliers important to JIT?
Relationships with suppliers are an important aspect of the JIT system. If the supplier does not deliver the raw materials
in time, it could become very expensive for the business.
A JIT manufacturer prefers a reliable, local supplier to meet
the small but frequent orders at short notice, in return for a long-term business relationship. JIT has very low inventory
holding costs (close to zero): however, inventory ordering costs are high.
What are the benefits of JIT
Benefits of just in time:
- Improved inventory control and reduced inventory waste
- Reduced storage and labour cost
- lower lead time
- long term relation with suppliers
- better customer service
- better control over manufacturing processes
What are dis- advantages of JIT?
Despite the magnitude of the preceding advantages, there are also some drawbacks associated with the JIT system:
- Since the manufacturer does not maintain high levels of inventory, any price fluctuations in raw materials could make
the JIT system costlier. - This model may not be helpful in cases of excess and unexpected demand, since it means few or no inventories of
finished goods are held. - Production is highly reliant on suppliers. If raw materials are not delivered on time, it could become very expensive
for the business. - It may need an investment in technology that links the information systems of the company and its suppliers.
Explain the ABC inventory control?
materials are divided into three categories:
- A category items
These items require high investment but only represent small amounts in terms of inventory items. Generally,
these items represent only 15% to 20% of inventory items but have a relatively high consumption (also referred to
as the 80/20 rule by the ‘Pareto approach’ where 80% of the output is determined by 20% of the input).
Due to the high value associated with A category items and the greatest potential to reduce costs or losses, these are closely monitored and controlled to ensure these items are not over- or under-stocked.
- B category items
These items represent 30% to 35% of inventory items by item type and about 20% of the value of consumption.
B category items are relatively less important than A items. However, these will be maintained with good records and regular attention.
- C category items
These items are the remaining items of inventory with a relatively low value of consumption. Usually they only
make up to 10% of the total value of consumption.
C category items are ordered on a half-yearly or yearly basis. It is not usually cost-effective to deploy tight inventory controls, as the value at risk of significant loss is relatively low.
What is VED analysis?
VED analysis
VED stands for vital, essential and desirable.
It is a popular technique, especially with companies at the start-up stage who are working with limited resources and small budgets.
Under-ordering can reduce the revenue stream while over-ordering can lead to capital being tied up.
The key objective of VED analysis is to identify the criticality of inventory items that the business cannot operate without.
Inventory items are classed based on the degree of criticality.
- Vital:
these are the vital items without which the production activities of the company would come to halt. These
inventories should always be kept in hand.
- Essential:
these are essential spare parts but whose non-availability may not adversely affect production. Such spare parts may be available from multiple sources within the country and the procurement lead time may not be long.
- Desirable:
desirable items are those items whose stock-out or shortage causes only a minor disruption for a short duration in the production schedule. The cost incurred is very nominal.
