Week 9 - Working Capital 2 Flashcards
What does optimisation mean?
Is the point where the gain achieved for a single unit increase is no longer greater than the damage or loss suffered
What is the impact of having too much stock? (2)
• May have to pay for a larger building to put added stock into
• Stock that stays in inventory too long may become obsolescent
What is the impact of having too little stock? (3)
• The service to customers will get worse and it is likely that you’ll be out of stock more often
• Increased delivery stocks as a result of more frequent stock orders
• Loose any bulk buying discounts
What is the Economic Order Quantity (EOQ) model? And what is a limitation of the model? (2)
• Is a model that takes into the financing cost (too much stock), the storage cost (too much stock) and the order and redelivery cost (too little stock)
• The model ignores “service level” effects and the damaged caused by letting customers which can impact sales
Interpretation of Economic Order Quantity (4)
• Finance and storage costs increase as stock increases
• Ordering and delivery costs decrease as stock increases
• Adding the 2 lines we can find the stock vs cost relationship
• EOQ is the optimal order quantity that minimises total costs (balancing holding and ordering costs)
Formula for Economic Order Quantity (EOQ)
Draw Economic Order Quantity model (Quantity-Time)
What is the formula for cost of inventory?
Cost of inventory = cost of ordering + cost of holding the stock
What is the formula for the cost of ordering?
Total order quantity / average order quantity x cost of each order
What is the formula for the cost of holding the stock?
Cost of each order x cost of holding the stock (storage + financing each item)
How do you workout whether a benefit for bulk buying is worth taking?
Workout the EOQ as before, calculating the inventory cost and then rework the cost with the new order level and the new savings
What are the two models which allow us to optimise cash use within a business?
• The Baumol
• The Miller-Orr
What is the Miller-Orr model? (4)
• Is a model that allows for variable cash needs
• The firm sets the lowest level of cash it is prepared to risk
• When the lower limit is reached the firm sells shirt term investment sufficient to reach a return point
• When cash reaches an upper limit it is reinvested in short term investment until it comes back to the return point
What is the formula for the spread? (The distance between upper and lower limit in the miller-Orr model)
What is the formula for the return point in the miller-Orr model?
What are the different costs that are incurred by holding inventory? (4)
• Holding costs such as insurance, rent and utility charges
• Replacement costs, including the cost of obsolete inventory
• The cost of the inventory itself
• The opportunity cost of cash tied up in inventory
What impact does lead time and demand have on managing inventory? (2)
• If demand and lead time is constant new inventory should be order when stock reaches the amount amount needed during lead time
• If demand or lead time is uncertain buffer stock should be used where the optimal level balances holding costs and the risk of running out of stock
What is the importance of cash management?
Cash management focuses on optimising the amount of cash available, maximising interest earned by spare funds not required immediately and reducing losses caused by delays in transmission of funds
3 Reasons why companies choose to hold cash
• Transactions motive - day to day transactions, balance cash inflows and outflows
• Precautionary motive - mitigate uncertainty for unexpected cash demand
• Speculative motive - hold cash for attractive investment opportunities that may arise
What are the assumptions of the EOQ model? (9)
• Constant Demand – Demand is known, constant, and uniform.
• Constant Lead Time – The time between ordering and receiving is fixed.
• Instantaneous Replenishment – Orders arrive immediately; no delays.
• No Quantity Discounts – Unit cost remains the same regardless of order size.
• Only Ordering & Holding Costs Matter – No consideration for shortages or transportation costs.
• No Stockouts or Shortages – Always enough inventory available.
• Single Product Scenario – EOQ applies to only one product at a time.
• Infinite Planning Horizon – Inventory decisions are ongoing indefinitely.
• Full Lot Delivery – Entire order is received at once
