Working Capital Management

Question 1

What three reasons do firms have to hold inventory?

Answer 1

TRANSACTION MOTIVE
PRECAUTIONARY MOTIVE
SPECULATIVE MOTIVE

Question 2

TRANSACTION MOTIVE

Answer 2

Firms hold inventory to meet production and sales requirements.

Question 3

PRECAUTIONARY MOTIVE

Answer 3

Firms hold additional amounts of inventory when future supply and demand is uncertain.

Question 4

SPECULATIVE MOTIVE

Answer 4

Firms hold higher or lower inventory level to speculate on the expected increase or decrease in future input prices.

Question 5

HOLDING COSTS

Answer 5

Cost of holding stock including:

• Opportunity cost of investment in inventories
• Incremental insurance costs
• Incremental material handling costs
• Cost of obsolescence and deterioration of inventories

Question 6

ORDERING COSTS

Answer 6

Incremental clerical costs of preparing a purchase order, placing an order, receiving deliveries and paying invoices.

Question 7

ACQUISITION COSTS

Answer 7

Not relevant.

Remain unchanged irrespective of the order size or inventory level.

Question 8

ECONOMIC ORDER QUANTITY

Answer 8

The optimum order size that will result in the total amount of the ordering and holding costs being minimised.

Trade-off between ordering costs and holding costs.

If more units are ordered at one time, fewer orders will be required per year.

• Reduction in ordering costs
• Increase in holding costs because larger average inventories must be maintained.

Question 9

EOQ Formula

Answer 9

EOQ = sqrt((2DO)/H)

D = Total demand for the period
O = Cost per order
H = Holding cost per unit (gallon)

Question 10

What is the assumption of the EOQ formula?

Answer 10

H and O are constant per unit and inventories are consumed evenly throughout the period.

Question 11

What are the assumptions of EOQ?

Answer 11

• Holding cost per unit will be constant.

- The average balance in inventory is equal to half of the order quantity.

Question 12

How can EOQ be applied to production run?

Answer 12

• The EOQ formula can be adapted to determine the optimum batch size when a set-up cost is incurred only once for each batch produced.
• The objective is to find the optimum number of units that should be manufactured in each production run.

Question 13

Example of how EOQ formula can be applied to production run.

Answer 13

Assume:
Sales demand (D) = 9,000 units
Cost per set up (S) = £90
Holding cost per unit (H) = £2

Q = sqrt((2DS)/H)

Question 14

QUANTITY DISCOUNT

Answer 14

Buying larger consignments leads to savings:

• Savings in purchase price (discount).
• Reduction in the total ordering cost.

Still need to compare the savings and increased holding costs.

Question 15

RE-ORDER POINT

Answer 15

The point at which the order should be placed to obtain additional inventories.

= lead time x the daily/weekly usage

Question 16

LEAD TIME

Answer 16

The time that will elapse between placing the order and the actual delivery of the inventories.

Question 17

SAFETY STOCKS

Answer 17

The amount of inventories that are held in excess of the expected use during the lead tie to provide a cushion against running out of stocks because of fluctuations in demand.

Under uncertainty, firms maintain a level of safety stocks

Question 18

When can stock out occur?

Answer 18

If actual demand increases or lead time is extended.

Question 19

What is the reorder point when demand and lead time are uncertain?

Answer 19

(average rate of usage* lead time) + safety stock

Question 20

STOCK OUT COSTS

Answer 20

Opportunity cost of running out of stock.

Question 21

Probability theory for safety stocks

Answer 21

Trade off relationship between stock-out costs and costs of holding safety stocks.

Need to minimise the sum of stock-out costs and costs of holding safety stocks.

Question 22

ABC classification method

Answer 22

• Classifies inventories into categories of importance.
• Estimate the total purchase cost for each item in inventory for a period.
• The top 10% of items in terms of the purchase cost for the period are classified as A items, the next 20% as B and the final 70% as C items.

Question 23

What are other factors to be considered for order quantity?

Answer 23

• Shortage of future supplies
  e. g. suppliers in danger of experiencing a strike.
• Future price increase
  e. g. rapid inflation expected.
• Obsolescence
  e. g. development in technology
• Steps to reduce safety stocks
  e. g. faster delivery speed

Question 24

Just-In-Time (JIT) systems

Answer 24

The purpose of JIT inventory and production system is to simplify the production process by removing non-value-added activities.

• Inventory management is crucial.
• Inventory is a major cause of non-value-added activities and cost.

Question 25

What are the key features of JIT?

Answer 25

• Strategic partnerships with suppliers that involve delivery of materials and goods immediately before they are required.
• Reduce the number of suppliers.
• Long-term contracts with suppliers.
• Specify quality standards in supplier contracts to reduce need for inspection.
• Use of e-commerce to place orders, and provide suppliers with online access to inventory flies and to pay invoices.

Question 26

COSTS OF JIT

Answer 26

• Substantial investment to change production facilities to minimise non-value-added activities.
• An increase in the risk of stock-out and the associated loss of production and sales.

Question 27

BENEFIT OF JIT

Answer 27

Savings in holding costs:

• Savings in inventory-carrying and insurance costs.
• Fewer losses due to spoilage, obsolescence and theft.
• No opportunity costs of high inventory.

Question 28

What is the impact of JIT on EOQ?

Answer 28

• JIT decreases the ordering cost: reduces the numerator.
• JIT proponents found that holding costs was underestimated in the past and holding costs are greater than previous estimation: increases the denominator.
• There, under JIT purchasing, the EOQ declines.
• EOQ model supports more frequent purchases of lower quantities.