Copyright 2005 by Thomson Learning, Inc. Chapter 4 Managing Inventory I N V.

Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.

Chapter 4Chapter 4Managing InventoryManaging Inventory

II N VN VII N VN V


The Cash Flow TimelineThe Cash Flow Timeline

OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent Cash PlacedPlaced Received Received Received Received Accounts CollectionAccounts Collection < < InventoryInventory > < Receivable > < Float > > < Receivable > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed

OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent Cash PlacedPlaced Received Received Received Received Accounts CollectionAccounts Collection < < InventoryInventory > < Receivable > < Float > > < Receivable > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed


ObjectivesObjectives

Appreciate impact of holding and ordering costs on Appreciate impact of holding and ordering costs on order quantityorder quantity

Traditional EOQ & quantity discountsTraditional EOQ & quantity discounts

Appreciate JIT conceptsAppreciate JIT concepts

Assess impact that different order quantities have on Assess impact that different order quantities have on timing and amount of paymentstiming and amount of payments

Use of balance fractions to monitor inventory balancesUse of balance fractions to monitor inventory balances


Concept of InventoryConcept of Inventory

Factor in the length of cash cycleFactor in the length of cash cycle Acts as a shock absorberActs as a shock absorber Three typesThree types

– raw materialsraw materials

– work-in-processwork-in-process

– finished goodsfinished goods

Motives for holding inventoryMotives for holding inventory– transactiontransaction

– precautionaryprecautionary

– speculativespeculative


Inventory Investment FunctionInventory Investment Function

Demand for productDemand for product Cost of holding inventoryCost of holding inventory

– insuranceinsurance

– storagestorage

– cost of capitalcost of capital

Cost of ordering inventoryCost of ordering inventory

Total cost = Order Cost + Holding CostTotal cost = Order Cost + Holding Cost= F x (T/Q) + H x (Q/2)= F x (T/Q) + H x (Q/2)


Order Cost and Holding Cost Trade-Order Cost and Holding Cost Trade-offoff

Order costs = F x (T/Q)

Order quantity, Q

$

Holding cost = H x (Q/2)


Economic Order QuantityEconomic Order Quantity

EOQ solution:EOQ solution: SQRT (2TF/H)SQRT (2TF/H)

Number of orders:Number of orders: T/QT/Q

Average inventory:Average inventory: Q/2Q/2

Usage rate:Usage rate: T/D (D=days)T/D (D=days)

Reorder point:Reorder point: (T/D) x Delivery Time(T/D) x Delivery Time


Quantity DiscountsQuantity Discounts

TC = Order Cost + Holding Cost + Item CostTC = Order Cost + Holding Cost + Item Cost

TC = (F x (T/Q)) + (H x (Q/2)) + (C’ x T)TC = (F x (T/Q)) + (H x (Q/2)) + (C’ x T)

TC = Order Cost + Holding Cost + Item CostTC = Order Cost + Holding Cost + Item Cost

TC = (F x (T/Q)) + (H x (Q/2)) + (C’ x T)TC = (F x (T/Q)) + (H x (Q/2)) + (C’ x T)


Inventory and the Cash Flow Inventory and the Cash Flow TimelineTimeline

Inventory orderedInventory ordered Inventory ordered Inventory orderedand receivedand received and received and received

< Inventory Held> <Inventory Held>< Inventory Held> <Inventory Held>

Time=>Time=>Cash paidCash paid Cash paid Cash paid Cash paid Cash paidfor inventoryfor inventory for inventory for inventory for holding & for holding &

ordering costsordering costs

Inventory orderedInventory ordered Inventory ordered Inventory orderedand receivedand received and received and received

< Inventory Held> <Inventory Held>< Inventory Held> <Inventory Held>

Time=>Time=>Cash paidCash paid Cash paid Cash paid Cash paid Cash paidfor inventoryfor inventory for inventory for inventory for holding & for holding &

ordering costsordering costs


Monitor the Inventory BalanceMonitor the Inventory Balance

Inventory control systemsInventory control systems

Inventory turnover ratioInventory turnover ratio– Sales or COGS / Inventory balanceSales or COGS / Inventory balance

Days COGS in inventoryDays COGS in inventory– Inventory balance / Daily COGS or SalesInventory balance / Daily COGS or Sales

Balance fraction approachBalance fraction approach– Develop monthly balance fractions based on the proportion of Develop monthly balance fractions based on the proportion of

items remaining in inventory from a given month’s purchase.items remaining in inventory from a given month’s purchase.


Reducing Investment in InventoryReducing Investment in Inventory

Problems were solved by adding more Problems were solved by adding more inventoryinventory

JIT redesigns systemJIT redesigns system

Redesign of production systemRedesign of production system– eliminate wasteeliminate waste

– eliminate production errorseliminate production errors

– improving qualityimproving quality

Need stable demandNeed stable demand


SummarySummary

Inventory decisions should be based on:Inventory decisions should be based on:– cost of holding inventorycost of holding inventory

– cost or ordering inventorycost or ordering inventory

– opportunity cost of fundsopportunity cost of funds

– quantity discountsquantity discounts

– is quantity workable within inventory management system?is quantity workable within inventory management system?

Inventory, if properly managed can be a major Inventory, if properly managed can be a major contributor to cash flow...contributor to cash flow...

if mismanaged, it can be a significant drain on cash.if mismanaged, it can be a significant drain on cash. Some traditional inventory monitoring tools can be Some traditional inventory monitoring tools can be

biased by sales and production trends.biased by sales and production trends.

Copyright 2005 by Thomson Learning, Inc. Chapter 4 Managing Inventory I N V.

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