15.3 Inventory Management

LG 3 15.3 Inventory Management

The first component of the cash conversion cycle is the average age of inventory. The objective for managing inventory, as noted earlier, is to turn over inventory as quickly as possible without losing sales from stockouts. The financial manager tends to act as an advisor or “watchdog” in matters concerning inventory. He or she does not have direct control over inventory but does provide input to the inventory management process.

DIFFERING VIEWPOINTS ABOUT INVENTORY LEVEL Differing viewpoints about appropriate inventory levels commonly exist among a

firm’s finance, marketing, manufacturing, and purchasing managers. Each views inventory levels in light of his or her own objectives. The financial manager’s gen- eral disposition toward inventory levels is to keep them low, to ensure that the firm’s money is not being unwisely invested in excess resources. The marketing manager, on the other hand, would like to have large inventories of the firm’s fin- ished products. This would ensure that all orders could be filled quickly, elimi-

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The manufacturing manager’s major responsibility is to implement the produc- tion plan so that it results in the desired amount of finished goods of acceptable quality available on time at a low cost. In fulfilling this role, the manufacturing manager would keep raw materials inventories high to avoid production delays. He or she also would favor large production runs for the sake of lower unit production costs, which would result in high finished goods inventories.

The purchasing manager is concerned solely with the raw materials invento- ries. He or she must have on hand, in the correct quantities at the desired times and at a favorable price, whatever raw materials are required by production. Without proper control, in an effort to get quantity discounts or in anticipation of rising prices or a shortage of certain materials, the purchasing manager may purchase larger quantities of resources than are actually needed at the time.

COMMON TECHNIQUES FOR MANAGING INVENTORY Numerous techniques are available for effectively managing the firm’s inventory.

Here we briefly consider four commonly used techniques. ABC System

ABC inventory system

A firm using the ABC inventory system divides its inventory into three groups: A,

Inventory management

B, and C. The A group includes those items with the largest dollar investment.

technique that divides

Typically, this group consists of 20 percent of the firm’s inventory items but 80

inventory into three groups—

percent of its investment in inventory. The B group consists of items that account

A, B, and C, in descending order of importance and level

for the next largest investment in inventory. The C group consists of a large

of monitoring, on the basis of

number of items that require a relatively small investment.

the dollar investment in each.

The inventory group of each item determines the item’s level of monitoring. The A group items receive the most intense monitoring because of the high dollar investment. Typically, A group items are tracked on a perpetual inventory system that allows daily verification of each item’s inventory level. B group items are frequently controlled through periodic, perhaps weekly, checking of their levels.

C group items are monitored with unsophisticated techniques, such as the two- two-bin method

bin method. With the two-bin method, the item is stored in two bins. As an item

Unsophisticated inventory-

is needed, inventory is removed from the first bin. When that bin is empty, an

monitoring technique that is

order is placed to refill the first bin while inventory is drawn from the second

typically applied to C group

bin. The second bin is used until empty, and so on.

items and involves reordering inventory when one of two bins

The large dollar investment in A and B group items suggests the need for a

is empty.

better method of inventory management than the ABC system. The EOQ model, discussed next, is an appropriate model for the management of A and B

economic order quantity

group items.

(EOQ) model Inventory management

Economic Order Quantity (EOQ) Model

technique for determining an item’s optimal order size,

One of the most common techniques for determining the optimal order size for which is the size that minimizes inventory items is the economic order quantity (EOQ) model. The EOQ model the total of its order costs and

considers various costs of inventory and then determines what order size mini-

carrying costs.

mizes total inventory cost.

order costs EOQ assumes that the relevant costs of inventory can be divided into order

The fixed clerical costs of

costs and carrying costs. (The model excludes the actual cost of the inventory item.)

placing and receiving an

Each of them has certain key components and characteristics. Order costs include

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Short-Term Financial Decisions

order, of processing the resulting paperwork, and of receiving an order and checking it against the invoice. Order costs are stated in dollars per order.

carrying costs Carrying costs are the variable costs per unit of holding an item of inventory for a

The variable costs per unit of

specific period of time. Carrying costs include storage costs, insurance costs, the costs

holding an item in inventory

of deterioration and obsolescence, and the opportunity or financial cost of having

for a specific period of time.

funds invested in inventory. These costs are stated in dollars per unit per period. Order costs decrease as the size of the order increases. Carrying costs, how- ever, increase with increases in the order size. The EOQ model analyzes the trade- off between order costs and carrying costs to determine the order quantity that minimizes the total inventory cost.

Mathematical Development of EOQ A formula can be developed for deter- mining the firm’s EOQ for a given inventory item, where

S = usage in units per period O = order cost per order

C = carrying cost per unit per period Q = order quantity in units

The first step is to derive the cost functions for order cost and carrying cost. The order cost can be expressed as the product of the cost per order and the number of orders. Because the number of orders equals the usage during the period divided by the order quantity ( S/Q), the order cost can be expressed as follows:

Order cost = O * (S , Q)

The carrying cost is defined as the cost of carrying a unit of inventory per period multiplied by the firm’s average inventory. The average inventory is the order quantity divided by 2 ( Q/2), because inventory is assumed to be depleted at a constant rate. Thus carrying cost can be expressed as follows:

(15.5) total cost of inventory

Carrying cost =

C * (Q , 2)

The firm’s total cost of inventory is found by summing the order cost and the

The sum of order costs and

carrying cost. Thus the total cost function is

carrying costs of inventory.

Total cost = [ O * (S , Q)] + [C * (Q , 2)]

Because the EOQ is defined as the order quantity that minimizes the total cost func- tion, we must solve the total cost function for the EOQ. 4 The resulting equation is

4. In this simple model the EOQ occurs at the point where the order cost [ O * (S , Q)] just equals the carrying cost [

C * (Q , 2)] . To demonstrate, we set the two costs equal and solve for Q:

[ O * (S , Q)] = [C * (Q , 2)] Then cross-multiplying, we get: 2* O*S=C*Q 2

Dividing both sides by

C, we get:

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Although the EOQ model has weaknesses, it is certainly better than subjec- tive decision making. Despite the fact that the use of the EOQ model is outside the control of the financial manager, the financial manager must be aware of its utility and must provide certain inputs, specifically with respect to inventory car- rying costs.

Personal Finance Example 15.4 3 Individuals sometimes are confronted with personal finance decisions involving cost trade-offs similar to the trade-off

between the fixed order costs and variable carrying costs of inventory that corpo- rations face. Take the case of the von Dammes, who are trying to decide whether

a conventional car (uses gas) or a hybrid car (uses gas and electric battery) would

be more cost effective.

The von Dammes plan to keep whichever car they choose for 3 years and expect to drive it 12,000 miles in each of those years. They will use the same dollar amount of financing repaid under the same terms for either car, and they expect the cars to have identical repair costs over the 3-year ownership period. They also assume that the trade-in value of the two cars at the end of 3 years will

be identical. Both cars use regular unleaded gas, which they estimate will cost, on average, $3.20 per gallon over the 3 years. The key data for each car follows:

Conventional

Hybrid

Total cost

Average miles per gallon

We can begin by calculating the total fuel cost for each car over the 3-year ownership period:

Conventional: 3(3 years * 12,000 miles per year) , 27 miles per gallon4

* $3.20 per gallon = 1,333.33 gallons * $3.20 per gallon = $4,267

Hybrid:

3(3 years * 12,000 miles per year) , 42 miles per gallon4

* $3.20 per gallon = 857.14 gallons * $3.20 per gallon = $2,743

To buy the hybrid car, the von Dammes will have to pay $2,800 more ($27,300 - $24,500) than the cost of the conventional car, but they will save about $1,524 ($4,267 - $2,743) in fuel costs over the 3-year ownership period. Ignoring differences in timing, on a strict economic basis they should buy the con- ventional car because the $2,800 marginal cost of the hybrid results in a marginal fuel cost savings of only $1,524. Clearly, other factors such as environmental concerns and the reasonableness of the assumptions could affect their decision.

reorder point The point at which to reorder

Reorder Point Once the firm has determined its economic order quantity, it inventory, expressed as days of must determine when to place an order. The reorder point reflects the number of

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usage of the inventory item. Assuming that inventory is used at a constant rate, the formula for the reorder point is

Reorder point = Days of lead time * Daily usage

(15.8)

For example, if a firm knows it takes 3 days to place and receive an order, and if it uses 15 units per day of the inventory item, then the reorder point is 45 units of inventory (3 days *

15 units/day). Thus, as soon as the item’s inventory level falls to the reorder point (45 units, in this case) an order will be placed at the

safety stock item’s EOQ. If the estimates of lead time and usage are correct, then the order

Extra inventory that is held to

will arrive exactly as the inventory level reaches zero. However, lead times and

prevent stockouts of important

usage rates are not precise, so most firms hold safety stock (extra inventory) to

items.

prevent stockouts of important items.

Example 15.5 3 MAX Company, a producer of dinnerware, has an A group inventory item that is vital to the production process. This item costs $1,500, and MAX uses 1,100

units of the item per year. MAX wants to determine its optimal order strategy for the item. To calculate the EOQ, we need the following inputs:

Order cost per order = $150 Carrying cost per unit per year = $200

Substituting into Equation 15.7, we get

2 * 1,100 * $150

EOQ =

B 41 units

$200

The reorder point for MAX depends on the number of days MAX operates per year. Assuming that MAX operates 250 days per year and uses 1,100 units of this item, its daily usage is 4.4 units (1,100 , 250). If its lead time is 2 days and MAX wants to maintain a safety stock of 4 units, the reorder point for this item is 12.8 units 3(2 * 4.4) + 44 . However, orders are made only in whole units, so the order is placed when the inventory falls to 13 units.

The firm’s goal for inventory is to turn it over as quickly as possible without stockouts. Inventory turnover is best calculated by dividing cost of goods sold by average inventory. The EOQ model determines the optimal order size and, indi- rectly, through the assumption of constant usage, the average inventory. Thus the EOQ model determines the firm’s optimal inventory turnover rate, given the firm’s specific costs of inventory.

Just-in-Time (JIT) System

just-in-time (JIT) system The just-in-time (JIT) system is used to minimize inventory investment. The phi-

Inventory management

losophy is that materials should arrive at exactly the time they are needed for pro-

technique that minimizes

duction. Ideally, the firm would have only work-in-process inventory. Because its inventory investment by having objective is to minimize inventory investment, a JIT system uses no (or very little)

materials arrive at exactly the time they are needed for

safety stock. Extensive coordination among the firm’s employees, its suppliers,

production.

and shipping companies must exist to ensure that material inputs arrive on time. Failure of materials to arrive on time results in a shutdown of the production line

suppliers. When quality problems arise, production must be stopped until the problems are resolved.

The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining efficiency by emphasizing quality of the materials used and their timely delivery. When JIT is working properly, it forces process inefficiencies to surface.

Knowing the level of inventory is, of course, an important part of any inventory management system. As described in the Focus on Practice box, radio frequency identification technology may be the “next new thing” in improving inventory and supply chain management.

Computerized Systems for Resource Control Today a number of systems are available for controlling inventory and other

resources. One of the most basic is the materials requirement planning (MRP) system. It is used to determine what materials to order and when to order them.

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focus on PRACTICE RFID: The Wave of the Future

Wal-Mart expects the RFID technol- ogy to improve its inventory manage- ment, and it remains committed to advancing its use of RFID. During the 2010 National Retail Federation’s Big Show convention, Wal-Mart’s CIO, Rollin Ford, said, “We’re still bullish on RFID.” He also indicated that Wal-Mart ran some apparel pilots last year that showed good results and that the retailer plans to “eat what we cook.” Wal-Mart manufactures some apparel items and controls its own supply chain, and Ford indicated that Wal- Mart plans to use RFID technology in its apparel supply chain. Wal-Mart will then share the benefits and best prac- tices with its suppliers, which might want to achieve the same benefits from the technology.

3 What problem might occur with the full implementation of RFID tech- nology in retail industries? Specifically, consider the amount of data that might be collected.

RFID-enabled. Although Wal-Mart’s ulti- mate goal is to have all of its 100,000-plus suppliers on board using electronic product codes (EPC) with RFID technology, progress has slowed as Wal-Mart’s suppliers remain uncon- vinced of RFID’s cost savings.

The major issue with RFID tags is per-chip cost. In 2004, when Wal-Mart announced its intent to use RFID tags, they sold for 30 to 50 cents each. Wal-Mart requested a price of 5 cents per tag, expecting increased demand and economies of scale to push the price down to make them more com- petitive with inexpensive barcodes. Increased demand has brought the price of current-generation RFID tags to about 15 cents apiece, but barcodes cost only a fraction of a cent. Barcodes help track inventory and can match a product to a price, but they lack the electronic tags’ ability to store more detailed information, such as the serial number of a product, the location of the factory that made it, when it was made, and when it was sold.

Wal-Mart Stores, Inc., the world’s number one

retailer, operates more than 8,400 retail units under 55 different banners in 15 countries and employs more than two million people around the world. What’s more, Wal-Mart came in first place among retailers in Fortune magazine’s 2010 Most Admired Companies survey. With fiscal 2010 sales of $405 billion, Wal-Mart is able to exert tremendous pressure on its suppliers. When Wal- Mart announced in April 2004 that it was beginning a pilot program to test radio frequency identification (RFID) technology to improve its inventory and supply chain management, suppliers and competitors took notice.

One of the first companies to intro- duce bar codes in the early 1980s, Wal-Mart required its top 100 suppli- ers to put RFID tags on shipping crates and pallets by January 2005, with the next 200 largest suppliers using the technology by January 2006. As of February 2007, Wal-Mart officials said that 600 of its suppliers were

in practice

materials requirement planning (MRP) system Inventory management technique that applies EOQ concepts and a computer to compare production needs to available inventory balances and determine when orders should be placed for various items on a product’s bill of

Source: “2010 Most Admired Companies,” Fortune (March 22, 2010); Wal-Mart, Wal-Mart 2010 Financial Report, http://cdn.walmartstores.com/sites/ AnnualReport/2010/PDF/01_WMT%202010_Financials.pdf; Mark Roberti, “Wal-Mart CIO Still ‘Bullish’ on RFID.” RFID Journal retail blog, http://www .rfidjournal.com/article/view/ 7315.

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MRP simulates each product’s bill of materials, inventory status, and manufac- turing process. The bill of materials is simply a list of all parts and materials that go into making the finished product. For a given production plan, the computer simulates material requirements by comparing production needs to available inventory balances. On the basis of the time it takes for a product that is in process to move through the various production stages and the lead time to get

manufacturing resource materials, the MRP system determines when orders should be placed for various planning II (MRP II)

items on the bill of materials. The objective of this system is to lower the firm’s

A sophisticated computerized

inventory investment without impairing production. If the firm’s pretax opportu-

system that integrates data

nity cost of capital for investments of equal risk is 20 percent, every dollar of

from numerous areas such as

investment released from inventory will increase before-tax profits by $0.20.

finance, accounting,

A popular extension of MRP is manufacturing resource planning II (MRP II),

marketing, engineering, and

which integrates data from numerous areas such as finance, accounting, mar-

manufacturing and generates production plans as well as

keting, engineering, and manufacturing using a sophisticated computer system.

numerous financial and

This system generates production plans as well as numerous financial and man-

management reports.

agement reports. In essence, it models the firm’s processes so that the effects of enterprise resource planning changes in one area of operations on other areas can be assessed and monitored. (ERP)

For example, the MRP II system would allow the firm to assess the effect of an

A computerized system that

increase in labor costs on sales and profits.

electronically integrates

Whereas MRP and MRP II tend to focus on internal operations, enterprise

external information about the

resource planning (ERP) systems expand the focus to the external environment

firm’s suppliers and customers

by including information about suppliers and customers. ERP electronically inte-

with the firm’s departmental

grates all of a firm’s departments so that, for example, production can call up

data so that information on all

sales information and immediately know how much must be produced to fill cus-

available resources—human and material—can be instantly

tomer orders. Because all available resources—human and material—are known,

obtained in a fashion that

the system can eliminate production delays and control costs. ERP systems auto-

eliminates production delays

matically note changes, such as a supplier’s inability to meet a scheduled delivery

and controls costs.

date, so that necessary adjustments can be made. INTERNATIONAL INVENTORY MANAGEMENT

International inventory management is typically much more complicated for exporters in general, and for multinational companies in particular, than for purely domestic firms. The production and manufacturing economies of scale that might be expected from selling products globally may prove elusive if prod- ucts must be tailored for individual local markets, as frequently happens, or if actual production takes place in factories around the world. When raw materials, intermediate goods, or finished products must be transported over long distances— particularly by ocean shipping—there will be more delays, confusion, damage, and theft than occur in a one-country operation. The international inventory manager, therefore, puts a premium on flexibility. He or she is usually less con- cerned about ordering the economically optimal quantity of inventory than about making sure that sufficient quantities of inventory are delivered where they are needed, when they are needed, and in a condition to be used as planned.

6 REVIEW QUESTIONS

15–8 What are likely to be the viewpoints of each of the following managers about the levels of the various types of inventory: finance, marketing,

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15–9 Briefly describe the following techniques for managing inventory: ABC system, economic order quantity (EOQ) model, just-in-time (JIT) system, and computerized systems for resource control—MRP, MRP II, and ERP.

15–10 What factors make managing inventory more difficult for exporters and

multinational companies?