Seminar onFinancial Management

Inventory Management

Mark S. Maglana, CompE, MM

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Contents

» Inventory in context» Defining “inventory”» Managing inventories

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Let’s put things in context

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» Current Assets» Cash» Marketable Securities» Accounts Receivable» Inventory!

» Current Liabilities» Accounts Payable» Short-term Borrowings

Working Capital

You are here!

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Net Working Capital

Current Assets – Current Liabilities

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Payment for raw materials

AccountsReceivable

Period

InventoryPeriod

AccountsPayablePeriod

Cash Conversion Cycle

The Cash Conversion Cycle

Raw materials purchased

Sale offinished goods

Cash collectedon sales

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Shortening the cash conversion cycle is a good thing.

Optimizing inventory levels can shorten the cash conversion cycle.

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Cash Conversion Cycle

Inv. period + A/R period – A/P period

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Inventory Period

360 / (Inventory Turnover)

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Inventory Turnover

(CoGS)/(Average Inventory)

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But what is this “Inventory”that you speak of?

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Inventory is composed of

»Raw materials»Goods in progress»Finished goods

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The decision to hold inventory involves a trade-off .

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If you decide to buy materials only as needed you incur higher costs.

Holding too little finished goods introduces the risk of losing a sale.

Not holding inventory introduces the risk of production delays.

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On the other hand...

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Money tied up in inventory does not earn interest.

Storage and insurance must be paid for.

Inventory gets spoiled and deteriorates.

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So how do we manage this Inventory thing?

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Consider this problem

A builder’s merchant faces a steady demand for engineering bricks.

When the merchant runs out of inventory, it replenishes the supply by placing an order for more bricks from the manufacturer.

What is the optimum level of inventory to keep?

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We now use the EOQ model to solve the problem.

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EO What???

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Economic Order Quantity

A model that minimizes the total variable costs involved in ordering

and holding inventory.

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To understand complex ideas, we often must break them down to their simplest parts, examining each, and later re-assembling them.

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Thus the following assumptions...

» The demand for the item is known» The lead time is known and fixed» Inflation is negligible» The receipt of an order occurs in an instant» There are no quantity discounts» Shortages or stock-outs do not occur

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Num

ber

of b

ricks

Time

2x

x

0 t+1 t+2 t+3 t+4

Inventory

Average Inv.

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There are two costs associated with the merchant’s inventory of bricks:

» Order Cost» Handling expense

» Delivery charges

» Carrying Cost» Cost of space, insurance, and losses

» Opportunity cost of capital

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But what about item cost?

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Demand = P 1,000,000 bricks/yearItem cost = P 10/brick

Order Size Orders/Year Total Item Cost1,000,000 1.0 P 10,000,000

500,000 2.0 10,000,000

200,000 5.0 10,000,000

100,000 10.0 10,000,000

60,000 16.7 10,000,000

50,000 20.0 10,000,000

20,000 50.0 10,000,000

10,000 100.0 10,000,000

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Total Costs

Order Costs + Carrying Costs

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Order Costs

Orders per Year x Cost per Order

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Cost/order = P 900

Order Size Orders/Year Order Costs1,000,000 1.0 P 900

500,000 2.0 1,800

200,000 5.0 4,500

100,000 10.0 9,000

60,000 16.7 15,030

50,000 20.0 18,000

20,000 50.0 45,000

10,000 100.0 90,000

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Carrying Costs

Ave. Inventory x C/C per Item

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Order Size Orders/Year Ave. Inv. Carrying Costs

1,000,000 1.0 500,000 250,000

500,000 2.0 250,000 125,000

200,000 5.0 100,000 50,000

100,000 10.0 50,000 25,000

60,000 16.7 30,000 15,000

50,000 20.0 25,000 12,500

20,000 50.0 10,000 5,000

10,000 100.0 5,000 2,500

Average Inventory = Order Size / 2Carrying Cost/Brick = P 0.5

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Order Size Order Costs Carrying Costs Total Cost

1,000,000 P 900 P 250,000 P 250,900

500,000 1,800 125,000 126,800

200,000 4,500 50,000 54,500

100,000 9,000 25,000 34,000

60,000 15,000 15,000 30,000

50,000 18,000 12,500 30,050

20,000 45,000 5,000 50,000

10,000 90,000 2,500 92,500

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Total Costs

Carrying Costs

Order Costs

Order size

Inve

ntor

y co

sts,

100

0’s

of P

esos

30

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Optimal ordersize = 60,000 bricks

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The EOQ may be found at the point where the slope of the

Total Costs curve equals zero.

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oa

i CQ

SCC

QQTC

OCCCTC

+=

+=

2)(

Where: Q = Order SizeCCi = Carrying Cost per ItemSa = Annual SalesCo = Cost per Order

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22

)(

2)(

Q

CSCC

dQ

QdTC

CQ

SCC

QQTC

oai

oa

i

−=

+=

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i

oa

oai

oai

CC

CSQ

Q

CSCC

Q

CSCC

2

2

20

2

2

2

=

=

−=

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i

oa

CC

CSQ

2=∗

Economic Order Quantity (A.K.A. Q Star)

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000,6050.0

)900)(000,000,1(2

=

×=∗Q

Using the formula in our example...

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But you can’t ignore quantity discounts!!?

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Demand = P 1,000,000 bricks/year

Order Size Orders/Year Item Cost Total I/C1,000,000 1.0 P 9 9,000,000

500,000 2.0 9 9,000,000

200,000 5.0 9 9,000,000

100,000 10.0 9 9,000,000

60,000 16.7 10 10,000,000

50,000 20.0 10 10,000,000

20,000 50.0 10 10,000,000

10,000 100.0 10 10,000,000

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Order Size Total Costs Total I/C TC + TIC

1,000,000 P 250,900 P 9,000,000 P 9,250,900

500,000 126,800 9,000,000 9,126,800

200,000 54,500 9,000,000 9,054,500

100,000 34,000 9,000,000 9,034,000

60,000 30,000 10,000,000 10,030,000

50,000 30,050 10,000,000 10,030,050

20,000 50,000 10,000,000 10,050,000

10,000 92,500 10,000,000 10,092,500

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Total Costs

Carrying Costs

Order Costs

Order size

Inve

ntor

y co

sts,

100

0’s

of P

esos

Item Cost

Qb

Breakpoint Quantity

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Qb Q* QbQ* Qb

Case 1 Case 2 Case 3

Q*

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To find the new Q*

First, check if your computed Q* is more than or equal to Qb.

If so, order at Q*.

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Qb Q*

Case 1

Order size

Inve

ntor

y co

sts,

100

0’s

of P

esos

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Otherwise...

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To find the new Q*

» Compute the Total Costs at Q* and Qb

including the Total Item Cost» Make sure to use the correct amount for Cost

per Item» Without discount for Q*

» With discount for Qb

» If Total Costs at Q* is less than Total Costs at Qb order at Q*

» Otherwise, order at Qb

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Q* Qb

Case 2

Order size

Inve

ntor

y co

sts,

100

0’s

of P

esos

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Q* Qb

Case 3

Order size

Inve

ntor

y co

sts,

100

0’s

of P

esos

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In our example...

Is Q* >= Qb?

No. Move along, folks!

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Compute for TC(Q*) and TC(Q b)

TC(Q*) = CC + OC + TIC= 15,000 + 15,000 + 10,000,000= 10,030,000

TC(Qb) = CC + OC + TIC= 25,000 + 9,000 + 9,000,000= 9,034,000

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Advanced EOQ can incorporate

» Unknown demand» Unknown lead times» Inflation» Delays in receipt of orders» Shortages or stock-out possibilities

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Remember...

» Short Cash Conversion Cycles are good for the company’s bottom line.

» Optimize your Inventory Period to minimize your Cash Conversion Cycle.

» One way to optimize Inventory Period is to use EOQ.

» One other (non-recommended) technique is the Hawaiian Method.

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Let’s give it a try...

» Suppose that a liter of chlorine for sanitizing swimming pools costs P25.

» 20 liters are consumed per day. » Each time an order is made, a total of P50 in

ordering charges is incurred while keeping it in stock costs P0.30 per liter-day.

» Just today, the supplier called in for a promo such that if you order 150 liters or more, you will get a 10% discount.

» Will you avail of the discount?

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End of Session