21-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides...

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 21

Management of Short-Term Assets:

Inventory

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Learning Objectives• Understand the importance of short-term assets

in the Australian economy.

• Identify the three major types of short-term assets.

• Evaluate the need for short-term asset management.

• Understand the relationship between short-term assets and short-term liabilities.

• Identify the benefits and costs of holding inventory.

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Learning Objectives (cont.)• Understand the nature of acquisition costs,

carrying costs and stockout costs.

• Understand and apply the economic order quantity model.

• Understand and apply models of inventory management under uncertainty.

• Understand the difference between specifying an acceptable probability of stockout and specifying an acceptable expected customer service level.

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Introduction• Both short-term and long-term assets require a

commitment of resources by the company and, therefore, both forms of investment warrant careful analysis.

• The management of short-term assets is important, given that the typical company holds around one-third of its total assets in short-term assets.

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Types of Short-Term Assets

• Inventory

– Raw materials, work in process, supplies used in operations, and finished goods.

• Liquid assets

– Cash and assets that are readily convertible into cash.

• Accounts receivable

– Money owed to a business for goods and services sold in the ordinary course of business.

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Short-Term Asset Management• The analysis of short-term asset management

assumes that markets are not frictionless and perfectly competitive.

• Holding inventories and cash is not costless, but delays in daily business can result if such short-term assets are mismanaged.

• Wealth maximisation remains the ultimate objective, but techniques other than net present value are often required.

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Managing Short-Term Assets and Liabilities

• Match maturity structure of assets and liabilities.

• Cash inflows from sale or use of assets can meet liabilities.

• If assets and liabilities are not matched well, company may not be able to meet obligations in timely fashion.

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Overview of Inventory Management• Raw materials

– Inventory that will form part of the completed product, but which has yet to enter the production process.

• Work in process

– Partially completed products that require additional processing before they become finished goods.

• Finished goods

– Completed products not yet sold (manufacturer) or merchandise on hand (retailer or wholesaler).

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• Inventory management is about balancing costs and benefits when choosing inventory levels.

• Benefits are ‘cost avoided’.

• Inventory management is therefore a problem of cost minimalisation.

• Costs of holding inventory:

– Acquisition costs.

– Carrying costs.

– Stockout costs.

Overview of Inventory Management (cont.)

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Inventory Costs: Retail and Wholesale• Acquisition costs

– Relevant costs include:

Ordering costs.

Freight and handling costs.

Quantity discounts forgone.

– Per unit of inventory, each of these costs will be lower, the larger the order placed.

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Inventory Costs: Retail and Wholesale (cont.)

• Carrying costs

– Relevant carrying costs include:

Opportunity cost of investment.

Storage costs.

Insurance premiums.

Deterioration and obsolescence.

Price movements.

– The higher the inventory level held, the higher the carrying costs.

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Inventory Costs: Retail and Wholesale (cont.)• Stockout costs

– Losses incurred when a company’s inventory of a particular item is completely exhausted.

– Potential loss of goodwill and possibility of loss of customers.

– Major benefit of holding inventory is the avoidance of stockout costs.

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Inventory Costs: Manufacturing• Raw materials

– Shortage of raw materials for a manufacturer will disrupt the production process and result in under-utilisation of labour and equipment.

• Finished goods

– The acquisition costs include set-up costs for a production run.

– Carrying costs and stockout costs are similar to those faced by retailers and wholesalers.

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Inventory Management Under Certainty

• Economic order quantity model

– The optimal quantity of inventory ordered that minimises total costs associated with inventory.

• Assumptions

– Demand for product is constant (per unit of time).

– Demand is known with certainty.

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Economic Order Quantity Model

Notation:

demand (in physical units) per period

acquisition costs ($) per order placed

carrying cost ($) per period per unit of

inventory, including opportunity cost

quantity (in physical units) pe

D

a

c

Q

r order

price ($) per unit of inventoryp

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Economic Order Quantity (cont.)Acquisition costs per year acquistion costs per order

number of orders per year

Average inventory level 2

Carrying costs per year annual carrying cost per unit of inventory

× average inventory

DaQ

Q

c

2

Q

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Economic Order Quantity (cont.) • Annual total costs (TC):

• Acquisition costs will increase as the order quantity is reduced, but carrying costs will increase as the order quantity increases.

• Economic order quantity:

caDQ 2 *

2

aD cQTC

Q

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Economic Order Quantity (cont.)

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Economic Order Quantity (cont.)• Cost estimation

– Relevant costs are incremental costs.

– Difficult to estimate.

– Fortunately, optimal order quantity and total inventory costs are fairly insensitive to errors in estimates of unit costs.

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• EOQ with positive lead time:

– EOQ model assumes order is instantly filled.

– With positive lead time, need to place order earlier — such that delivered as inventory reaches zero.

• EOQ with quantity discounts:

– Discounts for quantity purchases reduce the price of inventory and spread acquisition costs over a larger base.

Economic Order Quantity (cont.)

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To Incorporate Discounts• Determine optimal quantity in the absence of

quantity discounts.

• Calculate price paid for that quantity with the discount.

– For each of the quantity discounts, calculate the price payable for the quantity closest to the optimal quantity determined in 1.

– Calculate the total cost for each combination of price and quantity.

– Select the combination that achieves the lowest total cost.

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Inventory Management under Uncertainty• In reality, the level of demand and the rate at

which the raw materials inventory will be used in production are not known with certainty.

• Decisions:

– Quantity to be ordered.

– Reorder point: level of inventory at which a new order will be placed.

• With certainty, inventory ordered when inventory levels equal the demand during lead time.

• With uncertainty, an adjustment is necessary.

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Incorporating Uncertainty• To incorporate uncertainty:

– Quantity decision made as per EOQ.

– Add a safety stock to the reorder point.

• Safety stock:

– Additional inventory held when demand is uncertain to reduce the probability of stockouts.

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Determining Safety Stocks• The level of safety stock can be calculated by:

– Specifying an acceptable probability of a stockout occurring during lead time; or

– Specifying an acceptable expected level of customer service.

– Level of customer service is ratio of sales to orders.

– A stockout is costly if it means that orders are not filled — thus managing inventory to maintain a minimum customer service level is an important and useful approach.

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Inventory Management and the ‘Just-in-Time’ System

• The ‘just-in-time’ system is a way of organising the manufacture of goods such as motor vehicles, engines and power tools.

• It is based on the concept that raw materials, equipment and labour are each supplied only in amounts required, and at the times required, to perform the manufacturing task.

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Inventory Management and the ‘Just-in-Time’ System (cont.)

• This synchronisation of delivery with demand reduces inventory levels, lead times and delivery quantities.

• The aim of the system is to achieve an improvement in overall efficiency, as well as a reduction in inventory costs.

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Summary• Short-term assets include: inventory, liquid

assets and accounts receivable.

• Short-term asset management is important because markets are not frictionless and perfectly competitive — these frictions lead to the need to hold short-term assets.

• Short-term or current liabilities are also very important when determining a current asset management strategy.

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Summary (cont.) • Inventories — raw materials, work in progress and

finished goods.

• Too little inventory — stockout and lost sales.

• Too much inventory — high storage and insurance costs.

• Optimal inventory strategy involves balancing costs and benefits associated with inventory, including order and transport costs.

• Demand known with certainty — Economic Order Quantity (EOQ).

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Summary (cont.)• Demand is uncertain — include a margin for

uncertainty.

– Reorder point is brought forward compared to certainty case.

• Probability of stockout is not as important as losses associated with a stockout.

– Use a customer service goal to determine the margin for uncertainty.

• Just-in-time system reduces need for inventories but requires high degree of reliability up the supply chain.

21-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides...

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Transcript of 21-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides...