ACCA paper f9 financial management study materials F9FM session14 d08

SESSION 14 – INVENTORY MANAGEMENT OVERVIEW Objective To understand the costs and benefits of holding inventory and determine the Economic Order Quantity (EOQ) which minimises costs To appreciate other possible inventory control systems INVENTORY CONTROL EOQ MODEL Definition Determination of EOQ Complications Quantity discounts RE-ORDER LEVEL Definitions Constant demand during lead time Uncertain demand during lead time Service levels Definition Reasons for holding inventory Costs associated with inventory OTHER INVENTORY SYSTEMS Periodic review system ABC system Just-in-time (JIT) Perpetual inventory MRP 1401 SESSION 14 – INVENTORY MANAGEMENT INVENTORY CONTROL 1.1 Definition The systematic regulation of inventory levels If inventory is too high Inefficient ⇒ profit reduced If inventory is too low Insufficient to satisfy customers ⇒ profit reduced 1.2 Reasons for holding inventory To meet demand by acting as a buffer in times of unusually high consumption, i.e to reduce the risk of stockouts To ensure continuous production To take advantage of quantity discounts To buy in ahead of a shortage or ahead of a price rise For technical reasons (e.g maturing whisky in casks or keeping oil in pipelines) To reduce ordering costs 1.3 Costs associated with inventory Purchase price; Holding costs: cost of capital tied up; insurance; deterioration, obsolescence and theft; warehousing; stores administration Re-order costs: transport costs; clerical and administrative expenses; batch set-up costs for goods produced internally 1402 SESSION 14 – INVENTORY MANAGEMENT Shortage costs: production stoppages caused by lack of raw materials; stockout costs for finished goods – anything from a delayed sale to a lost customer; emergency re-order costs Systems costs – people and computers The benefits of holding inventory must outweigh the costs EOQ MODEL 2.1 Definition The Economic Order Quantity (EOQ) is the quantity of inventory that should be ordered each time a purchase order is made EOQ aims to minimise the costs which are relevant to ordering and holding inventory 2.2 Determination of EOQ x = order quantity CH = cost of holding one unit for one year D = annual demand CO = cost of placing an order The total annual relevant cost to be minimised = annual holding cost + annual order cost = the cost of holding one unit in inventory for one year × the average number of units held x CH + the cost of an order × the number of orders in a year = + D Co x The total cost is minimized when: x= 2C D CH 1403 SESSION 14 – INVENTORY MANAGEMENT EOQ graph $ Cost Total cost holding cost ordering cost EOQ x Order quantity Assumption of EOQ: purchase price per unit is constant; constant demand; no risk of stockouts Example Using the following data calculate the EOQ D = 40,000 units CO = $2 CH = $1 Solution EOQ = 1404 SESSION 14 – INVENTORY MANAGEMENT 2.3 Complications 2.3.1 Warehouse rental The EOQ model assumes that holding costs vary with the average inventory level However if a warehouse is rented on a long-term contract (rather than daily) then it needs to be large enough to hold the maximum level of stock, rather than the average must rent sufficient floor space to meet this quantity rather than x x (x/2) deal with this by doubling the floor space used by one unit when calculating holding cost, and then use the normal EOQ formula Example Annual demand = 3,000 units Reorder cost = $5 Holding cost = $3.33 per unit + rental of warehouse Each unit occupies 3m2 rented on annual contracts for $5 per m2 Solution D = CO = CH = 3,000 EOQ = 1405 SESSION 14 – INVENTORY MANAGEMENT 2.3.2 Cost of capital Inventory, like any other asset, must be matched by a liability Therefore there must be a cost of financing inventory This is a type of holding cost Illustration Cost of Capital = 10% Price per unit = $100 ∴ Holding cost = $100 × 0.1 = $10 This is in addition to any other holding costs you are given 2.4 Quantity discounts The supplier may offer a “bulk-buying” discount on each unit purchased for specified quantities above the EOQ In this case the purchase price obviously becomes a relevant factor in the decision To deal with this, calculate Total annual cost = Annual Annual holding Annual order + + purchase cost cost cost for each order quantity where discounts are available and at the order level calculated by the EOQ Choose the order quantity with the lowest total cost 1406 SESSION 14 – INVENTORY MANAGEMENT Example Annual demand Holding cost Reorder cost Purchase price = = = = 5,000 $7.50 $30 $1.10 A discount of 3% is available on orders of 300 units or more Required: Determine whether or not the discount is worthwhile Solution EOQ = Total cost at EOQ x CH = Holding Reorder $ D CO = x Purchase cost Total _ ––––– Total cost at order quantity = 300 units Holding x CH = Reorder D CO = x Purchase cost Conclusion: _ ––––– 1407 SESSION 14 – INVENTORY MANAGEMENT RE-ORDER LEVEL 3.1 Definitions Re-order level (ROL) is the level to which inventory should fall before a purchase order is made Lead time is the time between placing and receiving an order There are two possible situations to be dealt with: (1) Constant demand in lead time (2) Uncertain demand in lead time 3.2 Constant demand during lead time Re-order level (ROL) = lead time (days) × demand per day For example if demand is 40 units per day and lead time is two days - when inventory levels fall to 80 units then inventory would be re-ordered This can be shown graphically: INVENTORY LEVEL ROL { Lead time 3.3 TIME Uncertain demand during lead time There will be an expected level of demand, not a known level of demand A “buffer” or “safety” inventory will need to be held to reduce the risk of a stockout 1408 SESSION 14 – INVENTORY MANAGEMENT Method Calculate expected demand in the lead time (1) Expected lead time demand = ∑xi p(xi) where xi = level of demand p (xi) = probability of level of demand (2) Take each level of demand ≥ expected lead time demand as a possible reorder level and calculate the expected annual stockout cost (3) For each possible ROL calculate the expected annual buffer holding cost (4) Choose the ROL with the lowest sum of stock out and holding cost Example The following information relates to inventory levels of component XL5: Holding cost Stockout cost Lead time EOQ = $8 = $3 = week = 150 The company operates for 50 weeks per annum and weekly demand is given by: xi Demand 40 50 60 70 80 p(xi) Probability 0.1 0.2 0.4 0.2 0.1 Required: Calculate the optimum reorder level 1409 SESSION 14 – INVENTORY MANAGEMENT Solution Average demand in the lead time = Average annual demand = orders per annum = ROL Buffer Demand 60 70 80 Units short Probability Average = 70 10 Average = 80 20 Ave units short Exp annual stock-out cost Exp annual buffer holding cost _ _ _ _ _ _ _ _ _ _ _ _ –– –– –– Total annual cost $ –––– –––– –––– The optimum ROL is therefore 3.4 Service levels Setting a “service level” of 98% implies that the firm accepts a 2% chance of a stock-out Example Average weekly demand for an item of inventory is 300 units with a standard deviation of 40 units The lead time is one week Required: What ROL is needed to provide a service level of 95%? Normal distribution tables show that 5% of observations lie 1.645 standard deviations above the mean Solution 1410 SESSION 14 – INVENTORY MANAGEMENT OTHER INVENTORY SYSTEMS 4.1 Periodic review system The inventory levels are reviewed at fixed time intervals, and variable quantities will be ordered as appropriate The order size made is sufficient to return inventory levels to a pre-determined level A very simple method of inventory control – ideal where inventory control is only one of a person’s responsibilities 4.2 ABC system of inventory control The aim is to reduce the work involved in inventory control in a business which may have several thousand types of inventory items The inventory is categorised into class A, B or C according to the annual cost of the usage of that inventory item, or the difficulty of obtaining replacements, or the importance to the production process Class A will then take most of the inventory control effort, Class B less and Class C less still Commentary Whilst this seems acceptable for inventory of finished goods, it may cause problems for raw materials There may be an item which has a very small cost but which is vital for the manufacture of the finished product Such an item would have to be included in with the Class A items because of its inherent importance, rather than its cost 4.3 Just-in-time (JIT) In a JIT system production and purchasing are linked closely to sales demand on a week-toweek basis The aim is to create a continuous flow of raw materials inventory into work in progress, which becomes finished goods to go immediately to the customer This means that negligible inventory needs to be held Conditions necessary include the following: Flexibility of both suppliers and internal workforce to expand and contract output at short notice Raw material inventory must be of guaranteed quality – indeed, quality must be maintained at every stage Close working relationship with suppliers and, if possible, geographically proximity in order to make immediate deliveries A low inventory level normally requires short production runs This is only appropriate, therefore, where set-up costs are low High-technology production methods have made this easier to achieve 1411 SESSION 14 – INVENTORY MANAGEMENT The workforce must be willing to increase or decrease its working hours from one period to another This could be done by having a core workforce with a group of parttime or freelance workers The design of the factory must be such that JIT deliveries to all areas are possible Total reliance on suppliers for quality and delivery, and therefore very tight contracts with penalty clauses Significant investment by suppliers, and therefore long-term contracts 4.4 Perpetual inventory methods Where a firm keeps perpetual inventory records, there will frequently be a replenishment point that triggers an order Such a system relies upon the accuracy of the records, not on physical counts It is possible to use point of sale (POS) terminals that automatically update inventory records as each successive sale is made One advantage of such a system is the data it provides to management to determine which product lines are moving rapidly Sales managers may also use the data to make tactical decisions on special prices to sell slow-moving items 4.5 Material requirements planning (MRP) A system that uses the production schedule to decide what is needed and when This is then linked in with suppliers’ discounts, lead times, etc to devise an optimal inventory holding and ordering policy Key points They formula for the Economic order Quantity is provided in the exam – the key is to identify the relevant data Do not confuse the Economic Order Quantity (EOQ) with the Re –Order Level (ROL) EOQ tells us how large each order should be, ROL tells us when we should place on order for inventory Just-In-Time (JIT) is the other main inventory system to be familiar with FOCUS You should now be able to: apply the tools and techniques of inventory management 1412 SESSION 14 – INVENTORY MANAGEMENT EXAMPLE SOLUTIONS Solution — EOQ EOQ = × $2 × 40 ,000 $1 x = 400 units Solution — Floor space D = CO = CH = EOQ = 3,000 $3.33 + (2 × × 5) = $33.33 × × ,000 = 30 units 33.33 Solution — Quantity discount EOQ = × 30 × ,000 = 200 units 7.50 Total cost at EOQ 200 x × 7.50 CH = Holding 2 $ 750 5,000 D × 30 CO = 200 x 750 Reorder Purchase cost 5,000 × 1.10 5,500 _ Total 7,000 _ Total cost at order quantity = 300 units Holding 300 x × 7.50 CH = 2 1,125 Reorder 5,000 D CO = × 30 x 300 500 Purchase cost 5,000 × 1.10 × 0.97 5,335 _ 6,960 _ The discount is therefore worthwhile 1413 SESSION 14 – INVENTORY MANAGEMENT Solution — Re-order level Average demand in the lead time = 60 units Average annual demand = 60 × 50 = 3,000 units Since the EOQ = 150, there will be ,000 = 20 orders per annum 150 ROL Buffer Demand Units short Prob Ave units short Exp annual inventory out cost 60 70 80 10 20 0.2 0.1 2 × $3 × 20 × $3 × 20 _ Average 240 _ _ 0.1 –– –– × $3 × 20 _ 10 × $8 _ 60 _ 80 _ – –– _ 20 × $8 _ _ 160 _ 70 10 80 10 Average 80 20 80 – – –– The optimum ROL is therefore 70 units Solution — Service level SD = 40 45% 5% 300 ROL z = 1.645 (using normal distribution tables) ROL = 300 + (1.645 × 40) = 300 + 65.8 = 366 1414 Exp annual buffer holding cost Total annual cost $ _ 240 –––– 140 –––– 160 –––– ... costs for goods produced internally 1402 SESSION 14 – INVENTORY MANAGEMENT Shortage costs: production stoppages caused by lack of raw materials; stockout costs for finished goods – anything from... FOCUS You should now be able to: apply the tools and techniques of inventory management 1412 SESSION 14 – INVENTORY MANAGEMENT EXAMPLE SOLUTIONS Solution — EOQ EOQ = × $2 × 40 ,000 $1 x = 400... orders in a year = + D Co x The total cost is minimized when: x= 2C D CH 1403 SESSION 14 – INVENTORY MANAGEMENT EOQ graph $ Cost Total cost holding cost ordering cost EOQ x Order quantity Assumption