SHORT-TERM FINANCIAL MANAGEMENT Chapter 4 – Inventory Management Prepared by Patty Robertson May not be used without permission

I NVENTORY M ANAGEMENT Chapter 4 Agenda 2 Assess the tradeoffs associated with inventory, discuss the uses and limitations of the EOQ model, quantify the flow of inventory via balance fraction measures, and discuss trends in inventory management.

Cash Flow Timeline 3 The cash conversion period is the time between when cash is received versus paid. The shorter the cash conversion period, the more efficient the firm’s working capital.  The firm is a system of cash flows.  These cash flows are unsynchronized and uncertain. Note: The clock typically starts ticking when the order is received, not when the order is placed.

Inventory Management 4  In this chapter, we focus on inventory management.  In Chapter 7, we will discuss paying for the inventory.

Inventory Management 5  Financial Managers consider inventory an idle corporate resource.  They attempt to strike a balance between holding too much inventory and not enough to earn an appropriate rate of return. Too much results in a burden on the cash resources of a firm and has higher carrying costs. Too little could force customers to turn to competitors or question the quality of customer service.

Inventory Management 6  However, Financial Managers are not the only interested party.  Sales are somewhat uncertain; so, too, is the appropriate level of inventory.  Purchasing wants to keep raw materials on hand.  Production wants uninterrupted production.  Marketing and Sales wants inventory in the warehouse to sell.  Our view is from a financial perspective.

Inventory Management 7  Given uncertain customer demand, three levels of inventory must be managed:  Raw Materials (e.g. Steel)  Work-In-Process (e.g. Engine)  Finished Goods (e.g. Car)  In addition to uncertain customer demand, there is also the issue of timing of inventory deliveries versus inventory depletion ( stock out )  The rate at which inventory is used (constant, erratic, etc.)  Variability of the supply of raw materials, potential price changes, and economies of scale for large purchases.

Inventory Strategy Questions 8  So, how much inventory should we carry?  Should inventory be placed close to the point of purchase or the point of supply?  Should we institute a just-in-time (JIT) system?  Should we use a form of premium transportation for distribution?

Inventory Management 9  There are two direct costs associated with inventory levels: Ordering Costs - Clerical, receipt, inspection, returns, processing, transportation, unloading, handling, etc. Holding Costs – Opportunity cost, interest expense, labor, tracking, storage (rent/depreciation), insurance, utilities, security, taxes, obsolescence, breakage, theft, etc.

Inventory Management 10  The goal is to minimize the total cost of inventory given a desired level of customer service.  Inventory decisions should be based on:  The cost of ordering inventory  The cost of holding inventory The opportunity cost of funds  Any available discounts  These factors combine to result in optimal order quantities.

Inventory Management 11  The Total Cost of managing inventory without discounts is given by the following formula: Ordering Costs + Holding Costs = Total Cost = [F х ( T / Q )] + [H х ( Q / 2 )] Cost/Order х Number of Orders Holding Cost/Item х Average Inventory Balance  T = Total inventory units demanded  Q = Order quantity  F = Fixed Order Cost per order  H = Holding Cost per inventory unit  D = # days in production period  C = Cost of inventory unit  i = Daily opportunity cost # OrdersAvg. Inv.

Inventory Management 12  Total Cost = [F х ( T / Q )] + [H х ( Q / 2 )]  There exists some Q that minimizes the Total Cost.  The first expression includes Q in the denominator; with larger (but fewer) orders, Ordering Costs are lower.  The second expression includes Q in the numerator; with larger orders, Holding Costs are higher.  T = Total inventory units demanded  Q = Order quantity  F = Fixed Order Cost per order  H = Holding Cost per inventory unit  D = # days in production period  C = Cost of inventory unit  i = Daily opportunity cost

Ordering/Holding Cost Trade-Off 13 Total Cost first falls as units ordered increase, but then begins to increase. The optimum number of units to order is that order quantity that minimizes Total Cost.  T = Total inventory units demanded  Q = Order quantity  F = Fixed Order Cost per order  H = Holding Cost per inventory unit  D = # days in production period  C = Cost of inventory/unit for a given Q  i = Daily opportunity cost

Optimal Quantity (EOQ) Example 14  A firm estimates the need for:  500,000 tons (T) of scrap metal over a planning period (375 day production run)  Sales are not seasonal and are stable  Ordering Costs are $20.00/order (F)  Holding Costs are $1.25/ton (H)  The price is $0.50/ton (no discounts offered) (C’)  Delivery time is 2 days  Safety storage is 300 units  T= Total inventory units required  Q= Order quantity  F= Fixed Order Cost per order  H= Holding Cost per inventory unit  C’= Cost of inventory/unit for given Q

15  A firm estimates the need for:  500,000 tons (T) of scrap metal over a planning period  375 day production run  Sales are not seasonal and are stable.  Ordering Costs are $20.00/order (F)  Holding Costs are $1.25/ton (H)  The price is $0.50/ton (no discounts offered) (C’)  Delivery time is 2 days  Safety storage is 300 units Optimal Quantity (EOQ) Example  Total Cost = [F х ( T / Q )] + [H х ( Q / 2 )]  There exists some Q that minimizes the Total Cost. = [$20.00 х ( 500,000 / Q )] + [$1.25 х ( Q / 2 )]  T = Total inventory units demanded  Q = Order quantity  F = Fixed Order Cost per order  H = Holding Cost per inventory unit  D = # days in production period  C’ = Cost of inventory/unit for a given Q  i = Daily opportunity cost

Optimal Quantity to Order (EOQ) 16  The goal is to choose the Q that results in the optimal trade- off between Ordering and Holding Costs.  The Q that minimizes the Total Cost is called the Economic Order Quantity (EOQ).  Take the first derivative, set equal to zero and solve for Q to get:  T = Total inventory units demanded  Q = Order quantity  F = Fixed Order Cost per order  H = Holding Cost per inventory unit  D = # days in production period  C’ = Cost of inventory/unit for a given Q  i = Daily opportunity cost

Optimal Quantity (EOQ) Example 17  A firm estimates the need for:  500,000 tons (T) of scrap metal over a planning period  375 day production run  Sales are not seasonal and are stable  Ordering Costs are $20.00/order (F)  Holding Costs are $1.25/ton (H)  The price is $0.50/ton (no discounts offered) (C’)  Delivery time is 2 days  Safety storage is 300 units

Optimal Quantity (EOQ) Example 18  A firm estimates the need for:  500,000 tons (T) of scrap metal over a planning period  375 day production run  Sales are not seasonal and are stable  Ordering Costs are $20.00/order (F)  Holding Costs are $1.25/ton (H)  The price is $0.50/ton (no discounts offered) (C’)  Delivery time is 2 days  Safety storage is 300 units 4,000 units 4,000 4,000 4,000 Avg Inv 2,000 units

Optimal Quantity (EOQ) Example 19  By comparison, let’s diagram 8,000 tons per order.  Orders are placed half as often, but are twice as large. 8,000 units 4,000 units Avg Inv 2,000 units

 Ordering Costs = $20 х ( 500,000 / 500 )  1,000 orders  Holding Costs = $1.25 х ( 500 / 2 )  Purchase Cost = 500,000 х $0.50  Ordering Costs = $20 х ( 500,000 / 4,000 )  125 orders  Holding Costs = $1.25 х ( 4,000 / 2 )  Purchase Cost = 500,000 х $ Optimal Quantity (EOQ) Example  OC = [F х ( T / Q )]  HC = [H х ( Q / 2 )]  T = Total inventory units demanded  Q = Order quantity  F = Fixed Order Cost per order  H = Holding Cost per inventory unit  D = # days in production period  C’ = Cost of inventory/unit for a given Q  i = Daily opportunity cost

Optimal Quantity (EOQ) Example 21

Other Inventory Calculations 22  Number of Orders (T/Q)  = 500,000 / 4,000 = 125 orders  Average Inventory Balance (Q/2)  = 4,000 / 2 = 2,000 tons  Daily Usage Rate (T/D) (assume 375 day production run)  = 500,000 / 375 = 1,333 tons per day  Reorder Point (T/D) х Delivery Time (assume 2 days)  = 1,333 х 2 = 2,666 tons [F х ( T / Q )] + [H х ( Q / 2 )]  T = Total inventory units demanded  Q = Order quantity  F = Fixed Order Cost per order  H = Holding Cost per inventory unit  D = # days in production period  C’ = Cost of inventory/unit for a given Q  i = Daily opportunity cost

Reorder Point w/ Delivery Time 23 The number of days to receive a shipment after placing an order must be considered to avoid a stock out. Assume it is 2 days. Reorder Point = 2,666 tons  Management should reorder when inventory reaches 2,666 tons.  Two days later, when the inventory will be depleted, the new order arrives.  What happens if the shipment is delayed?

Reorder Point w/ Safety Stock 24 Safety Stock protects the firm from running out of inventory if sales are not stable or the production or delivery times are uncertain or unreliable. It increases average inventory. Reorder Point w/ Safety Stock Daily Usage Rate х Delivery Time + Safety Stock (assume 300) = Reorder Point = (1,333 х 2) = 2,966 tons

Reorder Point 25 Safety Stock protects the firm from running out of inventory if sales are not stable or the production or delivery times are uncertain or unreliable. Reorder Point w/ Safety Stock and Delivery Time

Monitoring Inventory Balances 26  Once the inventory policy has been established, it must be continually monitored:  Inventory Control Systems Inventory updated at point-of-sale  Inventory Turnover Approach Ratio analysis Inventory Turnover Ratio Days Inventory Held  Balance Fraction Approach Develop monthly balance fractions based on the proportion of items remaining in inventory from a given month’s purchase.

Reducing Inventory Investment 27  Once thought of as an asset, modern theory considers inventory a liability.  Just-In-Time (JIT) Minimize costs by efficiently monitoring the usage of raw materials and ordering replacements that arrive shortly before needed.

Trends in Inventory 28 Text