Management Accounting for Business Chapter 6 INVENTORY MANAGEMENT Dr. Mohamed A. Hamada Lecturer of Accounting Information Systems

LEARNING OBJECTIVES Describe the traditional inventory management model. Explain the calculation of Economic Order Quantity EOQ Discuss JIT inventory management.

What Is Inventory? Stock of items kept to meet future demand Purpose of inventory management how many units to order when to order

Types of Inventory Raw materials Purchased parts and supplies Work-in-process (partially completed) products (WIP) Items being transported Tools and equipment

Inventory Costs cost of holding an item in inventory Carrying cost cost of holding an item in inventory Ordering cost cost of replenishing inventory Shortage cost Temporary losses of sales when demand cannot be met

Inventory Control Systems Continuous system (fixed-order-quantity) constant amount ordered when inventory declines to predetermined level Periodic system (fixed-time-period) order placed for variable amount after fixed passage of time

Economic Order Quantity (EOQ) Models optimal order quantity that will minimize total inventory costs Basic EOQ model Production quantity model

EOQ: Definition Is a model that calculates the best quantity to order or produce. (Economic Order Quantity)

What are 2 basic questions addressed by EOQ? How much should be ordered (produced)? When should the order be placed (setup done)?

TOTAL COST: Background The total cost (TC) formula includes the following: P = $25 per order [cost of placing & receiving order (setup & production)] D = 10,000 [known demand] Q = 1,000 [order size (or production lot size)] C = $2 per unit [carrying cost of 1 unit for 1 year]

FORMULA: Total Cost Total cost (TC) equation 1: Total cost looks at all inventory costs. Total cost (TC) equation 1: = Ordering cost + Carrying cost = PD/Q + CQ/2 PD/Q = [(10,000/1,000) x $25] = $ 250 CQ/2 = [(1,000/2) x $2] = $1,000 TC = $1,250

How can the total cost be reduced? The EOQ model will compute the cheapest batch order size.

FORMULA: EOQ EOQ equation 2: = √ 2 x Order costs ÷ Unit Carrying cost EOQ is a calculation intended to lower total inventory costs. EOQ equation 2: = √ 2 x Order costs ÷ Unit Carrying cost = √ 2PD/C = √ 2 x $25 x 10,000 / $2 = √ 250,000 = 500

What do you do with the order quantity calculated by the EOQ model? Enter the order quantity into the TC equation in 1.

FORMULA: EOQ Cost Total cost (TC) equation 1: EOQ Total cost calculates TC using the EOQ batch size in units to cut total cost by $250. Total cost (TC) equation 1: = Ordering cost + Carrying cost = PD/Q + CQ/2 PD/Q = [(10,000/500) x $25] = $ 500 CQ/2 = [(500/2) x $2] = $ 500 TC = $1,000

FORMULA: Reorder Point (ROP) ROP identifies the proper time to place an order to avoid stockout. Reorder Point (ROP) equation 3: = Rate of usage x Lead time = 50 parts per day x 4 days = 200 parts

FORMULA: Safety Stock Safety stock provides a buffer to reorder point. = Lead time x (maximum – average usage) = 4 days x (60 – 50) = 40 parts

FORMULA: ROP + Safety Stock Safety stock adds a buffer to reorder point. Reorder Point (ROP) equation 4: = Rate of usage x Lead time + Safety stock = 50 parts per day x 4 days + 40 = 240 parts

Example Alex Company is a wholesaler. Alex purchases 800,000 units of product X each year for sale to retailers. The cost of placing an order is $40. The cost of holding one unit of inventory for one year is $4. Required 1. Compute the economic order quantity. 2. How many orders would Alex place under the EOQ policy? 3. Compute the annual ordering cost for the EOQ. 4. Compute the annual carrying cost for the EOQ. 5. Compute the total inventory-related cost at the EOQ.

Solution

JUST-IN-TIME (JIT): Definition Is a demand-pull manufacturing system that requires goods to be pulled through the system by present demand. It enables a firm to produce only what is required, in the correct quantity and at the correct time. Information is exchanged with suppliers and customers through EDI (Electronic Data Interchange) to help ensure that every detail is correct.

Electronic Data Interchange

JIT: Strategic Objectives Increase profits Improve competitive position BY Controlling costs Improving delivery performance Improving quality

Advantages of JIT Lower stock holding means a reduction in storage space which saves rent and insurance costs As stock is only obtained when it is needed, less working capital is tied up in stock There is less likelihood of stock perishing

LIMITATIONS OF JIT Time is required to build sound relations with suppliers Workers experience stress in changing over to JIT Production may be interrupted because of absence of inventory supply buffer

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