Copyright  2005 by Thomson Learning, Inc. Chapter 4 Managing Inventory I N V

Copyright  2005 by Thomson Learning, Inc. The Cash Flow Timeline Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received Payment Sent Cash Disbursed Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received Payment Sent Cash Disbursed

Copyright  2005 by Thomson Learning, Inc. Objectives v Appreciate impact of holding and ordering costs on order quantity v Traditional EOQ & quantity discounts v Appreciate JIT concepts v Assess impact that different order quantities have on timing and amount of payments v Use of balance fractions to monitor inventory balances

Copyright  2005 by Thomson Learning, Inc. Concept of Inventory v Factor in the length of cash cycle v Acts as a shock absorber v Three types –raw materials –work-in-process –finished goods v Motives for holding inventory –transaction –precautionary –speculative

Copyright  2005 by Thomson Learning, Inc. Inventory Investment Function v Demand for product v Cost of holding inventory –insurance –storage –cost of capital v Cost of ordering inventory v Total cost = Order Cost + Holding Cost = F x (T/Q) + H x (Q/2)

Copyright  2005 by Thomson Learning, Inc. Order Cost and Holding Cost Trade- off Order costs = F x (T/Q) Order quantity, Q $ Holding cost = H x (Q/2)

Copyright  2005 by Thomson Learning, Inc. Economic Order Quantity v EOQ solution:SQRT (2TF/H) v Number of orders:T/Q v Average inventory:Q/2 v Usage rate:T/D (D=days) v Reorder point:(T/D) x Delivery Time

Copyright  2005 by Thomson Learning, Inc. Quantity Discounts TC = Order Cost + Holding Cost + Item Cost TC = (F x (T/Q)) + (H x (Q/2)) + (C’ x T) TC = Order Cost + Holding Cost + Item Cost TC = (F x (T/Q)) + (H x (Q/2)) + (C’ x T)

Copyright  2005 by Thomson Learning, Inc. Inventory and the Cash Flow Timeline Inventory ordered Inventory ordered and received and received Time=> Time=> Cash paid Cash paid Cash paid for inventory for inventory for holding & ordering costs ordering costs Inventory ordered Inventory ordered and received and received Time=> Time=> Cash paid Cash paid Cash paid for inventory for inventory for holding & ordering costs ordering costs

Copyright  2005 by Thomson Learning, Inc. Monitor the Inventory Balance v Inventory control systems v Inventory turnover ratio –Sales or COGS / Inventory balance v Days COGS in inventory –Inventory balance / Daily COGS or Sales v Balance fraction approach –Develop monthly balance fractions based on the proportion of items remaining in inventory from a given month’s purchase.

Copyright  2005 by Thomson Learning, Inc. Reducing Investment in Inventory v Problems were solved by adding more inventory v JIT redesigns system v Redesign of production system –eliminate waste –eliminate production errors –improving quality v Need stable demand

Copyright  2005 by Thomson Learning, Inc. Summary v Inventory decisions should be based on: –cost of holding inventory –cost or ordering inventory –opportunity cost of funds –quantity discounts –is quantity workable within inventory management system? v Inventory, if properly managed can be a major contributor to cash flow... v if mismanaged, it can be a significant drain on cash. v Some traditional inventory monitoring tools can be biased by sales and production trends.