Week 14

Inventory Management

10b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Learning Outcomes
Explain the goals of inventory management.
Differentiate the traditional and modern techniques in inventory
management
Apply the principles and procedures in economic order quantity,
optimum production quantity, ABC classification, order point
model, order cycling system, two-bin system and min–max
system.
Determine the costs of stockouts in relation to safety stock.
Explain the concept of just-in-time inventory system.
Determine the optimal safety stock level.

10b.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Inventory Management
Inventory management is directly linked to the operating goal of
giving the best service to customers.
When a customer calls for a sales order, delivery must be done
at the fastest possible time and at the lowest possible costs.
Traditionally, company maintain a large stock of inventories to
meet the challenge of serving customers on time.
However, under the present managerial framework, serving
customers on time could be done by applying technology and
redesigning the processes of production.

10b.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Traditional Inventory
Management Techniques
Traditional inventory management techniques are based on old
production processes that include:
purchase of materials, receipts of material,
material warehousing,
materials issuances to production, material pre-production inspection,
conversion processes,
quality inspection of units produced,
finished goods warehousing,
pre-shipment inspection and delivery to customers.

10b.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Traditional Inventory
Management Techniques
Traditional inventory management focuses on
warehousing functions. Materials are purchase and
warehoused. Finished goods are warehoused as
well.
In this context, the traditional inventory models were
developed such as: economic order quantity model,
reorder point, two-bin system, order cycling method,
min-max method and ABC classification.

10b.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The EOQ Model
The economic order quantity (EOQ) refers to the units of materials that
should be purchased to minimize total relevant inventory costs.
Total inventory costs include the sum of ordering costs and carrying
costs.
Total relevant inventory costs do not include the purchase price in the
analysis because the unit purchase price remains the same regardless
of the order quantity the business places.
Ordering costs include those spent in placing an order waiting for an
order, inspection and receiving costs, setup costs, and quantity
discount lost.
Annual demand represents the annual need or requirement of the
business.
Order size refers to the number of units or amount purchased per order
batch.
10b.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The EOQ Model

EOQ (in units) = 2 x AD x CPO

CC per unit

EOQ (pesos) = 2 x AD in pesos x CPO

CC Ratio

CPO = cost per order

AD = annual demand
CC = carrying cost

10b.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basic EOQ
Assume an annual requirement of 24,000 units, a cost per unit
of P20, a cost per order of P750, and a carrying cost percentage
of 20%. Compute the EOQ in units and in pesos.
Answer: Applying the formula:
EOQ in units = 3,000 units
EOQ in pesos = P60,000

10b.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How Much to Order?

The optimal quantity to order

depends on:
Forecast usage
Ordering cost
Carrying cost

10b.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Reorder Point
Reorder point refers to the inventory level where a purchase order should be
placed.
Reorder point is the sum of lead time quantity and safety stock quantity.
Lead time refers to the waiting time from the date the order is placed until the
date the delivery is received.
Lead time quantity represents the normal usage during the lead time period.
Normal usage means the average usage of inventory during a period (i.e.,
annual demand/working days in a year)
Safety stock is set to serve as a margin in case of variations in normal usage
and normal lead time. Hence, there is safety stock variation in usage and safety
stock for variations in time.
The maximum inventory level is the sum of the safety stock quantity and the
order size. The minimum quantity is the safety stock quantity.

10b.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Reorder Point
Example: BSA Company has the following production data:
Annual requirement 40,000 units
Number of working days 320 days
Normal lead time 10 days
Maximum lead time 16 days
Maximum usage 150 units
EOQ 5,000 units
Question: Determine the lead time quantity, safe stock quantity, reorder point and maximum
inventory levels.
Lead time quantity = 125 units x 10 days =1,250 units
Safety stock quantity = 250 units + 750 units = 1,000 units
Reorder point = 1,250 units + 1,000 units = 2,250 units
Maximum inventory level = 1,000 units + 5,000 units = 6,000 units.

10b.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Stockout Costs
Inadequate inventory levels carried by a business have the following costs:
Extra-purchasing, handling and transportation costs
Lost sales and lost of customer goodwill
Additional clerical costs due to keeping customer-back order records
Inflation-oriented increases in prices when inventory purchases are deferred
Frequent stock-outs leading to disruption of production schedules, overtime and
extra setup time
Higher price due to small quantity (e.g. extra purchasing on transportation costs)
Foregone supplier’s discount

10b.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Modern Inventory
Management Model
Modern strategies and techniques of managing inventories depend on efficient
scheduling of production processes from the source of materials to the place of
customers. This change in strategy of inventory management comes to reality
due to the enormous contribution of technology.
Database of suppliers, company, and customers could now be shared on time
and each others needs could be filled out without waiting an order.
This is done through electronic data interchange (EDI).
The following inventory management modoels are now in practice
1. Just-in-time (JIT)
2. Computer-Integrated Manufacturing (CIM)
3. Marial Requirement Planning (MRP)
4. Manufacturing Resource Planning (MRP II)
5. Enterprise Resource Planning (ERP)

10b.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 JIT Inventory System
The JIT inventory model is anchored on the premise that materials should be
received just in time they are needed for production, and finished good are
completed just in time they are needed by the customers.
The fundamental objective of JIT is to produce and deliver what is needed, when
it is needed, at all stages of the production process just in time to be fabricated,
assembled and shipped to customers.
The benefits of JIT includes lower inventory level, faster response time, higher
output per unit, and fewer floor space requirements.
JIT is a pull system – inventories are pulled through production by current
demand, not pushed by anticipated demand.
The cost accounting technique used in the JIT inventory system is backflushing
costing.

10b.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Application of Concept

Task on Inventory Management.

10b.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.