Chapter 11

The
management
of inventory

Slides by Prof J Krüger &

Prof C Rootman
Learning outcomes: Chapter 11
 classify inventory
 do a valuation of inventory
 calculate the economic order quantity
 determine the carrying, ordering and shortage costs of
inventory
 determine the reorder point
 perform an ABC classification of inventory
 manage safety stock and inventory balances
 monitor inventory turnover rates
 prevent loss of inventory.

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Introduction
• Funds invested in inventory – lost opportunities
• Different managers view inventory differently
 Financial managers – cost-benefit perspective
 Marketing and production managers – inventory to fulfill
marketing and production requirements
 Purchasing managers – purchasing correct quantity and
quality to receive discounts while ensuring having
sufficient inventory to meet production needs

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Inventory as an investment
• Inventory required for production and distribution processes
 Period of time to process goods
• Investment in warehouse and storage
facilities, insurance coverage,
obsolescence and spoilage
• Nature of investment dependent on type of firm
 Service (eg plumbers)
 Manufacturing (eg VW, Parmalat)
 Retail (eg Spar, Bradlows)
 Fast food (eg McDonalds)

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Inventory as an investment (cont.)
• Overstock situations
 Opportunity cost
 Storage cost
 Obsolescence
 Fire and theft
 Price fluctuations
• Understock situations
 Loss of sales due to out-of-stock situations
 Customers lost to competitors selling same products

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 Inventory
Classification of inventory classification

Raw Work-in- Finished

• Raw materials materials progress goods

 Undergo change during production process

 Why store raw materials?
 Make scheduling of production easier
 Hedge against price changes
 Hedge against supply shortages
 Use quantity discounts

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Classification of inventory (cont.)
• Work-in-progress (WIP)
 Products in different stages of completion but not yet
completed
 Why store WIP inventories?
 Buffer production (own production)

Inventory
classification

Raw Work-in- Finished

materials progress goods
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Classification of inventory (cont.)
• Finished goods
Inventory
 Ready to be used by final consumer classification

 Why stock finished goods? Raw Work-in- Finished

materials progress goods
 Demand uncertainty
 Stabilise production – when using same equipment to
produce different products
 Reduction in setup costs

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Inventory valuation
• What is actual value of inventory on hand?
• Four methods (no calculations required)
 First-in, first-out (FIFO)
 Cost of goods sold based on first units placed in
inventory
 Last-in, first-out (LIFO)
 Cost of goods sold based on last units placed in
inventory while remaining inventory value based on
first goods placed in inventory
 Weighted average
 Inventory on hand divided by number of units in stock
 Specific identification
 Value of inventory based on specific items in stock and
its specific value
 ABC method (see next slide)
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ABC method
• Classify items smaller but meaningful components
• Based on costs, order lead time and stock out consequence
multiplier
ABC method

Class B Class C
Class A
Moderate value Low value inventory
High value items
inventory items items

20% of items 30% of items 50% of items

Higher annual Average annual Lowest consumption
consumption consumption rate
Valuable items Less important items Least valuable items
 No calculations required for this section 10
 Cost of

Cost of inventory inventory

Carrying cost Ordering Stock-out

• Carrying cost (Storage cost) costs costs

 Cost of warehousing inventory until used in production or

sold
 Include renting warehousing space or in-house storage
costs
 Change in direct proportion to average amount of
inventory in stock

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Cost of inventory (cont.)
• Carrying cost (cont.)
• Example: Bush Bay Ltd sells 20 000 units of gas lighters per
year and orders inventory four times a year. The firm
purchases inventory at R5 per unit. Cost of capital is 10%.
Storage costs amounts to R500, inventory insurance cost is
R800 and depreciation and obsolescence costs are R500 a
year.
Average inventory = (S / N) / 2
= (20 000 / 4) / 2
= 2 500 gas lighters (R12 500)
If NO safety stocks are carried, then average inventory
is 2 500 gas lighters.

S number of units sold per year,

N number of equal-sized orders placed per year 12
Cost of inventory (cont.)
• Carrying cost (cont.)
• But what about opportunity cost?
• Investment in inventory = R12 500
• Required rate of return = 10%
• Thus, opportunity cost = R1 250

• Total carrying cost ?????

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Cost of inventory (cont.)
• Carrying cost (cont.)
• Total carrying cost = Opportunity cost R1
250
Storage cost R 500
Inv Insurance cost R 800
Depr & Obsolescence cost R 500
R3 050
• TCC = C x P x A
= 0.244* x R5 x 2 500
= R3 050
C % carrying cost
P Price per unit
A Average inventory
*% carrying cost (3 050 / 12 500) is given an no amounts 14
Cost of inventory (cont.)
• Ordering cost
• TOC = F x (S / 2A)
F fixed cost per order
N number of orders per year
(quantity / 2 x avg inventory)
• Example: Bush Baby Ltd sells 20 000 units of gas lighters
per year and carries an average inventory of 2 500 units.
Fixed ordering cost for placing and receiving orders amount
to R50 per order.
TOC = F x (S / 2A)
= 50 x [20 000 / (2 x 2 500)]
= R200

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Cost of inventory (cont.)
• Shortage or stock-outs
 Profit loss
 Loss of sales
 Extra cost of ordering
 Potential loss of customers
 Cost associated with production schedule disruptions

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Cost of inventory (cont.)
• Total inventory costs (TIC)
• TIC = TCC + TOC (see slides 14 and 15)
= R3 050 + R200
= R3 250

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Cost of inventory (cont.)
• Economic order quantity (EOQ)

Figure 11.4: The economic ordering quantity

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Cost of inventory (cont.)
• EOQ (cont.)
• Example: Consider the following information supplied by
Bush Baby Ltd:
Annual sales (S) 20 000 units
Carrying cost (C) 24.40%
Purchase price peer unit (P) R5
Fixed cost per order (F) R50
EOQ = 2xFxS
CxP
= [(2 x R50 x 20 000) / (0.244 x R5)]0.5
= 1 280.37 units
CANNOT order 0.37 of a unit …therefore EOQ = 1 281
units (always round UP to nearest full unit) 19
Cost of inventory (cont.)
• Setting the reorder point
• ROP = lead time in days x daily sales
• Example: Assume Bush Baby Ltd sells 56 gas lighters per
day. It takes 10 days to receive orders.
ROP = 10 x 56
= 560 gas lighters

• When 560 gas lighters in stock, EOQ should be placed

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Cost of inventory (cont.)
• Just-in-time system (JIT)
 Inventory received as and when required
 Minimise inventory investment
• Materials requirement planning (MRP) system
 To determine what materials to order and when
 Bill of materials – list of parts and materials

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Cost of inventory (cont.)
• Safety Stock
 Why do we need safety stock?
 Sudden increase in demand
 Delays in receiving orders
 Why do safety stock levels vary?
 Certainty of demand forecasts
 Inventory shortage costs
 Probability of delays in delivery
 CC of addition inventory

 Leave out Setting the safety stock level and Safety stock
analysis pp 263-264 22
Quantity discounts
• Example: Bush Baby Ltd sells 20 000 units (S) of gas
lighters per year. The firm purchases its inventory at R5 (P)
per unit. The cost of carrying inventory (C) is 24.4% of
investment in inventory. Fixed ordering cost is R50 per
order. Discount of 2% on orders of 1 500 units or more.
• BUT EOQ is currently 1 280 units!
• Will it be beneficial to the firm to order (AND carry) 220
more units than the EOQ?
Step 1: Determine total inventory cost of EOQ
Step 2: Determine total inventory cost of 1 500 units
Step 3: Determine saving as a result of discount
Step 4: Make final decision

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Quantity discounts (cont.)
Step 1: Determine total inventory cost of EOQ
TIC = C x P x (EOQ /2) + F(S / EOQ)
= 0.244 x 5 x (1 280 / 2) + (50 x (20 000 / 1 280))
= R1 562.05

Step 2: Determine total inventory cost of 1 500 units

TIC = C x P x (EOQ /2) + F(S / EOQ)
= 0.244 x 4.90* x (1 500 / 2) + (50 x (20 000 / 1 500))
= R1 563.37
See slide 14 – A replaced by average EOQ
See slide 15 – A replaced by EOQ

*2% on purchase price of R5 per unit, ie 0.98 of R5 = R4.90

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Quantity discounts (cont.)
Step 3: Determine saving as a result of discount
• TIC will increase by R1.32 (R1 563.37 – R1 562.05) to order
and carry 1 500 units instead of 1 280 units
• R0.10 saving per lighter (0.02 x 5) R2 000 saving per
year (R0.10 x 20 000 units)

Step 4: Make final decision

• Saving of R2 000 outweigh additional carrying cost of R1.32

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Inflation
• Inflation influences inventory values

Increase
in
inflation

Influence
Increase
optimal
in interest
inventory
levels
levels

Increase
Decrease
in
in EOQ
carrying
and avg
cost per
inventory
unit
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Seasonal demand
• EOQ not appropriate – but what then?
• Use EOQ as starting point
 Use EOQ for each season – sales relatively stable for
each season
 Control inventory levels

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Inventory control systems
• Simple control systems
 Red-line method – inventory items stored
in a bin, red line drawn around inside of
bin at level of reorder point, order placed
when red line visible
 Two-bin method – inventory items
stored in two bins, when bin 1 is empty

• Computerised systems
 System updated as sales are made, inventory updated,
order placed when reorder point is reached
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Monitoring inventory balances
• Inventory turnover
 Rate at which firm depletes and replenishes inventory
 Number of times during a specific period inventory on
hand is turned into sales

• Inventory turnover in units

= Sales in units / Avg units of inventory on hand

• Inventory turnover in monetary value (See Chapter 4)

= Value of inventory / [(Begin value + End value) / 2]

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Monitoring inventory balances (cont.)
Example: The beginning inventory of cellular phones is 25
units (amounts to R3 000) and ending inventory of the same
item is 15 units (amounts to R1 800). Total units of phones
sold is 800 (amounts to R96 000). What is the inventory
turnover in units?
= Sales in units / Avg units of inventory on hand
= 800 / [(25 + 15) / 2]
= 40 times
And in monetary value (Rands)?
= Value of inventory / [(Begin value + End value) / 2]
= 96 000 / [(3 000 + 1 800) / 2]
= 40 times
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Monitoring inventory balances (cont.)
• Analysing turnover rates
Inventory turnover

Increasing High
• Increase in total profits • Out-of-inventory situations
• Use capital more efficiently • Increase in order and
• Decrease in fixed expenses receiving costs
per unit • Loss of quantity discounts
• Decrease in markdowns
• Possible to buy new
merchandise
• Merchandise kept fresh
(perishable)

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Preventing inventory losses

Preventing
inventory losses

Reduction of
Preventive
Proper control eventual losses
measures
through insurance

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Preventing inventory losses (cont.)
Preventing inventory
losses

Reduction of eventual
Proper control Preventive measures losses through
insurance

Proper
control

Checking deliveries for Searching

Regular stocktaking
quantities and quality employees

Perpetual inventory
Invoice or delivery note check Theft
system

Quantity check Periodic physical inventory

system

Quality check

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Preventing inventory losses (cont.)
Preventing inventory

• Adequate and secure storage losses

• Surveillance equipment, tagged or Proper control Preventive measures

Reduction of eventual
losses through
insurance

magnetic plastic devices (deactivated/removed)

• Effective store layout
 Eg small high-priced items behind counters
• Fire-detection and fire-fighting equipment

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Preventing inventory losses (cont.)
Preventing inventory
losses

Reduction of eventual
Proper control Preventive measures losses through
insurance

• Provision for inventory losses – payment of predetermined

premium transferring risk of inventory losses to insurance
company

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Alternatives to holding inventories
• Enter into future contracts to hedge against possible
fluctuations in prices of merchandise
• Offering longer sales terms or reduce prices as an
alternative to immediate availability of merchandise
• Reducing bigger stock holdings by using more reliable
production methods

36
Preparation for next session
• Work through Chapter 11
• Questions in study guide
• Problems at the end of the chapter relating to
the content already covered

• Read through Chapter 12 and download/print the

slides

• Individual tutorial B opens 15 April and closes 22

April

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