Working Capital

Management

Inventory
Key Learning Points

• Costs of holding inventory

• EOQ Economic order quantity
• JIT Just in time
Inventory (stock) Management

Almost every company will carry inventory of some sort even it if only inventories of
consumables i.e. stationery

For manufacturing companies inventories can amount to a substantial asset of the

business

A manufacturing company may hold:

• Raw materials
• WIP (Work-in- progress)
• Finished goods

There are number of costs associated with holding inventory.

The costs of inventory

Costs of high levels of inventory: -

 Finance cost
• Inventory levels need to be financed in some way
• Normally by an overdraft or loan
• The higher the level of inventory, the higher the level of finance costs

 Storage/warehousing cost
• Inventory needs to be stored
• The cost here could be the direct cost of warehousing
• This could be an external warehousing cost

 Obsolescence/damage
• The higher the level of inventory the greater the risk of obsolescence
• This is particularly relevant to technology goods as new products are frequently
introduced
• There is also the risk of theft
The costs of inventory

Costs of low levels of inventory: -

 Lost sales
• We may not have enough inventory to supply our customers
• This can lead to a loss of sales revenue and contribution
• Plus a potential loss of goodwill

 Increased ordering and delivery costs

• Lower levels of inventory lead to more frequent orders placed with suppliers
• This can increase the administration costs of placing orders and also the
delivery costs

 Lost quantity (bulk purchase) discounts

• If we buy smaller quantities we may not be able to take advantage of quantity
discounts being offered by the supplier
 EOQ – Economic Order Quantity

This is a model which can (in theory) be used to determine the optimum quantity of
inventory to order whenever an order for inventory is placed.

The model is based upon minimising the total inventory costs when taking into account
the following: -

• Finance costs
• Storage/warehousing costs
• Ordering and deliver costs

The model can be adapted to take into account quantity discounts but is too simplistic
to take into account potential lost sales revenue or obsolete and damaged inventory.
How does EOQ work?

EOQ is based on the relationship between the number of units ordered every time and
order is placed and the total costs of inventory.

EOQ identifies two types of inventory cost:

i. Holding Costs
• These are the finance and storage/warehousing costs
• They will increase as the number of units of inventory in each order increase
• The more inventory per order, the greater the average level of inventory and
therefore the greater the total annual holding cost

ii. Ordering Costs

• These are the ordering and delivery costs
• They will decrease as the number of units of inventory in each order increase
• The more inventory per order, the fewer the number of orders that will be placed
and therefore the lower the total annual ordering costs
EOQ – Diagrammatically
Total costs

Holding costs

Cost

Order costs

EOQ
Units per order

• The EOQ is the order quantity that minimises the total inventory costs
Assumptions of the EOQ

 Demand for the inventory is constant

• For a retailer this means that demand from customers is constant
• For a manufacturer it means that the raw material used in production is constant
• You can question if this is actually realistic

 The lead time is constant

• This means that we assume that the time between an order being placed and
the delivery of the inventory is the same for every order
• It also means that we know with certainty when inventory will be delivered and
therefore we only order when we need inventory
Assumptions of the EOQ

 No buffer inventory is held

• Because demand is constant and we know the lead time there is no need to
hold buffer inventory
• However this can be built into the model

 Purchase price is constant

• There is now change in the cost of purchasing new inventory
• However we will introduce bulk quantity discounts

These assumptions can be illustrated by the following graph!

EOQ – Diagrammatically

EOQ/Q

Units

Average stock = Q / 2

Time

New order delivered

Formula for EOQ

EOQ = √2.Co.D
Ch
Where:

D = annual demand for the inventory

Co = cost per order
Ch = holding cost of one unit of inventory for one year

Total annual cost of inventory = Annual holding costs + Annual ordering costs

Annual holding costs = Q / 2 x Ch

Annual ordering costs = D / Q x Co

Where:

Q = the order quantity

EOQ

Example 1

Horowitz is a small independent manufacturer of computers. As part of its

manufacturing process it requires 150,000 identical circuit boards which are all delivered
by the same supplier.

The cost of ordering and delivering is $800 per order placed. The cost of storing the
circuit boards within the business before being used in manufacturing is $3 per circuit
board per annum.

Each circuit board costs $10 to purchase and working capital is financed by a bank
overdraft at 8% interest per annum.

Required:

Using the EOQ model determine how many circuit boards should be ordered each time
an order is placed, and determine the total annual cost inventory.
EOQ

Example 1 - Answer

Co =

Ch =

D=

EOQ =

EOQ =

EOQ =
EOQ

Example 1 - Answer

Total annual inventory cost:

Annual holding costs = average stock x Ch

= Q / 2 x Ch
=

Annual ordering costs = No. of orders x Co

= D / Q x Co
=

Purchase cost of inventory =

Total inventory costs (including purchase costs)

EOQ

Example 2

Using the same information as in example 1.

The supplier now offered Horowitz a discount of 1% on the purchase price if 12,000
units or more were ordered every time an order was placed.

Required:

Should this discount be taken?

EOQ
Example 2 - Answer

Total annual inventory cost:

Annual holding costs = average stock x Ch

= Q / 2 x Ch
=

Annual ordering costs = No. of orders x Co

= D / Q x Co
=

Purchase cost of inventory =

Total inventory costs (including purchase costs)

Vs.
Total inventory costs (including purchase costs)

Therefore purchase 12,000 units per order and take the discount!
JIT – Just-in-time
An alternative view of inventory management is the reduction or elimination of
inventory. The supplier holds the inventory until it is needed and delivers just in
time for production.

Implications of JIT: -

• Total reliance on the supplier for both quality and reliability.

• Long-term contracts with supplier to make it worth their while building the factory,
developing the systems to service their customer.

• Supplier factory ideally located very close to customer.

• Very close working relationship. Suppliers’ workers will often spend time in the
customer’s factory and vice versa.

• Better factory design can also reduce the work-in-progress stock.

• Only produce for customer demand, hence no finished goods stock.

• Emphasis on quality (because of the elimination of the stock buffer).

• Operating JIT successfully can then open up further business opportunities.

Key Learning Points

• Costs of holding inventory

• EOQ Economic order quantity
• JIT Just in time
• Inventory control in reality
Working Capital
Management

Inventory