CDA COLLEGE BUS235: PRINCIPLES OF FINANCIAL ANALYSIS Lecture 11 Lecture 11 Lecturer: Kleanthis Zisimos

Inventory management and costs Inventory management and costs The economic ordering quantity (EOQ) model The economic ordering quantity (EOQ) model Inventory control systems Inventory control systems Monitoring inventory levels Monitoring inventory levels Lecture Topic List

Inventory management Inventory management examines approaches of managing inventory efficiently. Inventory management examines approaches of managing inventory efficiently. Inventory management focuses on four basic questions Inventory management focuses on four basic questions 1. How many units should be order? 2. At what point should inventory be ordered? 3. What inventory items require special attention? 4. Can changes in the costs of inventory be hedged?

Inventories are the stock of the business and can be classified as Raw materials Raw materials Work in progress and Work in progress and Finished goods Finished goods Inventory levels depend heavily upon sales and must be acquired ahead of sales. The goal of inventory management is to provide the inventories required to sustain operations at the lower possible cost. Inventories

Inventory costs An inventory cost is a cost assigned to goods that were either purchased or manufactured for resale. It is also known as ‘cost of sales’. It is the cost that we place on the Trading Account. An inventory cost is a cost assigned to goods that were either purchased or manufactured for resale. It is also known as ‘cost of sales’. It is the cost that we place on the Trading Account. We can broke down these costs in 3 categories We can broke down these costs in 3 categories 1. Purchase cost 2. Reorder costs 3. Inventory holding cost

Purchase cost This is the cost of purchasing the goods. Over a year the total cost will remain constant regardless of how we decide to have the items delivered. This is the cost of purchasing the goods. Over a year the total cost will remain constant regardless of how we decide to have the items delivered. This is the reason why purchases costs are irrelevant to our decisions and excluded from the analysis unless we are able to receive discounts for placing large orders. This is the reason why purchases costs are irrelevant to our decisions and excluded from the analysis unless we are able to receive discounts for placing large orders.

Reorder cost This is the cost of placing orders. It includes such costs as the administrative time included in placing an order, and the delivery cost charged for each order. This is the cost of placing orders. It includes such costs as the administrative time included in placing an order, and the delivery cost charged for each order. Total ordering cost = TOC =(F)(N) Total ordering cost = TOC =(F)(N) F=fixed cost per order N= equal size orders per year

Inventory holding cost This is the cost of holding items in inventory. It includes costs such as warehousing space and insurance and also the interest cost of money tied up in inventory. This is the cost of holding items in inventory. It includes costs such as warehousing space and insurance and also the interest cost of money tied up in inventory. Total Inventory holding Cost=TIH = (C) (P) (A) Total Inventory holding Cost=TIH = (C) (P) (A) Average Inventory = A = Units per order = U U= units per order P=Purchase cost per unit C=percentage holding cost

Total Inventory Costs = TIC = TIH + TOC = (C)(P)(A)+(F)(N) = (C)(P)(A)+(F)(N) Example 1. Find the total inventory costs if F = € 600 per order S = T shirts P = € 2 per t shirt N= 4 orders per year C=20% Total Inventory Costs

Example 2. Janis has demand for 40,000 desks per annual the purchase price of each desk is €25. There are ordering costs of € 20 for each order placed. Inventory holding costs amount to 10% per annual of inventory value Example 2. Janis has demand for 40,000 desks per annual the purchase price of each desk is €25. There are ordering costs of € 20 for each order placed. Inventory holding costs amount to 10% per annual of inventory value Calculate the total inventories costs for the following order quantities and the optimal quantity Calculate the total inventories costs for the following order quantities and the optimal quantity units units units units

What is the optimal inventory level which minimizes our costs and how can we determine the optimal inventory level? What is the optimal inventory level which minimizes our costs and how can we determine the optimal inventory level? The two most important approaches commonly used are the the economic ordering quantity (EOQ) model and the Just in time approach The two most important approaches commonly used are the the economic ordering quantity (EOQ) model and the Just in time approach Minimizing costs

The (EOQ) shows the optimal quantity of inventory that should be ordered and is found using the following formula The (EOQ) shows the optimal quantity of inventory that should be ordered and is found using the following formula EOQ = √ 2(F)(S) (C) (P) (C) (P) EOQ=economic ordering quantity F = Fixed Costs per order S = Annual sales in units C= percentage Holding cost P =Purchase cost per unit The EOQ formula

EOQ Example From the data of example 2 : From the data of example 2 : 1. Use the EOQ formula to calculate the Economic Order Quantity. 2. Calculate the total inventory costs for this order quantity

Quantity discounts IF discounts are offered for ordering large quantities then we must take the following steps for finding the optimal inventory level: IF discounts are offered for ordering large quantities then we must take the following steps for finding the optimal inventory level: Calculate EOQ ignoring discounts Calculate EOQ ignoring discounts Calculate the total annual inventory costs for this quantity including the Purchase cost, Calculate the total annual inventory costs for this quantity including the Purchase cost, Recalculate total annual inventory costs using the order size required to just obtain the discount Recalculate total annual inventory costs using the order size required to just obtain the discount Repeat for all discount levels Repeat for all discount levels Compare the costs and select the minimum cost alternative. Compare the costs and select the minimum cost alternative.

Under this approach, minimum inventories are held of Finished Goods, Work-in-Progress, and Raw Materials. Under this approach, minimum inventories are held of Finished Goods, Work-in-Progress, and Raw Materials. The conditions necessary for the business to be able to operate with minimum inventories include the following for: The conditions necessary for the business to be able to operate with minimum inventories include the following for: A) Finished Goods: a short production period, so that goods can be produced to meet demand a short production period, so that goods can be produced to meet demand good forecasting of demand good forecasting of demand Just In time approach

B) Work-in-Progress: a short production period. a short production period. the flexibility of the workforce to expand and contract production at short notice the flexibility of the workforce to expand and contract production at short notice C) Raw Materials: the ability to receive raw materials from suppliers as they are needed for production (instead of being able to take from inventory). the ability to receive raw materials from suppliers as they are needed for production (instead of being able to take from inventory). guaranteed quality of raw material supplies guaranteed quality of raw material supplies tight contracts with suppliers, with penalty clauses, because of the reliance placed on suppliers for quality and delivery times. tight contracts with suppliers, with penalty clauses, because of the reliance placed on suppliers for quality and delivery times.

The Reorder Point is the inventory level at which an order should be placed. The Reorder Point is the inventory level at which an order should be placed. Reorder point = Lead time in weeks X Weekly usage If a new order must be placed before the previous order is received, a goods in transit inventory will build up. Goods in transit are goods which have been ordered but have not been received. If a new order must be placed before the previous order is received, a goods in transit inventory will build up. Goods in transit are goods which have been ordered but have not been received. Reorder point = (Lead time weeks X Weekly usage) – Goods in transit Setting the reorder point

Companies use Inventory control systems to help them keep track of actual inventory levels and to insure that inventory levels are adjusted as sales change. Companies use Inventory control systems to help them keep track of actual inventory levels and to insure that inventory levels are adjusted as sales change. The methods-systems used are The methods-systems used are Red line method. Items are stocked in a bin, a red line is drawn around the bin at the level of reorder point and reorders are placed when the level of stock reached the red line Red line method. Items are stocked in a bin, a red line is drawn around the bin at the level of reorder point and reorders are placed when the level of stock reached the red line Out sourcing method. The practice of purchasing components rather than making them in house. Out sourcing method. The practice of purchasing components rather than making them in house. Inventory Control Systems

Computerized inventory control systems. The computer starts with an inventory count in memory. As withdrawals are made, they are recorded by the computer, and the inventory balance is revised.When the reorder point is reached, the computer automatically places an order. Computerized inventory control systems. The computer starts with an inventory count in memory. As withdrawals are made, they are recorded by the computer, and the inventory balance is revised.When the reorder point is reached, the computer automatically places an order. Just in Time Systems is a system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process. Just in Time Systems is a system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process. Inventory Control Systems