ANALYSIS OF INVENTORIES

FINAL TERM ASSIGNMENT

ANALYSIS OF FINANCIAL STATEMENTS

Analysis of inventories

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ANALYSIS OF FINANCIAL STATEMENTS Table of Contents

ANALYSIS OF INVENTORIES..............................................................................4 Introduction.....................................................................................................4 MANAGING INVENTORIES.................................................................................4 Controlling inventory.......................................................................................4 Inventory Costs................................................................................................5 Economic batch quantity.................................................................................8 Uncertainties in demand and lead times: the re-order level system...............9 Periodic review...............................................................................................10 Finite number of re-order levels....................................................................10 Maximum and minimum inventory levels......................................................11 Just-in-time (JIT) procurement........................................................................12 PURCHASING..................................................................................................12 The purchasing function.............................................................................12

SUBMITTED TO: FAHEEM

PROFESSOR AMIR

BY: BABAR JAFARI (9348) Centralised versus decentralised purchasing................................................14 Chapter roundup............................................................................................15 FALAK SHAH (9204) PRACTICE QUESTION......................................................................................16 HINA CHUGTAI (9370) PRACTICE QUESTION RABIA IRAM (9305)
The purchasing mix....................................................................................13 Building supplier relationships....................................................................14

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Chapter 4
ANALYSIS OF INVENTORIES
Topic list 2.3 Managing inventories 2.4 Purchasing Practice question

Introduction
You should be able to apply the EOQ model for inventory ordering; it is likely to feature somewhere in every paper. As well as doing the calculations, you need to explain its assumptions and the components of inventory costs. We also discuss in overview the impact of lean manufacturing and just-in-time on inventory control and other important aspects of purchasing.

1. MANAGING INVENTORIES
1.1 Business should consider at what level of inventory orders should be made, taking account of demand levels, delivery times and any uncertainties. Safety inventory may be held if uncertainties are particularly large.

Controlling inventory
1.2Almost every company carries inventories of some sort, even if they are only inventories of consumables such as stationery. For a manufacturing business, inventories, in the form of raw materials, work in progress (goods or projects on which work has been carried out but which are not yet ready for sale) and finished goods, may amount to a substantial proportion of the total assets of the business. 1.3 Some businesses attempt to control inventories on a scientific basis by balancing the costs of inventory shortages against those of inventory holding. a) The economic order quantity (EOQ) model can be used to decide the optimum order size for inventories which will minimize the costs of ordering inventories plus inventory holding costs. 4 | Page

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b) If discounts for bulk purchases are available, it may be cheaper to buy inventories in large order sizes so as to obtain the discounts. c) Uncertainty in the demand for inventories and/or the supply lead time may lead a company to decide to hold buffer inventories or safety inventories (thereby increasing its investment in working capital) in order to reduce or eliminate the risk of running out of inventory. KEY TERM Safety inventory is the quantity of inventories of raw materials, work in progress and finished go ods which are carried in excess of the expected usage during the lead time of an activity. The safety inventory reduces the probability of operations having to be suspended due to running out of inventories.

Inventory Costs
1.4 Inventory costs can be conveniently classified into four groups. a) Holding costs comprise the cost of capital tied up, warehousing and handling costs, deterioration, obsolescence, insurance and pilferage. b) Procuring costs depend on how the inventory is obtained but will consist of ordering costs for goods purchased externally, such as clerical costs, telephone charges and delivery costs. c) Shortage costs may be: i. The loss of a sale and the contribution which could have been earned from the sale. ii. The extra cost of having to buy an emergency supply of inventories at a high price. iii. The cost of lost production and sales, where the stock-out (running out of inventory) brings an entire process to a halt. a) The cost of the inventory itself, the suppliers price or the direct cost per unit of production will also need to be considered when the supplier offers a discount on orders for purchases in bulk. 1.5 Businesses need to be aware of rates of consumption/usage, and lead times, the time between placing an order with a supplier and the inventory becoming available for use. Re-order quantities: the basic EOQ model KEY TERM Economic order quantity (EOQ) is the most economic inventory replenishment order size, which minimises the sum of inventory ordering costs and inventory holding costs. EOQ is used in an 'optimising' inventory control system. 1.6Inventory holding and ordering costs can be minimised using the economic order quantity model. If discounts are offered for bulk purchases, the higher holding costs should be weighed against the lower ordering and purchasing costs. 1.7 Let D = the usage in units for one year (the demand) 5 | Page

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Co = the cost of making one order Ch = the holding cost per unit of inventory for one year Q = the reorder quantity

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a) Demand is constant. b) The lead time is constant or zero. c) Purchase costs per unit are constant (ie no bulk discounts). The total annual cost of having inventory (T) is: Holding costs + ordering costs. QCh + CoD 2 Q The order quantity, Q, which will minimise these total costs (T) is given by the following formula. (You do not need to know how this formula is derived.) Note that it is similar in form to the formula for the optimum sale quantity in Baumol's cash management model. Exam formula Economic Order Quantity EOQ = Where C0 = cost of placing an order Ch = cost of holding one unit in inventory for one year D = annual demand 1.8 Example: economic order quantity The demand for a commodity is 40,000 units a year, at a steady rate. It costs Rs.20 to place an order, and 40c to hold a unit for a year. Find the order size to minimise inventory costs, the number of orders placed each year, and the length of the inventory cycle. 1.9 Solution

The effect of discounts 1.10The solution obtained from using the simple EOQ formula may need to be modified if bulk discounts (also called quantity discounts) are available. 1.11To decide mathematically whether it would be worthwhile taking a discount and ordering larger quantities, it is necessary to minimise the total of: (a) Total material costs. (b) Ordering costs. (c) Inventory holding costs.

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1.12 The total cost will be minimised: a) At the pre-discount EOQ level, so that a discount is not worthwhile, or b) At the minimum order size necessary to earn the discount. 1.13 Example: bulk discounts The annual demand for an item of inventory is 45 units. The item costs Rs.200 a unit to purchase, the holding cost for one unit for one year is 15% of the unit cost and ordering costs are Rs.300 an order. The supplier offers a 3% discount for orders of 60 units or more, and a discount of 5% for orders of 90 units or more. What is the cost-minimising order size? 1.14 Solution The EOQ ignoring discounts is: 2x300x45 = 30 units 15% of 200 Purchases (no discount) 45 x Rs.200 Holding costs 15 units x Rs.30 Ordering costs 1.5 orders x Rs.300 Total annual cost 9,000 450 450 9,900

(i) With a discount of 3% and an order quantity of 60 units costs are as follows. Rs. Purchases Rs.9,000 x 97% 8,730 Holding costs 30 units x 15% of 97% of Rs.200 873 Ordering costs 0.7.5 orders x Rs.300 225 Total annual costs 9,828 (ii) With a discount of 5% and an order quantity of 90 units costs are as follows. Rs. Purchases Rs.9,000 x 95% 8,550.0 Holding costs 45 units x 15% of 95% of Rs.200 1,282.5 Ordering costs 0.5 orders x Rs.300 150.0 Total annual costs 9,982.5 The cheapest option is to order 60 units at a time. Note that the value of Ch varied according to the size of the discount, because Ch (see para 1.7) was a percentage of the purchase cost. This means that total holding costs are reduced because of a discount. This could easily happen if, for example, most of Ch was the cost of insurance, based on the cost of inventory held. Exercise 1
A company uses an item of inventory as follows.

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Purchase price: Rs.96 per unit Annual demand: 4,000 units Ordering cost: Rs.300 Annual holding cost: 10% of purchase price Economic order quantity: 500 units Should the company order 1,000 units at a time in order to secure an 8% discount?

Analysis of inventories

Solution The total annual cost at the economic order quantity of 500 units is as follows. Rs. Purchases 4,000 x Rs.96 384,000 Ordering costs Rs.300 x (4,000/500) 2,400 Holding costs Rs.96 x 10% x (500/2) 2,400 388,800 The total annual cost at an order quantity of 1,000 units would be as follows. Rs. Purchases Rs.384,000 x 92% 353,280 Ordering costs Rs.300 x (4,000/1,000) 1,200 Holding costs Rs.96 x 92% x 10% x (1,000/2) 4,416 358,896 The company should order the item 1,000 units at a time, saving Rs.(388,800 - 358,896) = Rs.29,904 a year.

Economic batch quantity

1.13The economic batch quantity is related to the economic order quantity, and is used when replenishment of inventory is gradual rather than instantaneous. It can be used when a company is making the items itself rather than ordering them. Production runs will be set up when necessary and production will take place until the order is completed. No further order is made, or inventory delivered, until the company is next on the point of running out of inventory. 1.14The extra information required for the economic batch quantity model is the annual rate at which inventories arrive in stores, R, and the formula is: Exam formula Economic Batch Quantity EBQ = 2CoD Ch(1-D/R)

Exercise 2 Maurice sells one product for which the annual demand is 50,000 units. Ordering costs are Rs.40 per order, holding costs Rs.0.50 per item per year. Required Calculate 2 The economic order quantity 9 | Page

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The economic batch quantity if Maurice is able to replenish its inventories at a rate of 200,000 units per year. Solution a) EOQ= 2CoD Ch 2x40x50,000 == 2,828 units 0.50

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b) EBQ

= =

2C D o Ch(1 D/R) 2x40x50,000 0.50(1 - 50,000 / 200,000) =3,266 units

Uncertainties in demand and lead times: the re-order level system

KEY TERM Re-order level = maximum usage x maximum lead time. It is the measure of inventory at which a replenishment order should be placed. Use of the above formula builds in a measure of safety inventory and minimises the possibility of the organisation running out of inventory, a stock-out. 1.17 The EOQ model assumes a level of stability which does not always apply in business.

1.18 When the volume of demand is uncertain, or the supply lead time is variable, there are problems in deciding what the re-order level should be. By holding a safety inventory, a company can reduce the likelihood that inventories run out during the re-order period (due to high demand or a long lead time before the new supply is delivered). The average annual cost of such a safety inventory would be: 1.19 Quantity of safety inventory (in units) x Inventory holding cost per unit per annum The diagram below shows how the inventory levels might fluctuate with this system. Points marked 'X' show the re-order level at which a new order is placed. The number of units ordered each time is the EOQ. Actual inventory levels sometimes fall below the safety inventory level, and sometimes the resupply arrives before inventories have fallen to the safety level, but on average, extra inventory holding amounts to the volume of safety inventory. The size of the safety inventory will depend on whether stockouts (running out of inventory) are allowed.

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1.21 In the modem manufacturing environment stockouts can have a disastrous effect on the production process. Nevertheless you may encounter situations where the risk of stockouts is assumed to be worth taking. In this case the re-order level may not be calculated in the way described above.

Periodic review
1.22 An alternative to the re-order level system is a periodic review system. Using this system, inventory levels are reviewed at fixed intervals, for instance the same day each month. Orders are then put through to top inventory up to pre-set levels.

Finite number of re-order levels

1.23 You may see a question where you are given a list of the re-order levels from which the business will select one. For each possible re-order level, and therefore each level of buffer inventory, calculate: a) The costs of holding buffer inventory per annum. b) The costs of stockouts (Cost of one stockout x expected number of stockouts per order x number of orders per year). 1.24 The expected number of stockouts per order reflects the various levels by which demand during the lead time could exceed the re-order level. Example: possibility of stockouts (1) If re-order level is 4 units, but there was a probability of 0.2 that demand during the lead time would be 5 units, and 0.05 that demand during the lead time would be 6 units, then expected number of stockouts = ((5 - 4) x 0.2) + ((6 - 4) x 0.05) = 0.3. Demand normally distributed Alternatively you may be told that demand is normally distributed. If this is the case you need to know: a) Average weekly demand. b) Standard deviation of demand. c) Lead time. d) Acceptable risk levels. Re-order level = (Average weekly demand x lead time) + xo Where x = number of standard deviations that correspond to the chance business wishes to have of avoiding stockouts o = standard deviation of demand 13 | P a g e

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1.26 Example: possibility of stockouts (2) Average weekly demand is 200 units, the standard deviation of demand (a) is 40 units and demand is normally distributed. Lead time for orders is one week. What re-order levels should the business set if it wishes to have a) A 90% chance b) A 95% chance c) A 99% chance of avoiding running out of inventory. The relevant values from normal distribution tables are respectively: a) 1.28 b) 1.65 c) 2.33 1.27 Solution Re-order level = (Average weekly demand x lead time) + xa a) Re-order level = (200 x 1) + (1.28 x 40)= 251.2 units b) Re-order level = 200 + (1.65 x 40)= 266 units c) Re-order level = 200 + (2.33 x 40)= 293.2 units

Maximum and minimum inventory levels

KEY TERM Maximum inventory level = re-order level + re-order quantity - (minimum usage x minimum lead time) It is the inventory level set for control purposes which actual inventory holding should never exceed. 1.28 The maximum level acts as a warning signal to management that inventories are reaching a potentially wasteful level. KEY TERM Minimum inventory level or safety inventory = re-order level - (average usage x average lead time) It is the inventory level set for control purposes below which inventory holding should not fall without being highlighted. 1.29 The minimum level acts as a warning to management that inventories are approaching a dangerously low level and that stockouts are possible. KEY TERM Average inventory = Minimum level + re-order quantity 2 14 | P a g e

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1.30 This formula assumes that inventory levels fluctuate evenly between the minimum (or safety) inventory level and the highest possible inventory level (the amount of inventory immediately after an order is received, safety inventory and reorder quantity).

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Just-in-time (JIT) procurement

1.31 1.32 The aim of Just-in-time is to hold as little inventory as possible and production systems need to be very efficient to achieve this. Just-in-time procurement means obtaining goods from suppliers at the latest possible time (ie when they are needed on the production line), thus avoiding the need to carry any materials or component inventory. Deliveries will be small and frequent rather than in bulk. Just-in-time procurement thus implies a mutually beneficial working relationship with suppliers. The aim is that suppliers guarantee to deliver raw materials components of appropriate quality always on time. In return the suppliers receive a long - term commitment to purchase their goods. Unit purchasing prices may need to be higher than in a conventional system to meet more rigorous quality and delivery requirements. However savings in production costs and reductions in working capital should offset these costs. Lean manufacturing implies a smooth and predictable production flow, with setup costs and time minimised. The aim is to match production with ultimate demand, and so work is only carried out in response to customer wishes. Production should be organised so that transfer times of raw materials and work-inprogress are kept to an absolute minimum. The maintenance programme should be sufficiently rigorous to stop machinery breaking down. The workforce is a key element in lean manufacturing. Flexibility and multi-skilling will minimise production delay caused by shortage or absence of staff. There also needs to be an emphasis on eliminating poor quality production, as scrapping work in progress and producing additional units can lead to delays. Introducing JIT/lean manufacturing might bring the following potential benefits. (a) Reduction in inventory holding costs. (b) Reduced manufacturing lead times. (c) Improved labour productivity. (d) Reduced scrap/rework/warranty costs. JIT will not be appropriate in all cases. For example, a restaurant might find it preferable to use the traditional economic order quantity approach for staple non-perishable food inventories but adopt JIT for perishable and 'exotic' items. In a hospital, a stockout could quite literally be fatal and JIT would be quite unsuitable.

1.33

1.34

1.35

1.36

1.37

1.31

2.1

2 PURCHASING

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2.2

The purchasing function

Purchases can account for a major part of a company's expenditure, but rarely get subjected to the planning and control constraints that are experienced by other business functions. This comment is not true of all branches of industry and commerce. In high street stores, 'buying' is recognised as one of the most important functions of the business.

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2.3 The effectiveness of the purchasing mn rti c a affects profit in three ways. a) Effective purchasing ensures the best value for money is obtained by the firm. b) Effective purchasing assists in meeting quality targets. Again this has an impact on a firm's longterm marketing strategy, if quality is an issue. c) An effective purchasing strategy minimises the amount of purchased material held in inventory.

The purchasing mix

2.3 The purchasing manager has to obtain the best purchasing quantity, quality, price, and delivery arrangements. Purchasing may be centralised or decentralised. The purchasing mix has implications for JIT and quality management. PURCHASING MIX Quantity Size and timing of orders dictated by balance between delays in production caused by insufficient inventory and costs of inventory-holding Quality Quality of goods required for the manufacturing process, and the quality of goods acceptable to customers Price Short-term trends may influence, but best value over period of time is most important Delivery Lead time between placing and delivery of an order and reliability of suppliers delivery arrangements Exercise 3 If a company operates a JIT production system, what does this imply for purchasing? Solution a) JIT systems and no-inventory production require the receipt of goods from suppliers at the latest possible time (ie when they are needed), to avoid the need to carry any materials or components in inventory. b) JIT seeks to avoid defects. Supplies must be of high quality to eliminate waste, as the quality of components can affect the quality of the end product. Thus reliability of delivery and certainty of quality are as important (if not more so) as price. SUPPLY STRATEGY Sources of supply Spread of supply Cost of supplies Make or buy decision Available sources, their location, reliability, importance of yourself to them Single source to get bulk discounts and minimise costs, or dual sourcing to avoid i lost production and complacency Speed of achievement of cost discounts through volume purchases More efficient to make goods in-house?

Suitability of existing Producing goods to required standard, ability to improve quality supplier 18 | P a g e

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i Selling point to buyer's customers eg makes of car supplied by car Image of reputation rental firms of suplier

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Building supplier relationships

2.25 Many companies are seeking to build up long-term relationships with suppliers, often offering them advice and help with product development, manufacturing processes and quality. This often leads to a reduction in the number of suppliers a firm deals with. This policy is a means of ensuring consistency of bought-in component quality, and facilitates JIT production. a) Advantages of closer relationships with suppliers include: i. Sharing of information. ii. Better co-ordination. iii. The security of the relationship enables long-term planning. iv. Equipment and components are consistent and compatible. v. Convenience for ordering supplies. vi. Discounts for bulk purchases. vii. Preferred customer status and better service agreements. viii.Products, upgrades and advice tailored to specific needs. a) Disadvantages i. Dependence on a supplier inhibits a firm's freedom. ii. It may turn out more expensive. iii. The balance of power might be unequal.

Centralised versus decentralised purchasing

2.6 There are advantages to both centralised and decentralised purchasing. Each organisation will make this decision on the basis of their own business and their own business environment. 2.7 Advantages of centralised purchasing a) The firm will be buying in larger quantities and so will be able to negotiate more substantial discounts. b) The organisation as a whole should be able to arrange more favourable credit terms than an individual branch. c) Inventory handling functions will be mainly centralised,- which should save costs - but some handling will still have to be done at branch level. d) It should be possible to hold lower overall levels of inventory than if inventory was being held at each branch. e) Only one buying department will be needed, which will save costs. Advantages of decentralised purchasing a) Local branches will be more in control of their production and sales if they have local control of purchasing. b) The purchasing requirements of individual branches may vary. For instance, some lines of inventory may sell better in some areas than others. 20 | P a g e

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c) Local branches will be able to form their own relationships with suppliers. There may be more mutual co-operation between a smaller organisation and its supplier than between a large purchasing department and a supplier. d) A local branch can be made more accountable for its own profitability and cash management if it has control of its own purchasing function.

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Chapter roundup
Inventory holding and ordering costs can be minimized by using the economic order quantity model. If discounts are offered for bulk purchases, the higher holding cost should be weighed against the lower ordering and purchasing costs. Businesses should consider at what level of inventory order should be made, taking account of demand levels, delivery times and any uncertainties. Safety inventory may be held if uncertainties are particularly large. The aim of Just-in-Time is to hold as little inventory as possible and production systems need to be very efficient to achieve this. Purchasing may be centralised or decentralised. The optima mix of quantity, quality, price and delivery arrangements should be sought.

Quick quiz 1. The basic EOQ formula for inventories indicates whether bulk discounts should be taken advantage of. True False 2. Identify the potential benefits of JIT manufacturing. 3. The Economic Order Quantity can be expressed as follows: 2CoD Ch What does Ch describe in this formula? A The cost of holding one unit of inventory for one year B The cost of placing one order C The cost of a unit of inventory D The customer demand for the item 4. Using the following information: Max lead time = 5 days Min lead time = 2 days Average lead time = 3 days Reorder level = 100 units Reorder quantity = 150 units Maximum usage = 60 units per day Average usage = 30 units per day Minimum usage = 20 units per day 22 | P a g e

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Calculate the maximum level of inventory. 5. Calculate the minimum level of inventory, using the information in question 7.

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Answers to quick quiz

1. False. It may be necessary to modify the formula to take account of bulk discounts. 2. a)Reduction in inventory holding costs b) Reduced manufacturing lead times c) Improved labour productivity d) Reduced scrap/rework/warranty costs 3. A The cost of holding one unit of inventory for one year

4. Maximum= re-order level + re-order quantity - (minimum usage x minimum lead time) level of inventory = 100 + 150 - (20 x 2) = 210 units 5. Minimum = re-order level -.(average usage x average lead time) level of inventory = 100 - (30 x 3) = 10 units

PRACTICE QUESTION
Student is advice to attempt the practice question 4.1 set under the examination conditions for his personal assessment. 4.1 AUTOWASH LTD. (a) Autowash Ltd manufactures and markets automatic washing machines. Among the many hundreds of components which it purchases each year from external suppliers for assembling into the finished article are drive belts, of which it uses 40,000 units pa. It is considering converting its purchasing, delivery and stock control of this item to a Just-In-Time system. This will raise the number of orders placed but lower the administrative and other costs of placing and receiving orders. If successful, this will provide the model for switching most of its inwards supplies on to this system. Details of actual and expected ordering and carrying costs are given in the table below. Actual Rs. 25 Rs. 2.50 20% Proposed Rs. 100 Rs. 2.50 20%

Ordering cost per order Purchase cost per item Inventory holding cost (as a percentage of the purchase cost)

To implement the new arrangements will require one-off' reorganization costs estimated at Rs. 4,000 which will be treated as a revenue item for tax purposes. The rate of corporation tax is 33% and Autowash can obtain finance at 12%. The effective life span of the new system can be assumed to be eight years. Required: 1. Determine the effect of the new system on the Economic Order Quantity (EOQ). 24 | P a g e

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2. Determine whether the new system is worthwhile in financial terms. (b) Briefly explain the nature and objectives of JIT purchasing agreements concluded between components users and suppliers.

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ANSWER 4.1 AUTOWASH LTD. (a) (i) formula: 2CoD Ch Before reorganisation Demand = 40,000 units per annum Ordering cost = Rs. 100 per order Carrying cost = 20% Purchase cost = Rs.2.50 per unit EOQ = EOQ = 2x100 x 40,000 2.50x0.2 6,000,000 = 4,000 units The Economic Order Quantity (EOQ) can be found by applying the

After reorganisation Demand = 40,000 units per annum Ordering cost = Rs.25 per order Carrying cost = 20% Purchase cost = Rs.2.50 per unit EOQ = EOQ = 2x25 x 40,000 2.50x0.2 4,000,000 = 2,000 units

(i) Implementation of the new system will affect both the total ordering costs per annum and the stockholding cost. Under the existing system thrsu costs are as follows Ordering cost EOQ is 4,000 units; demand is 40,000 units. Number of orders per year is therefore 10. Cost per order is Rs.100. Total ordering cost per annum (Rs.100 x 10) = Carrying cost EOQ is 4,000 units. Average stock is therefore 2,000 units. Cost is 2,000 x Rs.2.50 x 20% = Total annual cost Rs

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Under the proposed system these would become: Rs. Ordering cost EOQ is 2,000 units; demand is 40,000 units. Number of orders per year is therefore 20. Cost per order is Rs.25. Total ordering cost per annum (Rs.25 x 20) = Carrying cost EOQ is 2,000 units. Average stock is therefore 1,000 units. Cost is 1,000 x Rs.2.50 x 20% Total annual cost

500 500 1,000

The annual cost saving is therefore Rs.1000 (Rs.2,000 - Rs. 1,000). This will give rise to an after tax cash flow of Rs.670 (Rs.1000 x (1 - 0.33)). The cash flows can now be discounted at the cost of finance of 12%. It is assumed that tax is payable in the year in which it arises, and that the reorganizational cost are fully tax allowable. Year 0 (Rs.4,000) x (1 -0.33) x 1.000= Years 1-8 Rs.670 x 4.968 = NPV of reorganization Rs. (2,680.00) 3,328.56 648.56

(b) JIT manufacturing was originally developed in Japan. It represents a complete management philosophy and is more than just a collection of techniques.' It aims to manufacture to order for each customer and to eliminate idle resources in all areas of the company. In terms Of purchasing, a JIT system aims to ensure that components are delivered just immediately prior to the need to use them in the production process. It therefore requires a close relationship to be built up between, customer and supplier, the latter being required to deliver quality assured components to match production schedules. Suppliers in turn should benefit from firmer long-term sales as the purchaser reduces its number of sources. This should allow the supplier to achieve scale economies and improved production planning. The customer should achieve a reduction in ordering costs and in stock levels and associated carrying costs, and may also be able to save money in the area of quality control checking of suppliers' materials. Publications

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