Chapter 4 Managing Inventory

IIN V NV

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The Cash Flow Timeline

Order Order Placed Placed

Payment Sent Cash Payment Sent Cash Received Received Accounts Collection Accounts Collection < Inventory > < Receivable > < Float > < Inventory > < Receivable > < Float > Time ==> Time ==>

Order Order Received Received

Sale Sale

Accounts Accounts < Payable > < Payable > Invoice Received Invoice Received

Disbursement Disbursement < Float < Float > >

Payment Sent CashThomson Learning, Inc. Copyright 2005 by Disbursed Payment Sent Cash Disbursed

Objectives
y

Appreciate impact of holding and ordering costs on order quantity Traditional EOQ & quantity discounts Appreciate JIT concepts Assess impact that different order quantities have on timing and amount of payments Use of balance fractions to monitor inventory balances
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y y y

Concept of Inventory
y y y

Factor in the length of cash cycle Acts as a shock absorber Three types
raw materials work-in-process finished goods

Motives for holding inventory

transaction precautionary speculative

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Inventory Investment Function

y y

Demand for product Cost of holding inventory

insurance storage cost of capital

y y

Cost of ordering inventory Total cost = Order Cost + Holding Cost = F x (T/Q) + H x (Q/2)
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Order Cost and Holding Cost Tradeoff

$

Holding cost = H x (Q/2)

Order costs = F x (T/Q)

Order quantity, Q
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Economic Order Quantity

y y y y y

EOQ solution: Number of orders: Average inventory: Usage rate: Reorder point:

SQRT (2TF/H) T/Q Q/2 T/D (D=days)

(T/D) x Delivery Time

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Quantity Discounts

TC = Order Cost + Holding Cost + Item Cost TC = Order Cost + Holding Cost + Item Cost TC = (F x (T/Q)) + TC = (F x (T/Q)) + (H x (Q/2)) + (C x T) (H x (Q/2)) + (C x T)

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Inventory and the Cash Flow Timeline

Inventory ordered Inventory ordered and received and received < Inventory Held> < Inventory Held> Inventory ordered Inventory ordered and received and received <Inventory Held> <Inventory Held> Time=> Time=>

Cash paid Cash paid for inventory for inventory

Cash paid Cash paid for inventory for inventory

Cash paid Cash paid for holding & for holding & ordering costs ordering costs

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Monitor the Inventory Balance

y y

Inventory control systems Inventory turnover ratio

Sales or COGS / Inventory balance

Days COGS in inventory

Inventory balance / Daily COGS or Sales

Balance fraction approach

Develop monthly balance fractions based on the proportion of items remaining in inventory from a given months purchase.

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Reducing Investment in Inventory

y

Problems were solved by adding more inventory JIT redesigns system Redesign of production system
eliminate waste eliminate production errors improving quality

y y

Need stable demand

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Summary
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Inventory decisions should be based on:

cost of holding inventory cost or ordering inventory opportunity cost of funds quantity discounts is quantity workable within inventory management system?

y y y

Inventory, if properly managed can be a major contributor to cash flow... if mismanaged, it can be a significant drain on cash. Some traditional inventory monitoring tools can be biased by sales and production trends.
Copyright 2005 by Thomson Learning, Inc.