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Inventory Management

The first component of the cash conversion cycle is the average age of inventory. The objective for managing inventory, as noted above, is to turn over inventory as quickly as possible without losing sales from stockouts. The financial manager tends to act as an advisor or watchdog in matters concerning inventory; he or she does not have direct control over inventory but does provide input to the inventory management process.

Differing Viewpoints About Inventory Level

iffering viewpoints about appropriate inventory levels commonly e!ist among a firm"s finance, marketing, manufacturing, and purchasing managers. #ach views inventory levels in light of his or her own objectives. The financial managers general disposition toward inventory levels is to keep low, to ensure that the firm"s money is not being unwisely invested in e!cess resources. The marketing manager, on the other hand, would like to have large inventories of the firm"s finished products. This would ensure that all orders could be filled quickly, eliminating the need for backorders due to stockouts. The manufacturing managers major responsibility is to implement the production plan so that it results in the desired amount of finished goods of acceptable quality at a low cost. $n fulfilling this role, the manufacturing manager would keep raw materials inventories high to avoid production delays. %e or she also would favor large production runs for the sake of lower unit production costs, which would result in high finished goods inventories. The purchasing manger is concerned solely with the raw materials inventories. %e or she must have on hand, in the correct quantities at the desired times and at a favorable price, whatever raw materials are required by production. &ithout proper control, in order to get quantity discounts or in anticipation of rising prices or a shortage of certain materials, the purchasing manger may purchase larger quantities of resources than are actually needed at the time.

Common Techniques for Managing Inventory

'umerous techniques are available for effectively managing the firm"s inventory. %ere we briefly consider four commonly used techniques.

The ABC ystem

( firm using the ()* inventory system divides its inventory into three groups+ (, ), and *. The ( group includes those items with the largest dollar investment. Typically, this group consists of ,- percent of the firm"s inventory items but .- percent of its investment in inventory. The ) group consists of items that account for the ne!t largest investment in inventory. The * group consists of a large number of items that require a relatively small investment. The inventory group of each item determines the items" level of monitoring. The ( group items receive the most intense monitoring because of the high dollar investment. Typically, ( group items are tracked on a perpetual

inventory system that allows daily verification of each item"s inventory level. ) group items are frequently controlled through periodic, perhaps weekly, checking of their levels. * groups items are monitored with unsophisticated techniques, such as the two/bin method. &ith the two!bin metho", the item is stored in two bins. (s an item is needed, inventory is removed from the first bin. &hen that bin is empty, an order is placed to refill the first bin while inventory is drawn from the second bin. The second bin is used until empty, and so on. The large dollar investment in ( and ) group items suggests the need for a better method of inventory management than the ()* system. The #01 model, discussed ne!t, is an appropriate model for the management of ( and ) group items.

The #conomic $r"er %uantity &#$%' Mo"el

0ne of the most common techniques for determining the optimal order si2e for inventory items is the economic or"er quantity &#$%' mo"el. The #10 model considers various costs of inventory and then determines what order si2e minimi2es total inventory cost. #01 assumes that the relevant costs of inventory can be divided in to order costs and carrying costs. 3The model e!cludes the actual cost of the inventory item.4 #ach of them has certain key components and characteristics. $r"er costs include the fi!ed clerical of placing and receiving orders+ the cost of writing a purchase order, of processing the resulting paperwork, and of receiving an order and checking it against the invoice. 0rder costs are stated in dollars per order. Carrying costs are the variable costs per unit of holding an item of inventory for a specific period of time. *arrying costs include storage costs, insurance costs, the costs of deterioration and obsolescence, and the opportunity or financial cost of having funds invested in inventory. These costs are stated in dollars per unit per period. 0rder costs decrease as the si2e of the order increases. *arrying costs, however, increase with increases in the order si2e. The #01 model analy2es the trade off between order costs and carrying costs to determine the order quantity that minimizes the total inventory cost. Mathematical Development of EOQ ( formula can determining the firm"s #01 for a given inventory item, where 5 0 * 1 6 usage in units per period 6 order cost per order 6 carrying cost per unit per period 6 order quantity in units be developed for

The first step is to derive the cost functions for order cost and carrying cost. The order cost can be e!pressed as the product of the cost per order and the number of orders. )ecause the number of orders equals the usage during the period divided by the order quantity 3S/Q4, the order cost can be e!pressed as follows+ 0rder cost 6 0 ! 571 38.84

The carrying cost is defined as the cost of carrying a unit of inventory per period multiplied by the firm"s average inventory. The average inventory is the order quantity

divided by , 3Q/24, because inventory is assumed to be depleted at a constant rate. Thus carrying cost can be e!pressed as follows+ *arrying cost 6 * ! 17, 38.,4

The firm"s total cost of inventory is found by summing the order cost and the carrying cost. Thus the total cost function is Total cost 6 30 ! 571 9 3* : 17,4 38.;4

)ecause the #01 is defined as the order quantity that minimi2es the total cost function, we must solve the total cost function for the #01. The resulting equation is


2 XS X O C


(lthough the #01 model has weaknesses, it is certainly better than subjective decision making. espite the fact that the use of the #01 model is outside the control of the financial manger, the financial manager must be aware of its utility and must provide certain inputs, specifically with respect to inventory carrying costs. Reorder Point 0nce the firm has determined its economic order quantity, it must determine when to place an order. The reor"er point reflects the firm"s daily usage of the inventory item and the number of days needed to place and receive an order. (ssuming that inventory is used at a constant rate, the formula for the reorder point is =eorder point 6 ays of lead time : aily usage 38.>4

?or e!ample, it a firm knows it takes ; days to place and receive an order, and if it uses 8> units per day of the inventory item, then the reorder point is <> units of inventory 3; days : 8> units7day4. Thus, as soon as the item"s inventory level falls to the reorder point 3<> units, in this case4 an order will be placed at the item"s #01. $f the estimates of lead time and usage are correct, then the order will arrive e!actly as the inventory level reaches 2ero. %owever, lead times and usage rates are not precise, so most firms hold safety stoc( 3e!tra inventory4 to prevent stockouts of important items. @(: *ompany has an ( group inventory item that is vital to the production process. This item costs A8,>--, and @(: uses 8,8-- units of the item per year. @(: wants to determine its optimal order strategy for the item. To calculate the #01, we need the following inputs+ 0rder cost per order *arrying cost per unit per year 6 A8>6 A,--

5ubstituting into #quation 8<.B, we get


2 x1,100 x$150 41units $200

The reorder point for @(: depends on the number of days @(: operates per year. (ssuming that @(: operates ,>- days per year and uses 8,8-- units of this item, its

daily usage is <.< units, 38,8-- ,>-4. $f its lead time is , days and @(: wants to maintain a safety stock of < units, the reorder point for this item is 8,.. units C3, ! <.<4 9 <D. %owever, orders are made only in whole units, so the order is placed when the inventory falls to 8; units. The firm"s goal for inventory is to turn it over as quickly as possible without stockouts. $nventory turnover is best calculated by dividing cost of goods sold by average inventory. The #01 model determines the optimal order si2e and, indirectly, through the assumption of constant usage, the average inventory. Thus the #01 model determines the firm"s optimal inventory turnover rate, given the firm"s specific costs of inventory.

)ust!in!Time &)IT' ystem

The *ust!in!time &)IT' ystem is used to minimi2e inventory investment. The philosophy is that materials should arrive at e!actly the time they are needed for production. $deally, the firm would have only work/in/process inventory. )ecause its objective is to minimi2e inventory investment, a E$T system uses no 3or very little4 safety stock. #!tensive coordination among the firm"s employees, its suppliers, and shipping companies must e!ist to ensure that material inputs arrive on time. ?ailure of materials to arrive on time results in a shortdown of the production line until the materials arrive. Fikewise, a E$T system requires high/quality parts from suppliers. &hen quality problems arise, production must be stopped until the problems are resolved. The goal of the E$T system is manufacturing efficiency. $t uses inventory as a tool for attaining efficiency by emphasi2ing quality of the materials used and their timely delivery. &hen E$T is working properly, it forces inefficiencies to surface.

Materials +equirement ,lanning &M+,' ystem

@any companies use a materials requirement planning 3@=G4 system to determine what materials to order and when to order them. @=G applies #01 concepts to determine how much to order. )y means of a computer, it stimulates each product"s bill of materials, inventory status, and manufacturing process. The bill of materials is simply a list of all the parts and materials that go into making the finished product. ?or a given production plan, the computer simulates materials requirements by comparing production needs to available inventory balances. 0n the basis of the time it takes for a product that is in process to move through the various production stages and the lead time required to get materials, the @=G system determines when orders should be placed for the various items on the bill of materials. The advantage of the @=G system is that it forces the firm to consider its inventory needs more carefully. The objective is to lower the firm"s inventory investment without impairing production. $f the firm"s opportunity cost of capital for investments of equal risk is 8> percent, every dollar of investment released from inventory increases before/ ta! profits by A-.8>.

International Inventory Management

$nternational inventory management is typically much more complicated for e!porters in general, and for multinational companies in particular, than for purely domestic firms. The production and manufacturing economies of scale that might be e!pected from selling products globally may prove elusive if products must be tailored for individual local markets, as very frequently happens, or if actual production takes place in factories around the world. &hen raw materials, intermediate goods, or finished products must be transported long distances H particularly by ocean shipping H there will inevitably be more delays, confusion, damage, theft, and other difficulties than occur in a one/country operation. The international inventory manager therefore puts a premium on fle!ibility. %e or she is usually less concerned about ordering the economically optimal quantity of inventory than about making sure that sufficient quantities of inventory are delivered where they are needed, when they are needed, and in a condition to be used as planned.