Inventory Fundamentals

9/1/2015
InventoryFundamentals
Tuesday,September01,201510:56:04PM
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Inventory Fundamentals
IntroductiontoMaterialManagement
Contents
MasterScheduling
MaterialRequirementsPlanning
1.
Introduction
CapacityManagement
2.
AggregateInventoryManagement
ProductionActivityControl
3.
ItemInventoryManagement
Purchasing
4.
InventoryAndTheFlowOfMaterial
5.
SupplyAndDemandPatterns
6.
FunctionsOfInventories
7.
ObjectivesOfInventoryManagement
8.
InventoryCosts
Forecasting
OrderQuantities
IndependentDemandOrderingSystems9.
FinancialStatementsAndInventory
10.
AbcInventoryControl
PhysicalInventoryandWarehouseManagement
PhysicalDistribution
1.Introduction
inventoriesarematerialsandsuppliesthatabusinessorinstitutioncarrieseitherforsaleortoprovide
inputsorsuppliestotheproductionprocess.Allbusinessesandinstitutionsrequireinventories.Often
theyareasubstantialpartoftotalassets.
Financially,inventoriesareveryimportanttomanufacturingcompanies.Onthebalancesheet,they
usuallyrepresentfrom20%to60%oftotalassets.Asinventoriesareused,theirvalueisconverted
intocash,whichimprovescashflowandreturnoninvestment.Thereisacostforcarryinginventories,
whichincreasesoperatingcostsanddecreasesprofits.Goodinventorymanagementisessential.
Inventorymanagementisresponsibleforplanningandcontrollinginventoryfromtherawmaterialstage
tothecustomer.Sinceinventoryeitherresultsfromproductionorsupportsit,thetwocannotbe
managedseparatelyand,therefore,mustbecoordinated.Inventorymustbeconsideredateachofthe
planninglevelsandisthuspartofproductionplanning,masterproductionscheduling,andmaterial
requirementsplanning.Productionplanningisconcernedwithoverallinventory,masterplanningwith
enditems,andmaterialrequirementsplanningwithcomponentpartsandrawmaterial.
2.AggregateInventoryManagement
Aggregateinventorymanagementdealswithmanaginginventoriesaccordingtotheirclassification(raw
material,workinprocess,andfinishedgoods)andthefunctiontheyperformratherthanattheindividual
itemlevel.Itisfinanciallyorientedandisconcernedwiththecostsandbenefitsofcarryingthedifferent
classificationsofinventories.Assuch,aggregateinventorymanagementinvolves:
Flowandkindsofinventoryneeded.
Supplyanddemandpatterns.
Functionsthatinventoriesperform.
Objectivesofinventorymanagement.
Costsassociatedwithinventories.
3.ItemInventoryManagement
Inventoryisnotonlymanagedattheaggregatelevelbutalsoattheitemlevel.Managementmust
establishdecisionrulesaboutinventoryitemssothestaffresponsibleforinventorycontrolcandotheir
jobeffectively.Theserulesincludethefollowing:
Whichindividualinventoryitemsaremostimportant.
Howindividualitemsaretobecontrolled.
Howmuchtoorderatonetime.
Whentoplaceanorder.
Thischapterwillstudyaggregateinventorymanagementandsomefactorsinfluencinginventory
managementdecisions,whichinclude:
Typesofinventorybasedontheflowofmaterial.
Supplyanddemandpatterns.
Functionsperformedbyinventory.
Objectivesofinventorymanagement.
http://www.mdcegypt.com/Pages/Purchasing/Material%20Management/Inventory%20Fundamentals.asp
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Inventorycosts.
Finally,thischapterwillconcludewithastudyofthefirsttwodecisions,decidingtheimportanceof
individualenditemsandhowtheyarecontrolled.Subsequentchapterswilldiscussthequestionofhow
muchstocktoorderatonetimeandwhentoplaceorders.
4.InventoryAndTheFlowOfMaterial
Therearemanywaystoclassifyinventories.Oneoftenusedclassificationisrelatedtotheflowof
materialsinto,through,andoutofamanufacturingorganization,asshowninFigure9.1.
Rawmaterials.Thesearepurchaseditemsreceivedwhichhavenotenteredtheproduction
process.Theyincludepurchasedmaterials,componentparts,andsubassemblies.
Workinprocess(WIP).Rawmaterialsthathaveenteredthemanufacturingprocessandare
beingworkedonorwaitingtobeworkedon.
Finishedgoods.Thefinishedproductsoftheproductionprocessthatarereadytobesoldas
completeditems.Theymaybeheldatafactoryorcentralwarehouseoratvariouspointsinthe
distributionsystem.
Distributioninventories.Finishedgoodslocatedinthedistributionsystem.
Maintenance,repair,andoperationalsupplies(MROs).Itemsusedinproductionthat
donotbecomepartoftheproduct.Theseincludehandtools,spareparts,lubricants,and
cleaningsupplies.
Classificationofanitemintoaparticularinventorydependsontheproductionenvironment.For
instance,sheetsteelortiresarefinishedgoodstothesupplierbutarerawmaterialsandcomponent
partstothecarmanufacturer.
5.SupplyAndDemandPatterns
Ifsupplymetdemandexactly,therewouldbelittleneedforinventory.Goodscouldbemadeatthe
samerateasdemand,andnoinventorywouldbuildup.Forthissituationtoexist,demandmustbe
predictable,stable,andrelativelyconstantoveralongtimeperiod.
Ifthisisso,manufacturingcanproducegoodsonalineflowbasis,matchingproductiontodemand.
Usingthissystem,rawmaterialsarefedtoproductionasrequired,workflowfromoneworkstationto
anotherisbalancedsolittleworkinprocessinventoryisrequired,andgoodsaredeliveredtothe
customerattheratethecustomerneedsthem.FlowmanufacturingsystemswerediscussedinChapter
1.Becausethevarietyofproductstheycanmakeissolimited,demandhastobelargeenoughto
justifyeconomicallysettingupthesystem.Thesesystemsarecharacteristicofjustintime
manufacturingandwillbediscussedinChapter15.
Demandformostproductsisneithersufficientnorconstantenoughtowarrantsettingupalineflow
system,andtheseproductsareusuallymadeinlotsorhatches.Workstationsareorganizedby
function,forexample,allmachinetoolsinonearea,allweldinginanother,andassemblyinanother.
Workmovesinlotsfromoneworkstationtoanotherasrequiredbytherouting.Bythenatureofthe
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system,inventorywillbuildupinrawmaterials,workinprocess,andfinishedgoods.
6.FunctionsOfInventories
Inbatchmanufacturing,thebasicpurposeofinventoriesistodecouplesupplyanddemand.Inventory
servesasabufferbetween:
Supplyanddemand.
Customerdemandandfinishedgoods.
Finishedgoodsandcomponentavailability.
Requirementsforanoperationandtheoutputfromtheprecedingoperation.
Partsandmaterialstobeginproductionandthesuppliersofmaterials.Basedonthis,inventories
canbeclassifiedaccordingtothefunctiontheyperform.
a.AnticipationInventory
Anticipationinventoriesarebuiltupinanticipationoffuturedemand.Forexample,they
arecreatedaheadofapeaksellingseason,apromotionprogram,vacationshutdown,or
possiblythethreatofastrike.Theyarebuiltuptohelplevelproductionandtoreduce
thecostsofchangingproductionrates.
b.FluctuationInventory(SafetyStock)
Fluctuationinventoryisheldtocoverrandomunpredictablefluctuationsinsupplyand
demandorleadtime.Ifdemandorleadtimeisgreaterthanforecast,astockoutwill
occur.Safetystockiscarriedtoprotectagainstthispossibility.Itspurposeistoprevent
disruptionsinmanufacturingordeliveriestocustomers.Safetystockisalsocalled
bufferstockorreservestock.
c.LotSizeInventory
Itemspurchasedormanufacturedinquantitiesgreaterthanneededimmediatelycreate
lotsizeinventories.Thisistotakeadvantageofquantitydiscounts,toreduce
shipping,clerical,andsetupcosts,andincaseswhereitisimpossibletomakeor
purchaseitemsatthesameratetheywillbeusedorsold.Lotsizeinventoryissome
timescalledcyclestock.Itistheportionofinventorythatdepletesgraduallyas
customersorderscomeinandisreplenishedcyclicallywhensuppliersordersare
received.
d.TransportationInventory
Itemspurchasedormanufacturedinquantitiesgreaterthanneededimmediatelycreate
lotsizeinventories.Thisistotakeadvantageofquantitydiscounts,toreduce
shipping,clerical,andsetupcosts,andincaseswhereitisimpossibletomakeor
purchaseitemsatthesameratetheywillbeusedorsold.Lotsizeinventoryissome
timescalledcyclestock.Itistheportionofinventorythatdepletesgraduallyas
customersorderscomeinandisreplenishedcyclicallywhensuppliersordersare
received.
tA
I=.
365
whereIistheaverageannualinventoryintransit,tistransittimeindays,andAis
annualdemand.Noticethatthetransitinventorydoesnotdependupontheshipment
sizebutonthetransittimeandtheannualdemand.Theonlywaytoreducethe
inventoryintransit,anditscost,istoreducethetransittime.
e.ExampleProblem
Deliveryofgoodsfromasupplierisintransitfortendays.Iftheannualdemandis
5200units,whatistheaverageannualinventoryintransit?
Answer
10x5200
I==
142.5units
365
Theproblemcanbesolvedinthesamewayusingdollarsinsteadofunits.
f.HedgeInventory
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Someproductssuchasmineralsandcommodities,forexample,grainsoranimal
products,aretradedonaworldwidemarket.Thepricefortheseproductsfluctuates
accordingtoworldsupplyanddemand.Ifbuyersexpectpricestorise,theycan
purchasehedgeinventorywhenpricesarelow.Hedgingiscomplexandbeyondthe
scopeofthistext.
g.Maintenance,Repair,andOperatingSupplies(MRO)
MROsareitemsusedtosupportgeneraloperationsandmaintenancebutwhichdonot
becomedirectlypartofaproduct.Theyincludemaintenancesupplies,spareparts,and
consumablessuchascleaningcompounds,lubricants,pencils,anderasers.
7.ObjectivesOfInventoryManagement
Afirmwishingtomaximizeprofitwillhaveatleastthefollowingobjectives:
Maximumcustomerservice.
Lowcostplantoperation.
Minimuminventoryinvestment.
a.CustomerService
Inbroadterms,customerserviceistheabilityofacompanytosatisfytheneedsof
customers.Ininventorymanagement,thetermisusedtodescribetheavailabilityof
itemswhenneededandisameasureofinventorymanagementeffectiveness.The
customercanbeapurchaser,adistributor,anotherplantintheorganization,orthe
workstationwherethenextoperationistobeperformed.
Therearemanydifferentwaystomeasurecustomerservice,eachwithitsstrengths
andweaknesses,butthereisnoonebestmeasurement.Somemeasuresare
percentageofordersshippedonschedule,percentageoflineitemsshippedon
schedule,andorderdaysoutofstock.
Inventorieshelptomaximizecustomerservicebyprotectingagainstuncertainty.Ifwe
couldforecastexactlywhatcustomerswantandwhen,wecouldplantomeetdemand
withnouncertainty.However,demandandtheleadtimetogetanitemareoften
uncertain,possiblyresultinginstockoutsandcustomerdissatisfaction.Forthese
reasons,itmaybenecessarytocarryextrainventorytoprotectagainstuncertainty.
ThisinventoryiscalledsafetystockandwillbediscussedinChapter11.
b.OperatingEfficiency
Inventorieshelpmakeamanufacturingoperationmoreproductiveinfourways:
a.
Inventoriesallowoperationswithdifferentratesofproductiontooperate
separatelyandmoreeconomically.Iftwoormoreoperationsinasequencehave
differentratesofoutputandaretobeoperatedefficiently,inventoriesmustbuild
upbetweenthem.
b.
Chapter2discussedproductionplanningforseasonalproductsinwhichdemand
isnonuniformthroughouttheyear.Onestrategydiscussedwastolevel
productionandbuildanticipationinventoryforsaleinthepeakperiods.This
wouldresultinthefollowing:
Lowerovertimecosts.
Lowerhiringandfiringcosts.
Lowertrainingcosts.
Lowersubcontractingcosts.
Lowercapacityrequired.
Bylevelingproduction,manufacturingcancontinuallyproduceanamount
equaltotheaveragedemand.Theadvantageofthisstrategyisthatthecostsof
changingproductionlevelsareavoided.Figure9.2showsthisstrategy.
c.
Inventoriesallowmanufacturingtorunlongerproductionruns,whichresultinthe
following:
Lowersetupcostsperitem.Thecosttomakealotorbatchdepends
uponthesetupcostsandtheruncosts.Thesetupcostsarefixed,but
theruncostsvarywiththenumberproduced.Iflargerlotsarerun,the
setupcostsareabsorbedoveralargernumber,andtheaverage(unit)
costislower.
Anincreaseinproductioncapacityduetoproductionresourcesbeing
usedagreaterportionofthetimeforprocessingasopposedtosetup.
Timeonaworkcenteristakenupbysetupandbyruntime.Output
occursonlywhenanitemisbeingworkedonandnotwhensetupis
takingplace.Iflargerquantitiesareproducedatonetime,therearefewer
setupsrequiredtoproduceagivenannualoutputandthusmoretimeis
availableforproducinggoods.Thisismostimportantwithbottleneck
resources.Timelostonsetupontheseresourcesislostthroughput(total
production)andlostcapacity.
4.Inventoriesallowmanufacturingtopurchaseinlargerquantities,which
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resultsinlowerorderingcostsperunitandquantitydiscounts.
Butallofthisisataprice.Theproblemistobalanceinventoryinvestmentwiththe
following:
a.
Customerservice.Thelowertheinventory,thehigherthelikelihoodofa
stockoutandthelowerthelevelofcustomerservice.Thehighertheinventory
level,thehighercustomerservicewillbe.
b.
Costsassociatedwithchangingproductionlevels.Excessequipmentcapacity,
overtime,hiring,training,andlayoffcostswillallbehigherifproduction
fluctuateswithdemand.
c.
Costofplacingorders.Lowerinventoriescanbeachievedbyorderingsmaller
quantitiesmoreoften,butthispracticeresultsinhigherannualorderingcosts.
d.
Transportationcosts.Goodsmovedinsmallquantitiescostmoretomoveper
unitthanthosemovedinlargequantities.However,movinglargelotsimplies
higherinventory.
Ifinventoryiscarried,therehastobeabenefitthatexceedsthecostsofcarryingthat
inventory.Someoneoncesaidthattheonlygoodreasonforcarryinginventorybeyond
currentneedsisifitcostslesstocarryitthannot.Thisbeingso,weshouldturnour
attentiontothecostsassociatedwithinventory.
8.InventoryCosts
Thefollowingcostsareusedforinventorymanagementdecisions:
Itemcost.
Carryingcosts.
Orderingcosts.
Stockoutcosts.
Capacityassociatedcosts.
a.ItemCost
Itemcostisthepricepaidforapurchaseditem,whichconsistsofthecostoftheitem
andanyotherdirectcostsassociatedingettingtheitemintotheplant.Thesecould
includesuchthingsastransportation,customduties,andinsurance.Theinclusivecost
isoftencalledthelandedprice.Foranitemmanufacturedinhouse,thecostincludes
directmaterial,directlabor,andfactoryoverhead.Thesecostscanusuallybeobtained
fromeitherpurchasingoraccounting.
b.CarryingCosts
Carryingcostsincludeallexpensesincurredbythefirmbecauseofthevolumeof
inventorycarried.Asinventoryincreases,sodothesecosts.Theycanbebrokendown
intothreecategories:
I.
II.
III.
Capitalcosts.Moneyinvestedininventoryisnotavailableforotherusesandas
suchrepresentsalostopportunitycost.Theminimumcostwouldbetheinterest
lostbynotinvestingthemoneyattheprevailinginterestrate,anditmaybe
muchhigherdependingoninvestmentopportunitiesforthefirm.
Storagecosts.Storinginventoryrequiresspace,workersandequipment.As
inventoryincreases,sodothesecosts.
Riskcosts.Therisksincarryinginventoryare:
a.
Obsolescencelossofproductvalueresultingfromamodelorstyle
changeortechnologicaldevelopment.
b.
c.
Damageinventorydamagedwhilebeingheldormoved.
Pilferagegoodslost,strayed,orstolen.
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d.
Deteriorationinventorythatrotsordissipatesinstorageorwhoseshelf
lifeislimited.
Whatdoesitcosttocarryinventory?Actualfiguresvaryfromindustrytoindustryand
companytocompany.Capitalcostsmayvarydependinguponinterestrates,thecredit
ratingofthefirm,andtheopportunitiesthefirmmayhaveforinvestment.Storage
costsvarywithlocationandtypeofstorageneeded.Riskcostscanbeveryloworcan
becloseto100%ofthevalueoftheitemforperishablegoods.Thecarryingcostis
usuallydefinedasapercentageofthedollarvalueofinventoryperunitoftime(usually
oneyear).Textbookstendtouseafigureof2030%inmanufacturingindustries.This
isrealisticinmanycasesbutnotwithallproducts.Forexample,thepossibilityof
obsolescencewithfadorfashionitemsishigh,andthecostofcarryingsuchitemsis
greater.
c.ExampleProblem
Acompanycarriesanaverageannualinventoryof$2,000,000.Iftheyestimatethe
costofcapitalis10%,storagecostsare7%,andriskcostsare6%,whatdoesitcost
peryeartocarrythisinventory?
Answer
Totalcostofcarryinginventory=10%+7%+6%=23%
Annualcostofcarryinginventory=0.23x$2,000,000=$460,000
d.OrderingCosts
Orderingcostsarethoseassociatedwithplacinganordereitherwiththefactoryora
supplier.Thecostofplacinganorderdoesnotdependuponthequantityordered.
Whetheralotof10or100isordered,thecostsassociatedwithplacingtheorderare
essentiallythesame.However,theannualcostoforderingdependsuponthenumber
ofordersplacedinayear.
Orderingcostsinafactoryincludethefollowing:
Productioncontrolcosts.Theannualcostandeffortexpendedinproduction
controldependonthenumberofordersplaced,notonthequantityordered.The
fewerordersperyear,thelesscost.Thecostsincurredarethoseofissuingand
closingorders,scheduling,loading,dispatching,andexpediting.
Setupandteardowncosts.Everytimeanorderisissued,workcentershaveto
setuptoruntheorderandteardownthesetupattheendoftherun.These
costsdonotdependuponthequantityorderedbutonthenumberoforders
placedperyear.
Lostcapacitycost.Everytimeanorderisplacedataworkcenter,thetime
takentosetupislostasproductiveoutputtime.Thisrepresentsalossof
capacityandisdirectlyrelatedtothenumberofordersplaced.Itisparticularly
importantandcostlywithbottleneckworkcenters.
Purchaseordercost.Everytimeapurchaseorderisplaced,costsareincurred
toplacetheorder.Thesecostsincludeorderpreparation,followup,expediting,
receiving,authorizingpayment,andtheaccountingcostofreceivingandpaying
theinvoice.Theannualcostoforderingdependsuponthenumberoforders
placed.
Theannualcostoforderingdependsuponthenumberofordersplacedinayear.This
canbereducedbyorderingmoreatonetime,resultingintheplacingoffewerorders.
However,thisdrivesuptheinventorylevelandtheannualcostofcarryinginventory.
e.ExampleProblem
Giventhefollowingannualcosts,calculatetheaveragecostofplacingoneorder.
Productioncontrolsalaries=$60,000
Suppliesandoperatingexpensesforproductioncontroldepartment=$15,000
Costofsettingupworkcentersforanorder=$120
Ordersplacedeachyear=2000
Answer
fixedcosts
Averagecost=
+variablecost
numberoforders
$60.000+$15.000
=
+$120=$157.50
2000
f.StockoutCosts
Ifdemandduringtheleadtimeexceedsforecast,wecanexpectastockout.A
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stockoutcanpotentiallybeexpensivebecauseofbackordercosts,lostsales,and
possiblylostcustomers.Stockoutscanbereducedbycarryingextrainventoryto
protectagainstthosetimeswhenthedemandduringleadtimeisgreaterthanforecast.
g.CapacityAssociatedCosts
Whenoutputlevelsmustbechanged,theremaybecostsforovertime,hiring,training,
extrashifts,andlayoffs.Thesecapacityassociatedcostscanbeavoidedbyleveling
production,thatis,byproducingitemsinslackperiodsforsaleinpeakperiods.
However,thisbuildsinventoryintheslackperiods.
h.ExampleProblem
Acompanymakesandsellsaseasonalproduct.Basedonasalesforecastof2000,
3000,6000,and5000perquarter,calculatealevelproductionplan,quarterlyending
inventory,andaveragequarterlyinventory.
Ifinventorycarryingcostsare$3perunitperquarter,whatistheannualcostof
carryinginventory?Openingandendinginventoriesarezero.
Answer
QuarterI Quarter Quarter Quarter

2
3
4
Total
ForecastDemand
2000
3000
6000
5000
Production
4000
4000
4000
4000
16,000
EndingInventory 0
2000
3000
1000
AverageInventory
1000
2500
2000
500
InventoryCost
(dollars)
3000
7500
6000
1500
18,000
16,000
9.FinancialStatementsAndInventory
Thetwomajorfinancialstatementsarethebalancesheetandtheincomestatement.Thebalancesheet
showsassets,liabilities,andownersequity.Theincomestatementshowstherevenuesmadeandthe
expensesincurredinachievingthatrevenue.
a.BalanceSheet
Anassetissomethingthathasvalueandisexpectedtobenefitthefutureoperationof
thebusiness.Anassetmaybetangiblesuchascash,inventory,machinery,and
buildings,ormaybeintangiblesuchasaccountsreceivableorapatent.
Liabilitiesareobligationsoramountsowedbyacompany.Accountspayable,wages
payable,andlongtermdebtareexamplesofliabilities.
Ownersequityisthedifferencebetweenassetsandliabilities.Afteralltheliabilities
arepaid,itrepresentswhatisleftfortheownersofthebusiness.Ownersequityis
createdeitherbytheownersinvestingmoneyinthebusinessorthroughtheoperation
ofthebusinesswhenitearnsaprofit.Itisdecreasedwhenownerstakemoneyoutof
thebusinessorwhenthebusinesslosesmoney.
Theaccountingequation.Therelationshipbetweenassets,liabilities,andowners
equityisexpressedbythebalancesheetequation:
Assets=liabilities+ownersequity
Thisisabasicaccountingequation.Giventwoofthevaluesthethirdcanalwaysbe
found.
Balancesheet.Thebalancesheetisusuallyshownwiththeassetsontheleftside
andtheliabilitiesandownersequityontherightsideasfollows.
Assets
Liabilities
Cash
$100,000
Notespayable
$5,000
Accounts
receivable
$300,000
Accounts
payable
$20,000
Inventory
$500,000
Longtermdebt
$500,000
Fixedassets
$1,000,000
Totalliabilities
$525,000
Ownersequity
Capital
Retained
earnings
Totalassets
$1,900,000
Totalliabilities
and
ownersequity
$1,000,000
$375,000
$1,900,000
Capitalistheamountofmoneytheownershaveinvestedinthecompany.
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Retainedearningsareincreasedbytherevenuesacompanymakesanddecreased
bytheexpensesincurred.Thesummaryofrevenuesandexpensesisshownonthe
incomestatement.
b.ExampleProblem
a.
Iftheownersequityis$1,000andliabilitiesare$800,whataretheassets?
b.
Iftheassetsare$1,000andliabilitiesare$600,whatistheownersequity?
Answer
a.
Assets=Liabilities+ownersequity
Assets=$800+$1,000=$1,800
b.
Ownersequity=assetsliabilities
=$1,000$600=$400
c.IncomeStatement
Income(profit).Theprimarypurposeofabusinessistoincreasetheownersequityby
makingaprofit.Forthisreasonownersequityisbrokendownintoaseriesof
accounts,calledrevenueaccounts,whichshowwhatincreasedownersequity,and
expenseaccounts,whichshowwhatdecreasedownersequity.
Income=revenueexpenses
Revenuecomesfromthesaleofgoodsorservices.Paymentissometimesimmediate
intheformofcash,butoftenismadeasapromisetopayatalaterdate,calledan
accountreceivable.
Expensesarethecostsincurredintheprocessofmakingrevenue.Theyareusually
categorizedintothecostofgoodssoldandgeneralandadministrativeexpenses.
Costofgoodssoldarecoststhatareincurredtomaketheproduct.Theyinclude
directlabor,directmaterial,andfactoryoverhead.Factoryoverheadisallotherfactory
costsexceptdirectlaboranddirectmaterial.
Generalandadministrativeexpensesincludeallothercostsinrunningabusiness.
Examplesoftheseareadvertising,insurance,propertytaxes,andwagesandbenefits
otherthanfactory.
Thefollowingisanexampleofanincomestatement.
Revenue
Costofgoodssold
Directlabor
$1,000,000
$200,000
Directmaterial
400,000
Factoryoverhead
200,000
$800,000
Grossmargin(profit)
$200,000
Generalandadministrative
expenses
$100,000
Netincome(profit)
$100,000
d.ExampleProblem
Giventhefollowingdata,calculatethegrossmarginandthenetincome.
Revenue
=$1,500,000
Directlabor
=$300,000
Directmaterial
=$500,000
Factoryoverhead
=$400,000
expenses
=$150,000
Howmuchwouldprofitsincreaseif,throughbettermaterialsmanagement,material
costsarereducedby$50,000?
Revenue
Costofgoodssold
Directlabor
$1,500,000
$300,000
Directmaterial
500,000
Overhead
400,000
$1,200,000
Grossmargin(grossprofit)
$300,000
expenses
$150,000
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Netincome(profit)
$150,000
Ifmaterialcostsarereducedby$50,000,incomeincreasesby$50,000.Materials
managementcanhaveadirectimpactonthebottomlinenetincome.
e.CashFlowAnalysis
Wheninventoryispurchasedasrawmaterial,itisrecordedasanasset.Whenitenters
production,itisrecordedasworkinprocessinventory(WIP)and,asitisprocessed,
itsvalueincreasesbytheamountofdirectlaborappliedtoitandtheoverhead
attributedtoitsprocessing.Thematerialissaidtoabsorboverhead.Whenthegoods
arereadyforsale,theydonotbecomerevenueuntiltheyaresold.However,the
expensesincurredinproducingthegoodsmustbepaidfor.Thisraisesanother
financialissue:
Businessesmusthavethecashtopaytheirbills.Cashisgeneratedbysalesandthe
flowofcashintoabusinessmustbesufficienttopaybillsastheybecomedue.
Businessesdevelopfinancialstatementsshowingthecashflowsintoandoutofthe
business.Anyshortfallofcashmustbeprovidedfor,perhapsbyborrowingorinsome
otherway.Thistypeofanalysisiscalledcashflowanalysis
f.FinancialInventoryPerformanceMeasures
Fromafinancialpointofview,inventoryisanassetandrepresentsmoneythatistied
upandcannotbeusedforotherpurposes.Aswesawearlierinthischapter,inventory
hasacarryingcostthecostsofcapital,storage,andrisk.Financewantsaslittle
inventoryaspossibleandneedssomemeasureofthelevelofinventory.Total
inventoryinvestmentisonemeasure,butinitselfdoesnotrelatetosales.Two
measuresthatdorelatetosalesaretheinventoryturnsratioanddaysofsupply.
Inventoryturns.
Inventoryturns.Ideally,amanufacturercarriesnoinventory.Thisis
impractical,sinceinventoryisneededtosupportmanufacturingandoftento
supplycustomers.Howmuchinventoryisenough?Thereisnooneanswer.
Aconvenientmeasureofhoweffectivelyinventoriesarebeingusedisthe
inventoryturnsratio:
annual
costofgoodssold
Inventoryturns=
.
average
inventoryindollars
Thecalculationofaverageinventorycanbecomplicatedandisa
subjectforcostaccounting.Inthistextitwillbetakenasagiven.
Forexample,iftheannualcostofgoodssoldis$1millionandthe
averageinventoryis$500,000,then
$1,000,000
Inventoryturns=
=2
$500,000
Whatdoesthismean?Attheveryleast,itmeansthatwith$500,000
ofinventoryacompanyisabletogenerate$1millioninsales.If,
throughbettermaterialsmanagement,thefirmisabletoincreaseits
turnsratioto10,thesamesalesaregeneratedwithonly$100,000of
averageinventory,litheannualcostofcarryinginventoryis25%ofthe
inventoryvalue,thereductionof$400,000ininventoryresultsinacost
reduction(andprofitincrease)of$100,000.
g.ExampleProblem
a.
Whatwillbetheinventoryturnsratioiftheannualcostofgoodssoldis$24milliona
yearandtheaverageinventoryis$6million?
Answer
annualcostof
goodssold
Inventoryturns=
.
averageinventory
indollars
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24,000,000
==4
6,000,000
b.
Whatwouldbethereductionininventoryifinventoryturnswereincreasedto12times
peryear?
Answer
annualcostof
goodssold
Averageinventory=
.
inventoryturns
24,000,000
=.
12
=$2,000,000
Reductionininventory=6,000,000
2,000,000=$4,000,000
c.
Ifthecostofcarryinginventoryis25%oftheaverageinventory,whatwillthesavings
be?
Answer
Reductionininventory=$4,000,000
Savings=$4,000,000X
0.25=$1,000,000
h.Daysofsupply
Daysofsupplyisameasureoftheequivalentnumberofdaysofinventoryonhand,
basedonusage.Theequationtocalculatethedaysofsupplyis
inventoryon
hand
Daysofsupply=
.
averagedaily
usage
i.ExampleProblem
Acompanyhas9000unitsonhandandtheannualusageis48,000units.Thereare
240workingdaysintheyear.Whatisthedaysofsupply?
Answer
48,000
Averagedailyusage==200units
240
inventoryon
hand9000
Daysofsupply=
==45days
averagedaily
usage200
j.MethodsofEvaluatingInventory
Therearefourmethodsaccountingusestocostinventory:firstinfirstout,lastinfirst
out,averagecost,andstandardcost.Eachhasimplicationsforthevalueplacedon
inventory.Ifthereislittlechangeinthepriceofanitem,anyofthefourwayswill
produceaboutthesameresults.However,inrisingorfallingprices,therecanbea
pronounceddifference.Thereisnorelationshipwiththeactualphysicalmovementof
actualitemsinanyofthemethods.Whatevermethodisusedisonlytoaccountfor
usage.
Firstinfirstout(FIFO).
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Thismethodassumesthattheoldest(first)iteminstockissoldfirst.
Inrisingprices,replacementisatahigherpricethantheassumed
cost.Thismethoddoesnotreflectcurrentpricesandreplacementwill
beunderstated.Thereverseistrueinafallingpricemarket.
Lastinfirstout(LIFO).
Thismethodassumesthenewest(last)iteminstockisthefirstsold.
Inrisingprices,replacementisatthecurrentprice.Thereverseis
trueinafallingpricemarket.However,thecompanyisleftwithan
inventorythatmaybegrosslyunderstatedinvalue.
Averagecost.
Thismethodassumesanaverageofallpricespaidforthearticle.The
problemwiththismethodinchangingprices(risingorfalling)isthat
thecostusedisnotrelatedtotheactualcost.
Standardcost.
Thismethodusescostdeterminedbeforeproductionbegins.Thecost
includesdirectmaterial,directlabor,andoverhead.Anydifference
betweenthestandardcostandactualcostisstatedasavariance.
10.AbcInventoryControl
Controlofinventoryisexercisedbycontrollingindividualitemscalledstockkeepingunits(SKUs).In
controllinginventory,fourquestionsmustbeanswered:
a.
b.
Whatistheimportanceoftheinventoryitem?
c.
d.
Howmuchshouldbeorderedatonetime?
Howaretheytobecontrolled?
Whenshouldanorderbeplaced?
TheABCinventoryclassificationsystemanswersthefirsttwoquestionsbydeterminingthe
importanceofitemsandthusallowingdifferentlevelsofcontrolbasedontherelativeimportanceof
items.
Mostcompaniescarryalargenumberofitemsinstock.Tohavebettercontrolatareasonablecost,it
ishelpfultoclassifytheitemsaccordingtotheirimportance.Usuallythisisbasedonannualdollar
usage,butothercriteriamaybeused.
TheABCprincipleisbasedontheobservationthatasmallnumberofitemsoftendominatetheresults
achievedinanysituation.Thisobservationwasfirstmade
byanItalianeconomist,VilfredoPareto,andiscalledParetoslaw.Asappliedtoinventories,itis
usuallyfoundthattherelationshipbetweenthepercentageofitemsandthepercentageofannualdollar
usagefollowsapatterninwhich:
a.
About20%oftheitemsaccountforabout80%ofthedollarusage.
b.
c.
Thepercentagesareapproximateandshouldnotbetakenasabsolute.Thistypeofdistributioncanbe
usedtohelpcontrolinventory.
a.StepsinMakinganABCAnalysis
1.
Establishtheitemcharacteristicsthatinfluencetheresultsofinventorymanagement.
Thisisusuallyannualdollarusagebutmaybeothercriteria,suchasscarcityof
material.
2.
Classifyitemsintogroupsbasedontheestablishedcriteria.
3.
Applyadegreeofcontrolinproportiontotheimportanceofthegroup.
Thefactorsaffectingtheimportanceofanitemincludeannualdollarusage,unitcost,
andscarcityofmaterial.Forsimplicity,onlyannualdollarusageisusedinthistext.
Theprocedureforclassifyingbyannualdollarusageisasfollows:
1.
Determinetheannualusageforeachitem.
2.
3.
Multiplytheannualusageofeachitembyitscosttogetitstotalannualdollarusage.
4.
5.
Calculatethecumulativeannualdollarusageandthecumulativepercentageofitems.
Listtheitemsaccordingtotheirannualdollarusage.
ExaminetheannualusagedistributionandgrouptheitemsintoA,B,andCgroups
basedonpercentageofannualusage.
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b.ExampleProblem
Acompanymanufacturesalineoftenitems.Theirusageandunitcostareshownin
thefollowingtablealongwiththeannualdollarusage.Thelatterisobtainedby
multiplyingtheunitusagebytheunitcost.
a.
b.
Calculatetheannualdollarusageforeachitem.
c.
Calculatethecumulativeannualdollarusageandthecumulativepercentof
items.
d.
GroupitemsintoanA,B,Cclassification.
Listtheitemsaccordingtotheirannualdollarusage.
Answer
I.
II.
Calculatetheannualdollarusageforeachitem.
PartNumber
UnitUsage
1100
UnitCost$ Annual$Usage
2
2200
600
40
24,000
100
400
1300
1300
100
60
6000
10
25
250
100
200
1500
3000
400
200
10
500
500
Total
5510
$38,250
b.,c.,andd.
Part
Annual$ Cumulative Cumulative Cumulative Class
Number
Usage
$Usage
%$Usage
%ofItems
24,000
24,000
62.75
10
6000
30,000
78.43
20
3000
33,000
86.27
30
2200
35,200
92.03
40
1300
36,500
95.42
50
10
500
37,000
96.73
60
400
37,400
97.78
70
400
37,800
98.82
80
250
38.05
99.48
90
200
38,250
100
100
Thepercentageofvalueandthepercentageofitemsisoftenshownasagraphsuch
asinFigure9.3.
c.ControlBasedonABCClassification
UsingtheABCapproach,therearetwogeneralrulestofollow:
1.
Haveplentyoflowvalueitems.Citemsrepresentabout50%oftheitemsbut
accountforonlyabout5%percentofthetotalinventoryvalue.Carryingextra
stockofCitemsaddslittletothetotalvalueoftheinventory.Citemsare
reallyonlyimportantifthereisashortageofoneofthemwhentheybecome
extremelyimportantsoasupplyshouldalwaysbeonhand.Forexample,
orderayearssupplyatatimeandcarryplentyofsafetystock.Thatwaythere
isonlyonceayearwhenastockoutisevenpossible.
2.
Usethemoneyandcontroleffortsavedtoreducetheinventoryofhighvalue
items.Aitemsrepresentabout20%oftheitemsandaccountforabout80%of
thevalue.Theyareextremelyimportantanddeservethetightestcontroland
themostfrequentreview.
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Differentcontrolsusedwithdifferentclassificationsmightbethefollowing:
AItems:highpriority.Tightcontrolincludingcompleteaccuraterecords,
regularandfrequentreviewbymanagement,frequentreviewofdemand
forecasts,andclosefollowupandexpeditingtoreduceleadtime.
BItems:mediumpriority.Normalcontrolswithgoodrecords,regularattention,
andnormalprocessing.
CItems:lowestpriority.Simplestpossiblecontrolsmakesurethereare
plenty.Simpleornorecordsperhapsuseatwobinsystemorperiodicreview
system.Orderlargequantitiesandcarrysafetystock.
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