AF3112

MANAGEMENT ACCOUNTING 2
Inventory Management

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 AGENDA
Reasons for holding inventory
Objective of inventory management
Costs associated with inventory
The EOQ model of inventory management
The reorder point and safety stock
JIT purchasing
JIT production and inventory management

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 Types of Inventory

Raw Materials
Work-in-Process
 The level is a function of cycle time of a
product
Maintenance / Repair / Operating
(MRO)
 Materials necessary to keep machinery
and process productive
Finished Goods AF3112 - 2013 3
Reasons for Holding Inventory
Traditional reasons to hold inventory are:
 Demand uncertainty
 Machine failure

 To hedge against future price increases

 Defective parts

 Unavailable parts

 Late delivery of parts

 Unreliable production processes

 To take advantage of discounts

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 Objective of Inventory
Management
Objective of Inventory Management
 Minimize inventory-related costs
Involves 2 primary decisions:
 How much to order?
 The quantity that needs to be put in the warehouse
and involves carrying costs.
 When to order?
 This is the frequency of ordering per year and
involves ordering/purchasing costs.

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Costs Associated with Inventory
Purchasing Costs

Ordering Costs

Carrying Costs

Cost Associated
with Inventories Stockout Costs

Quality Costs

Shrinkage Costs

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Costs Associated with Inventory
Purchasing Costs
 Cost of goods acquired from suppliers, including
transportation costs
Ordering Costs
 Costs related to preparing and issuing orders and
receiving and inspecting the items included in the
orders
Carrying Costs
 opportunity costs of the investment tied up in
inventory
 storage costs (eg. space rental), insurance,
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Costs Associated with Inventory
Stockout Costs
 arising when a company runs out of a particular inventory for
which there is customer demand
 Lost sales, costs of expediting (extra setup, transportation, etc.)
and the costs of interrupted production
Quality Costs
 Costs incurred to prevent (or the costs arising as a result of) the
production of a low quality product (including prevention costs,
appraisal costs, internal failure costs and external failure costs)
Shrinkage costs
 Arising from theft by outsiders, embezzlement by employees,
misclassifications and clerical errors
 Difference between the cost of the inventory recorded on the
books and the cost of inventory when physically counted
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 The Economic Order Quantity
(EOQ) Model
Objective
 To determine the optimal quantity of inventory to
order in order to minimize the inventory related
costs.
Key Assumptions
 Demand, ordering costs, carrying costs and lead
time are known and constant
 Purchasing cost is unaffected by the order
quantity, thus is irrelevant
 Stockout cost is irrelevant
 Stockout can be completed avoided
 Quality costs and shrinkage costs are irrelevant
 They are only considered when they affect ordering or
carrying costs
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 The Economic Order Quantity
(EOQ) Model
Under such assumptions,
Relevant Total Inventory Costs =
Relevant Ordering Costs + Relevant Carrying Costs

Whereas,
Relevant Ordering Costs =
Number of purchase X Ordering cost per
orders per year purchase order
Relevant Carrying Costs =
Avg. Inventory (units) x Unit carrying cost per year

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The Economic Order Quantity
(EOQ) Model
Expressed in a formula, it yields:
D Q
TC= ×P + ×C
Q 2
DP QC
or TC= +
Q 2
Whereas
 TC = Total relevant cost of holding inventory
 D = Total demand in units
 P = Ordering cost per purchase order
 C = Carrying cost per unit of stock for 1 year
 Q = Order Quantity (in units)

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The Economic Order Quantity
(EOQ) Model
The optimal order quantity which minimizes
the total cost equation is known as the
economic order quantity (EOQ).
Algebraically,
2DP
EOQ=
C

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 Example 1 - EOQ
Demand for the year = 25,000 units
Current order quantity = 500 units
Relevant cost per order = $40 per order
Carrying cost = $2 per unit
Required: Compute the EOQ.

EOQ =  (2 x 25,000 x $40) / $2

EOQ =  1,000,000
EOQ = 1000 units

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 Example 2 - EOQ
Video store sells packages of blank video tapes. Video purchases
packages of video tapes from Oaks, Inc., at $15/package. Annual
demand is 12,844 packages.
Video store requires a 15% annual return on investment. Relevant
ordering cost per purchase order is $209.
Relevant carrying costs per package per year:
 Required annual ROI __________
 Relevant other costs __3.25_____
 Total carrying costs __________
The purchase-order lead time is two weeks.
Compute:
 EOQ

 The number of deliveries based on EOQ

 The relevant inventory costs based on the EOQ

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 Example 2 - EOQ
EOQ =
D
No. of deliveries = =
EOQ
Total inventory costs:
 TC =

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 Example 2 - EOQ
8,000
Relevant Total Costs (Dollars)

Annual relevant Q�
total costs
2
6,000
5,434

4,000 Annual relevant

ordering costs
Annual relevant
carrying costs DP
2,000
Q

600 988 1,200 1,800 2,400

Order Quantity (Units) EOQ
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 The Reorder Point
Objective
 Determine when to place the order
The Reorder Point
 Quantity of inventory on hand that triggers a
new purchase order
Since the order does not arrive warehouse
instantaneously, the re-order point will
depends on the lead time of the order.
Lead Time
 Time lag between ordering and the receiving of
the order
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 The Reorder Point
The equation for re-order point (ROP) is:

푅� = � × �

 Whereas: d = Units sold (i.e. demand) per

period
L = Lead time of purchase order

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The Reorder Point

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 Example – Reorder Point
Refer to the video store example.
The purchase order lead time = 2 weeks
Annual demand: 12,844 packages
 Or 247 (i.e. 12,844 / 52) packages per week
Reorder Point = 247 x 2 = 494 packages

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 Example – Reorder Point
988

Reorder Reorder
Point Point

494

Weeks 1 2 3 4 5 6 7 8
Lead Time Lead Time
2 weeks 2 weeks
Assumes that demand and purchase-order lead time are certain:
Demand = 247 tape packages/week Purchase-order lead time = 2 weeks
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 Safety Stock
Safety Stock
 Inventory held at all times regardless of the
quantity of inventory ordered using the EOQ
model.
 To serve as insurance against fluctuations in
demand.
Example (cont’d)
 If the maximum usage of the VCR part is 120
units per day, the average usage is 100 units
per day, and the lead time is 4 days.
 Determine the safety stock needed?
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 Safety Stock
Example (cont’d)
 Answer: 80. The working is as follows:
Maximum usage 120
Average usage -100
Difference 20
Lead time x 4
Safety stock 80

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 Comprehensive Example
Expedition Company manufactures edgers.
The manager is trying to determine the size of
the production. The controller has supplied
the following information:
Average demand for edgers: 720 per day
Maximum demand for edgers: 780 per day
Annual demand for edgers: 180,000
Unit carrying cost: $4
Setup cost: $10,000
Lead time: 22 days

Required: Compute the EOQ, safety stock and reorder point.

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 Comprehensive Example
First we compute the EOQ, as follows:

EOQ =  2PD/C
EOQ = (2 x 180,000 x $10,000)/$4

EOQ =  900,000,000
EOQ = 30,000 edgers

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 Comprehensive Example
Next, we compute the safety stock, as follows:
Maximum usage
780
Average usage
720
Difference
60
Finally, we compute the re-order point:
Lead time
Reorder point = (Average usage x Lead time) + Safety stock
x 22
Reorder point = (720 x 22) + 1,320
Safety stock
Reorder point = 17,160 edgers
1,320
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 JIT Purchasing
Just-in-time (JIT) purchasing
 The purchase of goods or materials such that a
delivery immediately precedes demand or use. That is,
JIT purchasing is making purchases in small order
quantities just as needed for productions or sales.
 Following its origin and development in Japan, largely
in the 1960s and 1970s and particularly at Toyota, JIT
migrated to Western industry in the 1980s, where its
features were put into effect in many manufacturing
companies.

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 JIT Purchasing
JIT purchasing is a response to the increases in the ordering
and carrying costs.
Proponents of JIT purchasing argue that the cost of carrying inventories
(i.e. C in the EOQ model) has been dramatically underestimated in the
past.
JIT purchasing reduces ordering costs (i.e. P in the EOQ model) in
three ways:
 Companies are establishing long-run purchasing agreements.

 Companies are using electronic links, such as the Internet, to

place purchase orders.
 Companies are increasing the use of purchase order cards
(similar to consumer credit cards).
 a form of company charge card that allows goods and services to be purchased
without using a traditional ordering process (abbreviated as PCard or P-Card).

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 Illustration: Benefits of JIT
Purchasing

Note: The ordering costs remains at $2.0 / order under both alternatives as
the company has been using Internet to place orders.
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Suppliers and JIT Purchasing
Supply chain
 Describes the flow of goods, services, and
information from the initial sources of
materials and services to the delivery of
products to consumers (both inside & outside
the firm)
Supply chain members share information and
plan/coordinate activities
Supplier evaluations are critical to JIT
Purchasing implementation
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Illustration: Supplier Evaluation

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 JIT Production
JIT (Lean) Production
 A “demand-pull” manufacturing system that
manufactures each component in a production line as
soon as and only when needed by the next step in the
production line.
Demand triggers each step of the production
process
 starting with customer demand for a finished product
and working backward.

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 JIT Production Goals
Produce close coordination among work-
stations
Smooth the flow of goods
Achieve low quantities of inventory
Aim to simultaneously:
 Meet customer demand in a timely manner
 Produce high quality products

 Generate the lowest possible costs

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 JIT Production Features
Production is organized in manufacturing cells
 A grouping of all the different types of equipment used
to make a given product.
Workers are hired and trained to be multi-skilled
(cross-trained).
Defects are aggressively eliminated, i.e. zero
defects.
Setup time is reduced.
Suppliers are selected on the basis of their ability to
deliver quality materials in a timely manner.
 Fewer, but more ultra-reliable suppliers.

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 End of Topic

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