Inventory Management

1
CHAPTER 20

• Inventory Management

2
Inventory Management in Retail Organizations

• Inventory Management is planning, coordinating,
  and controlling activities related to the flow of
  inventory into, through, and out of an
  organization.

3
Costs Associated with Goods for Sale

• Managing inventories to increase net income
  requires effectively managing costs that fall
  into these five categories
• Purchasing Costs
• Ordering Costs
• Carrying Costs
• Stockout Costs
• Quality Costs

4
Management of Inventory Costs

• Purchasing Costs the cost of goods acquired
  from suppliers, including freight.
• Ordering Costs the costs of preparing and
  issuing purchase orders receiving and inspecting
  the items included in the orders and matching
  invoices received, purchase orders, and delivery
  records to make payments.

5
Management of Inventory Costs

• Carrying Costs the costs that arise while
  holding inventory of goods for sale. This
  includes the opportunity cost of the investment
  tied up in inventory, and costs associated with
  storage.
• Stockout Costs the costs that result when a
  company runs out of a particular item for which
  there is customer demand (stockout) and the
  company must act quickly to meet the demand or
  suffer the costs of not meeting it.

6
Management of Inventory Costs

• Quality Costs the costs that result when
  features and characteristics of a product or
  service are not in conformance with customer
  specifications. These costs include
• Prevention
• Appraisal
• Internal Failure
• External Failure

7
The First Step in Managing Goods for Sale

• The first decision in managing goods for sale is
  how much to order of a given product.
• Economic Order Quality (EOQ) is a decision model
  that calculates the optimal quantity of inventory
  to order under a given set of assumptions.

8
Basic EOQ Assumptions

• There are only ordering and carrying costs.
• The same quantity is ordered at each reorder
  point.
• Demand, purchase-order lead time, ordering costs,
  and carrying costs are known with certainty.
• Purchasing costs per unit are unaffected by the
  quantity ordered
• No stockouts occur.
• EOQ ignores purchasing costs, stockout costs, and
  quality costs.

9
EOQ Formula

• D Demand in units for specified period
• P Relevant ordering costs per purchase order
• C Relevant carrying costs of one unit in stock
  for the time period used for D

10
Ordering Points

• The second decision in managing goods for sale is
  when to order a given product.
• Reorder Point the quantity level of inventory
  on hand that triggers a new purchase order.

11
Inventory Management and Safety Stock

• Safety Stock is inventory held at all times
  regardless of the quantity of inventory ordered
  using the EOQ model.
• Safety stock is a buffer against unexpected
  increases in demand, uncertainty about lead time,
  and unavailability of stock from suppliers.

12
Estimating Inventory-Related Relevant Costs

• Carrying Costs
• Stockout Costs
• Ordering Costs

13
Carrying Costs

• Relevant inventory carrying costs consist of
  relevant incremental costs and the relevant
  opportunity cost of capital.
• Relevant Incremental Costs those costs of the
  purchasing firm that change with the quantity of
  inventory held.

14
Opportunity Costs

• Relevant Opportunity Cost of Capital the return
  forgone by investing capital in inventory rather
  than elsewhere.
• This cost equals the required rate of return
  multiplied by the unit costs that vary with the
  number of units purchased and are incurred at the
  time the units are received.

15
Cost of a Prediction Error

• Three steps in determining the cost of a
  prediction error
• Compute the monetary outcome from the best action
  that could be taken, given the actual amount of
  the cost per purchase order.
• Compute the monetary outcome from the best action
  based on the incorrect amount of the predicted
  cost per purchase order.
• Compute the difference between Steps 1 2.

16
Just-in-Time Purchasing

• Just-in-Time (JIT) Purchasing is the purchase of
  materials or goods so they are delivered just as
  needed for production or sales.
• JIT is popular because carrying costs are
  actually much greater than estimated because
  warehousing, handing, shrinkage, and investment
  costs have not been correctly estimated.

17
JIT Purchasing

• JIT reduces the cost of placing a purchase order
  because
• Long-term purchasing agreements define price and
  quality terms. Individual purchase orders
  covered by those agreements require no additional
  negotiation regarding price or quality
• Companies are using electronic links to place
  purchase orders at a small fraction of
  traditional methods (phone or mail).
• Companies are using purchase-order cards.

18
Relevant Costs in JIT Purchasing

• Purchasing Costs
• Stockout Costs
• Quality Costs

19
JIT Purchasing and Supply-Chain Analysis

• 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 and outside
  the firm).
• Supply chain members share information and
  plan/coordinate activities.
• Supplier evaluations are critical to JIT
  purchasing implementation.

20
Inventory Management and Materials Requirements
Planning

• Materials Requirements Planning (MRP) a
  push-through system that manufactures finished
  goods for inventory on the basis of demand
  forecasts.

21
MRP Information Inputs

• MRP uses three information sources to determine
  the necessary outputs at each stage of production
• Demand forecasts of final products.
• A bill of materials detailing the materials,
  components, and subassemblies for each final
  product.
• The quantities of materials, components, and
  product inventories to determine the necessary
  outputs at each stage of production.

22
MRP

• Takes into account lead time to purchase
  materials and to manufacture components and
  finished products.
• Sets a master production schedule specifying
  quantities and timing of each item to be
  produced.
• The output of each department is pushed through
  the production line whether it is needed or not.
• Push Through may result in an accumulation of
  inventory.

23
Inventory Management and JIT Production

• JIT (Lean) Production is 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.
• Demand pulls an order through the production line
  .

24
JIT Production Goals

• Meet customer demand in a timely basis,
• With high-quality products,
• At the lowest possible cost.

25
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.
• Setup time is reduced.
• Suppliers are selected on the basis of their
  ability to deliver quality materials in a timely
  manner.

26
Other Benefits of JIT Production

• Lower overhead costs.
• Lower inventory levels.
• Heightened emphasis on improving quality by
  eliminating the specific causes of rework, scrap,
  and waste.
• Shorter manufacturing lead times.

27
JIT and Enterprise Resource Planning Systems (ERP)

• JIT success hinges on the speed of information
  flows from customers to manufacturers to
  suppliers.
• ERP is a system with a single database that
  collects data and feeds them into software
  applications supporting all of a firms business
  activities.
• ERP gives managers, workers, customers, and
  suppliers access to operating information.
• ERP can be expensive, large, and unwieldy.

28
Performance Measures and Control in JIT

• Financial performance measures such as inventory
  turnover ratio.
• Nonfinancial performance measures of time,
  inventory, and quality such as
• Manufacturing lead times,
• Units produced per hour,
• Days of inventory on hand,
• Setup time as a of total manufacturing time,
• Number of defective units as a of total units
  produced.

29
Backflush Costing

• Backflush Costing omits recording some or all of
  the journal entries relating to the stages from
  the purchase of direct materials to the sale of
  finished goods.
• Since some stages are omitted, the journal
  entries for a subsequent stage use normal or
  standard costs to work backward to flush out
  the costs in the cycle for which journal entries
  were not made.
• Contrasts to traditional normal and standard
  costing systems using sequential tracking
  recording journal entries at each trigger point
  in the production process.

30
Special Considerations in Backflush Costing

• Backflush costing does not necessarily comply
  with GAAP.
• However, inventory levels may be immaterial,
  negating the necessity for compliance.
• Backflush costing does not leave a good audit
  trail the ability of the accounting system to
  pinpoint the uses of resources at each step of
  the production process.

31
Problem 20-19

• EOQ for manufacturer.
• Lakeland Company makes lawnmowers.
• They purchase 18,000 rotary blades each year at a
  cost of 60 per unit.
• The company requires a 15 annual rate of return
  on investment.
• The carrying costs per unit is 6.00.
• The relevant ordering costs per purchase order is
  150.

32
What is the EOQ for the rotor blade part?

• Formula for EOQ
• Where D demand in units for a specified period.
• P relevant ordering cost per purchase order.
• C relevant carrying cost of one unit in stock
  for the time period used for D.

33
Calculation of EOQ
34
Calculation of Annual Relevant Ordering Cost
Where Q 600 units, the EOQ.
35
Annual Relevant Carrying Cost

• At the EOQ, total relevant ordering costs and
  total relevant carrying costs will be exactly
  equal. Therefore, total relevant carrying costs
  at the EOQ 4,500 (from requirement 2). We can
  also confirm this with direct calculation

36
Problem 20-19

• Assume that demand is uniform throughout the year
  and known with certainty so that there is no need
  for safety stock.
• The purchase order lead time is half a month.
• Calculate Lakelands reorder points for the rotor
  blade part.

37
Reorder Point

• Purchase order lead time is half a month.
• Monthly demand is 18,000 units 12 months
  1,500 units per month.
• Demand in half a month is .5 ? 1,500 units or 750
  units.
• Lakeland should reorder when the inventory of
  rotor blades falls to 750 units.

38
Problem 20-21

• Purchase order size for retailer, EOQ,
  just-in-time purchasing.
• Calculate EOQ with the following scenarios.

39
Scenario A

• D 6,000 P 30 C 1.

40
Scenario B

• D 6,000 P 30 C 1.50

41
Scenario C

• D 6,000 P 5 C 1.50

42
Problem 20-21 Part 2

• How does your answer to requirement one give
  insight into the retailers movement toward
  just-in-time purchasing policies?
• A just-in-time purchasing policy involves the
  purchase of goods or materials such that their
  delivery immediately precedes their demand or
  use.

43
Problem 20-22

• Just-In-Time Production, Relevant Benefits,
  Relevant Costs Problem.
• A hardware company manufactures brass door
  handles.
• They are considering a just-in-time system.
• The following slide details estimated costs and
  benefits of just-in-time production.

44
Improvements Resulting from Just- in-time

• Annual additional tooling cost would be 100,000.
• Average inventory would decline by 80 from the
  current level of 1 million.
• Insurance, space, material handling ,and set up
  costs, which currently totaled 300,000 annually,
  would decline by 25.
• Rework costs would decline by 30. The company
  currently incurs 200,000 in annual rework costs.

45
Improvements Resulting from Just- in-time

• Product price would increase by 4.00. Champion
  sells 40,000 units each year.
• The companys return on inventory investment is
  15 per year.

46
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
47
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
48
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
49
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
50
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
51
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
52
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
53
Calculate the net benefit or cost to the company
if it adopts just-in-time manufacturing.
54
What non-financial factors should they consider?

• The possibility of developing and implementing a
  detailed system for integrating the sequential
  operations of the manufacturing process. Direct
  materials must arrive when needed for each
  subassembly so that the production process
  functions smoothly.
• The ability to design products that use
  standardized parts and reduce manufacturing time.

55
What non-financial factors should they consider?

• The ease of obtaining reliable vendors who can
  deliver quality direct materials on time with
  minimum lead time.
• Willingness of suppliers to deliver smaller and
  more frequent orders.

56
What non-financial factors should they consider?

• The confidence of being able to deliver quality
  products on time. Failure to do so would result
  in customer dissatisfaction.
• The skill levels of workers to perform multiple
  tasks such as minor repairs, maintenance, quality
  testing and inspection.

57
Question

• Suppose the company implements JIT production.
  Give example of performance measures that might
  use to evaluate and controlled JIT production.
• Personal observation by production line workers
  and managers is more effective in JIT plants than
  in traditional plants.
• A JIT plants production process layout is
  streamlined. Operations are not obscured by piles
  of inventory or rework.
• As a result, such plants are easier to evaluate
  by personal observation than cluttered plants
  where the flow of production is not logically
  laid out.

58
Question

• Suppose the company implements JIT production.
  Give example of performance measures that might
  use to evaluate and controlled JIT production.
• Examples of nonfinancial performance measures of
  time, inventory, and quality include
• Manufacturing lead time
• Units produced per hour
• Machine setup time manufacturing time
• Number of defective units number of units
  completed

59
Question

• Suppose the company implements JIT production.
  Give example of performance measures that might
  use to evaluate and controlled JIT production.
• The success of a JIT system depends on the speed
  of information flows from customers to
  manufacturers to suppliers.
• The Enterprise Resource Planning (ERP) system
  has a single database, and gives lower-level
  managers, workers, customers, and suppliers
  access to operating information.
• This benefit, accompanied by tight coordination
  across business functions, enables the ERP system
  to rapidly transmit information in response to
  changes in supply and demand so that
  manufacturing and distribution plans may be
  revised accordingly.

60
Problem 20-27

• EOQ, Uncertainty, Safety Stock, Reorder Point
  Problem
• The Starr Company distributes electric motor.
• Annual demand (300 days) is 30,000 motors.
• EOQ 3,000
• Lead time is 5 days
• Annual carrying cost is 10.
• Additional stock out cost is 20 for each motor
  they are short.

61
Demand Analysis
62
Question

• Determine the level of safety stock the company
  should maintain in order to minimize the sum of
  expected stock out costs and carrying costs.
• When computing carrying costs, assume that the
  safety stock is on hand at all times and there is
  no overstocking caused by decreases in expected
  demand.
• Consider safety-stock levels of 0, 20, 40, and 60
  units.

63
Problem 20-27 continued

• The Starr Company is searching for the safety
  stock level that will minimize the expected total
  of the costs of carrying additional inventory and
  the costs associated with insufficient
  inventories (stock out costs).
• The present reorder point, alternative safety
  stock levels, and probability of usage during
  lead time have to be computed before this level
  can be determined.

64
Problem 20-27 continued
65
Problem 20-27 continued
66
Problem 20-27 continued
67
Problem 20-27 continued
Alternative safety stock levels would be the
number of units needed to cover possible demand
levels during lead time. These safety levels can
be determined as follows Possible safety stock
levels Possible demand Reorder point. The
alternative safety stock levels are 0, 20, 40,
and 60 units.
68
Problem 20-27 continued
69
Problem 20-27
Okay, lets see if we can figure out how to
calculate the best reorder point based on the
probabilities of stockouts given by the
author. This table presents a good format for
working a problem where there is a probability
distribution (a list of different possible
outcomes each with a different probability of
occurrence). Probability distribution? Gosh,
weve learned a new word. Save it for your next
statistics class!
70
Problem 20-27
The problem assumes safety stock levels coming in
steps of 20 (0,20,40,60). We start by assuming
a safety stock of 0. Later we will do
calculations based on safety stock levels of 20,
40, and 60.
71
Problem 20-27
The lowest level of weekly demand we could have
where there would be a stock out would be 520.
Why? Because in this model we consider assumes
changes in demand coming in units of 20. At a
weekly demand 500 or below, we can meet demand
since 500 is our minimum inventory. Where do we
get the minimum inventory level of 500? We assume
an existing inventory level of 500, because we
use 100 units a day, have a 5 day lead time for
receipt of new orders, and therefore order in
units of at 500 at a time.
72
Problem 20-27
How do we get 520? That is the first Demand
During Lead Time (shown on page 719) where we
would have a stock out. Why? At a demand of
500, we meet all orders. At a demand of 480 we
have 20 units left to spare, and so on.
73
Problem 20-27
If we have no safety stock (as shown in column 1)
then we have a total inventory of 500 units. At a
demand of 520 units, therefore, we are 20 units
short of meeting demand. We call this a stockout
of 20 units.
74
Problem 20-27
The problem tells us there is a 10 probability
that during any given month customers will order
520 units.
75
Problem 20-27
If we run out of stock before a new shipment
comes in, and therefore cannot meet customer
demand, 400 is the total cost to the company. We
calculate this by multiplying the 20 units
stockout by the cost of stockout 20 units x 20
per unit 400 total stockout cost.
76
Problem 20-27
How is this figure different from that shown in
column (5)? It is a yearly figure for one thing.
It is also probability adjusted, which means it
is the statistically expected cost of stockouts
for one year if we have no safety stock.
77
Problem 20-27
1
2
Arrow 1 There is no cost of carrying the safety
stock (8). Arrow 2 We will calculate total
relevant costs for all three states of nature
at 0 safety stock using a probability
distribution. The three states of nature are
demand of 520, demand of 540, and demand of 560.
This calculation will be made once we have filled
in the values for the three states of nature and
a safety stock of 0.
78
Problem 20-27
This figures in this row are calculated the same
was as in the row above, except we are doing the
calculation for a second state of nature (the
state of nature where the demand is 540 units
during the month. Notice that the probability of
this state of nature is 5, where the probability
for the first state of nature (a demand of 520)
was 10.
79
Problem 20-27
Now we do the same thing for the third state of
nature, the state of nature where demand is 560
during the period.
80
Problem 20-27
Lets see if we can explain what this figure
means. With 0 safety stock, there are only three
possible situations where we can have a stock
out state of nature 1 where demand is 520, state
of nature 2 where demand is 540, and state of
nature 3 where demand is 560. This covers 100 of
the situations where a stock out can occur.
81
Problem 20-27
To see what the expected cost of having 0 safety
stock, we must multiply the cost of each state of
nature by the probability it will occur. Then we
sum these values to get the expected stockout
cost from a 0 safety stock decision.
82
Problem 20-27
2
1
If these three states of nature (arrow 1)
constitute all situations where a stock out can
occur, why do the three probabilities (arrow 2)
only total 18 (instead of 100)? Answer The
other (100 18 82) of the time, demand is
less than 500 units.
83
Problem 20-27
This column has no figures in it because we are
dealing with an assumption where there is 0
safety stock, thus the cost of carrying the
safety stock is 0 in each of the three states of
nature (states of demand).
84
Problem 20-27
Now we sum columns (8) and (9) to find the
expected total relevant cost for all states of
nature where demand exceeds 500 units, and safety
stock is 0.
85
Problem 20-27
What next? We calculate the same cost for a
safety stock of 20, 40, and 60. We use the same
procedure as above, only different figures.
86
Problem 20-27
Several things to notice First there are only
two states of nature where we have demand in
excess of inventory with a safety inventory of
20. The first is the state of nature where demand
is 540, and the second is when it is 560. At 520
we cover demand.
87
Problem 20-27
Second, there is a carrying cost of safety stock
because we now have a safety stock of 20 units.
The cost is 20 units x 10.
88
Problem 20-27
Now we add to total from columns (7) and (8) to
get the total relevant carrying costs. This is
the sum of the expected value of column (7) and
the absolute value of column (8).
89
Problem 20-27
Now we do the same calculations for safety stock
inventory levels of 40 and 60.
90
Problem 20-27
Note that as stockout costs do down, carrying
costs go up. That makes sense.
91
Problem 20-27
We want the level of safety stock that minimizes
total relevant costs (40 units).
92
Problem 20-27

• If we decide on a 40 level of safety stock, what
  will our new reorder point be?
• 500 units regular inventory 40 units safety
  inventory stock 540 units reorder stock.

93
Problem 20-28

• EOQ is used for inventory control of heavy tires.
• Initial prediction of annual demand 2,000.
• Purchase price is 50 per tire.
• The order cost per purchase order is 40.
• The carrying cost per year is 4.00 per tire plus
  10 of the purchase price per tire.

94
Calculate Economic Order Quantity
95
Relevant Total Cost (RTC)
Annual Relevant Ordering Cost
Annual Relevant Carrying Cost
RTC


Note that annual relevant ordering cost is 600
Annual relevant carrying cost is also 600
Which makes sense since EOQ is when annual
relevant ordering cost is equal to annual
relevant carrying cost.
96
Question

• Suppose the owner is correct in all his
  predictions except the purchase price.
• If he had been a faultless predictor, he would
  have foreseen that the purchase price would drop
  to 30.
• What is the cost of the prediction error?

97
The Prediction Error

• The prediction error affects C, which is now
•   C 4 (10 ? 30) 7
•   D 2,000, P 40, C 7
•   EOQ 151.186 tires 151 tires

98
Approach

• To estimate the cost of a prediction error
• Compute the monetary outcome from the best action
  that could be taken, given the actual amount of
  the cost input.
• Compute the monetary outcome from the best action
  based on the incorrect amount of the predicted
  cost input.
• Compute the difference between the monetary
  outcomes from step one and stepped two.

99
Step 1

• Compute the monetary outcome from the best action
  that could be taken, given the actual amount of
  the cost input.

Best action that could be taken based on actual
cost input.
100
Step 2

• Compute the monetary outcome from the best action
  based on the incorrect amount of the predicted
  cost input.

Best action based on incorrect amount of
predicted input
Put another way, the only thing that changes in
the two equations is the EOQ amount. The correct
C is used in both equations.
101
Step 3

• Compute the difference from the two monetary
  outcomes.

102
Problem 20-29

• Margro Co. makes precision parts from steel bars.
• Inventory of raw steel averages 600,000.
• The company is concerned about the carrying cost
  of inventory.
• The steel supplier is willing to supply steel in
  smaller lots at no additional charge.
• The company is looking at a just-in-time
  inventory system.

103
Advantages of Just-in-Time

• By incurring overtime premiums of 40,000 per
  year, the company would only lose 20,000 units
  per year sales.
• Two warehouses would no longer be needed.
• One of these is rented at a cost of 60,000 per
  year.
• The other is owned and has 12,000 square feet,
  three force of which could be rented for 1.50
  per square foot per year.
• Insurance and property tax of 14,000 per year
  would be eliminated.

104
Additional Information

• Magrows required rate of return on investment is
  20 per year.
• The budgeted income statement is shown on the
  following slide.

105
Budgeted Income Statement
106
Required

• Calculate the estimated dollar savings or loss
  that would result from the adoption of
  just-in-time purchasing.
• Identify and explain other factors the company
  should consider before deciding whether to adopt
  just-in-time purchasing.

107
Calculation
Investment in inventory entails an opportunity
cost. Without an inventory we can invest this
600,000 elsewhere.
108
Calculation
109
Calculation
12,000 sq. feet x ¾ x 1.50 13,500 revenue
from renting vacated warehouse space.
110
Calculation
Overtime premium to minimize lost sales.
111
Calculation
112
Calculation
113
Calculation
114
Cash Savings (Excluding Lost Sales)
The author does not include lost sales in this
calculation, presumably because he just asked for
cash savings.
115
Conditions Necessary for JIT

• Commitment by top management.
• A redesign of the manufacturing process.
• Accurate sales forecasts.
• Use a standardized parts to reduce manufacturing
  time and cost.
• Reliable vendors who can deliver on time.

116
Problem 20-32

• A company is evaluating two suppliers of
  footballs.
• Pertinent information is shown on the next slide.

117
Pertinent Information
118
Calculate the relevant cost of purchasing from
each supplier

• See schedule on next slide.

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The End!