Chapter 4 Managing Inventory INV Copyright 1998 by
Chapter 4 Managing Inventory INV Copyright 1998 by Harcourt Brace &Company
The Cash Flow Timeline Order Placed Order Received Sale Cash Received Accounts Collection < Inventory > < Receivable > < Float > Time ==> Accounts < Payable > Invoice Received Disbursement < Float > Payment Cash Sent Paid Copyright 1998 by Harcourt Brace &Company
Objectives v Appreciate impact of holding and ordering costs on order quantity v Traditional EOQ & quantity discounts v Appreciate JIT concepts v Assess impact that different order quantities have on timing and amount of payments v Use of balance fractions to monitor inventory balances Copyright 1998 by Harcourt Brace &Company
Concept of Inventory v Factor in the length of cash cycle v Acts as a shock absorber v Three types – raw materials – work-in-process – finished goods v Motives for holding inventory – transaction – precautionary – speculative Copyright 1998 by Harcourt Brace &Company
Inventory Investment Function v Demand for product v Cost of holding inventory – insurance – storage – cost of capital v Cost of ordering inventory v Total cost = Order Cost + Holding Cost = F x (T/Q) + H x (Q/2) Copyright 1998 by Harcourt Brace &Company
Order Cost and Holding Cost Trade-off $ Holding cost = H x (Q/2) Order costs = F x (T/Q) Order quantity, Q Copyright 1998 by Harcourt Brace &Company
Economic Order Quantity v EOQ solution: SQRT (2 TF/H) v Number of orders: T/Q v Average inventory: Q/2 v Usage rate: T/D v Reorder point: (T/D) x Delivery Time (D=days) Copyright 1998 by Harcourt Brace &Company
Quantity Discounts TC = Order Cost + Holding Cost + Item Cost TC = (F x (T/Q)) + (H x (Q/2)) + (C’x. T) Copyright 1998 by Harcourt Brace &Company
Inventory and the Cash Flow Timeline Inventory ordered and received < Inventory Held> Inventory ordered and received <Inventory Held> Time=> Cash paid for inventory Cash paid for holding & ordering costs Copyright 1998 by Harcourt Brace &Company
Monitor the Inventory Balance v Inventory control systems v Inventory turnover ratio – Sales or COGS / Inventory balance v Days COGS in inventory – Inventory balance / Daily COGS or Sales v Balance fraction approach – Develop monthly balance fractions based on the proportion of items remaining in inventory from a given month’s purchase. Copyright 1998 by Harcourt Brace &Company
Reducing Investment in Inventory v Problems were solved by adding more inventory v JIT redesigns system v Redesign of production system – eliminate waste – eliminate production errors – improving quality v Need stable demand Copyright 1998 by Harcourt Brace &Company
Summary v 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? v Inventory, if properly managed can be a major contributor to cash flow. . . v if mismanaged, it can be a significant drain on cash. v Some traditional inventory monitoring tools can be biased by sales and production trends Copyright 1998 by Harcourt Brace &Company
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