Managing working

capital
Inventory management

The objectives of inventory management

Inventory is a major investment for many companies. Manufacturing
companies can easily be carrying inventory equivalent to between 50% and
100% of the revenue of the business. It is therefore essential to reduce the
levels of inventory held to the necessary minimum.

INVENTORY COST
Keeping inventory levels high is expensive owing to:
• Purchase costs
• Holding costs:
o The cost of capital
o Warehousing and handling costs
o Deterioration
o Obsolescence
o Insurance
o Pilferage

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 Managing working
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Inventory management 
P
rocuring
o Ordering cost
o Delivery cost
 Shortage cost
o Contribution from lost sales
o Extra cost of emergency inventory
o Cost of lost production and sales in a stock-out

Objective of inventory management

The objective of good inventory management is therefore to determine:
• The optimum re-order level – how many items are left in inventory when
the next order is placed, and

• The optimum re-order quantity – how many items should be ordered when
the order is placed for all material inventory items.

In practice, this means striking a balance between holding costs on the one
hand and stock out and re-order costs on the other. The balancing act
between liquidity and profitability, which might also be considered to be a
trade-off between holding costs and stockout/re-order costs, is key to any
discussion on inventory management.

Economic order quantity (EOQ)

For businesses that do not use just in time (JIT) inventory management
systems, there is an optimum order quantity for inventory items, known as the
EOQ.
The aim of the EOQ model is to minimise the total cost of holding and
ordering inventory.

Assume that demand is constant, the lead-time is constant or zero and

purchase costs per unit are constant (ie no bulk discounts).

Formula to learn

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 Managing working
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Inventory management

Where,
Let D = usage in units for one period (the demand)
Co = cost of placing one order
Ch = holding cost per unit of inventory for one period
Q = re-order quantity

The total annual cost of having inventory is:

a) Holding cost =
Q
--- X Ch
2

b) Ordering cost =

D
--- X Co
Q

Objective is to minimise the inventory holding and ordering cost.

Holding costs
The model assumes that it costs a certain amount to hold a unit of
inventory for a year (referred to as CH in the formula). Therefore, as the
average level of inventory increases, so too will the total annual holding
costs incurred.

Because of the assumption that demand per period is known and is

constant (see below), conclusions can be drawn over the average
inventory level in relationship to the order quantity.

When new batches or items of inventory are purchased or made at

periodic intervals, the inventory levels are assumed to exhibit the following
pattern over time.

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 Managing working
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Inventory management

We therefore see an upward sloping, linear relationship between the re- order
quantity and total annual holding costs.

Ordering costs
The model assumes that a fixed cost is incurred every time an order is placed
(referred to as CO in the formula). Therefore, as the order quantity increases,
there is a fall in the number of orders required, which reduces the total
ordering cost. However, the fixed nature of the cost results in a downward
sloping curved relationship.

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 Managing working
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Inventory management

Because you are trying to balance these two costs (one which increases as
re-order quantity increases and one which falls), total costs will always be
minimised at the point where the total holding costs equals the total ordering
costs. This point will be the economic order quantity.

When the re-order quantity chosen minimises the total cost of holding and
ordering, it is known as the EOQ.

Test your understanding 1

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 Managing working
capital
Inventory management
The demand for a commodity is 40,000 units a year, at a steady rate. It costs
$20 to place an order, and 40c to hold a unit for a year. Find the order size to
minimise inventory costs, the number of orders placed each year, the length
of the inventory cycle and the total costs of holding inventory for the year.

Test your understanding 2

Monthly demand for a product is 10,000 units. The purchase price is $10/unit
and the company’s cost of finance is 15% pa. Warehouse storage costs per
unit pa are $2/unit. The supplier charges $200 per order for delivery.
Calculate the EOQ.

EOQ with discount

Discounts may be offered for ordering in large quantities. If the EOQ is smaller
than the order size needed for a discount, should the order size be increased
above the EOQ?

Test your understanding 3

W Co is a retailer of barrels. The company has an annual demand of 30,000
barrels. The barrels cost $2 each. Fresh supplies can be obtained
immediately, with ordering and transport costs amounting to $200 per order.
The annual cost of holding one barrel in stock is estimated to be $1.20.
A 2% discount is available on orders of at least 5,000 barrels and a 2.5%
discount is available if the order quantity is 7,500 barrels or above.

Required:
Calculate the EOQ ignoring the discount and determine if it would change
once the discount is taken into account.

Test your understanding 4

D Co uses component V22 in its construction process. The company has a
demand of 45,000 components pa. They cost $4.50 each. There is no lead
time between order and delivery, and ordering costs amount to $100 per
order. The annual cost of holding one component in inventory is estimated to
be $0.65.
A 0.5% discount is available on orders of at least 3,000 components and a
0.75% discount is available if the order quantity is 6,000 components or
above.
Calculate the optimal order quantity.

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 Managing working
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Inventory management
Calculating the reorder level (ROL)
Having decided how much inventory to re-order, the next problem is when to
re-order. The firm needs to identify a level of inventory, which can be reached
before an order needs to be placed.

The ROL is the quantity of inventory on hand when an order is placed.

Re-order level = maximum usage maximum lead-time.

The re-order level is the measure of inventory at which a replenishment order

should be made.
a) If an order is placed too late, the organisation may run out of inventory,
a stock-out, resulting in a loss of sales and/or a loss of production.
b) If an order is placed too soon, the organisation will hold too much
inventory, and inventory-holding costs will be excessive.

Maximum inventory level = re-order level + re-order quantity – (minimum

usage minimum lead time)

The maximum level acts as a warning signal to management that inventories

are reaching a potentially wasteful level.

Minimum inventory or buffer safety inventory = re-order level – (average

usage average lead time)

Average inventory = buffer safety inventory+ re-order amount

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This formula assumes that inventory levels fluctuate evenly between the
buffer safety (or minimum) inventory level and the highest possible inventory
level (the amount of inventory immediately after an order is received, safety
inventory and re-order quantity).

Test your understanding 5

A company has an inventory management policy, which involves ordering
50,000 units when the inventory level falls to 15,000 units. Forecast demand
to meet production requirements during the next year is 310,000 units. You
should assume a 50-week year and that demand is constant throughout the
year. Orders are received two weeks after being placed with the supplier.
What is the average inventory level?

Test your understanding 6

TS Co has daily demand for ball bearings of 40 a day for each of the 250

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 Managing working
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Inventory management
working days (50 weeks) of the year. The ball bearings are purchased from a
local supplier for $2 each. The cost of placing an order is $64 per order,
regardless of the size of the order. The inventory holding costs, expressed, as
a percentage of inventory purchase price, is 25% per annum.

What is the economic order quantity?

Test your understanding 7

Which of the following is NOT a drawback of the EOQ model?

i. Assumes certain or zero lead times.

ii. Assumes certainty in demand.
iii. Assumes a small number of close suppliers.
iv. Ignores hidden costs such as the risk of obsolescence.

Test your understanding 8

PKA Co is a European company that sells goods solely within Europe. The
recently-appointed financial manager of PKA Co has been investigating
working capital management objectives and the working capital management
of the company, and has gathered the following information about the
inventory policy

The current policy is to order 100,000 units when the inventory level falls to
35,000 units. Forecast demand to meet production requirements during the
next year is 625,000 units. The cost of placing and processing an order is
$250, while the cost of holding a unit in stores is $0.50 per unit per year. Both
costs are expected to be constant during the next year. Orders are received
two weeks after being placed with the supplier. You should assume a 50-
week year and that demand is constant throughout the year.

1. What are the objectives of working capital management at PKA?

1. To ensure that PKA Co has sufficient liquid resources

2. To increase PKA Co’s profitability
3. To ensure that PKA Co’s assets give the highest possible returns

A. 1 only
B. 1 and 2 only
C. 2 and 3 only

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 Managing working
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Inventory management 1

, 2 and 3

2. What is the current minimum inventory level at PKA Co?

3.What is the economic order quantity?

Test your understanding 9

Victory is a retailer, specialising in vitamin supplements and health foods
claimed to enhance performance. One of the products purchased by Victory
for resale is a performance enhancing vitamin drink called 'Buzz'.

Victory sells a fixed quantity of 200 bottles of Buzz per week. The estimated
storage costs for a bottle of Buzz are $2.00 per annum per bottle.

Delivery from Victory's existing supplier takes two weeks and the purchase
price per bottle delivered is $20. The current supplier charges a fixed $75
order processing charge for each order, regardless of the order size.

Victory has recently been approached by another supplier of Buzz with the
following offer:

1.The cost to Victory per bottle will be $19 each.

2.There will be a fixed order processing charge of $250 regardless of order
size.
3.Delivery time will be one week.
4.Victory estimates that due to packaging differences, the storage cost per
bottle will be $1.80 per annum per bottle.

Required

A. Assuming Victory continues to purchase from the existing supplier,

calculate:
i. Economic order quantity
ii. Reorder level
iii. Total cost of stocking Buzz for one year to the nearest $

B.
i. Calculate the economic order quantity if Victory changes to the new
supplier and determine if it would be financially viable to change to this
new supplier.
ii. Discuss TWO limitations of the above calculations and briefly describe
THREE other non- financial factors to be taken into account before a
final decision is made.

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 Managing working
capital C.
Inventory management E

xplain what is meant by a Just-in-Time (JIT) system and briefly describe

FOUR of its main features

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