CHAPTER 7

MANAGING
INVENTORIES
SÜREYYA YILMAZ –RA
Working Capital Management
2018
INVENTORY MANAGEMENT TECHNIQUES
• A firm’s inventory may take different forms. For instance, a
manufacturing firm’s inventory is likely to consist of raw
materials, which are inputs to the production process;
work in progress, which are unfinished goods that are in
the process of being produced at the time the balance
sheets are closed; and finished goods, which are goods
that the firm has produced and is ready to ship.
INVENTORY MANAGEMENT TECHNIQUES
• Retailers typically have only finished goods in their
inventory, as they do not add value through a
manufacturing process. And service firms generally have
no goods to store.
• Together with investments in cash holdings and
receivables, investment in inventory constitutes the main
operating investment of many firms.
Why is such an investment so important to a
firm?
• Well, inventory balances can help firms meet variation in
demand, as well as variation in the supply of raw
materials.
• They can also allow for flexibility in the production
schedule, and they can allow a firm to take advantage of
economies related to purchase order size. Yet not all
types of inventory are easy to turn into cash.
• Inventory management involves the setting of inventory
levels so as to maximize the benefits while minimizing the
costs of holding inventory.
• Inventory management is important to most firms, for a
diverse set of reasons. For example, firms that sell goods
associated with high obsolescence rates (e.g., high-
technology goods or goods related to fashion trends)
need to take care to not set inventory levels so high that
they could suffer significant losses in terms of inventory
obsolescence.
• In addition, firms that sell perishable goods need to avoid
inventory levels that far exceed short-term demand to
avoid losses from perished inventory.
• On the other hand, firms that sell goods that are hard to
access (e.g. because they take a long time to produce,
they require imported materials with a long backlog time,
etc.) need to manage inventory levels to avoid losing
sales.
So how does a firm go about managing its
inventory?
• There are many techniques for inventory management.
Some firms do not set an explicit inventory policy, but
instead purchase inputs or goods on an as-needed basis.
• If inputs or goods can be accessed immediately and
goods can be sold at once, this mechanism might work
efficiently. The effectiveness of such a system depends on
factors such as potential quantity discounts, which would
be missed if orders are in small lots, and potential costs of
stock-out.
• Other firms, in contrast, prefer to buy large quantities to
take advantage of size discounts and to avoid stock-out
problems. However, this strategy might involve storage
and obsolescence costs.
• Additionally, absent a mechanism to determine the
optimal size and composition of inventory, this technique
may lead to over investment problems, specifically, the
cost of financing larger-than-needed investment in
inventory.
• A third way firms can manage their inventory is to follow
the ABC approach . To do so, a firm divides its inventory
into three classes—A, B, and C—based on annual volume
in monetary terms (estimated as annual demand
multiplied by unit cost).
• Class A consists of items that have a large effect on total
inventory value, class B consists of items that have less of
an effect on inventory value, and class C includes items
that contribute little to total inventory value.
• Based on this classification, firms maintain tighter physical
control over the class A items, that is, those items that
contribute most to inventory value.
• In a fourth approach, many firms manage their inventory
by combining the previous technique with cycle counting.
• Cycle counting involves physically counting a subset of
the total stock of inventory at predetermined points in
time. This combined approach helps a firm maintain
accurate inventory records and identify and resolve
inventory stock-outs on a timely basis.
• Finally, the best-known approach for managing inventory
is the economic order quantity (EOQ) approach. This
mechanism is based on the idea of minimizing the total
costs associated with inventory investment.
MEASURING INVENTORY
• Before a firm can think about optimal investment in
inventory, it needs to define a sensible measure of its
inventory balances.
• The first of these (day of inventories and inventories
turnover) measures, days of inventory, is calculated by
dividing the inventory account on the assets side of the
balance sheet by the daily cost of goods sold (CGS); that
is:
• Days of inventory, is calculated by dividing the inventory
account on the assets side of the balance sheet by the
daily cost of goods sold (CGS); that is:

• This figure can be interpreted as the average number of

days a firm can continue selling based on the inventory it
has in its warehouse, or the average number of days it
takes a firm to turn over its inventory.
• This number varies across firms depending on
• (1) the characteristics of the good itself (e.g., whether it
suffers from quick obsolescence, whether it requires more
time to build, etc.),
• (2) the competitive environment of the industry (which will
determine, for example, potential losses from stock outs),
• (3) firms’ idiosyncratic strategies
• (4) firm size (e.g., to benefit from economies of scale, new
small firms may maintain higher levels of inventory
relative to their still modest sales than more mature firms
will need to maintain).
• Inventory turnover, is estimated as:

• This figure captures the number of times a company sells

its inventory during a given period of time (usually a year,
quarter, or month).
• A low inventory turnover ratio means that each dollar of
investment that the firm puts into the warehouse is not
efficient in generating sales, due perhaps to market
conditions (if it happens to the whole industry) or to a firm-
specific business strategy or inefficiency.
• To see the importance of this ratio, recall that profitability
is a function of both margin and turnover.
• Thus, turnover is especially important for firms that rely on
high turnover to generate profits.
• A more accurate estimate can be obtained by using CGS
instead of sales. Further, since sales (or CGS) is obtained
for the entire year, whereas inventory is evaluated at a
particular point in time, a more correct estimate can be
obtained by using the firm’s average inventory over the
year, especially for seasonal businesses.
• This discussion suggests that a more accurate expression
for the estimation of a firm’s inventory turnover would be:

• Nevertheless, managers tend to use the sales-to-

inventory ratio rather than this alternative expression.
An Accounting Perspective
• A firm’s inventory balance is linked to the firm’s
purchases, sales, and initial balances of inventory. More
formally, a firm’s inventory balance can be expressed by:

• Firms may choose from various methodologies to value

inventory sold and residual inventory, or inventory held as
operating assets.
• Three common approaches are the first in first out (FIFO),
last in first out (LIFO), and next in first out (NIFO)
approaches.
• If the firm uses the FIFO approach, the first goods sold
will be the first ones used to compute CGS. In an
inflationary environment, accounting systems using FIFO
will report lower costs of goods sold and higher margins
due to the use of old, lower CGS in the cost of sales.
• For the same reason, this method tends to overestimate
the value of residual inventory. The higher inventory
valuation associated with this approach can be useful if
the firm intends to use inventory as collateral when
pursuing financing choices.
• If the firm instead uses the LIFO approach, it will estimate
CGS assuming that the first goods sold were the last to
enter its inventory. This method allows the firm to compute
its CGS close to current market costs.
• If prices show increasing patterns (as they typically do),
the firm will report lower margins, which in turn usually
lead to a lower tax bill.
• Finally, if the firm follows the NIFO approach, CGS is
computed using the cost of the next good to be included
in the inventory. This approach can be thought of as a
more extreme version of the current market pricing
approach associated with the LIFO method.
• We note that a firm can value its inventory following other
methodologies, such as average costing (where CGS is
based on a combination of all the goods available in
inventory) and standard costing (where measures are
assessed relative to predetermined standards). However,
a more rigorous presentation of all possible choices is
beyond the scope of this book.
CARRYING COSTS AND SHORTAGE COSTS
• Inventory investment is associated with two chief types of
costs: carrying costs , which capture the direct costs,
including opportunity costs, of holding inventory, and
shortage costs which is associated with regenerated
stock’s cost.
• On the carrying cost side, one of the first types of direct
cost to come to mind is likely storage costs. Holding a stock
of inventory implies the use of space dedicated to this
purpose. Such space has to be bought or rented.
• Moreover, this space probably requires some complements
such as shelves, boxes, mechanical lifts, and, depending
on the product, even cooling or other specific equipment.
• Other common types of direct cost include handling costs
(i.e., the costs of tracking inventory) and security costs (i.e.,
the costs of ensuring that the goods are free of other
unexpected costs; e.g., insurance costs). Obsolescence
that causes value losses can also be thought of as a direct
cost of holding inventory.
• The presence of these two types of costs—carrying costs
and shortage costs—implies a trade-off that each firm
needs to analyze. The most practical way of solving the
resulting problem is to find the combination of these two
costs that minimizes their sum.
ECONOMIC ORDER QUANTITY
• The EOQ approach is based on the idea of minimizing the
sum of a firm’s carrying and shortage costs.
• As we discussed earlier, carrying costs are increasing in
inventory investment, whereas shortage costs are
decreasing in this investment. The aim of the EOQ model
is simply to find the minimum total cost.
• So how does this model work? We begin by looking at
expressions for carrying and shortage costs. Carrying
costs can be estimated as the firm’s average inventory
times per-unit carrying costs, C , or:
Carrying Costs = Average Inventory x C
• To estimate the firm’s average inventory, we need to
consider the EOQ’s assumptions about inventory
management.
• The EOQ model assumes that inventory is sold off at a
constant rate; once exhausted, it is returned to some
optimal level, Q* .
• The model also assumes instantaneous receipt of ordered
material. This selling and restocking process generates a
pattern like the one depicted in Figure 7.1 .
• With this average value of inventory, carrying costs can be
computed as:

• Easy! Now, what about shortage costs?

• Assuming that restocking costs (including the cost of
placing orders and other administrative costs) are fixed at,
say, F , total restocking costs can be computed as:
Shortage Costs = F X Number of Orders

• To perform this calculation, we need to estimate the

number of times the firm will have to restock during the
year.
• If the firm has an annual demand for inventory
material equal to D , and if the firm purchases
Q each time it places an order, the number of
orders during the year will be equal to D / Q .
• Therefore, total shortage costs can be
estimated as:
• Given estimates for both components of inventory costs,
we can now estimate the total costs of holding inventory
as:
• In the previous formula, Q is our decision
variable; that is, we need to determine the
optimum order quantity, Q * .
• All the other variables ( C, F , and D ) are data we
need to provide to solve the problem. Using
maximum and minimum identification techniques,
Q * can be obtained by solving:
• Naturally, the optimum order quantity is increasing in total
demand, D. Additionally, Q * is increasing in per-order
fixed costs, F; that is, the higher these costs are, the more
the firm will attempt to avoid them by ordering larger
quantities each time it places an order.
• Finally, Q* is decreasing in C, the per-unit carrying costs;
thus, the higher these costs are, the lower the investment
in inventory the firm will be willingto make.
• EOQ model described earlier assumes, among other things,
that restocking is performed when inventory is completely
exhausted. However, while in reality this might be ideal (it
would help in minimizing average holdings), it is usually not
the case. Indeed, it is common to find firms placing orders
according to some predetermined lead time .
.
• Taking such behavior into account would naturally alter
our previous results, but the basic idea remains the same:
the order will be placed not at the time when inventory
reaches zero, but at a given lead time before the zero
boundary is reached.
• Similarly, the model can be adjusted to allow firms with
high potential stock-out costs to set pre-established safety
inventory levels that trigger new orders when such
thresholds are reached
INVENTORY AND HEDGING
• Inventory holdings can also help guard against
unfavorable changes in the price of raw materials, due, for
instance, to changes in commodity prices or to inflation.
Indeed, some firms go so far as to decide that, due to the
nature of their business, they do not want to hold any raw
material price risk and thus they purchase and maintain in
their inventory all their product needs for an entire project.
• This sort of hedging practice is quite common in the case
of construction projects, especially if the firm has agreed
to deliver the project at a fixed price.
OPTIMAL INVENTORY LEVELS
• Thus far we have discussed many factors that a firm
should consider in setting optimal inventory levels. Note
that we could add to the aforementioned criteria other
factors that may also be relevant to the management of
inventory.
• For example, if a firm produces and sells components for
replacement purposes, then it will probably need to hold a
much larger inventory than a similar firm that sells the
same components to original equipment manufacturers.
• Consider the case of a firm that sells auto parts for
replacement purposes: this firm will probably need to keep
in its inventory not only those components used in current
models but also those used in still-in-use older cars.
• Similarly, if a firm produces and sells within a highly
seasonal framework, then its optimal inventory will
depend on whether it employs seasonal or level
production systems.
CONCLUSION

• In this chapter, we started by discussing the importance of

efficient inventory management. The first part of the
chapter stressed the fact that, like other assets, inventory
is an investment and as such needs to be financed by the
firm.
• Next, we presented the main factors affecting firms’
inventory policies. Finally, we considered some of the
hedging implications of holding inventory, and we
provided a summary discussion on various factors
relevant to identifying optimal inventory balances.
NEXT WEEK
• CHAPTER 8 & 9