1

Managing inventories

capital

Chapter

22

2

22.1 Inventories

Retailers buy stock or inventory and sell it to customers; manufacturers buy raw material and
components, manufacturing or assembling goods and then selling these finished goods downstream
e.g. later in the supply chain, towards the ultimate consumer or customer.

Stock / inventories

Raw material

Materials and components used to manufacture or assemble finished

goods.

Work-in-progress

Incomplete finished goods e.g. finished goods which require further

work before they can be sold to customers.

Finished goods

Fully completed (manufactured) goods ready for sale.

Consumables

Disposable tools or materials used for the production e.g. lubricants or

cleaning material for machines, disposable tools or equipment.

Managing the procurement of raw material and components into the production process of an
organisation can be a major and complex process. Many organisations operate within just in time
(JIT) environments, attempting to minimise material inventory and handling, this typically requires
effective communication and good systems to allow uninterrupted flow of production. The
relationship between purchasing and other departments is a very important one; it ensures
inventory arrives at the right place, right time, right quality, right quantity and the right price.

Holding large levels of inventory enables an organisation to be more flexible to meet surges in
demand e.g. offer customers a large variety of goods and ‘immediately’, however holding large
levels of inventory can be very expensive.

Advantages of holding inventory

ü Discounts for bulk buying e.g. order higher volumes but less frequently
ü Reduction in transaction costs if buying higher volume but less frequently
ü Continuity of production e.g. avoids stock-outs and costly hold ups
ü Flexibility to meet surges in customer demand
ü Avoidance of price rises e.g. buy larger quantities when the price is lower

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Disadvantages of holding inventory

Higher risk of damage, deterioration and theft
Higher risk of stock obsolescence
Opportunity cost of money or cash tied up

Subsequent price reductions maybe be missed
Storage and administration cost of support e.g. warehousing, staff and systems


22.2 Costs of holding inventory

Inventory will always need to be held in a business to meet demand. But holding inventory costs
money.

Total cost of holding inventory

· Purchase price – the amount that was paid for the inventories

· Holding costs - These include storage costs, insurance costs, cost of deterioration and

damage, warehouse costs, labour and admin costs

· Re-order costs – these include administrative and transportation costs

· Shortage costs - these include cost of loss of sales, additional extra costs for emergency

orders. There could also be a long term loss of reputation to the business as a result of this.

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22.3 Inventory control systems

Inventory control systems are put in place by companies to ensure that there is enough stock held
which minimises costs without disrupting business.

4 main systems of stock policy are:

Reorder level

systems

Periodic review

systems

Economic order

quantity

(EOQ)

ABC system

Whenever the

current stock level

falls below a

standard reorder

level, a new order is

placed for a fixed

amount in order to

replenish stock.

Stock levels are

reviewed at

predetermined

intervals of time e.g.

1

st

day of each month.

Orders for stock will

be placed after

review.

The EOQ model

determines a fixed

quantity of stock to

order which would

minimise the total of

holding and ordering

cost.

High value (A)

Medium value (B)

Low value (C)

A fixed quantity is
ordered at variable

intervals of time.

A variable or fixed

quantity is ordered at

fixed intervals of

time.

A fixed quantity is
ordered at variable

intervals of time.

Higher value

items are

reviewed more

frequently and

controlled by a

greater extent than

low value items.

5

22.4 Economic order quantity (EOQ)

A mathematical calculation for a fixed quantity of inventory ordered each time (the EOQ), that
would minimise the total of holding and ordering cost. EOQ is an example of a continuous
inventory system.

EOQ model terminology

Lead time

How long it takes for the goods to be delivered once the order

has been placed.

Demand

The amount of inventory required to meet demand.

Stock-outs

When inventory actually runs out.

Reorder level

The level of inventory in hand before a new order is placed.

Buffer inventory

The minimum amount of inventory held at all times.

Maximum inventory

level

The most amount of inventory held at any time. Actual

inventory levels must not exceed this maximum level.

Assumptions of EOQ

· The level of customer demand is known

· The level of customer demand occurs at an even rate over time

· Constant purchase price of inventory

· A fixed cost exists for each order placed

· The lead time for inventory is constant e.g. how long it takes for inventory to be delivered

once an order has been placed

The formula for EOQ

EOQ =

2 x C

O

x D

C

H

Where

D

=

Annual demand (units)

C

O

=

Fixed cost for each order placed

C

H

=

Cost of holding one unit in stock for one year (this may include

a cost of capital for money’ tied up’ in the value inventory)

6

Note: At the EOQ point, the stock holding cost and ordering cost will be equal.

· Holding cost rises when the size of order increases. This is because a higher level of

average stock will be kept throughout the year. The holding cost would include the cost of
warehousing, staff and systems to support and maintain inventory, also the cost of
insurance, obsolescence, damage, deterioration and theft, even the cost of money or cash
tied up e.g. cost of capital, which is the opportunity cost of investing in inventory.

· Ordering cost falls when the size of order increases. This is because if the size of order

increases for the same quantity of inventory purchased annually, then less orders and
therefore administration cost would be required e.g. staff, paperwork, phone calls etc.

Example 22.1

Saffy Ltd manufactures a product called whatzits, which requires material X. Every year 3,000
units of material X are required. The cost of placing an order for material X is £200, and the cost
of holding one unit of material X for a year is £42. The cost of one unit of material X is £20.

(a)

What is the EOQ from material X assuming a 52-week?

(b)

What is the average frequency at which the purchase orders should be placed?

Cost
(£)

Holding Cost

£

Order Cost

EOQ

Quantity (size) of order

7

With the above example the ordering costs and holding costs for the whole year are as follows:

Annual ordering costs = {D x Co}/EOQ

Annual holding costs = {1/2 x EOQ x Ch}

Annual ordering costs

=

{3,000 x £200}/ 169

=

£3,550

Annual holding costs

=

½ x 169 x £42

=

£3,550

Note that with the holding costs, the average stock held is used (therefore need to half it). The 2
costs are equal.

The total annual costs

= annual ordering cost + annual holding cost + purchase cost

The total annual costs

=

£3,550 + £3,550 + (3,000 x £20)

=

£67,100

EOQ and quantity discounts

Suppliers may offer discounts for large orders placed. The question is do we take up the discount
offer and order above our EOQ? Obviously the total annual ordering costs will reduce, if the order
size is bigger, however the holding costs will increase.

The total annual costs of both the options needs to be calculated to establish which one is the best
option.

Example 22.2

Following on from the previous example, the suppliers of material X have offered a 5%
discount on the purchase price on all orders above 250 units.

Determine whether Saffy Ltd should take up the discount offer?

8

Example 22.3

Lucas Limited purchases 25,000 litres of a material each year from a single supplier. At the
moment, the company obtains the material in batch sizes of 800 litres.

The material costs £16 per litre
The cost of ordering a new batch from the supplier is £32
The cost of holding one litre of inventory is £4 per unit plus 15% of the purchase price of the
material.

Calculate the economic order quantity and the annual savings, which would be obtained
if this order quantity replaced the current order size of litres.


22.5 Just In Time (JIT) purchasing

The JIT philosophy requires that products should only be produced if there is an internal or
external customer waiting for them. It aims ideally for zero stock e.g. raw materials delivered
immediately at the time they are needed, no build up of work-in-progress in production and
finished goods only produced if there is a customer waiting for them. This means cash is not tied
up unnecessarily within raw material, work-in-progress or finished goods stock, allowing more
effective cash flow management for the organisation. This ensures that minimum level of
inventory is held, thereby reducing costs. JIT is a crucial part of total quality management systems.
JIT is an example of a chase demand strategy for balancing capacity (supply) and demand.

With a JIT system of purchasing inventories, the goods are only purchased when they are needed.
For this system to work, the following are crucial:

1. Closer relationships with suppliers maintained
2. Smaller and more frequent deliveries to plan and administrate
3. Higher quality machines with regular maintenance to avoid delays
4. Involvement and training of staff to maintain flexibility

If an organisation implements JIT, then it won’t be using EOQ model to order goods.

Benefits of JIT

· Lower stock is held and so there are cost savings in holding costs.

· Increased space in storage available to be used for other more productive activities.

· Smaller deliveries are easier to handle for staff.

· Products will be of a higher quality as there will be more time to focus on getting it right

the first time.

· More time to deal with other weaknesses in the inventory supply system such as reliability,

lead time and quality of supplies.

· Increased flexibility to deal with other one off special orders.

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Limitations of JIT

· The initial capital cost of implementing JIT will be substantial.

· Training will be required to all staff which may cause disruption.

· Very close relationships must be maintained with the suppliers, which may not always

occur and therefore disruption in goods being delivered.

· A detailed business process needs to be undertaken and better quality machinery purchased

which will add to cost.

· Any disruption to deliveries will have a major impact on sales as goods cannot be delivered

to customers.

22.6 Centralised versus decentralised purchasing

For a company with various locations, a decision needs to be taken as to who does the ordering of
goods. Are they purchased locally (decentralised) or is done centrally through head office? The
purchasing function is very important to inventories as the right mix of quantity, quality, price and
delivery times.

Centralised purchasing

Decentralised purchasing

Advantages

Advantages

All goods are purchased centrally enabling

bulk purchases and therefore larger

discounts.

Purchasing is done locally, and the prices

and quantities are decided locally.

Better credit terms can be negotiated with

large purchases.

Local purchasing may be of a better quality
than centralised purchasing, with the use of

different suppliers.

Less staff will be required therefore saving

costs.

Local purchasing is more flexible, and local

purchasing department will be able to

respond quickly to low stock levels and

favourable prices.

Better control systems can be established

centrally with specialist staff.

Disadvantages

Disadvantages

Central purchasing can be de-motivating for

local staff as there is less empowerment

Quality of goods will vary across the

locations

There may be better quality goods and prices

available locally

Won’t be able to take advantage of bulk

discounts

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Key summary of chapter

Raw material

Materials and components used to manufacture or assemble finished

goods.

Work-in-progress

Incomplete finished goods e.g. finished goods which require further

work before they can be sold to customers.

Finished goods

Fully completed (manufactured) goods ready for sale.

Consumables

Disposable tools or materials used for the production e.g. lubricants or

cleaning material for machines, disposable tools or equipment.

Total cost of holding inventory

· Purchase price – the amount that was paid for the inventories

· Holding costs - These include storage costs, insurance costs, cost of deterioration and

damage, warehouse costs, labour and admin costs

· Re-order costs – these include administrative and transportation costs

· Shortage costs - these include cost of loss of sales, additional extra costs for emergency

orders. There could also be a long term loss of reputation to the business as a result of this.

11

The formula for EOQ

EOQ =

2 x C

O

x D

C

H

Where

D

=

Annual demand (units)

C

O

=

Fixed cost for each order placed

C

H

=

Cost of holding one unit in stock for one year (this may include

a cost of capital for money’ tied up’ in the value inventory)

Reorder level

systems

Periodic review

systems

Economic order

quantity

(EOQ)

ABC system

Whenever the current

stock level falls below

a standard reorder

level, a new order is

placed for a fixed

amount in order to

replenish stock.

Stock levels are

reviewed at

predetermined intervals

of time e.g. 1

st

day of

each month. Orders for

stock will be placed

after review.

The EOQ model

determines a fixed

quantity of stock to

order which would

minimise the total of

holding and ordering

cost.

High value (A)

Medium value (B)

Low value (C)

A fixed quantity is
ordered at variable

intervals of time.

A variable or fixed

quantity is ordered at

fixed intervals of time.

A fixed quantity is
ordered at variable

intervals of time.

Higher value items

are reviewed more

frequently and

controlled by a

greater extent than

low value items.

12

Annual ordering costs = {D x Co}/EOQ

Annual holding costs = {1/2 x EOQ x Ch}

The total annual costs

= annual ordering cost + annual holding cost + purchase cost

Cost
(£)

Holding Cost

£

Order Cost

EOQ

Quantity (size) of order

13

The JIT philosophy requires that products should only be produced if there is an internal or

external customer waiting for them. It aims ideally for zero stock

1. Closer relationships with suppliers maintained
2. Smaller and more frequent deliveries to plan and administrate
3. Higher quality machines with regular maintenance to avoid delays
4. Involvement and training of staff to maintain flexibility

Centralised versus decentralised purchasing

For a company with various locations, a decision needs to be taken as to who does the ordering of
goods. Are they purchased locally (decentralised) or is done centrally through head office? The
purchasing function is very important to inventories as the right mix of quantity, quality, price and
delivery times.

14

Solutions to Lecture Examples

Example 22.1

(a)

EOQ = sq root of

2 x C

O

x D

= sq rt of 2 x £200 x 3,000 = 169 units

C

H

£42

(b)

Weekly demand = 3,000 / 52 weeks =

57 units

So each order of 169 units will last 169 / 57 =

3 weeks frequency of orders

Example 22.2

Order size 250 (

\ number of orders pa = 3,000 / 250 = 12)

Annual ordering costs = {demand x Co}/quantity = (3,000 x £200) / 250 = £ 2,400

Annual holding costs = {1/2 x quantity x Ch}= ½ x 250 x £42

= £ 5,250

Annual purchase cost = 3,000 units x £20 x 95%

= £57,000

Total annual cost with 250 order size

= £64,650

Total annual costs with EOQ of 169

=£67,100

Therefore the discount is worth taking with annual savings of {67,100 – 64,650} = £2,450




Example 22.3

a)

Identify the equation elements

D

=

Annual demand

25,000

C

O

=

Cost of placing one order

£32

C

H

=

Holding cost

£4 + (15% x £16 = £2.40)

EOQ = sq root of 2 x 32 x 25,000 / (6.40)

=

500 litres per order

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Annual savings – compare holding costs and ordering costs for 800 litres and 500 litres

800 litres

500 litres

Holding costs

½ x 800 x 6.4 = 2,560

½ x 500 x 6.4 =

1,600

Ordering costs

25k / 800 x £32 = 1,000

25k / 500 x £32=

1,600

Total

3,560

3,200

Therefore annual savings will be £3,560 - £3,200 = £360