INVENTORY FUNDAMENTALS

INVENTORY FUNDAMENTALS

INTRODUCTION

Inventories are materials and supplies that a business or institution carries either for sale or to provide inputs or supplies to the production process.  All businesses and institutions require inventories.  Often are a substantial part of total assets.

Financially, inventories are very important to manufacturing companies.  On the balance sheet, they usually represent from 20% to 60% of total assets.  As inventories are used, their value is converted into cash, which increases operating costs and decreases profits.  Good inventory management is essential.

Inventory management is responsible for planning and controlling inventory from the raw material stage to the customer.  Since inventory either results from production or supports it, the two cannot be managed separately and, therefore, must be coordinated. Inventory must be considered at each of the planning levels and is thus part of production planning, master production scheduling, and material requirements planning.  Production planning is concerned with overall inventory, master planning with end items, and material requirements planning with component parts and raw material.

INVENTORY AND THE FLOW OF MATERIAL

There are many ways to classify inventories.  One often-used classification is related to the flow of materials into, through, and out of a manufacturing organization.

·         Raw materials. These are purchased items received that have not entered the production process.  They include purchased materials, component parts, and subassemblies.

·         Work-in-process (WIP).  Raw materials that have entered the manufacturing process and are being worked on or waiting to be worked on.

·         Finished goods.  The finished products of the production process that are ready to be sold as completed items.  They may be held at a factory or central warehouse or at various points in the distribution system.

·         Distribution inventories.  Finished goods located in the distribution system.

·         Maintenance, repair, and operational supplies (MROs).  Items used in production that do not become part of the product.  These include hand tools, spare parts, lubricants, and cleaning supplies.

Classification of an item into a particular inventory depends on the production environment.  For instance, sheet steel or tires are finished goods to the supplier but are raw materials and component parts to the car manufacturer.

FUNCTIONS OF INVENTORIES

In batch manufacturing, the basic purpose of inventories is to decouple supply and demand.  Inventory serves as a buffer between:

·         Supply and demand

·         Customer demand and finished goods

·         Finished goods and component availability

·         Requirements for an operation and the output from the preceding operation

·         Parts and materials to begin production and the suppliers of materials

Based on this, inventories can be classified according to the function they perform.

·         ANTICIPATION INVENTORY.  Anticipation inventories are built up in anticipation of future demand.  For example, they are created ahead of a peak selling season, a promotion program, vacation shutdown, or possibly the threat of a strike.  They are built up to help level production and to reduce the costs of changing production rates.

·         FLUCTUATION INVENTORY (SAFETY STOCK).  Fluctuation inventory is held to cover random unpredictable fluctuations in supply and demand or lead time.  If demand or lead time is greater than forecast, a stockout will occur.  Safety stock is carried to protect against this possibility.  Its purpose is to prevent disruptions in manufacturing or deliveries to customers.  Safety stock is also called buffer stock or reserve stock.

·         LOT-SIZE INVENTORY.  Items purchased or manufactured in quantities greater than needed immediately create lot-size inventories.  This is to take advantage of quantity discounts; to reduce shipping, clerical, and setup costs; and in cases where it is impossible to make or purchase items at the same rate that they will be used or sold.  Lot-size inventory is sometimes called cycle stock.  It is the portion of inventory that depletes gradually as customers orders come in and is replenished cyclically when suppliers´ orders are received.

·         TRANSPORTATION INVENTORY.  Transportation inventories exist because of the time needed to move goods from one location to another such as from a plant to a distribution center or a customer.  They are sometimes called pipeline or movement inventories.  The average amount of inventory in transit is:  I=tA/365.  Where I is the average annual inventory in transit, t is transit time in days, and A is annual demand.  Notice that the transit inventory does not depend upon the shipment size but on the transit time and the annual demand.  The only way to reduce the inventory in transit, and its cost, is to reduce the transit time.

EXAMPLE PROBLEM

Delivery of goods from a supplier is in transit for 10 days.  If the annual demand is 5200 units, what is the average annual inventory in transit?

ANSWER

I=10X5200/365=142.5units

The problem can be solved in the same way using dollars instead of units.

·         HEDGE INVENTORY.  Some products such as a minerals and commodities – for example, grains or animal products – are traded on a worldwide market.  The price for these products fluctuates according to world supply and demand.  If buyers expect prices to rise, they can purchase hedge inventory when prices are low.  Hedging is complex and beyond the scope of this text.

·         Maintenance, repair, and operating supplies (MROs).  MRO are items used to support general operations and maintenance but  that do not become directly part of a product.  They include maintenance supplies, spare parts, and consumables such as cleaning compounds, lubricants, pencils, and erasers.

FINANCIAL INVENTORY PERFORMANCE MEASURES

From a financial point of view, inventory is an asset and represents money that is tied up and cannot be used for other purposes. As we saw previously in this chapter, inventory has a carrying cost – the costs of capital, storage, and risk. Finance wants as little inventory as possible and needs  some measure of the level of inventory. Total inventory investment is one measure,  but in itself does not relate to sales. Two measures that do relate to sales are the inventory turns ratio and days of supply.

INVENTORY TURNS

Ideally, a manufacturer carries no inventory.  This is impractical, since inventory is needed to support manufacturing and often to supply customers.  How  much inventory is enough? There is no one answer.  A convenient measure of how effectively inventories are being used is the inventory turns ratio: inventory turns = annual costs of goods sold / average inventory in dollars.

The calculation of average inventory can be complicated and is a subject for cost accounting.  In this text it will be taken as a given.

For example, if the annual cost of goods sold is $1 million and the average inventory is $500,000, then:

Inventory turns= $1milion/$500,000=2

What does this mean? At the very least, it means that with $500,000 of inventory a company is able to generate $1 million in sales.  If, through better materials management, the firm is able to increase its turns ratio to 10, the same sales are generated with only $100,000 of average inventory.  If the annual cost of carrying inventory is 25% of the inventory value, the reduction of $400,000 in inventory results in a cost reduction (and profit increase) of $100,000.

EXAMPLE PROBLEM

1.       What will be the inventory turns ratio if the annual cost of goods sold is $24 million a year and the average inventory is $6 million?

ANSWER

Inventory turns = annual cost of goods sold/average inventory in dollars

IT=24,000,000/6,000,000=4

2.       What would be the reduction in inventory if inventory turns were increased to 12 times per year?

ANSWER

Average inventory = annual cost of goods sold / inventory turns

AI=24,000,000/12=2,000,000

Reduction in Inventory = 6,000,000 – 2,000,000 = 4,000,000

3.       If the cost of carrying inventory is 25% of the average inventory, what will the savings be?

ANSWER

Reduction in inventory = $4million

Savings = $4million X 0.25 = $1 million

DAYS OF SUPPLY

Is a measure of the equivalent number of days of inventory on hand, based on usage.  The equation to calculate the days of supply is: DAYS OF SUPPLY= INVENTORY ON HAND/ AVERAGE DAILY USAGE.

EXAMPLE PROBLEM

A company has 9000 units on hand and the annual usage is 48,000 units.  There are 240 working days in the year.  What is the days of supply?

ANSWER

Average daily savings = 48,000/240=200units

Days of supply = inventory on hand / average daily usage = 9000/200 = 45 days

METHODS OF EVALUATING INVENTORY

There are four methods accounting uses to “cost” inventory: first in first out, last in first out, average cost, and standard cost.  Each has implications for the value placed on inventory. If there is little change in the price of an item,  any of the fours ways will produce about the same results.  However, in rising of falling prices, there can be a pronounced difference.  There is no relationship with the actual physical movement of actual items in any of the methods. Whatever method is used is only to account for usage.

First in first out (FIFO). This method assumes that the oldest (first) item in stock is sold first. In rising prices, replacement is at a higher price than the assumed cost.  This method does not reflect current prices, and replacement will be understated. The reverse is true in a falling price market.

Last in first out (LIFO). This method assumes the newest (last) item in stock is the first sold.  In rising prices, replacement is at the current price.  In a falling price market existing inventory is overvalued. However, the company is left with an inventory that may be grossly understated in value.

Average cost.  This method assumes an average of all prices paid for the article. The problem with this method in changing prices (rising or falling) is that the cost used is not related to the actual cost.

Standard cost.  This method uses cost determined before production begins.  The cost includes direct material, direct labor, and overhead.  Any difference between the standard cost and actual cost is stated as a variance.

ABC INVENTORY CONTROL

Control of inventory is exercised by controlling individual items, which is called stock-keeping units (SKUs).  In controlling inventory, four questions must be answered:

1. What is the importance of the inventory item?
2. How are they to be controlled?
3. How much should be ordered at one time?
4. When should an order be placed?

The ABC inventory classification system answers the first two question by determining the importance of items and thus allowing different levels of control based on the relative  importance of items.

Most companies carry a large number of items in stock.  To have better  control at a reasonable cost, it is helpful to classy fy the items according to their importance.  Usually this is based on annual dollar usage, but other criteria may be used.

The ABC principle is based on the observation that a small number of items often dominate the results achieved in any situation.  This observation was first made by an Italian economist, Vilfredro Pareto, and is called Pareto´s Law.  As applied to inventories, it is usually found that the relationship between the percentage of items and the percentage of annual dollar usage follows a pattern in which three groups can be defined:

GROUP A            About 20% of the items account for about 80% of the dollar usage.

GROUP B            About 30% of the items account for about 15% of the dollar usage.

GROUP C            About 50% of the items account for about 5% of the dollar usage.

The percentages are approximate and should not be taken as absolute.  This  type of distribution can be used to help control inventory.

STEPS IN MAKING AN ABC ANALYSIS

1. Establish the item characteristics that influence the results of inventory management.  This is usually annual dollar usage but may be other criteria, such as scarcity of material.
2. Classify items into groups based on the established criteria.
3. Apply a degree of control in proportion to the importance of the group.

The factors affecting the importance of an item include annual dollar usage, unit cost, and scarcity of material.  For simplicity, only annual dollar usage is used in this text.  The procedure for classifying by annual dollar usage is a follows:

1. Determine the annual usage for each item.
2. Multiply the annual usage of each item by its cost to get is total annual dollar usage.
3. List the items according to their annual dollar usage.
4. Calculate the cumulative annual dollar usage and the cumulative percentage of items.
5. Examine the annual usage distribution and group the items into A, B, and C groups based on percentage of annual usage.

EXAMPLE PROBLEM

A company manufactures a line of ten items.  The usage and unit cost are shown in the following table, along with the annual dollar usage.  The latter is obtained by multiplying the unit usage by the unit cost.

a)      Calculate the annual dollar usage for each item.

b)      List the items according to their annual dollar usage.

c)       Calculate the cumulative annual dollar usage and the cumulative percentage of items.

d)      Group items into an A, B, C classification.

ANSWER

a)      Calculate the annual dollar usage for each item.

PART NUMBER	UNIT USAGE	UNIT COST $	ANNUAL $ USAGE
1	1100	2	2200
2	600	40	24000
3	100	4	400
4	1300	1	1300
5	100	60	6000
6	10	25	250
7	100	2	200
8	1500	2	3000
9	200	2	400
10	500	1	500
TOTAL	5510		38250

b)      b, c, and d.

PART NUMBER	ANNUAL $ USAGE	CUMULATIVE $ USAGE	CUMULATIVE %$ USAGE	CUMULATIVE % OF ITEMS	CLASS
2	24000	24000	62.75	10.	A
5	6000	30000	78.43	20	A
8	3000	33000	86.27	30	B
1	2200	35200	92.03	40	B
4	1300	36500	95.42	50	B
10	500	37000	96.73	60	C
9	400	37400	97.78	70	C
3	400	37800	98.82	80	C
6	250	38050	99.48	90	C
7	200	38250	100.00	100	C

CONTROL BASED ON ABC CLASSIFICATION

Using the ABC approach, there are two general rules to follow:

1. Have plenty of low-value items.  C items represent about 50% of the items but account for only about 5% percent of the total inventory value.  Carrying extra stock of C items adds little to the total value of the inventory.  C items are really only important if there is a shortage of one of them – when they become extremely important – so a supply should always be on hand.  For example, order a year´s supply at a time and carry plenty of safety stock. That way there is only once a year when a stockout is even possible.
2. Use the money and control effort saved to reduce the inventory of high-value items.  A items represent about 20% of the items and account for about 80% of the value. They are extremely important and deserve the tightest control and the most frequent review.

Different controls used with different classifications might be the following:

• A items: high priority.  Tight control including complete accurate records, regular and frequent review by management, frequent review of demand forecasts, and close follow-up and expediting to reduce lead time.
• B items: medium priority.  Normal controls with good records, regular attention, and normal processing.
• C items: lowest priority.  Simplest possible controls – make sure there are plenty.  Simple or no records; perhaps use a two-bin system or periodic review system. Order large quantities and carry safety stock.

INVENTORY RECORD ACCURACY

The usefulness of inventory is directly related to its accuracy.  Based on the inventory record, a company determines net requirements for an item, releases orders based on material availability, and performs inventory analysis.  If the records are not accurate, there will be shortages of material, disrupted schedules, late deliveries, lot sales, low productivity,  and excess inventory (of the wrong things).

These three pieces of information must be accurate: part description (part number), quantity, and location. Accurate inventory records enable firms to:

• Operate an effective materials management system.  If inventory records are inaccurate, gross-to-net calculations will be in error.
• Maintain satisfactory customer service.  If records show an item is in inventory when it is not, any order promising that item will be in error.
• Operate effectively and efficiently. Planners can plan, confident that the parts will be available.
• Analyze inventory.  Any analysis of inventory is only as good as the data it is based on. 

Inaccurate inventory records will result in:

• Lost sales.
• Shortages and disrupted schedules.
• Excess inventory (of the wrong things).
• Low productivity.
• Poor delivery performance.
• Excessive expending, since people will always be reacting to a bad situation rather than planning for the future.

CAUSES OF INVENTORY RECORD ERRORS

Poor inventory record accuracy can be caused by many things, but they all result from poor record-keeping systems and poorly trained personnel. Some examples of causes of inventory record error are:

• Unauthorized withdrawal of material.
• Unsecured stockroom.
• Poorly trained personnel.
• Inaccurate transaction recording.  Errors can occur because of inaccurate piece counts, unrecorded transactions, delay in recording transactions, inaccurate material location, and incorrectly identified parts.
• Poor transaction recording systems.  Most systems today are computer based and can provide the means to record transactions properly.  Errors, when they occur, are usually the fault of human input to the system.  The documentation reporting system should be designed to reduce the likelihood of human error.
• Lack of audit capability.  Some program of verifying the inventory counts and locations is necessary. The most popular one today is cycle counting, discussed in the next section.

MEASURING INVENTORY RECORD ACCURACY

Inventory accuracy ideally should be 100%.  Banks and other financial institutions reach this level.  Other companies can move toward this potential.

FIGURE 12.3 SHOWS 10 INVENTORY ITEMS, THEIR PHYSICAL COUNT, AND THE QUANTITY SHOWN ON THEIR RECORD. WHAT IS THE INVENTORY ACCURACY? THE TOTAL OF ALL ITEMS IS THE SAME , BUT ONLY 2 ON THE 10 ARE CORRECT.  IS THE ACCURACY 100% OR 20% OR SOMETHING ELSE?

PART NUMBER	INVENTORY RECORD	SHELF COUNT
1	100	105
2	100	100
3	100	98
4	100	97
5	100	102
6	100	103
7	100	99
8	100	100
9	100	97
10	100	99
TOTAL	1000	1000

TOLERANCE

To judge inventory accuracy, a tolerance level for each part must be specified.  For some items, this may mean no variance; for others, it may be very difficult or costly to measure and control to 100% accuracy.  An example of the latter might be nuts or bolts ordered and used in the thousands.  For these reasons, tolerances are set for each item.  Tolerance is the amount of permissible variation between an inventory record and a physical count.

Tolerances are set on individual items based on value, critical nature of the item, availability, lead time, ability to stop production, safety problems, or the difficulty of getting precise measurement.

FIGURE 12.4 SHOWS THE SAME DATA AS THE PREVIOUS FIGURE BUT INCLUDES TOLERANCES. THIS INFORMATION TELLS US EXACTLY WHAT INVENTORY ACCURACY IS.

PART NUMBER	INVENTORY RECORD	SHELF COUNT	TOLERANCE	WITHIN TOLERANCE	OUTSIDE TOLERANCE
1	100	105	+ - 5%	X
2	100	100	+ - 0%	X
3	100	98	+ -3%	X
4	100	97	+ -2%		X
5	100	102	+ -2%	X
6	100	103	+ -2%		X
7	100	99	+ -3%	X
8	100	100	+ -0%	X
9	100	97	+ -5%	X
10	100	99	+ -5%	X
TOTAL	1000	1000

EXAMPLE PROBLEM

Determine which of the following items are within tolerance.  Item A has a tolerance of + -5%; item B, + -2%; item C, + -3%; and item D, + -0%.

PART NUMBER	SHELF COUNT	INVENTORY RECORD	TOLERANCE
A	1500	1550	+ -5%
B	120	125	+ -2%
C	225	230	+ -3%
D	155	155	+ -0%

ANSWER

ITEM A. With a tolerance of + -5%, variance can be up to + -75 units. Item A is within tolerance.

ITEM B. With a tolerance of + -2%, variance can be up to + -2 units. Item B is outside tolerance.

ITEM C. With a tolerance of + -3%, variance can be up to + -7 units, Item C is within tolerance.

ITEM D. With a tolerance of + -0%, variance can be up to + -0 units, Item D is within tolerance.

AUDITING INVENTORY RECORDS

Errors occur, and they must be detected so inventory accuracy is maintained.  There are two basic methods of checking the accuracy of inventory records: periodic (usually annual) counts of all items and cyclic (usually daily) counts of specified items.  It is important to audit record accuracy, but it is more important to audit the system to find the causes of record inaccuracy and eliminate them.  Cycle counting does this; periodic audits tend not to.

Periodic (annual) inventory.  The primary purpose of a periodic (annual) inventory is to satisfy the financial auditors that the inventory records represent the value of the inventory.  To planners, the physical inventory represents an opportunity to correct any inaccuracies in the records.  Whereas financial auditors  are concerned with the total value of the inventory, planners are concerned with item detail.

The responsibility for taking the physical inventory usually rests with the materials manager who should ensure that a good plan exists and it is followed.  George Plossl once said that taking a physical inventory was like painting: the results depend on good preparation.  There are three factors in good preparation: housekeeping, identification, and training.

HOUSEKEEPING.  Inventory must be sorted and the same parts collected together so they can easily be counted.  Sometimes items can be precounted and put into sealed cartons.

IDENTIFICATION.  Parts must be clearly indentified and tagged with part numbers.  This can, and should, be done before the inventory is taken.  Personnel who are familiar with parts identification should be involved and all questions resolved before the physical inventory starts.

TRAINING.  Those who are going to do the inventory must be properly instructed and trained in taking inventory.  Physical inventories are usually taken once a year, and the procedure is not always remembered from year to year.

Process.  Taking a physical inventory consists of four steps:

1.       Count items and record the count on a ticket left on the item.

2.       Verify this count by recounting or by sampling.

3.       When the verification is finished, collect the tickets and list the items in each department.

4.       Reconcile the inventory records for differences between the physical count and inventory dollars.  Financially, this step is the job of accountants, but materials personnel are involved in adjusting item records to reflect what is actually on hand.  If major discrepancies exist, they should be checked immediately.

Taking a physical inventory is a time-honored practice in many companies mainly because it has been required for an “accurate” appraisal of inventory value for the annual financial statements.  However, taking an annual physical inventory presents several problems. Usually  the factory has to be shut down, thus losing production; labor and paperwork are expensive; the job is often done hurriedly and poorly since there is doing the inventory are not used to the job and are prone to making errors.  As a result, more errors often are introduced into the records than are eliminated.

Because of these problems, the idea of cycle counting has developed.

Cycle counting.  Cycle counting is a system of counting inventory continually throughout the year.  Physical inventory counts are scheduled so that each item is counted on a predetermined schedule.  Depending on their importance, some items are counted frequently throughout the year whereas others are not.  The idea is to count selected items each day.

The advantages to cycle counting are:

• Timely detection and correction of problems.  The purpose of the count is first to find the cause of error and then to correct the cause so the error is less likely to happen again.
• Complete or partial reduction of lost production.
• Use of personnel trained and dedicated to cycle counting.  This provides experienced inventory takers who will not make the errors “once-a-year” personnel do.  Cycle counters are also trained to identify problems and to correct them.

Count frequency.  The basic idea is to count some items each day so all items are counted a predetermined number of times each year.  The number of times an item is counted in a year is called its count frequency.  For an item, the count frequency should increase as the value of the item and number of transactions (chance of error) increase.  Several methods can be used to determine the frequency.  Three common ones are the ABC method, zone method, and location audit system.

• ABC method.  This is a popular method.  Inventories are classified according to the ABC system.  Some rule is established for count frequency.  For example, A items might be counted weekly or monthly; B items, bimonthly or quarterly; and C items, biannually or once a year.  On this basis, a count schedule can be established.  Figure shows an example of a cycle count scheduled using the ABC system.

Classification	Number of items	Count Frequency per Year	Number  of counts per Year	% of Total counts	Counts per Day
A B c	1000 1500 2500	12 4 1	12,000 6,000 2,500	58.5 29.3 12.2	48 24 10
Total counts per year                                                    20,500 Workdays per year                                                        250 Counts per day                                                               82

EXAMPLE PROBLEM

A company has classified its inventory into ABC items.  It has decided that A items are to be counted once a month; B items, four times a year; a C items, twice a year.  There are 2000 A items, 3000 B items, and 5000 C items in inventory.  Develop a schedule of the counts for each class of item.

ANSWER

Classification	Number of items	Count Frequency per Year	Number  of counts per Year	% of Total counts	Counts per Day
A B c	2,000 3,500 5,000	12 4 2	24,000 12,000 10,000	52.2 26.1 21.7	96 48 40
Total counts per year                                                    46,500 Workdays per year                                                        250 Counts per day                                                               184

• Zone method.  Items are grouped by zones to make counting more efficient.  The system is used when a fixed-location system is used, or when work-in-process or transit inventory is being counted.
• Location audit system.  In a floating-location system, goods can be stored anywhere, and the system records where they are.  Because of human error, these locations may not be 100% correct.  If material is mislocated, normal cycle counting may not find it.  In using location audits, a predetermined number of stock locations are checked each period.  The item numbers of the material in each bin are checked against inventory records to verify stock point locations.

A cycle counting program may include all these methods.  The zone method is ideal for fast-moving items.  If a floating-location system is used, a combination of ABC and location audit is appropriate.

When to count.  Cycle counts can be scheduled at regular intervals or on special occasions.  Some selection criteria are:

• When an order is placed.  Items are counted just before an order is placed.  This has the advantage of detecting errors before the order is placed and reducing the amount of work by counting at a time when stock is low.
• When an order is received.  Inventory is at its lowest level.
• When the inventory record reaches zero.  Again, this method has the advantage of reducing work.
• When a specified number of transactions have occurred.  Errors occur when transactions occur.  Fast-moving items have more transactions and are more prone to error.
• When an error occurs.  A special count is appropriate when an obvious error is detected..  This may be a negative balance on the stock record or when no items can e found although the record shows some in stock.

Pull System.  Demand on a workstation should come from the next workstation.  The pull system starts at the end of the line and pulls product from the preceding operation as needed.  The preceding operation does not produce anything unless a signal is sent from the following operation to do so.  The system for signaling demand depends on the physical layout and conditions in the plant.  The most well-known system is the Kanban system.  The details vary, but it is basically a two-bin, fixed-order-quantity, order-point system.  A small inventory of parts is held at the user operation – for example, two containers (bins) of parts.  When one in is used up, it is sent back to the supplier operation and is the signal for the supplier operation to make a container of parts.  The containers are a standard size and hold a fixed number of parts (order quantity).  This system also makes the counting and control of WIP inventory much easier.

The pull system was developed as an alternative to classical “push” MRP.  The underlying concept is not to preplan and generate schedules but instead to react to the final customer order and produce only what is  needed to satisfy demand and then only when it is needed.  Essentially, this system is much the same as the basic reorder point system used for independent inventory.  If this is the case, why can it work now when it did nor work effectively for so many years before MRP? MRP was primarily designed as a more effective alternative to reorder points because reorder points did not work well.

The major reason reorder points normally do not work well in a dependent inventory environment is a significant violation of the assumption of relatively constant demand that allows a reorder point to work well in some independent inventory environments.  A simple example may help illustrate the problem.

Suppose the product is a specific model of bicycle.  The bicycles are made in batches, which is a typical mode of production for an assemble-to-order environment.  The batch size is 200 bicycles.

Now we look at an item of dependent inventory that is one level lower on the bill of materials – the bicycle seat.  Suppose it has a lot size of 300, a two-week lead time, and, since we are examining the use of a reorder point, a reorder point of 80.

EXAMPLE 1 – In this case suppose we have an inventory of 290 seats.  A new batch of bicycles has just been ordered, requiring us to use 200 of the seats in a very short time.  We are left, therefore, with 90 seats – 10 above the reorder point.  We do not reorder since the reorder point has not been reached.  The 90 will stay in inventory until the next order for the bicycles is generated, which may be a significant time.  When that order does come to build another 200 bicycles, we can only build 90 because that is the only inventory we have. We need to immediately order another lot of 300, but it will be two weeks before they are available.

EXAMPLE 2 – Now let us assume we have less inventory – enough less that by building the lot of 200 bicycles we will hit the seat reorder point.  Suppose we have 270 seats.  The order for 200 bicycles comes in, we use 200 seats, and the seat reorder points is reached.  That will cause us to immediately reorder.  Two weeks later the 300 seats arrive and are added to the 70 left in stock.  We now have 370 seats that will stay in inventory (costing a lot of money) until the next time we build the bicycles, which may be a very long time.

As the example illustrates, the lot-sizing problem with dependent inventory often results in either a crisis shortage or a replenishment of stock well before it is actually needed.  This example shows that the critical conditions causing the problem are the large lot sizes and the long lead times, both of which are major targets of JIT waste reduction.

First, let us look again at the standard EOQ model that helps determine the most economical lot size.  It is, of course, the basic trade-off of inventory holding cost and order cost.

A fundamental assumption of this model is that the two major costs involved are known and relatively fixed.  While this essentially true with holding cost, it is not true with order cost.  If the order cost is equipment setup, then a major JIT effort is to reduce this setup cost.  If it is a purchased item, the major effort is to work with suppliers to reduce the cost and time of purchase order and delivery.  With these efforts, the order cost curve is driven downward and to the left.

When these actions are taken, a new total cost curve based on the new order cost curve is generated, resulting in a significantly smaller EOQ.

This implies the economic-order quantities and the reorder points are very small, meaning that we will be ordering frequently but in very small batches.  Since the actions are also taken at the final product level, there will be, in the preceding bicycle example, frequent lots of a very small quantity of bicycles built requiring small lots of seats frequently reordered.

If we are to reexamine the scenario with the bicycles seats, we now see the impact.  The lot size for the bicycles is very small, as is the lot size for the seats.  Lead time to replenish the seats, also a target for JIT improvement, has shrunken as well.  Suppose the bicycle lot size is now 7 and the seat lot size is 10.  The reorder point for the seats is now zero.  If we build one lot size of bicycles, we will have not reached the seat reorder point, and it appears as if we do not have enough seats to make another lot of bicycles.  With such a small seat lot size, however, we can easily afford to keep two, three, or even more lots on hand (the number being dependent on the new replenishment lead time). We can therefore build the next lot of bicycles with the second lot of seats while the first lot of seats is being replenished.

INVENTORY COSTS

The following costs are used for inventory management decisions:

• Item cost.
• Carrying costs.
• Ordering costs.
• Stockout costs.
• Capacity-associated costs.

ITEM COST

Item cost is the price paid for a purchased item, which consists of the cost of the item and any other direct costs associated in getting the item into the plant.  These could include such things as transportation, custom duties, and insurance.  The inclusive cost is often called the landed price.  For an item manufactured in-house, the cost includes direct material, direct labor, and factory overhead.  These costs can usually be obtained from either purchasing or accounting.

CARRYING COSTS

Carrying costs include all expenses incurred by the firm because of the volume of inventory carried. As inventory increases, so do these costs.  They can be broken down in to three categories:

1.       Capital costs. Money invested in inventory is not available for other uses and as such represents a lost opportunity cost, The minimum cost would be the interest lost by not investing the money at the prevailing interest rate, and it may be much higher depending on investment opportunities for the firm.

2.       Storage costs.  Storing inventory requires space, workers, and equipment.  As inventory increases, so do these costs.

3.       Risk cost. The risks in carrying inventory are:

3.1.    Obsolescence; loss of product value resulting from a model or style change or technological development.

3.2.    Damage; inventory damaged while being held or moved.

3.3.    Pilferage; goods lost, strayed, or stolen.

3.4.    Deterioration; inventory that rots or dissipates in storage or whose shelf life is limited.

What does is cost to carry inventory? Actual figures vary from industry to industry and company to company.  Capital costs may vary depending upon interest rates, the credit rating of the firm, and the opportunities the firm may have for investment.  Storage costs vary with location and type of storage needed.  Risk costs can be very low or can be closed to 100% of the value of the item for perishable goods.  The carrying cost is usually defined as a percentage of the dollar value of inventory per unit of time (usually one year).  Textbooks tend to use a figure of 20%-30% in manufacturing industries.  This is realistic in many cases but not with all products. For example, the possibility of obsolescence with fad or fashion items is high, and the cost of carrying such items is greater.

EXAMPLE PROBLEM

A company carries an average annual inventory of $2,000,000.  If it estimates the cost of capital is 10%, storage costs are 7%, and risk costs are 6%, what does it cost per year to carry this inventory?

ANSWER

Total cost of carrying inventory = 10% + 7% + 6% = 23%

Annual cost of carrying inventory = 0.23 x $2,000,000 = $460,000

ORDERING COSTS

Ordering costs are those costs associated with placing an order either with the factory or a supplier.  The cost of placing an order does not depend upon the quantity ordered.  Whether a lot of 10 or 100 is ordered, the costs associated with placing the order are essentially the same.  However, the annual cost of ordering depends upon the number of orders placed in a year.

Ordering costs in a factory include the following:

• Production control costs.  The annual cost and effort expended in production control depends on the number of orders placed, not on the quantity ordered.  The fewer orders per year, the less cost. The costs incurred are those of issuing and closing orders, scheduling, loading, dispatching, and expediting.
• Setup and teardawn costs.  Every time and order is issued, work centers have to set up to run the order and tear down the setup at the end of the run.  These costs do not depend upon the quantity ordered but on the number of orders placed per year.
• Lost capacity cost.  Every time an order is placed at a work center, the time taken to set up is lost as productive output time.  This represents a loss of capacity and is directly related to the number of orders placed.  It is particularly important and costly with bottleneck work centers.
• Purchase order cost.  Every time a purchase order is placed, costs are incurred to place the order.  These costs include order preparation, follow-up, expediting, receiving, authorizing payment, and the accounting cost of receiving and paying the invoice.

The annual cost of ordering depends upon the number of orders placed in a year.  This can be reduced by ordering more at one time, resulting in the placing of fewer orders.  However, this drives up the inventory level and the annual cost of carrying inventory.

EXAMPLE PROBLEM

Given the following annual costs, calculate the average cost of placing one order.

Production control salaries = $60,000

Supplies and operating expenses for production control department = $15,000

Cost of setting up work centers for an order = $120

Orders placed each year = 2,000

ANSWER

AVERAGE COST = (FIXED COSTS/NUMBER OF ORDERS) + VARIABLE COSTS

AC = $60,000 + $15,000/2000 +$120 = $157.50

STOCKOUT COSTS

If demand during the lead time exceeds forecast, we can expect a stockout.  A stockout can potentially be expensive because of back-order costs, lost sales, and possibly lost customers.  Stockout can be reduced by carrying extra inventory to protect against those times when the demand during lead time is greater than forecast.

CAPACITY-ASSOCIATED COSTS

When output levels must be changed, there may be costs for overtime, hiring, training, extra shifts, and layoffs.  These capacity-associated costs can be avoided by leveling production, that is, by producing items in slack periods for sale in peak periods.  However, this builds inventory in the slack periods.

EXAMPLE PROBLEM

A company makes and sells a seasonal product.  Based on a sales forecast of 2000, 3000, 6000, and 5000 per quarter, calculate a level production plan, quarterly ending inventory, and average quarterly inventory.

If inventory carrying costs are $3 per unit per quarter, what is the annual cost of carrying inventory? Opening and ending inventories are zero.

ANSWER

		Q1	Q2	Q3	Q4	Q5
Forecast Demand		2,000	3,000	6,000	5,000	16,000
Production		4,000	4,000	4,000	4,000	16,000
Ending Inventory	0	2,000	3,000	1,000	0
Average Inventory		1,000	2,500	2,000	500
Inventory cost (dollars)		3,000	7,500	6,000	1,500	18,000

FINANCIAL STATEMENTS AND INVENTORY

The two major financial statements are the balance sheet and the income statement.  The balance sheet shows assets, liabilities, and owners´ equity.  The income statement shows the revenues made and the expenses incurred in achieving that revenue.

BALANCE SHEET

An asset is something that has value and is expected to benefit the future operation of the business.  An asset may be tangible, such as cash, inventory, machinery, and buildings, or may be intangible, such as accounts receivable or a patent.

Liabilities are obligations or amounts owed by a company.  Accounts payable, wages payable, and long-term debt are examples of liabilities.

Owners´ equity is the difference between assets and liabilities.  After all the liabilities are paid, it represents what is left for the owners of the business.  Owners´ equity is created either by the owners investing money in the business or through the operation of the business when it earns a profit.  It is decreased when owners take money out of the business or when the business loses money.

The accounting equation.  The relationship between assets, liabilities, and owners´ equity is expressed by the balance sheet equation:

Assets = liabilities + owners´ equity

This is a basic accounting equation.  Given two of the values, the third can always be found.

EXAMPLE PROBLEM

a)      If the owners equity is $1,000 and liabilities are $800, what are the assets?

b)      If the assets are &1,000 and liabilities are $600, what is the owners equity?

ANSWER

a)      Assets = Liabilities + owners equity

Assets = 800 + 1,000 = 1,800

b)      Owners equity = assets – liabilities

Owners equity = 1,000 – 600 = 400

BALANCE SHEET.  The balance sheet is usually shown with the assets on the left side and the liabilities and owners equity on the right side as follows.

ASSETS

Cash                                                     $   100,000

Accounts receivable                      $   300,000

Inventory                                           $   500,000

Fixed assets                                      $1,000,000

TOTAL ASSETS                                  $1,900,000

LIABILITIES

NOTES PAYABLE                              $5,000

ACCOUNTS PAYABLE                     $20,000

LONG.TERM DEBT                          $500,000

TOTAL LIABILITIES                           $525,000             

OWNERS EQUITY

Capital                                                 $1,000,000

Retained earnings                          $375,000

Total liabilities and OW                 $1,900,000

CAPITAL is the amount of money the owners have invested in the company.

RETAINED EARNINGS are increased by the revenues a company makes and decreased by the expenses incurred.  The summary of revenues and expenses is shown on the income statement.

INCOME STATEMENT

Income (profit). Te primary purpose of a business is to increase the owners equity by making a profit. For this reason owners equity is broken down into a series of accounts, called revenue accounts, which show what increased owners equity, and expense accounts, which show what decreased owners equity.

                               Income = revenue – expenses

REVENUE comes from the sale of goods or services.  Payment is sometimes immediate in the form of cash, but often is made as a promise to pay at a later date, called an account receivable.

EXPENSES are the costs incurred in the process of making revenue.  They are usually categorized into the cost of goods sold and general and administrative expenses.

COST OF GOODS SOLD are costs that are incurred to make the product.  They include direct labor, direct material, and factory overhead. Factory overhead is all other factory costs except direct labor and direct material.

GENERAL AND ADMINISTRATIVE EXPENSES include all other costs in running a business. Examples of these are advertising, insurance, property taxes, and wages and benefits other than direct material, direct labor, and factory overhead costs.

The following is an example of an income statement.

Revenue $1,000,000

Cost of goods sold

                Direct labor $200,000

                Direct material 400,000

                Factory overhead 200,000

                TOTAL 800,000

Gross margin (profit) $200,000

General and administrative expenses $100,000

Net income (profit) $100,000

EXAMPLE PROBLEM

Given the following data, calculate the gross margin and the net income.

                REVENUE $1,500,000

                DIRECT LABOR $300,00

                DIRECT MATERIAL $500,000

                FACTORY OVERHEAD $400,000

                GENERAL AND ADMINISTRATIVE EXPENSES $150,000

How much would profits increase if, through better materials management, material costs are reduced by $50,000?

REVENUE $1,500,000

COST OF GOODS SOLD

                DIRECT LABOR 300,000

                DIRECT MATERIAL 500,000

OVERHEAD 400,000

                TOTAL 1,200,000

GROSS MARGIN (GROSS PROFIT) 300,000

GENERAL AND ADMINSITRATIVE EXPENSES 150,000

NET INCOME (PROFIT) 150,000

If material costs are reduced by $50,000, income increases by $50,000.  Materials management can have a direct impact on the bottom line-net income.

CASH FLOW ANALYSIS

When inventory is purchased as raw material, it is recorded as an asset. When it enters production, it is recorded as work-in-process (WIP) inventory, and as it is processed, its value increases by the amount of direct labor applied to it and the overhead attributed to its processing.  The material is said to absorb overhead. When the goods are ready for sale, they do not become revenue until they are sold. However, the expenses incurred in producing the goods must be paid for.  This raises another financial issue: Businesses must have the cash to pay their bills.  Cash is generated by sales, and the flow of cash into a business must be sufficient to pay bills as they become due. Businesses develop financial statements showing the cash flows into and out of the business. Any shortfall of cash must be provided for, perhaps by borrowing or in some other way.  This type of analysis is called cash flow analysis.