Financial Decisions. 2 & 3. Inventory Management. Economic Order Quantity Reorder Levels Safety Stock Lead Times

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1 Financial Decisions 2 & 3. Inventory Management Economic Order Quantity Reorder Levels Safety Stock Lead Times Instructor: A. Ashta References: Ross, Westerfield Jordan: Ch. 17 Emery, Finnerty & Stowe: Ch. 23 1

2 Inventory Management Types of inventories: Raw materials Work-in-process Finished goods For this course Assume trading company Only one class of inventory Can be generalized for raw material inventory 2

3 Inventory Holdings for the Eyssell Corporation Starting inventory: Q = 3,600 1,800 = Q / 2 Average inventory Ending inventory: Weeks 8 The Eyssell Corporation starts with inventory of 3,600 units. The quantity drops to zero by the fourth week. The average inventory is Q/2 = 2,600/2 = 1,800 over the period. 3

4 Cost of Holding Inventory Cost of holding inventory ($) Total costs of holding inventory Carrying costs Restocking costs Size of inventory Q* orders (Q) Optimal size of inventory order Restocking costs are increased when the firm holds a small quantity of inventory. Carrying costs are increased when there is a large quantity of inventory on hand. Total costs are the sum of the carrying and restocking costs. 4

5 Holding Costs Interest cost on financial commitment Warehousing costs Storage taxes, if any Insurance Rework Breakage Spoilage 5

6 Try Q If a company s carrying costs are $ 5 millio per year and its fixed order costs are $ 8 million per year, do you think the firm keeps too much inventory or too little? Why? Answer 6

7 Economic Order Quantity (EOQ) Model Let S = constant usage rate of the inventory. F = fixed cost of ordering inventory. C = carrying cost per unit of inventory for the period. Q = units of inventory ordered. 7

8 Economic Order Quantity (EOQ )Model Total cost = = Annual Ordering Cost + Annual Carrying Cost = FS + Q CQ 2 To minimise total cost with respect to quantity dtc dq = F * S Q / 2 + C 2 = 0 EOQ * = 2FS C 8

9 EOQ Model: Acer Exampel The Acer Co. sells 10,000 units per year. The cost of placing one order is $50 and it costs $4 per year to carry one unit of inventory. What is Acer s EOQ? 9

10 EOQ Model: Acer Exampel S= units per year. F= $ C= $ per year EOQ * = 2FS C 10

11 EOQ Model Average inventory Q/2 =. Number of orders per year S/Q = Time between orders 365 * Q/S = days. 11

12 EOQ Model Annual ordering cost F(S/Q) = per year. Annual holding cost C(Q/2) = per year. Total annual cost per year. 12

13 Quantity Discounts and the EOQ Model Quantity discounts can impact on the optimal order size. Suppose Acer were offered a discount of $0.02 per unit if it ordered in lots of 600. Is it worth taking the discount? 13

14 Quantity Discounts and the EOQ Model Total cost with this order size = = Annual Ordering Cost + Annual Carrying Cost Total Discounts FS CQ = + ds Q 2 = 14

15 Brooks Problem Brooks Manufacturing uses 8,000 subframes per week and then reorders another 8,000. If the relevant carrying cost per subframe is $25, and the fixed order cost is $1,O00, is Brook s inventory policy optimal? Why or why not? 15

16 Inventory Management with Uncertainty Types of uncertainty: Future demand Inventory usage rate Delivery time To protect against stockouts, the firm must maintain a safety stock of inventory. Stockouts result in: lost sales customer ill will production down-time For a billion dollar retailer, $ 40 million lost sales from stockouts Stockouts cause walkouts (Corsten & Gruen, HBR Apr 2004) 31% 26% 9% 15% 19% Stockouts cause walkouts (Corsten & Gruen, HBR Apr 2004) 100% 80% 60% 40% 20% 0% Cosmetics Shampoo Coffee Salted Snacs 21 Do not purchase Delay purchase subsititute same brand subsititute different brand buy itme at another store Do not purchase Delay purchase subsititute samebrand subsititute different brand buy item at another store 16

17 11 September Attack on NYC Government responded by security checks Interrupted the free flow of goods Enterprises got goods late Enterprises found themselves without stock Production halted This could wipe out enterprises So: Safety stock required 17

18 Safety Stocks Inventory (units) Safety stock Minimum inventory level Time With a safety stock, the firm reorders when inventory reaches a minimum level. 18

19 Reorder Points and Lead Times Inventory (units) Reorder point Time Delivery time Delivery time When there are lags in delivery or production times, the firm reorders when inventory reaches the reorder point. 19

20 Safety Stocks and Reorder Points Inventory (units) Reorder point Delivery time Delivery time Minimum inventory level Time By combining safety stocks and reorder points, the firm maintains a buffer against unforeseen events. 20

21 Inventory Management with Uncertainty Reorder point Expected lead-time demand + Safety stock. Annual cost Ordering cost + Carrying cost + Stockout costs. 21

22 Inventory Management with Uncertainty Inventory Level Reorder Point Safety Stock Level Lead Time Time 22

23 ABC System of Inventory Management Inventory items are classified into three groups on the basis of critical needs. Group A items are most critical. Group C items are least critical. Critical items are managed very carefully. 23

24 ABC System of Inventory Management Value of inventory 100% 70% Suppose 15% of our items accounted for 70% of our sales. They would be A items, managed most carefully. A items B items C items Number of items 24

25 Another way of looking at ABC Inventory Analysis 100 Percent of inventor y value A Group 57% B Group 27% C Group 16% % 40% 50% 60 Percent of inventory items

26 Just-In-Time (JIT) Inventory Systems Materials should arrive exactly as they are needed in the production process. Reduces inventory holding costs Important factors determining success of JIT systems: Planning requirements Supplier relations Setup costs Other cost factors Impact on credit terms 26

27 Try Q What is the effect of a move to JIT on Answer Inventory turnover ratio Total asset turnover ratio Return on Equity 27

28 Source: Callioni et al: «Inventory-Driven Costs» in HBR, March

29 Hewlett Packard: Inventory Driven Costs Type of costs Example Increase with Solutions Size of raw material inventory Just in time Component Devaluation Cost Amount of price If cost of chips used by decrease HP falls after it buy them Number of buffer stocks Reduce buffer points Number of factories Consolidating manufacturing Price Protection Costs Product Return Costs Obsolescence Costs Reimburse dealers if HP reduces final retail prices Take back unsold goods End of life write off discounts before discontinuation Dealers inventories Distribution costs & time Dealer inventory Dealer inventory Source: Callioni et al: «Inventory-Driven Costs» in HBR, March 2005 Keep minimum stock with dealers Give incentives for dealers to keep lower inventories Keep minimum stock with dealers Manage timing of new introduction 29

30 Supply chains: Agile, Adaptable and Aligned The best supply chains are not just Fast Cost effective They are also Agile Short-term reactivity to change in demand/environment Adaptable Respond to long-term structural shifts Aligned Create incentives to keep the interests of all the supply chain partners in mind Source: LEE, Hau L.: «The Triple-A Supply Chain» in HBR, October 2004 (worth reading for a more strategy orientation) «Inventory Management: A way to give it a grade» in Konwledge@Wharton, ref 1395 dt. 09/02/