TOPIC 1 WORKING CAPITAL MANAGEMENT

TOPIC 1

WORKING CAPITAL
MANAGEMENT

ROSMARIA ISMAIL DPA40103 FINANCIAL MANAGEMENT 2
COMMERCE DEPARTMENT
POLITEKNIK MELAKA

1.2 Provide the discussion and calculation on inventory control
1.2.1 Explain the importance of inventory control
1.2.2 Categorize types of inventories
1.2.3 Calculate inventory management techniques:

a. Carrying cost
b. Ordering cost
c. Reorder point
d. Average inventory
e. Total cost
f. Economic order quantity (EOQ)

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1.2

INVENTORY
CONTROL

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INTRODUCTION

Inventories are important in a firm’s operations. Why ???
Typically act as buffers at several points in the purchasing-production-marketing process, in
ensuring that there exists sufficient inventory to allow for production to carry on (in the case
of raw materials) and for the satisfaction of customer orders (in the case of finished goods)
Inventory management ensures that firms have sufficient inventory for production and for
sale to customers.
Types and level of inventory investment will largely relate to the firm’s operations.

A wholesaler will only carry finished goods purchased for resale.
Firm that involved in the production process will carry all types of inventories.

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REASONS TO KEEP STOCK

To avoid shortage of inventory
To make each function of production process independent
To lessen the cost of ordering
To enjoy a discount for bulk purchases

To avoid inflation effects and shortage of supplies

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IMPORTANCE OF INVENTORY CONTROL

 To minimize the investment levels in the inventories.

 This will release tied up funds in inventories, which is less productive, to be
used in other more profitable investment; thus improving firm’s profitability.

 Sufficient inventories are important to satisfy the production and sales
demands.

 This will smooth out production process and provides better product
selections & prompt deliveries.

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RISK & RETURN TRADE OFF

If the level of inventory is too low, the various functions of business do not
operate independently, and delays in product & customer delivery can result.
But a lower level of inventory can also save the firm money & increase returns.
Moreover, as the size of inventory increases, storage & handling costs as well as
the required return on capital invested in the inventory rise.

As the inventory a firm holds is increased, the risk of running out of inventory
is lessened, but inventory expenses rise.

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TYPES OF INVENTORY

Raw Materials Work In Finished
(RM) Progress (WIP) Goods (FG)

Consist of the basic materials Consists of partially finished Consist of goods for which
that have been purchased goods that require additional the production has been

from other firms to be used in work before they become completed but the goods are
the firm’s production finished goods. not yet sold.
operations.
This type of inventory splits This type of inventory
This type of inventory splits the various production uncouples the production and
the production function from operations into different
stages. sales function.
the purchasing function.

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FACTORS DETERMINING THE LEVEL OF
INVENTORY REQUIRED

Level of RM required depends on the forecast level of sales and hence, the
production quantities budgeted for, and the supply reliability.

Level of WIP required depends on the overall length of each production cycle
and stages within each cycle.

Level of FG required influenced by the rate of sales, cost of carrying the
inventory, cost of ordering replacement stocks and cost of running out of
stocks.

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INVENTORY MANAGEMENT TECHNIQUES

Effective inventory management is directly related to the size of the
investment in inventory.
In order to effectively manage the investment in inventory, 2 problems
must be dealt with : the order quantity problem and the reorder point
problem.
Techniques : EOQ MODEL , ABC SYSTEM, JIT SYSTEM, MRPS

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Order Quantity Problem

Involves determining the optimal order size for an inventory item given its expected usage, carrying cost, and
ordering cost.

The Economic Order Quantity (EOQ) model attempts to determine the order size that will minimize total inventory
costs.

 TOTAL CARRYING COSTS = (average inventory) x (carrying cost per unit)
(HOLDING @ STORAGE)
= [(Q / 2) + SS ] x C

Q = inventory order size (units)
C = carrying cost per unit
SS = Safety Stock

VC per unit of holding an item of inventory for a specified period of time. These include storage costs,
insurance costs, costs of deterioration & obsolescence, & the opportunity cost of funds invested in
inventory.

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Order Quantity Problem

 TOTAL ORDERING COSTS = (no. of orders) x (ordering cost per order)

= (S / Q) x O

S = total DD in units
O = ordering cost per order

Include the administration cost of placing & receiving orders, which consists of the cost of writing
a PO, processing it & checking it with the invoice.

 TOTAL INVENTORY COSTS = TOTAL CARRYING COSTS + TOTAL ORDERING COSTS
= [ [(Q / 2) + SS] x C ] + [ (S / Q) x O ]

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Order Quantity Problem

EOQ model examines the TRADE OFF between carrying & ordering costs so as to determine the
order quantity that minimizes total inventory costs.

 Ordering costs DECREASES as the size of the order INCREASES

 Carrying costs INCREASE as the size of the order INCREASES

EOQ = 2 (S) (O) / C 13
Assumptions :
i. Constant demand
ii. Constant unit price
iii. Constant carrying costs & ordering costs
iv. Instantaneous delivery
v. Independent orders

Order Point Problem

EOQ model makes simplistic assumptions  future demand is known with certainty; inventory is used at a
constant rate; and inventory is replenished immediately.
However, in reality, businesses are fraught with uncertainty.
Types of uncertainty :

 Fluctuating future demand
 Variable inventory usage rate
 Differing delivery times from suppliers
The above types of uncertainties can cause firms to face the possibility of stock outs that will result in :
 Loss of sales
 Customer’s ill will
 Production downtime
To overcome any problems associated with stock outs, firms typically hold safety stock as a precautionary
measure.

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Order Point Problem 15

SAFETY STOCK
Inventory held to accommodate any unusually large and unexpected usage during delivery
time. Also known as buffer stocks.
SS are required whenever there are uncertainties in the lag period between reorder point and
delivery.
These uncertainties relate to usage rate and delivery time which may change unexpectedly.
For example, if usage rate during the lag period is unexpectedly high or if delivery time is
lengthened, the firm may run out of stock if no safety stocks are maintained.
Factors to decide the appropriate SS :
 Uncertainty of expected demand or expected sales
 Shortage of inventory and its cost of shortage
 Uncertainty of delivery time
How much SS to hold????? Described as the order point problem  the lowest level inventory
is allowed to decrease before new orders for stock is made.

Order Point Problem

 REORDER POINT
The ROP is influenced by 2 factors :
▻ Lead time for stocks to be delivered by the supplier (delivery time).
▻ The SS level desired.

REORDER POINT = SAFETY STOCK + DELIVERY-TIME STOCK
= SS + [DELIVERY TIME x (S / DAYS IN A YEAR)]

** order new inventory when the level of inventory falls to this level
** 1 year = 365 days = 52 weeks

 AVERAGE INVENTORY = (EOQ / 2) + SAFETY STOCK

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EXAMPLE

Cheta Enterprise, a maintenance workshop owned by Encik Maman uses 25,200 units of spare
parts per year (average 70 units for every working day). Purchase order cost is RM25 per order.
This shop orders 280 units in each order. Inventory storage cost is RM5 per unit per year. Assume
there are 360 days per year.

You are required to calculate :
(a) Total ordering cost per year.
(b) Total storage cost per year.
(c) Total inventory cost per year.
(d) Economic Order Quantity (EOQ).
(e) Total inventory cost per year based on the EOQ model.
(f) Reorder point with assumption that lead time is 3 days.
(g) Safety stock and re-order point if use of spare part is increased to 75 units per day.

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THANKS!

Any questions?

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