SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 4 – Inventory Management
Prepared by Patty Robertson
May not be used without permission
2
Chapter 4 Agenda
INVENTORY MANAGEMENT
Assess the tradeoffs associated with
inventory, discuss the uses and
limitations of the EOQ model, quantify
the flow of inventory via balance
fraction measures, and discuss trends
in inventory management.
Cash Flow Timeline
3
The cash
conversion
period is the
time between
when cash is
received versus
paid.

The firm is a system of cash flows.

These cash flows are unsynchronized and uncertain.
The shorter the
cash conversion
period, the
more efficient
the firm’s
working capital.
Note: The clock typically starts ticking when the order is
received, not when the order is placed.
Inventory Management
4


In this chapter, we focus on inventory management.
In Chapter 7, we will discuss paying for the
inventory.
Inventory Management
5

Financial Managers consider inventory an idle
corporate resource.
 They
attempt to strike a balance between holding too
much inventory and not enough to earn an
appropriate rate of return.
 Too
much results in a burden on the cash resources of a
firm and has higher carrying costs.
 Too
little could force customers to turn to competitors or
question the quality of customer service.
Inventory Management
6



However, Financial Managers are not the only
interested party.
Sales are somewhat uncertain; so, too, is the
appropriate level of inventory.

Purchasing wants to keep raw materials on hand.

Production wants uninterrupted production.

Marketing and Sales wants inventory in the warehouse to
sell.
Our view is from a financial perspective.
Inventory Management
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



Given uncertain customer demand, three levels of inventory must be
managed:

Raw Materials (e.g. Steel)

Work-In-Process (e.g. Engine)

Finished Goods (e.g. Car)
In addition to uncertain customer demand, there is also the issue of
timing of inventory deliveries versus inventory depletion (stock out)
The rate at which inventory is used (constant, erratic, etc.)
Variability of the supply of raw materials, potential price changes,
and economies of scale for large purchases.
Inventory Strategy Questions
8




So, how much inventory should we carry?
Should inventory be placed close to the point of
purchase or the point of supply?
Should we institute a just-in-time (JIT) system?
Should we use a form of premium transportation for
distribution?
Inventory Management
9

There are two direct costs associated with
inventory levels:
 Ordering
Costs - Clerical, receipt, inspection, returns,
processing, transportation, unloading, handling, etc.
 Holding
Costs – Opportunity cost, interest expense, labor,
tracking, storage (rent/depreciation), insurance, utilities,
security, taxes, obsolescence, breakage, theft, etc.
Inventory Management
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

The goal is to minimize the total cost of inventory
given a desired level of customer service.
Inventory decisions should be based on:

The cost of ordering inventory

The cost of holding inventory



The opportunity cost of funds
Any available discounts
These factors combine to result in optimal order
quantities.
Inventory Management
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
The Total Cost of managing inventory without discounts is
given by the following formula:
Ordering Costs
+ Holding Costs
= Total Cost
Cost/Order х Number of Orders
Holding Cost/Item х Average Inventory Balance
= [F х (T/Q)] + [H х (Q/2)]
# Orders
Avg. Inv.

T = Total inventory units demanded

Q = Order quantity

F = Fixed Order Cost per order

H = Holding Cost per inventory unit

D = # days in production period

C = Cost of inventory unit

i = Daily opportunity cost
Inventory Management
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
Total Cost = [F х (T/Q)] + [H х (Q/2)]
 There


exists some Q that minimizes the Total Cost.
The first expression includes Q in the denominator; with larger
(but fewer) orders, Ordering Costs are lower.
The second expression includes Q in the numerator; with larger
orders, Holding Costs are higher.

T = Total inventory units demanded

Q = Order quantity

F = Fixed Order Cost per order

H = Holding Cost per inventory unit

D = # days in production period

C = Cost of inventory unit

i = Daily opportunity cost
Ordering/Holding Cost Trade-Off
13
Total Cost
first falls as
units ordered
increase, but
then begins
to increase.
The optimum
number of
units to order
is that order
quantity that
minimizes
Total Cost.

T = Total inventory units demanded

Q = Order quantity

F = Fixed Order Cost per order

H = Holding Cost per inventory unit

D = # days in production period

C = Cost of inventory/unit for a given Q

i = Daily opportunity cost
Optimal Quantity (EOQ) Example
14

A firm estimates the need for:

500,000 tons (T) of scrap metal over
a planning period (375 day
production run)

Sales are not seasonal and are stable

Ordering Costs are $20.00/order (F)

Holding Costs are $1.25/ton (H)

The price is $0.50/ton (no discounts
offered) (C’)

Delivery time is 2 days

Safety storage is 300 units

T = Total inventory units required

Q = Order quantity

F = Fixed Order Cost per order

H = Holding Cost per inventory unit

C’ = Cost of inventory/unit for given Q
Optimal Quantity (EOQ) Example
15

A firm estimates the need for:









500,000 tons (T) of scrap metal over a planning period

T = Total inventory units demanded
375 day production run

Q = Order quantity
Sales are not seasonal and are stable.

F = Fixed Order Cost per order
Ordering Costs are $20.00/order (F)

H = Holding Cost per inventory unit
Holding Costs are $1.25/ton (H)

D = # days in production period
The price is $0.50/ton (no discounts offered) (C’)

C’ = Cost of inventory/unit for a given Q
Delivery time is 2 days

i = Daily opportunity cost
Safety storage is 300 units
Total Cost = [F х (T/Q)] + [H х (Q/2)]
 There
=
exists some Q that minimizes the Total Cost.
[$20.00 х (500,000/Q)] + [$1.25 х (Q/2)]
Optimal Quantity to Order (EOQ)
16

The goal is to choose the Q that results in the optimal tradeoff between Ordering and Holding Costs.

The Q that minimizes the Total Cost is called the Economic Order
Quantity (EOQ).

Take the first derivative, set equal to zero and solve for Q to get:
EOQ 
2T F 
H

T = Total inventory units demanded

Q = Order quantity

F = Fixed Order Cost per order

H = Holding Cost per inventory unit

D = # days in production period

C’ = Cost of inventory/unit for a given Q

i = Daily opportunity cost
Optimal Quantity (EOQ) Example
17

A firm estimates the need for:








500,000 tons (T) of scrap metal over a planning period
375 day production run
Sales are not seasonal and are stable
Ordering Costs are $20.00/order (F)
Holding Costs are $1.25/ton (H)
The price is $0.50/ton (no discounts offered) (C’)
Delivery time is 2 days
Safety storage is 300 units
EOQ 
EOQ 
2T F 
H
2500,000$20  4,000 tons
$1.25
Optimal Quantity (EOQ) Example
18

A firm estimates the need for:








500,000 tons (T) of scrap metal over a planning period
375 day production run
Sales are not seasonal and are stable
Ordering Costs are $20.00/order (F)
Holding Costs are $1.25/ton (H)
The price is $0.50/ton (no discounts offered) (C’)
Delivery time is 2 days
Safety storage is 300 units
4,000
units
Avg Inv
2,000
units
4,000
4,000
4,000
Optimal Quantity (EOQ) Example
19

By comparison, let’s diagram 8,000 tons per order.
8,000
units
4,000
units
Avg Inv
2,000
units

Orders are placed half as often, but are twice as large.
Optimal Quantity (EOQ) Example
20


(T /
OC = [F х Q)]
HC = [H х (Q/2)]

T = Total inventory units demanded

Q = Order quantity

F = Fixed Order Cost per order

H = Holding Cost per inventory unit

D = # days in production period

C’ = Cost of inventory/unit for a given Q

i = Daily opportunity cost
Period Inventory Requirement
500000
Ordering Costs
$20.00
Per Order
Holding Costs
$1.25
Per Ton
Quantity (Q )
Total Costs
Ordering Costs
Holding Costs (based
on average inventory)
Purchase Cost
500
$270,313
$20,000
$313
$250,000

Ordering Costs = $20 х (500,000/500)

Holding Costs = $1.25 х (500/2)

Purchase Cost = 500,000 х $0.50
4000
$255,000
$2,500
$2,500
 1,000 orders
$250,000

Ordering Costs = $20 х (500,000/4,000)  125 orders

Holding Costs = $1.25 х (4,000/2)

Purchase Cost = 500,000 х $0.50
Optimal Quantity (EOQ) Example
21
Period Inventory Requirement
500000
Ordering Costs
$20.00
Per Order
Holding Costs
$1.25
Per Ton
Quantity (Q )
Total Costs
Ordering Costs
Holding Costs (based
on average inventory)
Purchase Cost
500
$270,313
$20,000
$313
$250,000
1000
$260,625
$10,000
$625
$250,000
1500
$257,604
$6,667
$938
$250,000
2000
$256,250
$5,000
$1,250
$250,000
2500
$255,563
$4,000
$1,563
$250,000
3000
$255,208
$3,333
$1,875
$250,000
3500
$255,045
$2,857
$2,188
$250,000
4000
$255,000
$2,500
$2,500
$250,000
4500
$255,035
$2,222
$2,813
$250,000
5000
$255,125
$2,000
$3,125
$250,000
5500
$255,256
$1,818
$3,438
$250,000
6000
$255,417
$1,667
$3,750
$250,000
Other Inventory Calculations
22

Number of Orders (T/Q)


Average Inventory Balance (Q/2)


T = Total inventory units demanded

Q = Order quantity

F = Fixed Order Cost per order

H = Holding Cost per inventory unit

D = # days in production period

C’ = Cost of inventory/unit for a given Q

i = Daily opportunity cost
= 4,000 / 2 = 2,000 tons
[F х (T/Q)] + [H х (Q/2)]
Daily Usage Rate (T/D) (assume 375 day production run)


= 500,000 / 4,000 = 125 orders

= 500,000 / 375 = 1,333 tons per day
Reorder Point (T/D) х Delivery Time (assume 2 days)

= 1,333 х 2 = 2,666 tons
Reorder Point w/ Delivery Time
23
Reorder Point = 2,666 tons
The number
of days to
receive a
shipment
after placing
an order
must be
considered to
avoid a stock
out.


Management should reorder when inventory reaches
2,666 tons.
Two days later, when the inventory will be depleted, the
new order arrives.
Assume it is
2 days.

What happens if the shipment is delayed?
Reorder Point w/ Safety Stock
24
Safety Stock
protects the
firm from
running out
of inventory
if sales are
not stable or
the
production
or delivery
times are
uncertain or
unreliable.
It increases
average
inventory.
Reorder Point w/ Safety Stock
Daily Usage Rate х Delivery Time
+ Safety Stock (assume 300)
= Reorder Point
= (1,333 х 2) + 300 = 2,966 tons
Reorder Point
25
Safety Stock
protects the
firm from
running out
of inventory
if sales are
not stable or
the
production
or delivery
times are
uncertain or
unreliable.
Reorder Point w/ Safety Stock and
Delivery Time
Monitoring Inventory Balances
26

Once the inventory policy has been established, it must
be continually monitored:

Inventory Control Systems


Inventory Turnover Approach


Inventory updated at point-of-sale
Ratio analysis

Inventory Turnover Ratio

Days Inventory Held
Balance Fraction Approach

Develop monthly balance fractions based on the proportion of
items remaining in inventory from a given month’s purchase.
Reducing Inventory Investment
27

Once thought of as an asset, modern theory
considers inventory a liability.
 Just-In-Time
 Minimize
(JIT)
costs by efficiently monitoring the usage of raw
materials and ordering replacements that arrive shortly
before needed.
Trends in Inventory
28
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