Lecture
6
1

 Raw materials & purchased parts
 Partially completed goods called work in progress
 Finished-goods inventories
 ( manufacturing firms ) or merchandise
( retail stores )
 Replacement parts, tools, & supplies
 Goods-in-transit to warehouses or customers
2

 To meet anticipated demand
 To smooth production requirements
 To decouple operations
 To protect against stock-outs
 To take advantage of order cycles
 To help hedge against price increases
 To permit operations
 To take advantage of quantity discounts
3

 To achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds
 Level of customer service
 Costs of ordering and carrying inventory
4

 Lead time : time interval between ordering and receiving the order
 Holding (carrying) costs : cost to carry an item in inventory for a length of time, usually a year
 Ordering costs : costs of ordering and receiving inventory
 Shortage costs : costs when demand exceeds supply
5

Inventory Classification Systems
ABC Analysis

Divides inventory into three classes based on annual dollar volume

Class A - high annual dollar volume

Class B - medium annual dollar volume

Class C - low annual dollar volume

Used to establish policies that focus on the few critical parts and not the many trivial ones
 No “hard-and-fast” rule to classify into different categories
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Item
Stock
Number
#10286
#11526
#12760
#10867
#10500
#12572
#14075
#01036
#01307
#10572
Percent of
Number of
Items
Stocked
20%
30%
50%
Annual
Volume
(units) x Unit Cost =
1,000 $ 90.00
500 154.00
1,550
350
1,000
600
2,000
100
1,200
250
17.00
42.86
12.50
$ 14.17
.60
8.50
.42
.60
Annual
Dollar
Volume
$ 90,000
77,000
Percent of
Annual
Dollar
Volume
38.8% 72%
Class
A
33.2% A
$ 26,350
15,001
12,500
$ 8,502
1,200
850
504
150
$232,057
11.3%
6.4% 23%
5.4%
3.7%
.5%
.4% 5%
.2%
.1%
B
B
B
C
C
C
C
C
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 Economic order quantity (EOQ) model
 Economic production model (EPQ)
 Quantity discount model
8

Profile of Inventory Level Over Time
Q
Quantity on hand
Usage rate
Reorder point
Receive order
Place order
Receive order
Lead time
Place order
Receive order
Time
9

Total cost =
Annual carrying cost
+
Annual ordering cost
TC =
Q
H
2
+
D
Q
S
Formula (11-1)
10

The Total-Cost Curve is U-Shaped
TC

Q
H
2

D
S
Q
Q
O
( optimal order quantity)
Ordering Costs
Order Quantity
(Q)
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The total cost curve reaches its minimum where the carrying and ordering costs are equal.
Q
OPT
=
2DS
=
H
2(Annual Demand)(Or der or Setup Cost)
Annual Holding Cost
Formula (11-2)
Number of orders per year = D/Q
0
Length of order cycle = Q
0
/D
Formula (11-3)
12

Inventory Management – In-class Example
 Number 2 pencils at the campus book-store are sold at a fairly steady rate of 60 per week. It cost the bookstore $12 to initiate an order to its supplier and holding costs are $0.005 per pencil per year.


Determine







(a) The optimal number of pencils for the bookstore to purchase to minimize total annual inventory cost,
(b) Number of orders per year,
(c) The length of each order cycle,
(d) Annual holding cost,
(e) Annual ordering cost, and
(f) Total annual inventory cost.
(g) If the order lead time is 4 months, determine the reorder point.
 Illustrate the inventory profile graphically.
What additional cost would the book-store incur if it orders in batches of 1000?
13

(a)
(d)
(e)
(f)
(g)
(b)
(c)
14

 Only one product is involved
 Annual demand requirements known
 Demand is even throughout the year
 Lead time does not vary
 Each order is received in a single delivery
 There are no quantity discounts
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 The EOQ with quantity discounts model is applicable where a supplier offers a lower purchase cost when an item is ordered in larger quantities.
 This model's variable costs are
 Annual holding,
 Ordering cost, and
 Purchase costs
 For the optimal order quantity, the annual holding and ordering costs are not necessarily equal.
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 Formulae
 Optimal order quantity: the procedure for determining Q * will be demonstrated
 Number of orders per year: D / Q *
 Time between orders (cycle time): Q */ D years
 Total annual cost: (formula 11.9 of book)
TC

Q
*
2
H

D
Q
*
S

D .
P
(holding + ordering + purchase)
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 Walgreens carries Fuji 400X instant print film
 The film normally costs Walgreens $3.20 per roll
 Walgreens sells each roll for $5.25


Walgreens's average sales are 21 rolls per week
Walgreens’s annual inventory holding cost rate is 25%
 It costs Walgreens $20 to place an order with Fujifilm, USA
 Fujifilm offers the following discount scheme to Walgreens
 7% discount on orders of 400 rolls or more
 10% discount for 900 rolls or more, and

 15% discount for 2000 rolls or more
Determine Walgreen’s optimal order quantity
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19

 Too much inventory
 Tends to hide problems
 Easier to live with problems than to eliminate them
 Costly to maintain
 Wise strategy
 Reduce lot sizes
 Reduce safety stock
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The Balance Sheet – Dell Computer Co.
28-Jan-00 29-Jan-99 Change Percent
Current assets:
Cash
Short-term investments
Account receivables, net
Inventories
Other
Total current assets
Property, plant, and equipment, net
Long-term investments
Equity securities and other
investments
Goodwill and others
Total assets
LIABILITIES AND STOCKHOLDERS' EQUITY
$3,809
323
2,608
391
550
7,681
765
1,048
1,673
304
$11,471
$1,726
923
2,094
273
791
5,807
523
532
---
15
$2,083
(600)
514
118
(241)
1,874
242
516
1,673
289
$6,877 $4,594
1927%
67%
121%
-65%
25%
43%
-30%
32%
46%
97%
Current liabilities:
Accounts payable
Accrued and other
Total current liabilities
Long-term debt
Other
Total liabilities
Stockholders' equity:
Preferred stock
Common stock and capital in excess of $0.01 per value
Retained earnings
Other
Total stockholders' equity
Total liabilities and
stockholders' equity
$3,538
1,654
5,192
508
463
6,163
---
3,583
1,260
465
5,308
$11,471
$2,397 $1,141
1,298
3,695
512
349
4,556
---
1,781
606
(66)
2,321
356
1,497
(4)
114
1,607
1,802
654
531
2,987
$6,877 $4,594
48%
27%
41%
-1%
33%
35%
101%
108%
129%
67%
21

(in millions, except per share amount)
Net revenue
Cost of revenue
Gross margin
Operating expenses:
Selling, general and administrative
Research, development, and engineering
Total operating expenses
Operating income
Other income
Income before income taxes
Provision for income taxes
Net income
Earnings per common share:
Basic
Diluted
Weighted average shares outstanding:
Basic
Diluted
Retained Earnings:
Balances at beginning of period
Net income
Repurchase of common stocks
Balances at end of period
Fiscal Year Ended
28-Jan-00 29-Jan-99
$25,265 $18,243
20,047 14,137
5,218 4,106
2,387
568
2,955
2,263
1,788
272
2,060
2,046
188
2,451
38
2,084
785 624
$1,666 $1,460
$0.66
$0.61
2,536
2,728
$0.58
$0.53
2,531
2,772
606
1,666
607
1,460
(1,012) (1,461)
$1,260 $606
22

 What It Measures : The extent to which a firm uses debt financing
 How You Compute : The ratio of total debt to total assets
Total debt
Debt ratio =
Total assets

$6, 163
$11, 471

23

 What It Measures : How effectively a firm is managing its inventories.
 How You Compute : This ratio is computed by dividing sales by inventories
Inventory turnover ratio =
Average
Sales inventory balance

$ 25 , 265
($ 273

$ 391 ) / 2

76 .
10 times
24








Recognize that not every tool is the best fit for every problem
Pay attention to variability


Forecasting
Inventory management - Deliveries from suppliers
Build flexibility into models
Pay careful attention to technology
 Opportunities
 Improvement in service and response times
 Risks
 Costs involved
 Difficult to integrate
 Need for periodic updates
 Requires training
Garbage in, garbage out
 Results and recommendations you present are only as reliable as the model and its inputs
Most decisions involve tradeoffs
Not a good idea to make decisions to the exclusion of known information
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