Notes on Working Capital - Inventory Management

Inventory Management

  • Definition of Inventory

    • Also known as stock

    • Includes goods to be sold (retail/manufacturing), raw materials, and work in progress

    • Service companies may also maintain some inventory

  • Costs of Inventory

    • High Inventory Costs:

    • Purchase cost

    • Holding costs (storage, theft, obsolescence, damage, insurance)

    • Low Inventory Risks:

    • Stockout leads to lost contributions and emergencies

    • High reorder costs

    • Loss of quantity discounts

  • Efficient Stock Holding

    • Optimum Reorder Level: Amount of goods remaining when reorder occurs

    • Optimum Reorder Quantity: Quantity ordered each time

    • Balance between holding costs, stockout costs, and reorder costs (liquidity vs profitability)

  • Key Terms

    • Lead Time: Time from order placement to delivery

    • Buffer Stock: Minimum inventory level kept for emergencies due to demand variability

  • Economic Order Quantity (EOQ)

    • Aim: Minimize total holding and ordering costs

    • Relevant Costs:

    • Variable holding cost: CHC_H per item

    • Fixed order cost: COC_O per order

    • EOQ formula: EOQ=2C<em>ODC</em>HEOQ = \sqrt{\frac{2C<em>OD}{C</em>H}}

    • Where DD = annual demand

  • EOQ Assumptions

    • Constant and known demand & lead time

    • Constant purchase price

    • Buffer stock typically not necessary (but might be maintained)

  • EOQ Example

    • Example numbers:

    • Demand = 30,000 units/year

    • Order Cost = £40

    • Holding Cost = £0.25/unit

  • Quantity Discounts

    • Calculate EOQ ignoring discounts

    • If EOQ < discount threshold, evaluate total inventory costs

    • Compare costs for EOQ vs minimum order for discount

  • Reorder Level

    • Determined by demand and lead time

    • Example: If lead time is 2 weeks and depletion rate is known, find reorder level based on inventory usage during lead time

    • Buffer stock is often kept due to variability in demand

  • Stock Management Systems

    • Bin Systems: E.g., two-bin method for stock management

    • Periodic Review: Inventory levels reviewed at fixed intervals

    • Just in Time (JIT): Methods to minimize inventory and enhance customer service

    • Focuses on producing exactly when needed and in required quantities

    • Aims to reduce capital tied in stock and eliminate non-value-adding activities

  • JIT Implementation

    • Involves reducing batch sizes and timely delivery of materials

    • Requires a good supplier relationship and reliability

    • Needs long-term trust and physical proximity to suppliers