Inventory Management and Cost Categories

Inventory Management

• The objective of inventory management is to maintain a sufficient amount of inventory to ensure smooth operation of production and marketing functions while avoiding excessive and slow-moving inventory.

Major Categories of Inventory Costs

• Ordering Costs/Setup Costs: all paperwork needed to place the order and shipping costs.
• Carrying Costs: including holding costs, storage costs, risk costs, and capital costs.
• Stockout Costs: costs resulting from not having a product available for sale when required, including:
  • Disruption of production (added labor and overhead costs)
  • Extra costs of uneconomic production runs
  • Extra costs of purchasing and transportation
  • Foregone quantity discounts
  • Loss of customer goodwill

Determining Optimum Inventory Level

• To minimize stockout costs, compute the least total cost (stockout cost + carrying cost).
• Example: Casino Company determines the amount of safety stock that will result in the lowest cost.

Inventory Control Systems

• Min-Max System: inventory levels are kept at pre-determined minimum and maximum levels.
• Two-Bin System: inventory is maintained in two bins, signaling the need to reorder when the first bin is fully consumed.
• Red-Line Method: similar to the first two systems, inventory reorder point is set once the red-line is breached.
• Order-Cycling System: physical count is done at predetermined periodic intervals to determine reorder point.
• Statistical Inventory Control System: statistical and mathematic models are used.
• Turnover Rates: inventories are kept in stock based on the speed of its movement.
• ABC System: goods are classified as types A, B, or C depending on their value and inventory turnover rate.
• Just-In-Time Systems: system where zero or minimum level of inventory is kept to reduce cost of money tied up with inventory.

Mathematical and Statistical Models

• Economic Order Quantity (EOQ) Model: Total ordering costs = Total carrying costs.
• Tabular Method, Graphic Method, and Formula Method: used to calculate EOQ.
• Formula Method: EOQ = √(2 x S x OC / CC), where S = annual sales demand or usage, OC = cost per order, and CC = carrying cost.
• Optimum Number of Orders: S / EOQ.
• Annual Ordering Costs: S x OC / EOQ.
• Average Inventory: EOQ / 2.
• Annual Carrying Costs: CC x EOQ / 2.

Reorder Point (ROP)

• ROP Formula: ROP = Lead Time Usage + Safety Stock.
• Alternative Formula: ROP = Average daily sales or usage x Maximum lead time in days.
• Components: Lead Time Usage (LTU), Safety Stock, Normal lead time in days, and Average daily sales or usage in units.

Inventory Turnover

• Inventory Turnover Formula: Cost of Sales / Average Inventory.
• Example: Earth Corporation increases inventory turnover from 9 times per year to 12 times per year, resulting in savings.