Inventory Management and Financial Goals

Inventory System

• Inventory is the stock of items or resources used in an organization. This can include raw materials, finished products, component parts, supplies, and work in process.
• An inventory system is a set of policies and controls that monitor inventory levels, determine appropriate levels to maintain, when stock should be replenished, and how large orders should be.

Primary Goal in Financial Management

• The primary goal in financial management is the maximization of shareholder wealth.
• To achieve this, strategic plans and operations should be focused on maximizing revenues and minimizing costs, expenses, and losses.

Inventory Costs

• Holding (carrying) costs: Costs associated with storage, handling, and insurance of inventory.
• Setup (production change) costs: Costs for arranging specific equipment setups.
• Ordering costs: Costs associated with placing an order.
• Shortage costs: Costs related to canceling an order, or difficulties in meeting customer demand.

Inventory Systems Models

• Single-period inventory model: A one-time purchasing decision, such as a vendor selling t-shirts at a football game. This model aims to balance the costs of overstocking and understocking.
• Multi-period inventory models: Models used for situations requiring inventory management over a series of time periods.
  • Fixed-order quantity models (EOQ): An inventory control model where the amount requisitioned is fixed, and orders are placed when the inventory level reaches a predetermined point.
  • Fixed-time period models: Inventory orders are placed at fixed intervals of time, such as monthly.

Fixed-Order Quantity Model Assumptions

• Consistent and uniform product demand throughout the period.
• Constant lead time from ordering to receipt.
• Constant price per unit of product.
• Constant ordering/setup costs.
• All demands for the product will be met (no backorders).
• Inventory holding cost is based on average inventory.

Fixed-Order Quantity Model Behavior

• The system begins by receiving a pre-determined reorder quantity (Q).
• Inventory is depleted over time.
• When the inventory level reaches the reorder point (R), a new order is placed for Q units.
• The cycle repeats.

Cost Minimization Goal

• By combining item holding and ordering costs, the total cost curve can be determined.
• The optimal order quantity (Qopt) minimizes the total costs.
• There is a direct relationship between order size and the total cost to carry. A decrease in order size results in a decrease in the total cost to carry; an increase in order size increases the total cost to carry.
• There is an inverse relationship between order size and total cost per order. A decrease in order size results in an increase in the total cost per order; an increase in order size results in a decrease in the total cost per order.

EOQ Model Formula

• Total cost (TC) is calculated by summing the annual purchase cost and annual ordering costs, plus annual holding costs.
• This formula utilizes variables such as annual demand (D), cost per unit (C), ordering cost per order (S), holding cost per unit (H), and reorder point (R).
• The optimal order quantity (Q₂) is a critical element in minimizing total costs.
• Lead time (L) is the time from placing an order to receiving it.

Deriving EOQ

• Using calculus, the derivative of the total cost function with respect to Q is taken.

• Setting this derivative equal to zero determines the optimized (cost-minimized) order quantity (Q_opt), which will be the minimum total cost.

• The reorder point (R) is calculated by multiplying the average daily demand (d) and the lead time (L).

Example (1) and Solution

• Problem data including annual demand, daily demand (days per year), cost to place an order, holding cost per unit per year, lead time, and cost per unit are given.
• The EOQ is calculated using the formula.
• The reorder point is calculated based on the daily demand.
• The analysis concludes that a specified number of quality units, or 90 units in this case, minimizes costs.

Example (2)

• Problem data, including annual demand, daily demand, order cost, holding cost (10% of cost per unit), lead time, and unit cost, is given.
• A similar calculation is followed to find the EOQ, and reorder point.
• For example, an estimated order, with 366 quality units, minimizes total costs.

Application and Considerations

• The cost-minimizing EOQ and reorder point are needed to successfully manage inventory levels for companies.
• EOQ and reorder points address questions about optimal order sizes to avoid stockouts and excessive inventory while maintaining low costs.
• Advance inventory orders are fine for business considerations.

Problem Solving Quiz

• The problem presents relevant data like annual demand, ordering costs, carrying costs, and the current ordering quantity.
• Individuals need to compute and determine the following: economic order quantity, number of orders per year, annual ordering cost, annual carrying cost, and total annual cost.

This quiz covers key concepts in inventory management and financial management, including inventory systems, costs, and the primary goal of maximizing shareholder wealth. Test your understanding of how these elements interact in an organization.