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.