Chapter 7 Pages 119 - 130-converted.docx

CHAPTER 7 / MATERIALS Obsolescence. When materials or components become out-of-date and are no longer required, existing inventories must be thrown away and their cost must be written off to the statement or profit or loss (income statement). Deterioration. When materials in store deteriorate to the...

CHAPTER 7 / MATERIALS Obsolescence. When materials or components become out-of-date and are no longer required, existing inventories must be thrown away and their cost must be written off to the statement or profit or loss (income statement). Deterioration. When materials in store deteriorate to the extent that they are unusable, they must be thrown away (with the likelihood that disposal costs would be incurred) and again, the value written off inventory plus the disposal costs will be a charge to the statement of profit or loss (income statement). Stockout costs (costs of running out of inventory) If too much inventory is held, holding costs will be incurred unnecessarily. But if too little inventory is held, the business may run out of inventory and incur stockout costs. Stockout costs include: Lost contribution from lost sales Loss of future sales due to disgruntled customers Loss of customer goodwill as the product they require is not available Cost of production stoppages Labour inefficiency costs due to frustration over stoppages Extra ordering costs for urgent, small quantity orders A business has to decide the optimum amount of inventory to hold so that the overall COSt Of inventory (purchase, ordering, holding and stockout costs) is minimised. Other reasons for holding inventories Businesses hold inventories to ensure sufficient goods are available to meet expected production requirements. Other reasons for holding inventories are as follows. To provide a buffer between processes To meet any future shortages To take advantage of bulk purchasing discounts To absorb seasonal fluctuations and any variations in usage and demand To allow production processes to flow smoothly and efficiently As a necessary part of the production process (such as when maturing cheese) As a deliberate investment policy, especially in times of inflation or possible shortages Inventory control levels can be calculäted in order to maintain inventories at the optimum level. The three critical control levels are reorder level, minimum level and maximum level. ' "Based on"an aha ysis"of past inventor usage and delves tmes,"inventory"control levels can be " " " " calculated and used to maintain inventory at their optimum level (in other words, a level which minimises costs). These levels will determine 'when to order’ and ’how many to order'. Reorder level When inventories reach the reorder level, an order should be placed to replenish inventories. The reorder level is determined by considering: The maximum rate of consumption The maximum lead time The maximum lead time is the time between placing an order with a supplier, and the inventory becoming available for use. Reorder level = maximum usage x maximum lead time *!-›’. ‘ Minimum level The minimum level is a warning level to draw management attention to the fact that inventories are approaching a dangerously low level and that stockouts are possible. 0“ 0 "*. ”I” Minimum level = reorder level — (average usage x average lead time) Maximum level The maximum level also acts as a warning level to signal to management that inventories are reaching a potentially wasteful level. A large retailer with multipleoutlets maintains a central warehouse from which the outlets are supplied. The following information is availablefor Part NumberSF525. Average usage 350 per day Minimum usage T80 per day Maximum usage 420 per day Lead time for replenishment 1 1—15 days Re-order quantity 6,500 units Re-order level 6,300 units Based on the data above, what is the maximum level of inventory? A 5,250 B 6,500 C 10,820 D 12,800 Based on the data above, what is the approximate number of Part Number SF525 carried as buffer inventory7 A 200 B 720 C 1,680 D l ,750 Maximum inventory level = reorder level + reorder quantity — (min usage x min lead time) = 6,300 + 6,500 — (180 x 1 1) = 10,820 The correct answer is C. You should have eliminated option A immediately because the maximum inventory level cann0t be less than the reorder quantity. Buffer inventory — minimum level Minimum level = reorder level — (average usage x average lead time) = 6,300 — (350 13) = 1,750. The correct answer is D. Option A could again be easily eliminated. With minimum usage of 180 per day, a buffer inventory of only 200 would not be much of a buffer! ing a CHAPTER 7 // MATERIALS Reorder quantity This is the quantity of inventory which is to be ordered when inventory reaches the reorder level. If it is set so as to minimise the total costs associated with holding and ordering inventory, then it is known as the economic order quantity. Average inventory The formula for the average inventory level assumes that inventory levels fluctuate evenly between the minimum (or safety) inventory level and the highest possible inventory level (the amount of inventory immediately after an order is received, ie safety inventory + reorder quantity). Average inventory — safety inventory + ‘/z reorder quantity Average inventory A component has a safety inventory of 500, a re-order quantity of 3,000 and a rate of demand which varies between 200 and 700 per week. What is the approximate average inventory7 Plied. A 2,000 B 2,300 ‹ ” “” C 2,500 D 3,500 /\verage inventory = safety inventory + */2 reorder quantity — 500 + (0.5 x 3,000) = 2,000 The correct answer is A. S 3Ot Economic order quantity (EOQ) Economic order theory assumes that the average inventory held is equal to one half of the reorder quantity (although, if an organisation maintains some sort of buffer or safety inventory then average inventory = buffer inventory + half of the reorder quantity). We have seen that there are certain costs associated with holding inventory. These costs tend to increase with the level of inventories, and so could be reduced by ordering smaller amounts from suppliers each time. On the other hand, as we have seen, there are costs associated with ordering from suppliers: documentation, telephone calls, payment of invoices, receiving goods into stores and so on. These costs tend to increase if small orders are placed, because a larger number of orders would then be needed for a given annual demand. Example: Economic order quantity Suppose a company purchases raw material at a cost of $16 per unit. The annual demand for the raw material is 25,000 units. The holding cost per unit is $6.40 and the cost of placing an order is $32. We can tabulate the annual relevant costs for various order quantities as follows. Order quantity(units) Note 100 200 300 400 500 600 800 1,000 Averageinventory(units) 1 50 100 150 200 250 300 400 500 Numberoforders 2 250 125 83 63 50 42 31 25 Annual holding cost 3 320 640 960 T,280 1,600 1,920 2,560 3,200 Annual order cost 4 8,000 4,000 2,656 2,016 1,600 1,344 992 800 Total relevant cost 8,320 4,640 3,616 3,296 3,200 3,264 3,552 4,000 Notes Average inventory = Order quantity - 2 (ie assuming no safety inventory) Number of orders = annual demand - order quantity Annual holding cost = Average inventory $6.40 Annual order cost = Number of orders $32 You will see that the economic order quantity is 500 units. At this point the total annual relevant costs are at a minimum. Example: Economic order quantity graph We can present the information in the table above in graphical form. The vertical axis represents the relevant annual costs for the investment in inventories, and the horizontal axis can be used to represent either the various order quantities or the average inventory levels; two scales are actually shown on the horizontal axis so that both items can be incorporated. The graph shows that, as the average inventory level and order quantity increase, the holding cost increases. On the other hand, the ordering costs decline as inventory levels and order quantities increase. The total cost line represents the sum of both the holding and the ordering costs. Annual costs Economic order quantity graph 9,000 — 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Total costs Holding costs Ordering costs Order quantity (units) Average inventory level (units) 100 200 300 400 500 Note that the total cost line is at a minimum for an order quantity of 500 units and occurs at the point where the ordering cost curve and holding cost curve intersect. The EO\Z is therefore found at the point where holding costs equal ordering costs. ’aW 2. JOO 500 25 ?00 300 00 ›° 5.6.3 EOQ formula The EOQ formula is as follows. EOQ = where C, = cost of holding one unit of inventory for one time period Ct = cost of ordering a consignment from a supplier D = demand during the time period Use the formula to calculate the EOQ in the example in Paragraph 5.6.1 above. asts e !sent the EOQ 2 x $32 x 25,000 ' \ $6.40 = 250 000 = 500 units ›oth A manufacturing company uses 25,000 components at an even rate during a year. Each order placed with the supplier of the components is for 2,000 components, which is the economic order quantity. The company holds a buffer inventory of 500 components. The annual cost of holding one component in inventory is $2. What is the total annual cost of holding inventory of the component? A $2,000 B $2,500 C $3,000 AN$W ER D $4,000 mint oint Although the basic principles of inventory control are not difficult in themselves, you will appreciate by now that an effective system requires a good deal of administrative effort, even if only a few items of inventory are involved. There is therefore a good deal to be gained from computerisation of this function. A typical computerised inventory file would contain a record for each item, each record having fields (individual pieces of data) as follows. Inventory code: a unique inventory code to identify each item. This could be in bar code form for large organisations. Descriptions a brief description is helpful when perusing inventory records and probably essential when printing out lists of inventory for stocktaking purposes. Ideally the system will generate purchase orders which also require brief narrative details. Supplier code: this would match the code for the supplier in the purchase ledger. Supplier's reference number: again this information would be needed for purchase orders. Quantity per unit: this would specify how many individual items there were per 'unit'. This is sometimes called the 'factor'. (fJ Cost price per item. Control levels: there would be a field for each of the four control levels (minimum and maximLlM inventory, reorder level and reorder quantity). (h› Location: a location code could be included if it were not part of the inventory code itself. Movements history: there could be fields for issues per day, per week, during the last month, in the last year and so on. Job code: there might be a field allowing costs to be linked to specific jobs. Inventories could be 'reserved' for jobs due to be started in the next week, say. Inventory reports A system with fields such as those above might be able to generate the following reports. Daily listing: a daily list of all items ordered, received, issued or placed on reserve. This might have 'exception reports' for unusual movements of inventory and for items that had reached the reorder level. Inventory lists: lists could be produced for stocktaking purposes, with inventory codes, descriptions and locations. This could be restricted to certain types of inventory, such as high value items or inventories with high turnover. Inventory movements: a report of inventory movements over time would help in setting control levels and in identifying 'slow-moving inventory' that is not really required. Inventory valuations: this would show Current balances and place a value on inventories according to which calculation method (FIFO, LIF0, and so on) was in use. Supplier analysis: this would list all the items of inventory purchased from the same supplier, and might be useful for placing orders Tseveral items could be ordered at the same time, cutting delivery costs). Bill of materials Many computerised inventory control systems have a bill of materials facility. This allows assembly records (sometimes called explosion records) to be compiled, containing details of the various assemblies that make up the final product. A CD player, for example may have three main assemblies — the motor mechanism, the electronics and the outer casing. Each individual assembly could be further broken down into its constituent materials and components. A common fallacy It is sometimes assumed that computerising inventory records will guarantee they are t00% accurate. In fact discrepancies are just as likely to occur in a computerised as a non-computerised system. Stocktaking is thus equally important in a computerised inventory system as it is in a manual system.