Analysis of Financial Statements Chap 4

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Chapter 4





Business should consider at what level of inventoryorders should be made

taking account of demand levels

delivery times and any uncertainties

Safety inventory may be held if uncertainties areparticularly large



Inventory costs can be conveniently classifiedinto four groups

Holding costs

Procuring costs

Shortage costs

The cost of the inventory itself



Economic order quantity (EOQ) is the most economic inventoryreplenishment order size, which minimizes the sum of inventory orderingcosts and inventory holding costs. EOQ is used in an 'optimizing’ inventory

control system.



EOQ formula may need to be modified if bulkdiscounts (also called quantity discounts) are

available Discount benefits in the form of

1. Total material costs

2. Ordering costs

3. Inventory holding costs



It is used when

replenishment of inventory is gradual rather than

instantaneouswhen a company is making the items itself rather

than ordering them



Re-order level = maximum usage x maximum lead time

It is the measure of inventory at which a replenishmentorder should be placed

By holding a safety inventory, a company can reduce thelikelihood that inventories run out during the re-order period



Maximum inventory level =

re-order level + re-order quantity - (minimum usage x minimum lead time)

▪

It is the inventory level set for control purposes which actualinventory holding should never exceed

Minimum inventory level or safety inventory =re-order level - (average usage x average lead time)

▪ It is the inventory level set for control purposes below whichinventory holding should not fall without being highlighted.



The aim of Just-in-time is to hold as little inventory as possible

Obtaining goods from suppliers at the latest possible time

JIT implies a mutually beneficial working relationship with suppliers



Purchasing may be centralized or decentralized

The effectiveness of the purchasing method affects profit in

three ways

1) Effective purchasing ensures the best value for money is obtained by the firm.

2) Effective purchasing assists in meeting quality targets.

3) An effective purchasing strategy minimizes the amount of purchased material held in

inventory.



Advantages of centralized purchasing The firm will be buying in larger quantities and so will be able to negotiate

more substantial discounts. It should be possible to hold lower overall levels of inventory than if inventory

was being held at each branch.

Only one buying department will be needed, which will save costs.

Advantages of decentralized purchasing Local branches will be more in control of their production and sales if they

have local control of purchasing.

The purchasing requirements of individual branches may vary. For instance,some lines of inventory may sell better in some areas than others. Local branches will be able to form their own relationships with suppliers. A local branch can be made more accountable for its own profitability and

cash management if it has control of its own purchasing function.





Advantages of closer relationships with suppliersinclude: Sharing of information. Better co-ordination.

The security of the relationship enables long-term planning. Discounts for bulk purchases. Preferred customer status and better service agreements.

Disadvantages Dependence on a supplier inhibits a firm's freedom. It may turn out more expensive. The balance of power might be unequal.



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Analysis of Financial Statements Chap 4