PM Inventory

7/30/2019 PM Inventory

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Inventory Management

Inventory


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Overview

Opposing Views of Inventories Nature of Inventories

Fixed Order Quantity Systems

Fixed Order Period Systems Other Inventory Models

Some Realities of Inventory Planning

Wrap-Up: What World-Class Companies Do


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Opposing Views of Inventory

Why We Want to Hold Inventories Why We Not Want to Hold Inventories


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Why We Want to Hold Inventories

Improve customer service Reduce certain costs such as

ordering costs

stockout costs acquisition costs

start-up quality costs

Contribute to the efficient and effective operation ofthe production system


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Why We Want to Hold Inventories

Finished Goods Essential in produce-to-stock positioning strategies

Necessary in level aggregate capacity plans

Products can be displayed to customers

Work-in-Process

Necessary in process-focused production

May reduce material-handling & production costs

Raw Material Suppliers may produce/ship materials in batches

Quantity discounts and freight/handling $$ savings


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Why We Do Not Want to Hold Inventories

Certain costs increase such as carrying costs

cost of customer responsiveness

cost of coordinating production

cost of diluted return on investment

reduced-capacity costs

large-lot quality cost

cost of production problems


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Nature of Inventory

Two Fundamental Inventory Decisions Terminology of Inventories

Independent Demand Inventory Systems

Dependent Demand Inventory Systems Inventory Costs


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Two Fundamental Inventory Decisions

How much to order of each material when orders areplaced with either outside suppliers or production

departments within organizations

When to place the orders


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Independent Demand Inventory Systems

Demand for an item carried in inventory isindependent of the demand for any other item in

inventory

Finished goods inventory is an example

Demands are estimated from forecasts and/or

customer orders


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Dependent Demand Inventory Systems

Items whose demand depends on the demands forother items

For example, the demand for raw materials and

components can be calculated from the demand for

finished goods

The systems used to manage these inventories are

different from those used to manage independent

demand items


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Inventory Costs

Costs associated with ordering too much (representedby carrying costs)

Costs associated with ordering too little (represented

by ordering costs)

These costs are opposing costs, i.e., as one increases

the other decreases

. . . more


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Inventory Costs (continued)

The sum of the two costs is the total stocking cost(TSC)

When plotted against order quantity, the TSC

decreases to a minimum cost and then increases

This cost behavior is the basis for answering the first

fundamental question: how much to order

It is known as the economic order quantity (EOQ)


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Balancing Carrying against Ordering Costs

Annual Cost ($)

Order Quantity

Minimum

Total Annual

Stocking Costs

AnnualCarrying Costs

AnnualOrdering Costs

Total AnnualStocking Costs

Smaller Larger

Lowe

r

Higher

EOQ


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Fixed Order Quantity Systems

Behavior of Economic Order Quantity (EOQ)Systems

Determining Order Quantities

Determining Order Points


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Behavior of EOQ Systems

As demand for the inventoried item occurs, theinventory level drops

When the inventory level drops to a critical point, the

order point, the ordering process is triggered

The amount ordered each time an order is placed is

fixed or constant

When the ordered quantity is received, the inventory

level increases . . . more


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Behavior of EOQ Systems

An application of this type system is the two-binsystem

A perpetual inventory accounting system is usually

associated with this type of system


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Determining Order Quantities

Basic EOQ EOQ for Production Lots

EOQ with Quantity Discounts


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Fixed order quantity system

Maximum stock

ROL

Q

Av

T1 T2

Average inventoryQ/2

LT

Point of order Point of re orderT


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A company makes 2000 units p.a.. Each unit needs a component Z.

Z costs Rs 10 per unit and its holding cost is Rs 2.4 per anum.

Cost of placing an order is Rs 150 and is not related to size.

Company works for 250 days an year.Lead time for delivery is 15 Days.

Let Q be the fixed order quantity. Q= D/N

N be the number of orders placed. N= D/QC be the Carrying cost per unit per anum. C= Q/2* Rate

D be the annual demand

S be the ordering cost per order. S = given fixed rate


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100 20 120 3000 3120

200 10 240 1500 1740

400 5 480 750 1230

500 4 600 600 1200

1000 2 1200 300 1500

2000 1 2400 150 2550

Order

Quantity

No of

orders

Carrying

costs

Ordering

costs

Total variable

cost

Q

N =

D/Q

C=Q/2

X 2.4

S = N X

150 TVC = C+S

Iterations

Daily consumption of Z = 2000/250= 8

ROR= 8 X 15 =120 pcs.


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Model I: Basic EOQ

Typical assumptions made annual demand (D), carrying cost (C) and ordering

cost (S) can be estimated

average inventory level is the fixed order quantity

(Q) divided by 2 which implies

no safety stock

orders are received all at once

demand occurs at a uniform rate

no inventory when an order arrives

. . . more


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Model I: Basic EOQ

Assumptions (continued) Stockout, customer responsiveness, and other costs

are inconsequential

acquisition cost is fixed, i.e., no quantity discounts

Annual carrying cost = (average inventory level) x

(carrying cost) = (Q/2)C

Annual ordering cost = (average number of orders per

year) x (ordering cost) = (D/Q)S . . . more


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CDS /2=EOQ

Model I: Basic EOQ

Total annual stocking cost (TSC) = annual carryingcost + annual ordering cost = (Q/2)C + (D/Q)S

The order quantity where the TSC is at a minimum

(EOQ) can be found using calculus (take the first

derivative, set it equal to zero and solve for Q)


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Example: Basic EOQ

Economical Order Quantity (EOQ)

D = 5,750,000 tons/year

C = .40(22.50) = $9.00/ton/year

S = $595/order

= 27,573.135 tons per order

EOQ = 2DS/C

EOQ = 2(5,750,000)(595)/9.00


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Example: Basic EOQ

Total Annual Stocking Cost (TSC)

TSC = (Q/2)C + (D/Q)S

= (27,573.135/2)(9.00)

+ (5,750,000/27,573.135)(595)= 124,079.11 + 124,079.11

= $248,158.22

Note: Total Carrying Costequals Total Ordering Cost


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Example: Basic EOQ

Number of Orders Per Year= D/Q

= 5,750,000/27,573.135

= 208.5 orders/year

Time Between Orders

= Q/D

= 1/208.5

= .004796 years/order

= .004796(365 days/year) = 1.75 days/order

Note: This is the inverse

of the formula above.


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Model II: EOQ for Production Lots

Used to determine the order size, production lot, if anitem is produced at one stage of production, stored in

inventory, and then sent to the next stage or the

customer

Differs from Model I because orders are assumed tobe supplied or produced at a uniform rate (p) rate

rather than the order being received all at once


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Model II: EOQ for Production Lots

It is also assumed that the supply rate, p, is greaterthan the demand rate, d

The change in maximum inventory level requires

modification of the TSC equation

TSC = (Q/2)[(p-d)/p]C + (D/Q)S

The optimization results in

dpp

CDS2=EOQ


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Model 2 determining EOQ for production lots

d=rate at which units are used p= rate at which units are produced

Maximum inventory level= inventory build up rate X

period of delivery= (p-d) (Q/p)

Average inventory level=1/2(max +min inventory)=

{(p-d) (Q/p)+0}=Q/2{(p-d)/p}


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Example: EOQ for Production Lots

Highland Electric Co. buys coal from CedarCreek Coal Co. to generate electricity. CCCC can

supply coal at the rate of 3,500 tons per day for

$10.50 per ton. HEC uses the coal at a rate of 800

tons per day and operates 365 days per year.HECs annual carrying cost for coal is 20% of the

acquisition cost, and the ordering cost is $5,000.

a) What is the economical production lot size?b) What is HECs maximum inventory level for coal?


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Economical Production Lot Size

d = 800 tons/day; D = 365(800) = 292,000 tons/year

p = 3,500 tons/day

S = $5,000/order C = .20(10.50) = $2.10/ton/year

= 42,455.5 tons per order

EOQ = (2DS/C)[p/(p-d)]

EOQ = 2(292,000)(5,000)/2.10[3,500/(3,500-800)]


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Total Annual Stocking Cost (TSC)

TSC = (Q/2)((p-d)/p)C + (D/Q)S

= (42,455.5/2)((3,500-800)/3,500)(2.10)

+ (292,000/42,455.5)(5,000)= 34,388.95 + 34,388.95

= $68,777.90

Note: Total Carrying Costequals Total Ordering Cost


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Maximum Inventory Level

= Q(p-d)/p

= 42,455.5(3,500800)/3,500

= 42,455.5(.771429)= 32,751.4 tons Note: HEC will use 23%

of the production lot by the

time it receives the full lot.


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Model III: EOQ with Quantity Discounts

Under quantity discounts, a supplier offers a lowerunit price if larger quantities are ordered at one time

This is presented as a price or discount schedule, i.e.,

a certain unit price over a certain order quantity range

This means this model differs from Model I because

the acquisition cost (ac) may vary with the quantity

ordered, i.e., it is not necessarily constant

. . . more


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Under this condition, acquisition cost becomes anincremental cost and must be considered in the

determination of the EOQ

The total annual material costs (TMC) = Total annual

stocking costs (TSC) + annual acquisition cost

TSC = (Q/2)C + (D/Q)S + (D)ac

. . . more


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To find the EOQ, the following procedure is used:1. Compute the EOQ using the lowest acquisition cost.

If the resulting EOQ is feasible (the quantity canbe purchased at the acquisition cost used), thisquantity is optimal and you are finished.

If the resulting EOQ is not feasible, go to Step 2

2. Identify the next higher acquisition cost.


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3. Compute the EOQ using the acquisition cost fromStep 2.

If the resulting EOQ is feasible, go to Step 4.

Otherwise, go to Step 2.

4. Compute the TMC for the feasible EOQ (just foundin Step 3) and its corresponding acquisition cost.

5. Compute the TMC for each of the lower acquisitioncosts using the minimum allowed order quantity for

each cost.6. The quantity with the lowest TMC is optimal.


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Example: EOQ with Quantity Discounts

A-1 Auto Parts has a regional tire warehouse inAtlanta. One popular tire, the XRX75, has estimated

demand of 25,000 next year. It costs A-1 $100 to

place an order for the tires, and the annual carrying

cost is 30% of the acquisition cost. The supplierquotes these prices for the tire:

Q ac

1499 $21.60500999 20.95

1,000 + 20.90


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Economical Order Quantity

This quantity is not feasible, so try ac = $20.95

This quantity is feasible, so there is no reason to tryac = $21.60

i iEOQ = 2DS/C

3EOQ = 2(25,000)100/(.3(20.90) = 893.00

2EOQ = 2(25,000)100/(.3(20.95) = 891.93


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Compare Total Annual Material Costs (TMCs)TMC = (Q/2)C + (D/Q)S + (D)ac

Compute TMC for Q = 891.93 and ac = $20.95

TMC2 = (891.93/2)(.3)(20.95) + (25,000/891.93)100

+ (25,000)20.95

= 2,802.89 + 2,802.91 + 523,750

= $529,355.80


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Compute TMC for Q = 1,000 and ac = $20.90TMC3 = (1,000/2)(.3)(20.90) + (25,000/1,000)100

+ (25,000)20.90

= 3,135.00 + 2,500.00 + 522,500= $528,135.00 (lower than TMC2)

The EOQ is 1,000 tires

at an acquisition cost of $20.90.


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Determining Order Points

Basis for Setting the Order Point DDLT Distributions

Setting Order Points


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EOP = 2S / DC

Determining the EOP

Using an approach similar to that used to deriveEOQ, the optimal value of the fixed time between

orders is derived to be


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Basis for Setting the Order Point

In the fixed order quantity system, the orderingprocess is triggered when the inventory level drops to

a critical point, the order point

This starts the lead time for the item.

Lead time is the time to complete all activities

associated with placing, filling and receiving the

order.

. . . more


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During the lead time, customers continue to drawdown the inventory

It is during this period that the inventory is vulnerable

to stockout (run out of inventory)

Customer service level is the probability that a

stockout will not occur during the lead time

. . . more


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The order point is set based on the demand during lead time (DDLT) and

the desired customer service level

Order point (OP) = Expected demand during lead

time (EDDLT) + Safety stock (SS)

The amount of safety stock needed is based on the

degree of uncertainty in the DDLT and the customer

service level desired


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DDLT Distributions

If there is variability in the DDLT, the DDLT isexpressed as a distribution

discrete

continuous

In a discrete DDLT distribution, values (demands)

can only be integers

A continuous DDLT distribution is appropriate when

the demand is very high

Setting Order Point


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Setting Order Point

for a Discrete DDLT Distribution

Assume a probability distribution of actual DDLTs isgiven or can be developed from a frequency

distribution

Starting with the lowest DDLT, accumulate the

probabilities. These are the service levels for DDLTs

Select the DDLT that will provide the desired

customer level as the order point


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Example: OP for Discrete DDLT Distribution

One of Sharp Retailers inventory items is nowbeing analyzed to determine an appropriate level of

safety stock. The manager wants an 80% service

level during lead time. The items historical DDLT

is:DDLT (cases) Occurrences

3 8

4 6

5 4

6 2


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OP for Discrete DDLT Distribution

Construct a Cumulative DDLT DistributionProbability Probability of

DDLT (cases) of DDLT DDLT or Less

2 0 0

3 .4 .4

4 .3 .7

5 .2 .9

6 .1 1.0To provide 80% service level, OP = 5 cases

.8

i i i i


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OP for Discrete DDLT Distribution

Safety Stock (SS)OP = EDDLT + SS

SS = OP EDDLT

EDDLT = .4(3) + .3(4) + .2(5) + .1(6) = 4.0SS = 54 = 1

Setting Order Point


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Setting Order Point

for a Continuous DDLT Distribution

Assume that the lead time (LT) is constant Assume that the demand per day is normally

distributed with the mean (d ) and the standard

deviation (sd )

The DDLT distribution is developed by adding

together the daily demand distributions across the

lead time

. . . more

Setting Order Point


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Setting Order Point


The resulting DDLT distribution is a normaldistribution with the following parameters:

EDDLT = LT(d)

sDDLT = LT d( )2

Setting Order Point


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Setting Order Point


The customer service level is converted into a Z valueusing the normal distribution table

The safety stock is computed by multiplying the Z

value by sDDLT.

The order point is set using OP = EDDLT + SS, or by

substitution

2

d

OP = LT(d) + z LT( )

E l OP C ti DDLT Di t ib ti


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Auto Zone sells auto parts and supplies

including a popular multi-grade motor oil. When the

stock of this oil drops to 20 gallons, a replenishment

order is placed. The store manager is concerned that

sales are being lost due to stockouts while waitingfor an order. It has been determined that lead time

demand is normally distributed with a mean of 15

gallons and a standard deviation of 6 gallons.

The manager would like to know the probabilityof a stockout during lead time.

Example: OP - Continuous DDLT Distribution



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EDDLT = 15 gallons sDDLT = 6 gallons

OP = EDDLT + Z(sDDLT )

20 = 15 + Z(6)5 = Z(6)

Z = 5/6

Z = .833



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Standard Normal Distribution

0 .833

Area = .2967

Area = .5

Area = .2033

z



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The Standard Normal table shows an area of .2967for the region between thez= 0 line and thez= .833

line. The shaded tail area is .5 - .2967 = .2033.

The probability of a stockout during lead time is

.2033

R l f Th b i S tti OP


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Set safety stock level at a percentage of EDDLTOP = EDDLT + j(EDDLT)

where j is a factor between 0 and 3.

Set safety stock level at square root of EDDLT

OP = EDDLT +

Rules of Thumb in Setting OP

EDDLT

Fi d O d P i d S t


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Fixed Order Period Systems

Behavior of Economic Order Period (EOP) Systems Economic Order Period Model

Beha ior of Economic Order Period S stems


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Behavior of Economic Order Period Systems

As demand for the inventoried item occurs, theinventory level drops

When a prescribed period of time (EOP) has elapsed,

the ordering process is triggered, i.e., the time

between orders is fixed or constant At that time the order quantity is determined using

order quantity = upper inventory target - inventory

level + EDDLT

. . . more



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After the lead time elapses, the ordered quantity isreceived , and the inventory level increases

The upper inventory level may be determined by the

amount of space allocated to an item

This system is used where it is desirable to physicallycount inventory each time an order is placed

Other Inventory Models


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Other Inventory Models

Hybrid Inventory Models Single-Period Inventory Models

Hybrid Inventory Models


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Optional replenishment model Similar to the fixed order period model

Unless inventory has dropped below a prescribed

level when the order period has elapsed, no order

is placed

Protects against placing very small orders

Attractive when review and ordering costs are

large . . . more



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Base stock model Start with a certain inventory level

Whenever a withdrawal is made, an order of equal

size is placed

Ensures that inventory maintained at an

approximately constant level

Appropriate for very expensive items with small

ordering costs

Single Period Inventory Models


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Order quantity decision covers only one period Appropriate for perishable items, e.g., fashion goods,

certain foods, magazines

Payoff tables may be used to analyze the decision

under uncertainty

. . . more



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One of the following rules can be used in the analysis greatest profit

least total expected long and short costs

least total expected costs



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ABC Classification EOQ and Uncertainty

Dynamics of Inventory Planning

ABC Classification


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ABC Classification

Start with the inventoried items ranked by dollarvalue in inventory in descending order

Plot the cumulative dollar value in inventory versus

the cumulative items in inventory

. . . more

ABC Classification


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ABC Classification

Typical observations A small percentage of the items (Class A) make up

a large percentage of the inventory value

A large percentage of the items (Class C) make up

a small percentage of the inventory value

These classifications determine how much attention

should be given to controlling the inventory of

different items

EOQ and Uncertainty


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EOQ and Uncertainty

The TSC and TMC curves are relatively flat,therefore moving left or right of the optimal order

quantity on the order quantity axis has little effect on

the costs

Estimation errors of the values of parameter used tocompute an EOQ usually do not have a significant

impact on total costs

. . . more

EOQ and Uncertainty


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EOQ and Uncertainty

Many costs are not directly incorporated in the EOQand EOP formulas, but could be important factors

Emergency procedures to replenish inventories

quickly should be established



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Continually review ordering practices and decisions Modify to fit the firms demand and supply patterns

Constraints, such as storage capacity and available

funds, can impact inventory planning

Computers and information technology are used

extensively in inventory planning

Wrap-Up: World-Class Practice


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Wrap-Up: World-Class Practice

Inventory cycle is the central focus of independentdemand inventory systems

Production planning and control systems are

changing to support lean inventory strategies

Information systems electronically link supply chain

Inventories


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Inventories

The cost of inventories is reported on the balance sheet and

reflects the price of goods purchased from other companiesor the costs to manufacture those goods if internallyproduced.

Costs will vary over time and for changes in market

conditions. Consequently, the goods available for sale will likely vary

in cost from one period to the nexteven if the quantity ofgoods available remains the same.

Inventories


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Inventories

Inventory costs either are reported on the balancesheet or they are transferred to the income

statement as an expense (cost of goods sold) to

match against sales revenues.

The process for which costs are removed from thebalance sheet is important.

Capitalization Costs


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Capitalization Costs

Capitalization means that a cost is recorded on the

balance sheet and is not immediately expensed on theincome statement.

Once costs are capitalized, they remain on the balancesheet as assets until they are used up, at which time they

are transferred from the balance sheet to the incomestatement as expense.

If costs are capitalized rather than expensed, then assets,current income, and current equity are all greater.

Cost Capitalization


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Cost Capitalization

For purchased inventories (such as with merchandisers),

the amount of cost capitalized is the purchase price.

For manufacturers, the capitalization issue is moredifficult.

Manufacturing costs consist of three components:

1. Raw materials2. Direct labor

3. Manufacturing overhead (all manufacturing costsexcept raw materials and direct labor)

Manufacturing Costs


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Manufacturing Costs

Raw materials cost is relatively easy to compute. Design

specifications list the components of each product, andtheir purchase costs are readily determined.

Labor cost in a unit of inventory is based on how long eachunit takes to build and the rates for each labor class

working on that product. Overhead costs include the manufacturing plant

depreciation, utilities, plant supervisory personnel, and soforth.

Cost of Goods Sold


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Cost of Goods Sold

When inventories are used up in production or aresold, their cost is transferred from the balancesheet to the income statement as cost of goods sold(COGS). COGS is then matched against salesrevenue to yield gross profit:

Sales revenue

- COGS

Gross profit

The Cost of Goods Sold Computation


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C G S C p

Inventory Cost Flows to

Fi i l St t t


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Financial Statements

Inventory Costing Methods


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ve to y Cost g et ods

F irst-I n. Fi rst-Out (FI FO). This method assumes that the

first units purchased are the first units sold.

Last-In, Fi rst-Out (LI FO). The LIFO inventory costingmethod assumes that the last units purchased are the firstto be sold.

Average cost. The average cost method assumes that theunits are sold without regard to the order in which theyare purchased. Instead, it computes COGS and endinginventories as a simple weighted average.


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Inventory Costing Effects on

I St t t


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Income Statement

Inventory Costing Effects on

Balance Sheet


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Balance Sheet

In periods of rising prices, and assuming that thecompany has not previously liquidated olderlayers of inventories, using LIFO would yieldending inventories at costs that can be markedlylower than replacement cost.

As a result, balance sheets using LIFO do notaccurately represent the current investment ininventories.

Inventory Costing Effects on Cash Flows


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y g

In periods of rising prices, companies can get caught in a

cash flow squeeze as they pay higher taxes and mustreplenish inventories at higher replacement costs thanoriginally purchased. This can lead to liquidity problems.

One reason frequently cited for using LIFO is the reducedtax liability in periods of rising prices.

Companies using LIFO may also be required to disclosethe amount at which inventories would have been reportedhad it used FIFO. The difference between these twoamounts is called the LIFO reserve.

CATs LIFO Reserve


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Impairment of Inventories


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p

Companies are required to write down the carrying amount ofinventories on the balance sheet if, at the statement date, thereported cost exceeds their market value (determined as thecurrent replacement cost).

This is called reporting inventories at the lower of cost or

market. Inventory book value is written down to market value.

Inventory write-down is reflected as an expense (part ofcost of goods sold) on the income statement.

Gross profit analysis


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p y

Gross profit ratio equals gross profit divided by sales. This

is an important ratio and is frequently monitored bycompany management and external equity analysts alike.

The gross profit ratio is frequently used instead of thedollar amount of gross profit as it allows for comparisonsacross companies.

A decline in this ratio is usually cause for concern since itindicates that the company has less ability to mark up thecost of its products into selling prices.

Possible Causes for a Decline in Gross Profit Ratio


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Possible Causes for a Decline in Gross Profit Ratio

Some possible reasons for a decline in Gross Profit Ratio follow:

Product line is stale. Perhaps it is out of fashion and thecompany has had to resort to markdowns to reduceoverstocked inventories. Or, perhaps the product lineshave lost their technological edge and are no longer indemand.

New competitors enter the market. Since there are nowsubstitutes available from competitors, increased sellingprices is less likely.

General decline in economic activity. This could reduce

demand for its products. The recession of the early 2000sresulted in reduced gross profits for many companies.

Inventory is overstocked. If a company produces too manygoods and finds itself in an overstock position, it canreduce selling prices to move inventory.

Inventory Turnover Rates for Selected Companies


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Long-Term Assets


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Long-term assets mainly consist of property,

plant, and equipment (PPE).

These assets often makeup the largest asset

amounts.

Future expenses arising from these long-termassets often makeup the larger expense amounts

typically reflected in depreciation expense and

asset write-downs.

Capitalization of Costs


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An expenditure is only reflected on the balance sheet as an asset if it

possesses two characteristics:1. It is owned or controlled by the entity, and

2. It provides future expected benefits.

Owning the asset means the entity has title to the asset as provided ina purchase contract.

Future expected benefits usually mean cash inflows. Companies can only capitalize costs for which the associated cash

inflows are directly linked.

The amount of costs that can be reported as an asset is limited to anamount no greater than the expected future cash inflows from theinvestment.

Capitalizing vs. Expensing


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The qualification that only those costs for which

the associated cash inflows are directly linkedis an

important one.

The following costs are typically expensed:

Research & Development (R&D)

Advertising Costs

Employee Wages

Depreciation Factors and Process


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Depreciation requires the following estimates:1. Useful lifeperiod of time over which the asset is

expected to generate cash inflows

2. Salvage valueExpected disposal amount for the assetat the end of its useful life

3. Depreciation ratean estimate of how the asset will beused up over its useful life.

Depreciation Rate Assumptions


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1. The asset is used up by the same amount eachperiod

2. The asset is used up more in the early years of its

useful life3. The asset is used up in proportion to its actual

usage

Variance in Depreciation


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A company can depreciate different assets using different depreciation

rates (and different useful lives). Whatever depreciation rate is chosen, however, it must generally be

used throughout the useful life of that asset.

Changes to depreciation rates can be made, but they must be justifiedas providing better quality financial reports.

The using up of an asset generally relates to physical or technologicalobsolescence.

Physical obsolescencerelates to an assets diminished capacity toproduce output.

Technological obsolescencerelates to an assets diminishedefficiency in producing output in a competitive manner.

Depreciation Methods


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All depreciation methods have the following

general formula:

Depreciation Methods:

1. Straight-line method

2. Accelerated Methods (Double-declining-

balance method)

Straight-line Method


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Straight-line method: Under the straight-line (SL)

method, depreciation expense is recognized evenly

over the estimated useful life of the asset.

Consider the following example

An asset (machine) with the following details:(1) cost of $100,000

(2) salvage value of $10,000

(3) useful life of 5 years

Straight-line Depreciation Example


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For the straight-line method, we use our illustrative asset toassign the following amounts to the depreciation formula:

SL Example


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For the assets first year of usage, $18,000 ($90,000 * 20%) of

depreciation expense is reported in the income statement. At the end ofthat first year the asset is reported on the balance sheet as follows:

Net book value (NBV) is cost less accumulated depreciation.

At the end of year 2, the net book value will be reduced by another$18,000 to $64,000.

Double-declining-balance method


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Double-declining-balance method. For the double-

declining-balance (DDB) method, we use our

illustrative asset to assign the following amounts to

the depreciation formula:

Double-declining-balance method


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The asset is reported on the balance sheet as follows:

In the second year, $24,000 ($60,000 40%) of

depreciation expense is recorded in the income statementand the NBV of the asset on the balance sheet follows:

DDB Depreciation Schedule


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Comparison of Depreciation Methods


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Uni ts-of-Output Al location Method(Al location Varies

Each Period Depending upon Output)

Annual Allocation =

outputsyear'currentoutputtotalEstimated

salvage)estimated-(Cost

E l C t $2 000 000


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Example: Cost = $2,000,000

Estimated Salvage = $100,000

Estimated Useful Life = 8 years

Total Estimated Output Over Life

of Asset = 750,000 units

Current Year Output = 80,000 units

Current Year

Allocation ($2,000,000 - $100,000) 750,000

= $2.533 per unit 80,000 units

= $202,667

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