TOPIC 7: INVENTORY MANAGEMENT

Topic Learning Outcomes

After this topic, you should be able to:
1. Differentiate various views of inventory management.
2. Discuss and apply the EOQ model.
3. Apply the common techniques for managing inventory.

Be Engaged
Read:
Gardenia expects P8B in sales in 2019

Leading bread manufacturer Gardenia Bakeries targets to cash in close to P8 billion worth of sales this year as
the company inaugurated its most advanced breadmaking facility yet.

Company president Simplicio Umali Jr. said Gardenia made about P6.8 billion worth of sales last year.
“We hope to close the year with P8 billion in terms of sales,” he said. To reach P8 billion, the company has to
grow at least 18 percent this year.

Gardenia inaugurated its second-largest manufacturing facility in the country on Tuesday. The fully automated
facility, which can produce 400,000 loaves and buns a day, is located in an industrial park in Mabalacat,
Pampanga. On the sidelines of the inauguration, Umali told reporters that the robust market demand prompted
the company to fully use the plant’s capacity in one year, instead of three years as earlier expected.
This means the factory will have three shifts at the end of the year, with each shift having about 100 workers
doing various jobs such as quality checks and distribution. For now, it is operating on one work shift.

At the full capacity of all its plants, the company can make 1.8 million loaves and buns. But while he said
Gardenia has already cornered 60 percent of the market, he said it was getting “very small” profit margins.

He did not disclose figures, only attributing this to the high costs of its ingredients, which are mostly imported,
as well as the inability of the market to absorb higher costs. “You can’t price yourself too high because the
market will not buy your product,” he said. “In terms of profitability, it will still be very low. But we expect to
recover this over time in the coming years because you have to recover first the investment in the factories,”
he said. Apart from the P2-billion plant in Pampanga, Gardenia opened another facility in Mindanao earlier this
year, a P1-billion breadmaking plant that can produce 130,000 loaves and buns a day.

Excerpt from: [Link]

Think:
1. What are the advantages and of automation and computerization of production lines and inventory of
companies?
2. Why do you think the company above successfully earns profit despite the complexity of its operation?
3. Do you think there is a convergence of financial and operating function within the company above?
Why or why not?
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 Let’s Discuss
1. Differing Viewpoints about Inventory Level
2. Common Techniques for Managing Inventory
3. International concerns about Inventory
4. Inventory Costs: Carrying, Ordering, Stock-out cost
5. Inventory control system including EOQ model, safety stock, reorder point

Differing Viewpoints about Inventory Level

Optimal inventory levels depend on sales, so sales must be forecasted before target inventories can be
established. Moreover, because errors in setting inventory levels lead to lost sales or excessive carrying costs,
inventory management is quite important.

ABC inventory system

• Inventory management technique that divides inventory into three groups—A, B, and C, in descending
order of importance and level of monitoring—on the basis of the dollar investment in each.

two-bin method
• Unsophisticated inventory monitoring technique that is typically applied to C group items and involves
reordering inventory when one of two bins is empty.

economic order quantity (EOQ) model

• Inventory management technique for determining an item’s optimal order size, which is the size that
minimizes the total of its order costs and carrying costs.

Economic Order Quantity (EOQ) model and Reorder point Model

order costs
• The fixed clerical costs of placing and receiving an inventory order.

carrying costs
• The variable costs per unit of holding an item in inventory for a specific period of time.

total cost of inventory

• The sum of order costs and carrying costs of inventory.

Economic Order Quantity (EOQ) Model

• used to identify the order size that will minimize the sum of the annual costs of holding inventory and
ordering inventory.
• Assumption of basic EOQ model
1. Only one product is involved
2. Annual demand requirement is known
3. Demand is spread evenly throughout the year
4. Lead time is always constant
5. Each order is received in a single delivery
6. No quantity discount is granted
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 • The optimal order quantity reflects a trade-off between carrying costs and ordering costs: As order size
varies, one type of cost will increase while the other decreases.

The EOQ formula:

Where:
Q0 = the EOQ
D = Annual Demand for quantity of inventory
S = ordering cost per order
H = holding cost or carrying cost of inventory per unit

The computation of Annual Carrying cost:

Note:
• The term (Q / 2) or (EOQ / 2) is the average inventory
• If the company has a safety stock policy, the average inventory is (Q / 2) + Safety Stock in no. of units

The computation of Annual Ordering cost:

Note:
• The term (D / Q) or (D / EOQ) is the no. of orders per year
• If the company has a safety stock policy, the no. of orders per year is still the same.

The computation of Total annual cost:

Note:

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 • These two variables in determining the Total cost are always equal if the Quantity Used to derive them
are the EOQ

Inventory Cycle
A cycle begins with receipt of an order of Q units, which are withdrawn at a constant rate over time. When the
quantity on hand is just sufficient to satisfy demand during lead time, an order for Q units is submitted to the
supplier. Because it is assumed that both the usage rate and the lead time do not vary, the order will be
received at the precise instant that the inventory on hand falls to zero. Thus, orders are timed to avoid both
excess stock and stockouts. Illustration:

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Illustration of tradeoff between inventory level and number of order (Inverse relationship):

When the number of orders increases the level of inventory decreases since the company orders more often
then can replenish the inventory most often result to less holding of inventory, and vice versa

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The Curve of Carrying Cost, Ordering cost and total cost:

Analysis:
a. Annual Carrying cost is directly related to order quantity. Since the company order more units or
goods, they will incur more carrying cost.
b. Annual Ordering cost is inversely related to the order quantity. When the firm orders in more units in
one order, the number of orders it needs per year decreases.
c. The intersection of the curve in (a) and (b) is the optimal or the economic order quantity, where the
total cost of carrying and ordering (total annual cost) are at lowest, and t the total cost of carrying and
ordering are always equal at this point.

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 Reorder point
• The point at which to reorder inventory, expressed as days of lead time multiplied by daily usage.
• reflects the number of days of lead time the firm needs to place and receive an order and the firm’s
daily usage of the inventory item.
• When the quantity on hand of an item drops to this amount, the item is reordered.

The goal in ordering is to place an order when the amount of inventory on hand is sufficient to satisfy demand
during the time it takes to receive that order (i.e., lead time). There are four determinants of the reorder point
quantity:
1. The rate of demand (usually based on a forecast).
2. The lead time.
3. The extent of demand and/or lead time variability.
4. The degree of stockout risk acceptable to management.

Reorder point model

If demand and lead time are both constant, the reorder point is simply
ROP = (Average Daily Usage * Normal lead time)

Note:
• The ROP is the same as the Normal Lead Time usage under this scenario where demand and lead
time is constant

When variability is present in demand or lead time, it creates the possibility that actual demand will exceed
expected demand, in this case the ROP is the

ROP = (Average Daily Usage * Normal lead time) + Safety Stock

Safety Stock = (Maximum Lead time – Normal lead time) * Average Daily Usage

Illustration: How safety stock reduces the risk of stockout

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 Note:
• The safety stock is computed as the inventory usage during the under certain time between the
Normal lead time and maximum expected lead time.
• ROP under this scenario is the NLT usage plus the safety stock that act as a buffer.

ILLUSTRATIVE PROBLEMS
Bulldogs Corp. projects its sales to be P60,000,000., which equates to 12,000 units this year. As a result of
holding inventories, insurance, storage, taxes and other cost are incurred amounted to P1.60 per unit, which
includes allocation of loss due to theft and obsolescence and opportunity cost of cash tied up. Every time
Bulldogs Corp. makes an order, P6.00 is incurred. On the average it takes 6 days to make and receive an order.
(Use 360 days a year)

1. What is the economic order quantity (EOQ)? 300

2. What is the average inventory? 150
3. How much is the annual cost of carrying inventory? 240
4. How many orders will be placed during the year? 40
5. How many days will each order last? 9 days
6. How much transaction cost are incurred each year? 240
7. How much is the annual cost of inventory? 480

8. How long is the normal lead time? 6 days

9. How many units of inventory is the average daily usage? 33.33
10. What is the normal lead time usage? 200
11. What amount of inventory is reorder point (what is the reorder point)? 200 units

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Solution:

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Assuming Bulldogs Corp.’s inventory may take as 7.5 days to respond:
1. How much safety stock should the company keep? 50 units

2. What is the economic order quantity (EOQ)? 300 units

3. What is the average inventory? 200
4. How much is the annual cost of carrying inventory? 320
5. How many orders will be placed during the year? 40
6. How many days will each order last? 9 days
7. How much transaction cost are incurred each year? 240
8. How much is the annual cost of inventory? 560

9. How long is the normal lead time? 6 days

10. How many units of inventory is the average daily usage? 33.33
11. What is the normal lead time usage? 200
12. What amount of inventory is reorder point (what is the reorder point)? 250 units

Solution:

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 References
Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
Roque, R. S. (2013). Reviewer in Management Advisory Services.

Other online resources

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